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I started to read about panel regression models. However, I am a bit confused about the different model specifications in the fixed effects model:

Does a fixed effects panel regression always mean that I introduce dummy variables for the cross-sections (e.g., for each country in my sample) and then run e.g. an OLS estimation?

What is the difference between adding fixed effects dummies to the regression model and the fixed effects estimator?

Thanks for your help!

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To see equality, let us first derive the FE estimator.

Define the residual-maker matrix \begin{align*} \underset{(M\times M)}{\mathbf{Q}}&:=\mathbf{I}_M-\mathbf{1}_M(\mathbf{1}_M'\mathbf{1}_M)^{-1}\mathbf{1}_M'\\ &=\mathbf{I}_M-\left(% \begin{array}{ccc} 1/M & \cdots & 1/M \\ \vdots & \ddots & \vdots \\ 1/M & \cdots & 1/M \\ \end{array}% \right), \end{align*} where $M$ denotes the number of observations per individual unit in the panel.

Premultiplication with $\mathbf{Q}$ centers the $\mathbf{y}_i$ and $\mathbf{Z}_i$ around their averages over $m$, \begin{align*} \mathbf{Q}\mathbf{y}_i&=\mathbf{y}_i-\mathbf{1}_M\mathbf{1}_M'\mathbf{y}_i/M\\&=\mathbf{y}_i-\mathbf{1}_M\overline{y_{i}}. \end{align*} The also implies that every time invariant variable from the set of regressors $\mathbf{Z}_i$ turns into a column of zeros, and hence is eliminated from the data.

This is a serious disadvantage of the FE estimator. Consider the example of wage regressions for a panel of employees. Variables such as gender or schooling are of primary interest, but (typically) do not change over time (anymore).

As $\mathbf{Q}\mathbf{1}_M=\mathbf{0}$, we have that, using the error-component model $\mathbf{y}_i=\mathbf{Z}_i\mathbf{\delta}+\mathbf{1}_M\alpha_i+\mathbf{\eta}_{i}$, where $\eta_i$ denotes the $M$-vector of idiosyncratic time-varying errors, \begin{align*} \mathbf{Q}\mathbf{y}_i&=\mathbf{Q}\mathbf{F}_i\mathbf{\beta}+\mathbf{Q}\mathbf{\eta}_{i}\qquad i=1,\ldots,n\\ \tilde{\mathbf{y}}_i&\equiv\tilde{\mathbf{F}}_i\mathbf{\beta}+\tilde{\mathbf{\eta}}_{i}, \end{align*} where $\mathbf{F}_i$ is the $(M\times L_b)$-matrix of the observations on the time variant regressors. Stacking the observations over the $n$ units gives $$ \underset{(Mn\times 1)}{\tilde{\mathbf{y}}}:=\left(% \begin{array}{c} \tilde{\mathbf{y}}_1 \\ \vdots \\ \tilde{\mathbf{y}}_n \\ \end{array}% \right)\qquad\underset{(Mn\times L_b)}{\tilde{\mathbf{F}}}:=\left(% \begin{array}{c} \tilde{\mathbf{F}}_1 \\ \vdots \\ \tilde{\mathbf{F}}_n \\ \end{array}% \right) $$

The FE estimator is simply OLS applied to these $Mn$ observations: \begin{align*} \widehat{\mathbf{\beta}}_{\text{FE}}&=(\tilde{\mathbf{F}}'\tilde{\mathbf{F}})^{-1}\tilde{\mathbf{F}}'\tilde{\mathbf{y}} \end{align*}

To see the equality between FE and least squares dummy variables, stack the observations a bit further: \begin{equation} \underset{(Mn\times 1)}{\mathbf{y}}:=\left(% \begin{array}{c} \mathbf{y}_1 \\ \vdots \\ \mathbf{y}_n \\ \end{array}% \right)\;\underset{(Mn\times L_b)}{\mathbf{F}}:=\left(% \begin{array}{c} \mathbf{F}_1 \\ \vdots \\ \mathbf{F}_n \\ \end{array}% \right) \end{equation} and \begin{equation} \underset{(Mn\times 1)}{\mathbf{\eta}}:=\left(% \begin{array}{c} \mathbf{\eta}_1 \\ \vdots \\ \mathbf{\eta}_n \\ \end{array}% \right)\; \underset{(n\times 1)}{\mathbf{\alpha}}:=\left(% \begin{array}{c} \alpha_1 \\ \vdots \\ \alpha_n \\ \end{array}% \right). \end{equation}

Further, let $$ \underset{(Mn\times n)}{\mathbf{D}}:=\mathbf{I}_n\otimes\mathbf{1}_M=\left(% \begin{array}{ccc} \mathbf{1}_M & & \mathbf{O} \\ & \ddots & \\ \mathbf{O}& & \mathbf{1}_M \\ \end{array} \right) $$

Then, the linear panel data model from under an error component assumption in matrix notation is obtained as $$ \mathbf{y}=\mathbf{D}\mathbf{\alpha}+\mathbf{F}\mathbf{\beta}+\mathbf{\eta}, $$ a dummy-variable model.

