Question

Suppose a manufacturing firm has two factories (Factory 1 and Factory 2), and a single production process (Process A) that is used in both factories. A new process (Process B) is developed that potentially reduces production costs. To test whether Process B is less costly than Process A, an experiment is designed where:

1. Within each Factory, products are assigned randomly to Process A or Process B.
2. Production costs for each product are recorded.

Note that resources (i.e. materials, workers, equipment) are not reassigned across factories.

Let Y_i be the cost of producing product i, let X_i be 1 if Process B is used to produce i and 0 if Process A is used, and let W_i be 1 if product i is produced in Factory 1 and 0 if it is produced in Factory 2.

In a regression of Y_i on X, it is advisable to: (choose the correct answer)

		Exclude Wi as products are randomly assigned and including Wi would increase standard errors
		Exclude Wi as it is uncorrelated with Xi
		Include Wi as E(ui | Xi) ≠ 0, but E(Xi | Wi) = 0
		Include Wi as E(ui | Xi) ≠ 0, but E(ui | Xi, Wi) = E(ui | Wi)

Answer 1

Since, within each Factory, products are assigned randomly to Process A or Process B, so, there will be no effect on factory (Wi) on production costs (Wi). Thus, we need to exclude Wi.

Exclude W_i as products are randomly assigned and including W_i would increase standard errors