Which of the following statements is true?
A)Fixed effects estimation is not suitable when the unobserved cluster effect is correlated with one or more explanatory variables.
B)Fixed effects approach is not applicable if the key explanatory variables change only at the level of the cluster.
C)The ordinary least squares standard errors are incorrect when there is cluster effect.
D)Random effects estimation can be applied to a cluster sample only if the unobserved cluster effect is correlated with one or more explanatory variables.

Question

Quizplus · Accepted Answer

The ordinary least squares standard errors assume that observations are independent, which is not the case when there is clustering. The correct standard errors should account for this correlation, or else they will be overstated and confidence intervals will be too narrow. Both fixed and random effects estimations attempt to solve this problem by accounting for the clustering, but fixed effects estimation will be biased if the unobserved cluster effect is correlated with the explanatory variables, while random effects estimation assumes that the unobserved cluster effect is uncorrelated with the explanatory variables. The fact that the key explanatory variables change only at the level of the cluster does not affect the applicability of the fixed effects approach. Finally, random effects estimation can be applied to a cluster sample regardless of whether the unobserved cluster effect is correlated with the explanatory variables.

Which of the Following Statements Is True