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ECONOMETRICS I

(EKN309)

CHAPTER 2
TWO VARIABLE REGRESSION ANALYSIS:
SOME BASIC IDEAS
 Chapter 1: the concept of regression in broad terms.
 Chapter 2 and 3: introduction to the theory underlying the simplest possible
regression analysis – the bivariate, or two-variable, regression:
where the dependent variable (the regressand) is related to a single
explanatory variable (the regressor).

$ .Table 2. and Weekly Family Consumption Expenditure Y.1 Weekly Family Income X.

1 Conditional distribution of expenditure for various levels of income (data of Table 2.Figure 2.1) .

Definition of ‘population regression curve’:  Geometrically.  More simply. It is the locus of the conditional means of the dependent variable for the fixed values of the explanatory variable(s). . It is the curve connecting the means of the subpopulations of Y corresponding to the given values of the regressor X.

2.1): the expected value of the distribution of Y given 𝑋𝑖 is functionally related to 𝑋𝑖 . (2. 𝟐.2. (2. – here. X.2 THE CONCEPT OF POPULATION REGRESSION FUNCTION (PRF)  Each conditional mean 𝐄 𝐘 𝐗 is a function of 𝑋𝑖 where 𝑋𝑖 is a given value of X. . In our example: 𝐸 𝑌 𝑋𝑖 is a linear function of 𝑋𝑖 . 𝟏 𝑓 𝑋𝑖 : some function of the explanatory variable.1): conditional expectation function (CEF) or population regression function (PRF) or population regression (PR). linear function. (2.2. 𝐸 𝑌 𝑋𝑖 = 𝑓 𝑋𝑖 𝟐.2.1): how the mean or average response of Y varies with X.

i.2 THE CONCEPT OF POPULATION REGRESSION FUNCTION (PRF) (cont’d) what form does the function 𝒇 𝑿𝒊 assume?  It gives the functional form of the PRF however in real situations we do not have the entire population available for examination. 𝟐. its functional form is an empirical question. Assume that consumption expenditure is linearly related to income. so the PRF. The relationship btw consumption expenditure and income. 𝐸 𝑌 𝑋𝑖 is assumed to be a linear function of 𝑋𝑖 : 𝐸 𝑌 𝑋𝑖 = β1 + β2 𝑋𝑖 (𝟐.  So. 𝟐) .2.e.

the β’s.2. is a linear function of the parameters. - Functional form examples?  Linearity in the parameters: - The conditional expectation of Y. - Functional form examples? .3 THE MEANING OF THE TERM LINEAR  Linearity in the variables: - The conditional expectation of Y is a linear function of 𝑋𝑖 . - The regression curve is a straight line. 𝐸 𝑌 𝑋𝑖 .

the X’s. the β’s (that is. the parameters are raised to the first power only). It may or may not be linear in the explanatory variables.From now on the term ‘linear’ regression will always mean a regression that is linear in the parameters. .

3 Linear Regression Models Model linear in parameters? Model linear in variables? YES NO YES Linear regression model (LRM) Linear regression model (LRM) NO Nonlinear regression model (NLRM) Nonlinear regression model (NLRM) .Table 2.

1: the values. too.1: given the income level of 𝑋𝑖 . . family consumption expenditure on the average increases.  What about the consumption expenditure of an individual family in relation to its (fixed) level of income? Table 2. that is. Figure 2.2.4 STOCHASTIC SPECIFICATION OF PRF  Figure 2. an individual family’s consumption expenditure is clustered around the average consumption of all families at that 𝑋𝑖 . around its conditional expectation.1 + Figure 2.1: as family income increases.

1)? The sum of two components: systematic (or deterministic) component AND random (or nonsystematic) component. 𝟒.4 STOCHASTIC SPECIFICATION OF PRF (cont’d) we can express the deviation of an individual 𝒀𝒊 around its expected value as follows: 𝑢𝑖 = 𝑌𝑖 − 𝐸 𝑌 𝑋𝑖 𝑂𝑅 𝑌𝑖 = 𝐸 𝑌 𝑋𝑖 + 𝑢𝑖 (𝟐. HOW DO WE INTERPRET (2.4. 𝑢𝑖 : the stochastic disturbance OR stochastic error term. 𝟏) The deviation 𝑢𝑖 is an unobservable random variable – positive or negative values-. .2.

𝟐 − that we are familiar with.2) into (2. NOW.1): 𝑌𝑖 = 𝐸 𝑌 𝑋𝑖 + 𝑢𝑖 𝑡𝑢𝑟𝑛𝑠 𝑜𝑢𝑡 𝑡𝑜 𝑏𝑒 𝑌𝑖 = β1 + β2 𝑋𝑖 + 𝑢𝑖 𝟐. 𝟐.4.3) .4.4 STOCHASTIC SPECIFICATION OF PRF (cont’d) If 𝑬 𝒀 𝑿𝒊 is linear in 𝑿𝒊 : 𝑬 𝒀 𝑿𝒊 = β𝟏 + β𝟐 𝑿𝒊 𝒂𝒔 𝒊𝒏 (𝟐. 𝟐)  Substitute (2. consider the individual consumption expenditures when 𝑋 = $80: the following 5 equations constitute(2.2. 𝟒.2.

