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A critical assessment of the two-way fixed-effects model for firm-level dependent variables

Author

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  • Johannes Carow

    (Johannes Gutenberg University Mainz)

Abstract

Since the seminal work from Bertrand & Schoar (2003), the separate estimation of person effects and firm effects remains a widely used method in the analysis of firm-level dependent variables. Recently, this class of models has experienced serious methodological criticism, stating that person effects only reflect spurious variation. Rather than rejecting this estimation technique per se, I recommend a strategy based on simulation analysis to test for the presence of person effects. This strategy takes limitations of a previous test for idiosyncratic person effects into account. Further, I show that the estimation of person effects is subject to attenuation bias and that the size of this bias increases in the number of persons per firm-year. I also demonstrate that the use of Unconditional Quantile Regressions for estimated person effects can produce statistical artefacts at the upper and lower tail of the distribution. Additionally, attenuation bias impairs the analysis of the correlation of person effects pertaining to different dependent variables.

Suggested Citation

  • Johannes Carow, 2024. "A critical assessment of the two-way fixed-effects model for firm-level dependent variables," Working Papers 2405, Gutenberg School of Management and Economics, Johannes Gutenberg-Universität Mainz.
    • Handle: RePEc:jgu:wpaper:2405
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    File URL: https://download.uni-mainz.de/RePEc/pdf/Discussion_Paper_2405.pdf
    File Function: First version, 2024
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    More about this item

    Keywords

    Two-way fixed-effects; simulations; managers; spurious variation; attenuation bias;
    All these keywords.

    JEL classification:

    • C15 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Statistical Simulation Methods: General
    • C18 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Methodolical Issues: General
    • C21 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Cross-Sectional Models; Spatial Models; Treatment Effect Models
    • L25 - Industrial Organization - - Firm Objectives, Organization, and Behavior - - - Firm Performance

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