1. What Are Logit and Probit Models?

 Definition:

o Logit Model: A regression model used to estimate probabilities of a binary outcome

(0 or 1) using the logistic function.

o Probit Model: A regression model for binary outcomes using the cumulative normal
distribution function.

 Key Concept: Both models deal with binary dependent variables, but differ in how they map
the linear predictor to probabilities.

2. Why Use Logit and Probit Models?

 Challenges with OLS:

o OLS is unsuitable for binary outcomes because predicted probabilities can fall
outside the range [0, 1].

o Residuals are heteroscedastic and violate normality.

 Advantages:

o Logit and Probit ensure probabilities are constrained within [0, 1].

o They account for non-linearity in relationships between predictors and outcomes.

o Provide insights into the likelihood of an event occurring.

3. How Do Logit and Probit Models Work?

a) Logit Model

 Logistic Function: P(Y=1∣X)=eβ0+β1X1+⋯+βkXk1+eβ0+β1X1+⋯+βkXkP(Y = 1 | X) = \frac{e^{\

beta_0 + \beta_1 X_1 + \dots + \beta_k X_k}}{1 + e^{\beta_0 + \beta_1 X_1 + \dots + \beta_k
X_k}}P(Y=1∣X)=1+eβ0+β1X1+⋯+βkXkeβ0+β1X1+⋯+βkXk

 The log-odds transformation (logit): Logit(P)=ln⁡(P1−P)=β0+β1X1+⋯+βkXk\text{Logit}(P) = \

ln \left(\frac{P}{1-P}\right) = \beta_0 + \beta_1 X_1 + \dots + \beta_k X_kLogit(P)=ln(1−PP
)=β0+β1X1+⋯+βkXk

 Interpretation:

o Coefficients represent changes in the log-odds of the outcome for a unit change in
the predictor.

b) Probit Model

 Probit Function: P(Y=1∣X)=Φ(β0+β1X1+⋯+βkXk)P(Y = 1 | X) = \Phi(\beta_0 + \beta_1 X_1 + \

dots + \beta_k X_k)P(Y=1∣X)=Φ(β0+β1X1+⋯+βkXk)

o Φ\PhiΦ is the cumulative normal distribution function.

  Interpretation:

o Coefficients indicate changes in the z-score (standardized probability) for a unit

change in the predictor.

Comparison:

 Logit: Uses the logistic function for ease of interpretation.

 Probit: Uses the normal cumulative function, making it slightly more complex but useful in
certain scenarios.

4. When to Use Logit and Probit Models?

 Data Requirements:

o Dependent variable is binary (e.g., success/failure, yes/no).

o Predictors can be categorical or continuous.

 Choosing Between Logit and Probit:

o Logit: When interpretability of odds is crucial (e.g., marketing studies).

o Probit: When modeling latent variables or assuming a normal error distribution (e.g.,
psychological or behavioral studies).

5. Key Steps to Build the Models

a) Data Preparation

 Convert binary outcomes to 0/1.

 Ensure no multicollinearity among predictors.

 Standardize continuous predictors if needed.

b) Model Estimation

 Logit: Use Maximum Likelihood Estimation (MLE) to fit the logistic regression.

 Probit: Use MLE for fitting, with cumulative normal distribution.

c) Model Evaluation

 Goodness-of-Fit:

o Pseudo R² (e.g., McFadden R²).

o Log-likelihood values.

 Classification Accuracy:

o Sensitivity, specificity, precision.

 Validation:
 o Train-test split or cross-validation.

6. Practical Applications

 Logit:

o Predicting loan default (finance).

o Customer churn prediction (marketing).

o Disease diagnosis (healthcare).

 Probit:

o Studying policy adoption likelihood (economics).

o Risk modeling (insurance).

7. Key Takeaways

 Similarities: Both models are for binary dependent variables and rely on MLE for estimation.

 Differences:

o Logit uses logistic distribution; Probit uses normal distribution.

o Logit is more interpretable in terms of odds.

 Selection: Often based on context and theoretical underpinnings.

