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Econometrics Paper
Likelihood corrections for two-way models
Koen Jochmans and Taisuke Otsu
February 2018
Paper No' EM 598:
Full Paper (pdf)

JEL Classification: C12; C14

Tags: asymptotic bias; bias correction; fixed effects; information bias; modified profile likelihood; panel data; mcmc; penalization; rectangular-array asymptotics

The use of two-way fixed-effect models is widespread. The presence of incidental parameter bias, however, invalidates statistical inference based on the likelihood. In this paper we consider modifications to the (profile) likelihood that yield asymptotically unbiased estimators as well as likelihood-ratio and score tests with correct size. The modifications are widely applicable and easy to implement. Our examples illustrate that the modifications can lead to dramatic improvements relative to the maximum likelihood method both in terms of point estimation and inference.