Chapter 6 Linear regression in R

6.1 Introduction

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There are a number of different ways how we can represent a linear regression. The first expression shows how the outcome vector $\mathbf{y}$ is a linear combination of a number of observable vectors ${\mathbf{x}}_{\mathbf{i}}$ and an unobserved vector $\mathbf{e}$. The second line is an abreviated notation where we group all the observable vectors in a matrix $X$. The typical assumption is that the unobserved vector follows a normal distribution with a standard deviation $\sigma$. The last line explicitly states that $\mathbf{y}$ has a normally distributed random component.

$$\begin{array}{rl}\mathbf{y}& =a+b_1{\mathbf{x}}_{\mathbf{1}}+...+b_n{\mathbf{x}}_{\mathbf{n}}+\mathbf{e}\\ \mathbf{y}& =a+\mathbf{b}X+\mathbf{e}\\ \mathbf{y}& \sim \mathcal{N}(a+\mathbf{b}X,\sigma )\end{array}$$

To esimate the coefficients $a$, $b_1$ and $b_2$ in R, we have to run the following piece of code.

reg <- lm(y ~ x1 + x2, data = my_data_set)
summary(reg)

6.2 Linear regression with non-linear theories

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Linear regressions can be used with a non-linear theory with some transformations. The matching theory of CEO compensation implies that when there are an infinite amount of firms, the relation between the CEO compensation ($W$) and the firm value ($V_0$) is given by equation (6.1).

We can see how well the logarithmic transformation works on the simulated data by transformating the scale of Figure 5.4

Figure 6.1: The logarithmic transformation of simulated data

plot_exp +
  scale_x_continuous(trans = "log", 
                     breaks = scales::pretty_breaks(n = 2))  +
  scale_y_continuous(trans = "log", 
                     breaks = scales::pretty_breaks(n = 2))

One reason why it does not work perfectly is that the reservation wage $w_0$ might be set too low in the simulation. You can see that the line is approximately linear for the largest firms. The real models assume that we have an infinite number of firms and we are only interested in the largest 500 firms, that is the most right part of the graph. This explanation also illustrates how simulating from your theory can help you to understand the theory better. One of the homework exercises asks you to check whether the transformation works better once you simulate more firms.

Let us now see how well the log transformation works on the real S&P500 compensation data. First, we load the data in.

us_comp <- readRDS("data/us-compensation.RDS") %>%
  rename(total_comp = tdc1)
us_value <- readRDS("data/us-value.RDS") %>%
  rename(year = fyear, market_value = mkvalt)
summary(us_value$market_value)

##      Min.   1st Qu.    Median      Mean   3rd Qu.      Max.      NA's 
##       0.0     880.9    2359.4   12259.8    7836.2 1966078.9      3502

We have a bunch of observations with missing values (NA) for the market value of the firm. I will not further investigate this but you should definitely do this in your own project.

We combine the market value data with the CEO compensation data with the left_join function. left_join is a function that joins two datasets together based on key variables that identify which observations from one dataset should be matched with which observations from the other dataset. The join functions in the tidyverse can be a lifesaver if you are working with multiple datasets that need to be merged.

us_comp_value <- left_join(select(us_comp, gvkey, year, total_comp),
                          us_value, by = c("year", "gvkey"))
glimpse(us_comp_value)

## Rows: 22,948
## Columns: 5
## $ gvkey        <chr> "001004", "001004", "001004", "001004", "001004", "001004…
## $ year         <dbl> 2011, 2011, 2012, 2013, 2014, 2015, 2016, 2017, 2018, 201…
## $ total_comp   <dbl> 5786.400, 5786.400, 4182.832, 5247.779, 5234.648, 3523.96…
## $ market_value <dbl> 485.2897, 485.2897, 790.0029, 961.3080, 1046.3954, 842.51…
## $ ni           <dbl> 67.723, NA, 55.000, 72.900, 10.200, 47.700, 56.500, 15.60…

Because there are some CEOs with $0\mathrm{\$}$ compensation, I use the $log(x+1)$ transformation. Another option would have been to exclude these obervations.

reg <- lm(log(total_comp + 1) ~ log(market_value), 
          data = us_comp_value)
# summary(reg)
print(summary(reg), digits = 1L)

## 
## Call:
## lm(formula = log(total_comp + 1) ~ log(market_value), data = us_comp_value)
## 
## Residuals:
##    Min     1Q Median     3Q    Max 
##  -10.4   -0.3    0.1    0.5    3.5 
## 
## Coefficients:
##                   Estimate Std. Error t value Pr(>|t|)    
## (Intercept)          5.260      0.030     176   <2e-16 ***
## log(market_value)    0.382      0.004     103   <2e-16 ***
## ---
## Signif. codes:  0 '***' 0.001 '**' 0.01 '*' 0.05 '.' 0.1 ' ' 1
## 
## Residual standard error: 0.9 on 20083 degrees of freedom
##   (2863 observations deleted due to missingness)
## Multiple R-squared:  0.3,    Adjusted R-squared:  0.3 
## F-statistic: 1e+04 on 1 and 20083 DF,  p-value: <2e-16

The summary gives way to much information but I am just restricting the number of significant digits because that is my biggest concern. You can just use summary(reg). We can also plot the log-log relation between firm value and CEO compensation in figure.

Figure 6.2: CEO compensation and firm value on the log-log scale

plot_check <-
  ggplot(data = us_comp_value,
         aes(y = total_comp, x = market_value)) +
  geom_point(alpha = .10) +
  scale_x_continuous(trans = "log",
                     breaks = scales::breaks_log(n = 5, base = 10),
                     labels = function(x) prettyNum(x/1000,
                                                    digits = 2)) + 
  scale_y_continuous(trans = "log1p",
                     breaks = c(10e2, 10e3, 10e4, 10e5, 10e6), 
                     labels = function(x) prettyNum(x/1000,
                                                    digits = 2)) + 
  ylab("compensation ($ million)") +
  xlab("market value ($ billion)")
print(plot_check)

## Warning: Removed 2863 rows containing missing values (geom_point).

On the log-log scale, we see that there are some CEOs with very low compensation compared to the bulk of the observations. In the next figure, we will just ignore those.

plot_check2 <- plot_check +
  scale_x_continuous(trans = "log", limits = c(5, NA),
               breaks = scales::log_breaks(n = 5, base = 10),
               labels = function(x) prettyNum(x/1000, digits = 2)) +
  scale_y_continuous(trans = "log1p", limits = c(5, NA),
               breaks = scales::log_breaks(n = 5, base = 10),
               labels = function(x) prettyNum(x/1000, digits = 2)) 

## Scale for 'x' is already present. Adding another scale for 'x', which will
## replace the existing scale.

## Scale for 'y' is already present. Adding another scale for 'y', which will
## replace the existing scale.

Figure 6.3: CEO compensation and firm value on the log-log scale

print(plot_check2)

## Warning: Removed 2956 rows containing missing values (geom_point).

Although there still a lot of variation visible, the relation in Figure 6.3 looks reasonably linear. The goal of plotting the data is to get an idea whether the data reflect the explicit and implicit assumptions in your theory and your statistical model. One of those assumptions is that the relation between compensation and value is linear on the log-log scale. Plotting the data also showed us that there are some CEOs with very low or $0$ compensation. In a real, study you would want to investigate why this is the case. For instance, you might have an error in the database.