8. Example

Logit Example:

Predicting whether a customer will purchase a product based on age and income:

P(Purchase=1)=eβ0+β1Age+β2Income1+eβ0+β1Age+β2IncomeP(\text{Purchase} = 1) = \frac{e^{\
beta_0 + \beta_1 \text{Age} + \beta_2 \text{Income}}}{1 + e^{\beta_0 + \beta_1 \text{Age} + \beta_2
\text{Income}}}P(Purchase=1)=1+eβ0+β1Age+β2Incomeeβ0+β1Age+β2Income

Probit Example:

Modeling the likelihood of policy approval based on education and experience:

P(Approve=1)=Φ(β0+β1Education+β2Experience)P(\text{Approve} = 1) = \Phi(\beta_0 + \beta_1 \

text{Education} + \beta_2 \text{Experience})P(Approve=1)=Φ(β0+β1Education+β2Experience)

The Linear Probability Model (LPM)

1. What is the Linear Probability Model (LPM)?

  Definition:
The Linear Probability Model (LPM) is a regression model used for binary dependent
variables. It applies Ordinary Least Squares (OLS) to estimate the probability of an event
occurring (dependent variable YYY) based on predictor variables XXX.

 Model Equation:

P(Y=1∣X)=β0+β1X1+β2X2+⋯+βkXkP(Y = 1 | X) = \beta_0 + \beta_1 X_1 + \beta_2 X_2 + \dots + \

beta_k X_kP(Y=1∣X)=β0+β1X1+β2X2+⋯+βkXk

Here, P(Y=1∣X)P(Y = 1 | X)P(Y=1∣X) represents the probability of Y=1Y = 1Y=1, and βi\beta_iβi are the
regression coefficients.

 Outcome:
The predicted probabilities are linear functions of the predictors XXX.

2. Why Use the Linear Probability Model?

 Advantages:

1. Simple to Implement: The LPM uses OLS, which is widely understood and easy to
compute.

2. Interpretation of Coefficients: The coefficients (βi\beta_iβi) directly indicate the

change in the probability of Y=1Y = 1Y=1 for a one-unit change in XiX_iXi.

3. Baseline Model: It serves as a starting point for binary outcome modeling before
moving to more complex models like Logit or Probit.

3. Why is the LPM Not Widely Used?

Despite its simplicity, the LPM has several limitations that make it less suitable in practice:

a) Predicted Probabilities Can Be Outside [0, 1]

 LPM assumes linearity, which can result in probabilities less than 0 or greater than 1, making
them invalid as probabilities.

b) Violates OLS Assumptions

 Heteroscedasticity: The variance of the error term depends on the predictors, violating the
assumption of constant variance in OLS.

 Non-Normal Errors: The error term is not normally distributed because the dependent
variable is binary.

c) Poor Fit to Nonlinear Relationships

 LPM cannot capture the nonlinear nature of probabilities (which should flatten near 0 and 1).
This leads to inaccurate estimates for predictors with extreme values.

d) Issues with Interpretation

  While coefficients are interpretable, their validity is questionable due to the model's flawed
assumptions.

e) Lack of Robustness

 The LPM is sensitive to specification errors and performs poorly compared to Logit and
Probit models.

4. Comparison with Logit and Probit Models

Linear Probability Model

Feature Logit Model Probit Model
(LPM)

Always between 0 and

Predicted Probabilities Can be < 0 or > 1 Always between 0 and 1
1

Error Term Non-normal, heteroscedastic Normal/logistic Normal distribution

Nonlinear
Cannot capture Captures Captures
Relationships

In terms of odds/log-
Interpretation Easy In terms of z-scores
odds

Complexity Simple Moderate Moderate

5. When Should the LPM Be Used?

 Exploratory Analysis: For initial examination of relationships between predictors and a

binary outcome.

 Quick Checks: When interpretability is more important than predictive accuracy.

 Small Datasets: In some cases, LPM may serve as a useful baseline model if the dataset is
small and computational resources are limited.

6. Example

LPM Equation:

P(Purchase=1)=0.3+0.05×Income−0.02×AgeP(\text{Purchase} = 1) = 0.3 + 0.05 \times \text{Income} -

0.02 \times \text{Age}P(Purchase=1)=0.3+0.05×Income−0.02×Age

 Interpretation:

o For every additional unit increase in income, the probability of purchasing increases
by 5%.

o For every additional year of age, the probability of purchasing decreases by 2%.
  Limitation: If Income=100\text{Income} = 100Income=100, the probability might exceed 1,
which is invalid.

