The Ratio Problem
32 Pages Posted: 15 Jun 2020
Date Written: May 1, 2020
We use the term "ratio problem" to describe the omitted variable and measurement error bias that can arise when a ratio is the dependent variable in an economic model. First, we show how bias can arise from the omission of two classes of variables based on a ratio's denominator. As an example, we demonstrate that the widely-cited "inverse-U" relationship between managerial ownership and Tobin's Q is reversed when these variables are included. Second, we show how measurement error in the ratio's denominator can produce bias. We provide empirical tests and solutions, and urge caution about ratios as dependent variables.
Keywords: Omitted Variable Bias, Measurement Error, Tobin's Q, Corporate Governance
JEL Classification: C01, C13, C58, G30, G34
Suggested Citation: Suggested Citation