QUESTION 3. are in what factors determine the price of house. You conduct the fo

Question

QUESTION 3. are in what factors determine the price of house. You conduct the following hedonic model for housing prices: log(Priceu) Be B Rooms B2 log(SQFT) Balog(Lot) B.DIST Rooms, SQFT, Lot, and DIST are the price, number of the rooms, square footage, size of the lot, and distance to the highway of the house, respectively. Below is a scatter plot of the residuals against number of the rooms in the house (figure 1): Number of Rooms vs. Residuals Number of Rooms Figure 1. Number of rooms and residuals from the OLS estimation a. What problem do you think you might have? How do you state the problem in statistical b. language? problem? What are the consequences of this c. What would you do to test for it? your results might d. If the test is positive, how would you correct for it? How do you think change as a result of that correction? One of your classmates suggested plotting the histogram of the residuals to detect other potential model misspecifications. Below is a histogram of the residuals (figure 2): Page 4 of 6

Explanation / Answer

a. The problem is that the explanatory variable NUMBER OF ROOMS as correlated with the RESIDUAL and hence the target variable, i.e. the house price will also be influenced by this. As NUMBER OF ROOMS increases the size if the Residual also increases.

b. If this problem is present, we cannot access the actual influence of that variable on the target variable, since it's inflated or deflated due to error or residual.

c. To test for it, one can plot the data, as in the picture in the question provided.

d. If we see that there is a very high correlation, we would have to remove the variable or do variable transformation, this might lower the effect of the correlation.

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