7. Key Takeaways

 LPM is a simple, easy-to-interpret model for binary outcomes but has significant limitations
due to its linearity and inability to handle probabilities properly.

 It is rarely used in practice, with Logit and Probit models being preferred for their robustness
and realistic probability predictions.

Would you like additional examples or help creating exercises to explore these models further?

Why Exponential Form in Logit Model?

The Logit Model uses an exponential form to express the relationship between the predictors (XXX)
and the probability of an outcome (PPP) because probabilities are bounded between 0 and 1. Here's
a simple explanation:

1. Problem with Linear Models

 In a linear model (P=β0+β1XP = \beta_0 + \beta_1 XP=β0+β1X), probabilities can exceed the
valid range of [0, 1], which doesn't make sense.

 A nonlinear transformation like the exponential form ensures probabilities remain within
the valid range.

2. The Role of the Exponential Function

 The exponential function (exe^{x}ex) is always positive and grows smoothly.

 In the logit model, the probability is expressed as: P(Y=1∣X)=eβ0+β1X1+eβ0+β1XP(Y = 1 | X) =

\frac{e^{\beta_0 + \beta_1 X}}{1 + e^{\beta_0 + \beta_1 X}}P(Y=1∣X)=1+eβ0+β1Xeβ0+β1X

 This logistic function maps any value of XXX (from −∞-\infty−∞ to +∞+\infty+∞) into
probabilities between 0 and 1.

3. Meaning of the Exponential Form

 Odds Representation: The exponential term, eβ0+β1Xe^{\beta_0 + \beta_1 X}eβ0+β1X,

represents the odds of the event occurring.

 Log-Odds Transformation: The logit model works with the natural log of the odds (log-odds):
Logit(P)=ln⁡(P1−P)=β0+β1X\text{Logit}(P) = \ln\left(\frac{P}{1-P}\right) = \beta_0 + \beta_1
XLogit(P)=ln(1−PP)=β0+β1X The exponential function reverses the log transformation to
return to odds.
4. Key Intuition

 Linear in Log-Odds: The relationship between predictors (XXX) and log-odds is linear.

 Nonlinear in Probability: The exponential form converts linear log-odds into valid
probabilities.

 Interpretation: The coefficient β1\beta_1β1 reflects how a unit change in XXX multiplies the
odds by eβ1e^{\beta_1}eβ1.

5. Simple Example

Imagine a model predicting whether someone buys a product (Y=1Y = 1Y=1):

P(Buy=1)=e−2+0.5⋅Income1+e−2+0.5⋅IncomeP(\text{Buy} = 1) = \frac{e^{-2 + 0.5 \cdot \

text{Income}}}{1 + e^{-2 + 0.5 \cdot \text{Income}}}P(Buy=1)=1+e−2+0.5⋅Incomee−2+0.5⋅Income

 Exponential Part: e−2+0.5⋅Incomee^{-2 + 0.5 \cdot \text{Income}}e−2+0.5⋅Income gives the

odds of buying.

 Probability Conversion: The formula ensures the result is between 0 and 1.

Summary

 The exponential form is used in the logit model to ensure valid probabilities while modeling
a linear relationship in log-odds.

 It provides a mathematically sound and interpretable framework for binary outcomes.

In the logit model (and logistic regression), the terms −z-z−z and +z+z+z appear because of the
nature of the logistic function used to model probabilities. Let’s break this down step by step:

1. The Logistic Function

The logistic function for the probability PPP of an event happening (Y=1Y = 1Y=1) is:

P(Y=1)=ez1+ezP(Y = 1) = \frac{e^z}{1 + e^z}P(Y=1)=1+ezez

Here, z=β0+β1X1+β2X2+⋯+βkXkz = \beta_0 + \beta_1 X_1 + \beta_2 X_2 + \dots + \beta_k X_kz=β0
+β1X1+β2X2+⋯+βkXk, which is the linear combination of predictors.