𝟓) Thus.because the expected value of a constant is that constant 𝐸 𝑌𝑖 𝑋𝑖 = 𝐸 𝑌 𝑋𝑖 + 𝐸 𝑢𝑖 𝑋𝑖 (𝟐.4 STOCHASTIC SPECIFICATION OF PRF (cont’d)  Take the expected value of (2.2. the assumption that the regression line passes through the conditional means of Y implies that the conditional mean values of 𝑢𝑖 (conditional upon the given X’s) are zero. 𝟒. . 𝟒. then 𝐸 𝑢𝑖 𝑋𝑖 = 0 (𝟐. 𝟒) AND since 𝐸 𝑌𝑖 𝑋𝑖 = 𝐸 𝑌 𝑋𝑖 .4.1) on both sides: 𝐸 𝑌𝑖 𝑋𝑖 = 𝐸 𝐸 𝑌 𝑋𝑖 Since 𝐸 𝐸 𝑌 𝑋𝑖 itself: + 𝐸 𝑢𝑖 𝑋𝑖 = 𝐸 𝑌 𝑋𝑖 .

.2.5 THE SIGNIFICANCE OF THE STOCHASTIC DISTURBANCE TERM 1. 𝑢𝑖 . captured in 𝑢𝑖 . Vagueness of theory ignorant or unsure about the other variables affecting Y. 2. we may not have quantitative information about them. 𝑢𝑖 : as a substitute for all the excluded or omitted variables from the model. 3. Core variables versus peripheral variables The joint influence of all or some of the variables are so small and it is meaningless to introduce them into the model explicitly. combined effect being treated as a random variable. Unavailability of data Even if we know what some of the excluded variables are.

5. Poor proxy variables Errors in measurement where data may not be measured accurately. 6.2. 𝑢𝑖 representing all other variables. Principle of parsimony To keep the as simple as possible.5 THE SIGNIFICANCE OF THE STOCHASTIC DISTURBANCE TERM (cont’d) 4. Intrinsic randomness in human behavior Even if we succeed in introducing all the relevant variables into the model. some ‘intrinsic’ randomness in individual Y’s that cannot be explained. . 𝑢𝑖 ’s reflecting this randomness. 𝑢𝑖 representing the errors of measurement. The scattergram: helpful if two-variable model is concerned. 7. Wrong functional form Correct variables explaining a phenomenon but not sure about the functional form.

6 THE SAMPLE REGRESSION FUNCTION (SRF) what if we do not have the information on population? What we have is a sample of Y values corresponding to some fixed X’s.2.4.1: presenting the population. not a sample  Table 2. OUESTION: From the sample of Table 2. can we predict the average weekly consumption expenditure Y in the population as a whole corresponding to the chosen X’s? OR Can we estimate the PRF from the sample data? .4 AND 2.5: a randomly selected sample of Y values for the fixed X’s.  Table 2.

TWO RANDOM SAMPLES FROM THE POPULATION GIVEN IN TABLE 2.1: .

4 and 2.2.5: .6 THE SAMPLE REGRESSION FUNCTION (SRF) (cont’d) Plotting tha data of Tables 2.

𝟏) A particular numerical value obtained by the estimatır in an application is known as an estimate. 𝟔.2. .2.6 THE SAMPLE REGRESSION FUNCTION (SRF) (cont’d) the concept of the sample regression function (SRF):  The sample counterpart of (2.2) may be written as: 𝑌𝑖 = β1 + β2 𝑋𝑖 (𝟐.

2.2) may be written as: 𝑌𝑖 = β1 + β2 𝑋𝑖 + 𝑢𝑖 (𝟐. 𝑢𝑖 : the (sample) residual term. 𝟐) (2.4.1).6 THE SAMPLE REGRESSION FUNCTION (SRF) (cont’d) the concept of the sample regression function (SRF):  The sample counterpart of (2. .6.2): the stochastic form of SRF given in (2. 𝟔. which is an estimate of 𝑢𝑖 .6.

𝟐) WHY? Because more often we do not have data for all the population.TO SUM UP  Our primary objective in regression analysis is to estimate the PRF 𝑌𝑖 = β1 + β2 𝑋𝑖 + 𝑢𝑖 𝟐. 𝟒. 𝟔. . 𝟐  on the basis of the SRF 𝑌𝑖 = β1 + β2 𝑋𝑖 + 𝑢𝑖 (𝟐.

For 𝑋 = 𝑋𝑖 .  In terms of the SRF: The observed 𝑌𝑖 can be expressed as 𝑌𝑖 = 𝑌𝑖 + 𝑢𝑖 (𝟐. 𝟒) . 𝟔. 𝟑)  In terms of the PRF: The observed 𝑌𝑖 can be expressed as 𝑌𝑖 = 𝐸 𝑌 𝑋𝑖 + 𝑢𝑖 (𝟐.5 . 𝟔.4 and 2. we have one (sample) observation 𝑌 = 𝑌𝑖 see tables 2.

5 SAMPLE AND POPULATION REGRESSION LINES .FIGURE 2.

. can we devise a rule or method that will make this ‘approximation’ as ‘close’ as possible? OR:  How should the SRF be constructed so that β1 is as ‘close’ as possible to the true β1 AND β2 is as ‘close’ as possible to the true β2 even though we will never know the true β1 𝑎𝑛𝑑 β2 ? CHAPTER 3: procedures that tell us how to construct the SRF to mirror the PRF as faithfully as possible.THE CRITICAL QUESTION  Granted that the SRF is but an approximation of the PRF.