Efficient Estimation of Time-Invariant and Rarely Changing Variables in Finite Sample Panel Analyses with Unit Fixed Effects

Abstract

This paper suggests a three-stage procedure for the estimation of time-invariant and rarely changing variables in panel data models with unit effects. The first stage of the proposed estimator runs a fixed-effects model to obtain the unit effects, the second stage breaks down the unit effects into a part explained by the time-invariant and/or rarely changing variables and an error term, and the third stage reestimates the first stage by pooled OLS (with or without autocorrelation correction and with or without panel-corrected SEs) including the time-invariant variables plus the error term of stage 2, which then accounts for the unexplained part of the unit effects. We use Monte Carlo simulations to compare the finite sample properties of our estimator to the finite sample properties of competing estimators. In doing so, we demonstrate that our proposed technique provides the most reliable estimates under a wide variety of specifications common to real world data.