An economist wants to study the effect of income on savings. He collected data on 120 identical twins. Which of the following methods of estimation is the most suitable method, if income is correlated with the unobserved family effect?
A)Random effects estimation
B)Fixed effects estimation
C)Ordinary least squares estimation
D)Weighted Least squares estimation

Question

Quizplus · Accepted Answer

Since the economist collected data on identical twins, there could be unobserved family effects that are correlated with income and savings. Fixed effects estimation is particularly useful in controlling for unobserved characteristics that do not vary over time, such as genetic background or family environment. Therefore, fixed effects estimation would be the most suitable method for studying the effect of income on savings in this scenario. Random effects estimation assumes that unobserved factors are uncorrelated with the explanatory variable of interest, which may not hold in this case. Ordinary least squares estimation would not account for unobserved heterogeneity, leading to biased estimates. Weighted least squares estimation is generally used when there is heteroscedasticity in the data, which is not a concern in this scenario.

An Economist Wants to Study the Effect of Income on Savings