Discretizing Unobserved Heterogeneity

Abstract: We study discrete panel data methods where unobserved heterogeneity is revealed in a first step, in environments where population heterogeneity is not discrete. We focus on two-step grouped fixed-effects (GFE) estimators, where individuals are first classified into groups using kmeans clustering, and the model is then estimated allowing for group-specific heterogeneity. Our framework relies on two key properties: heterogeneity is a function - possibly nonlinear and time-varying - of a low-dimensional continuous latent type, and informative moments are available for classification. We illustrate the method in a model of wages and labor market participation, and in a probit model with time-varying heterogeneity. We derive asymptotic expansions of two-step GFE estimators as the number of groups grows with the two dimensions of the panel. We propose a data-driven rule for the number of groups, and discuss bias reduction and inference.