The probability of the event not happening (Y=0Y = 0Y=0) is:

P(Y=0)=1−P(Y=1)P(Y = 0) = 1 - P(Y = 1)P(Y=0)=1−P(Y=1)

Substituting P(Y=1)P(Y = 1)P(Y=1) into 1−P(Y=1)1 - P(Y = 1)1−P(Y=1), we get:

P(Y=0)=11+ezP(Y = 0) = \frac{1}{1 + e^z}P(Y=0)=1+ez1

2. Why −z-z−z?
The expression for P(Y=0)P(Y = 0)P(Y=0) can also be rewritten using −z-z−z instead of +z+z+z:

P(Y=0)=e−z1+e−zP(Y = 0) = \frac{e^{-z}}{1 + e^{-z}}P(Y=0)=1+e−ze−z

This works because of the following mathematical property of exponents:

11+ez=e−z1+e−z\frac{1}{1 + e^z} = \frac{e^{-z}}{1 + e^{-z}}1+ez1=1+e−ze−z

So, instead of using zzz, we use −z-z−z to simplify the expression for P(Y=0)P(Y = 0)P(Y=0).

3. Intuition Behind −z-z−z and +z+z+z

 +z+z+z represents the log-odds of Y=1Y = 1Y=1 (the event happening).

 −z-z−z represents the log-odds of Y=0Y = 0Y=0 (the event not happening).

Since P(Y=1)P(Y = 1)P(Y=1) and P(Y=0)P(Y = 0)P(Y=0) must add up to 1:

P(Y=1)+P(Y=0)=1P(Y = 1) + P(Y = 0) = 1P(Y=1)+P(Y=0)=1

Their expressions are complementary:

P(Y=1)=ez1+ez,P(Y=0)=e−z1+e−zP(Y = 1) = \frac{e^z}{1 + e^z}, \quad P(Y = 0) = \frac{e^{-z}}{1 + e^{-

z}}P(Y=1)=1+ezez,P(Y=0)=1+e−ze−z

4. Symmetry of the Logistic Function

The logistic function is symmetric about P=0.5P = 0.5P=0.5:

 At z=0z = 0z=0, P(Y=1)=P(Y=0)=0.5P(Y = 1) = P(Y = 0) = 0.5P(Y=1)=P(Y=0)=0.5.

 For positive zzz (+z+z+z), P(Y=1)>0.5P(Y = 1) > 0.5P(Y=1)>0.5, meaning the event is more
likely.

 For negative zzz (−z-z−z), P(Y=1)<0.5P(Y = 1) < 0.5P(Y=1)<0.5, meaning the event is less likely.

This symmetry ensures that probabilities stay between 0 and 1 regardless of whether zzz is positive
or negative.

5. Key Takeaways

 −z-z−z and +z+z+z appear due to the mathematical properties of the logistic function,
ensuring valid probabilities.

 +z+z+z: Used for the probability of the event happening (Y=1Y = 1Y=1).

 −z-z−z: Used for the probability of the event not happening (Y=0Y = 0Y=0).

 The logistic function ensures probabilities remain between 0 and 1.

Let’s break down the steps leading to the equation Pi1−Pi=eZi\frac{P_i}{1 - P_i} = e^{Z_i}1−PiPi=eZi
and understand how it is derived.
1. The Logistic Function

The probability of owning a house, PiP_iPi, is given by:

Pi=eZi1+eZiP_i = \frac{e^{Z_i}}{1 + e^{Z_i}}Pi=1+eZieZi

where ZiZ_iZi is the linear predictor (e.g., Zi=β0+β1X1+…Z_i = \beta_0 + \beta_1 X_1 + \dotsZi=β0+β1
X1+…).

