In order to employ the LSDV approach in a one-way fixed effects model, we have to:
A) Create a dummy variable for every unit and include it in the model.
B) Create a dummy variable for every unit and include all but one in the model.
C) Subtract the unit specific averages from both the dependent and independent variables.
D) Create dummy variables for every unit and subtract the unit specific average from the dependent variable.

Question

Quizplus · Accepted Answer

In a one-way fixed effects model, we need to account for the unobserved heterogeneity across the units by including unit-specific fixed effects. This can be done by creating a dummy variable for each unit and including it in the model. However, to avoid the dummy variable trap, we need to exclude one of the dummy variables. By doing so, we are essentially absorbing the fixed effect associated with the excluded dummy variable into the intercept term. Therefore, the correct choice is to create a dummy variable for every unit and include all but one in the model (i.e. option B). Option A is incorrect because including all the dummy variables would lead to the dummy variable trap. Option C is incorrect because subtracting the unit-specific averages from the independent variables would not solve the problem of unobserved heterogeneity. Option D is incorrect because we need to absorb the fixed effects associated with the dummy variables into the intercept, rather than subtract the unit-specific averages from the dependent variable.

In Order to Employ the LSDV Approach in a One-Way