That is, we can also obtain an estimator of $\mathbf{\beta}$ from an OLS regression on the regressors and $n$ individual specific effects.

Now, note that the Frisch-Waugh-Lovell Theorem says that the OLS estimator of $\mathbf{\beta}$ can be found by regressing $\mathbf{M}_{\mathbf{D}}\mathbf{y}$ on $\mathbf{M}_{\mathbf{D}}\mathbf{F}$, where $$\underset{(Mn\times Mn)}{\mathbf{M}_{\mathbf{D}}}:=\mathbf{I}-\mathbf{D}(\mathbf{D}'\mathbf{D})^{-1}\mathbf{D}'$$ Using symmetry and idempotency of $\mathbf{M}_{\mathbf{D}}$ gives \begin{equation} \widehat{\mathbf{\beta}}_{\text{LSDV}}=(\mathbf{F}'\mathbf{M}_{\mathbf{D}}\mathbf{F})^{-1}\mathbf{F}'\mathbf{M}_{\mathbf{D}}\mathbf{y} \end{equation}

Now, \begin{align*} \mathbf{M}_{\mathbf{D}}&=\mathbf{I}_{Mn}-(\mathbf{I}_n\otimes\mathbf{1}_M)[(\mathbf{I}_n\otimes\mathbf{1}_M)'(\mathbf{I}_n\otimes\mathbf{1}_M)]^{-1}(\mathbf{I}_n\otimes\mathbf{1}_M)'\\ &=\mathbf{I}_{n}\otimes\mathbf{I}_{M}-(\mathbf{I}_n\otimes\mathbf{1}_M)[(\mathbf{I}_n\otimes\mathbf{1}_M')(\mathbf{I}_n\otimes\mathbf{1}_M)]^{-1}(\mathbf{I}_n\otimes\mathbf{1}_M')\\ &=\mathbf{I}_{n}\otimes\mathbf{I}_{M}-(\mathbf{I}_n\otimes\mathbf{1}_M)[\mathbf{I}_n\otimes\mathbf{1}_M'\mathbf{1}_M]^{-1}(\mathbf{I}_n\otimes\mathbf{1}_M')\\ &=\mathbf{I}_{n}\otimes\mathbf{I}_{M}-(\mathbf{I}_n\otimes\mathbf{1}_M)[\mathbf{I}_n\otimes M]^{-1}(\mathbf{I}_n\otimes\mathbf{1}_M')\\ &=\mathbf{I}_{n}\otimes\mathbf{I}_{M}-(\mathbf{I}_n\otimes\mathbf{1}_M)\left[\mathbf{I}_n\otimes \frac{1}{M}\right](\mathbf{I}_n\otimes\mathbf{1}_M')\\ &=\mathbf{I}_{n}\otimes\mathbf{I}_{M}-(\mathbf{I}_n\otimes\mathbf{1}_M)\left[\mathbf{I}_n\otimes \frac{1}{M}\mathbf{1}_M'\right]\\ &=\mathbf{I}_{n}\otimes\mathbf{I}_{M}-\mathbf{I}_n\otimes\mathbf{1}_M\frac{1}{M}\mathbf{1}_M'\\ &=\mathbf{I}_{n}\otimes\left(\mathbf{I}_{M}-\frac{1}{M}\mathbf{1}_M\mathbf{1}_M'\right)\\ &=\mathbf{I}_n\otimes\mathbf{Q} \end{align*}

Thus, \begin{align*} \mathbf{M}_{\mathbf{D}}\mathbf{F}&=(\mathbf{I}_n\otimes\mathbf{Q})\mathbf{F}\\ &=\left(% \begin{array}{ccc} \mathbf{Q} & & \\ & \ddots & \\ & & \mathbf{Q} \\ \end{array} \right)\mathbf{F}\\ &=\tilde{\mathbf{F}}, \end{align*} so that $$\widehat{\mathbf{\beta}}_{\text{LSDV}}=\widehat{\mathbf{\beta}}_{{FE}}.$$

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Least Square Dummy Variable (LSDV : Regress with group dummies) and the Within estimator (Also known as the Fixed effect estimator : Regress with demeaned variables) are exactly the same. The Within estimator is just a computational trick for estimating the fixed effect. However, if you want to do compute the Within estimator manually, you have to be careful to remove the correct number of degrees of freedom in your regression, otherwise you will underestimate the standard errors. But most of the statistical packages do this correction for you (xtreg, fe in Stata for example).

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To add to @J-B 's answer: I believe the two approaches are only the same (or better: lead to the same results) when you are dealing with a balanced panel set. For unbalanced panel data, the results are different depending on which one of the two approaches you use. At least this was the case when I tried it in Stata, please correct me if I'm wrong.

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