The probability of not owning a house, 1−Pi1 - P_i1−Pi, is:

1−Pi=1−eZi1+eZi=11+eZi1 - P_i = 1 - \frac{e^{Z_i}}{1 + e^{Z_i}} = \frac{1}{1 + e^{Z_i}}1−Pi=1−1+eZieZi

=1+eZi1

2. The Odds Ratio

The odds of owning a house (the ratio of PiP_iPi to 1−Pi1 - P_i1−Pi) is:

Pi1−Pi\frac{P_i}{1 - P_i}1−PiPi

Substitute PiP_iPi and 1−Pi1 - P_i1−Pi into this ratio:

Pi1−Pi=eZi1+eZi11+eZi\frac{P_i}{1 - P_i} = \frac{\frac{e^{Z_i}}{1 + e^{Z_i}}}{\frac{1}{1 + e^{Z_i}}}1−PiPi

=1+eZi11+eZieZi

3. Simplify the Fraction

Simplify the fraction:

Pi1−Pi=eZi1+eZi⋅1+eZi1\frac{P_i}{1 - P_i} = \frac{e^{Z_i}}{1 + e^{Z_i}} \cdot \frac{1 + e^{Z_i}}{1}1−PiPi

=1+eZieZi⋅11+eZi

Here, 1+eZi1 + e^{Z_i}1+eZi in the numerator and denominator cancels out:

Pi1−Pi=eZi\frac{P_i}{1 - P_i} = e^{Z_i}1−PiPi=eZi

4. Final Result

Thus, the odds of owning a house can be expressed as:

Pi1−Pi=eZi\frac{P_i}{1 - P_i} = e^{Z_i}1−PiPi=eZi

This equation shows that the odds ratio increases exponentially with ZiZ_iZi.

Key Takeaway

The key step is recognizing that PiP_iPi and 1−Pi1 - P_i1−Pi share the same denominator (1+eZi1 +
e^{Z_i}1+eZi), which cancels out when you compute their ratio.

Would you like a numerical example or more clarification?

4o
What Does Odds Ratio Mean?

The odds ratio (OR) is a way to compare the likelihood of an event happening to the likelihood of it
not happening. It provides a measure of association between a predictor (e.g., income, education)
and the probability of an outcome (e.g., owning a house).

Definition

Odds are the ratio of the probability of an event happening (PPP) to the probability of it not
happening (1−P1 - P1−P):

Odds=P1−P\text{Odds} = \frac{P}{1 - P}Odds=1−PP

The odds ratio compares odds between two groups or situations.

Why Do We Take Odds Ratios?

Odds ratios are used because:

1. Relative Measure of Effect:

o The odds ratio tells us how much more likely (or less likely) an event is to happen
when a predictor changes.

o For example, if the odds ratio is 2, it means the event is twice as likely under the
given condition.

2. Interpretable Impact:

o In logistic regression, the coefficient (β\betaβ) is in log-odds form. By taking the

exponential (eβe^\betaeβ), we convert it to an odds ratio, making it easier to
interpret.

3. Nonlinear Relationships:

o Probabilities are bounded between 0 and 1, but odds and odds ratios can take any
positive value, making them more suitable for modeling relationships with
predictors.

Key Intuition

 Odds: "If the probability of owning a house is 0.8, the odds are 0.80.2=4\frac{0.8}{0.2} =
40.20.8=4." This means owning a house is 4 times more likely than not owning one.

 Odds Ratio: Compares odds across groups. For instance:

o Odds of owning a house for Group A: 4 (owning 4 times more likely than not).

o Odds of owning a house for Group B: 2.

o Odds Ratio: 42=2\frac{4}{2} = 224=2. Group A is twice as likely to own a house

compared to Group B.
How Is It Used in Logistic Regression?

In the logistic regression model:

Log-Odds=Z=β0+β1X\text{Log-Odds} = Z = \beta_0 + \beta_1 XLog-Odds=Z=β0+β1X

 eZe^ZeZ: The odds of the event occurring.

 eβ1e^{\beta_1}eβ1: The odds ratio, showing how the odds change for a one-unit increase in
XXX.

Example:

 If β1=0.7\beta_1 = 0.7β1=0.7, then e0.7≈2e^{0.7} \approx 2e0.7≈2.

 Interpretation: A one-unit increase in XXX doubles the odds of the event occurring.

When to Use Odds Ratios

 When modeling binary outcomes (e.g., success/failure, yes/no).

 To measure the effect of predictors on the odds of an outcome.

 In cases where probabilities are too small or too large to compare directly, odds ratios help
scale the impact.

Summary

 Odds Ratio: A measure of how much the odds of an event change with a predictor.

 Why Use It: It simplifies interpretation in logistic regression and provides a consistent scale
for comparing effects across different predictors.