You are on page 1of 46

# ECONOMETRICS I

(EKN309)

CHAPTER 1
THE NATURE OF REGRESSION ANALYSIS
Regression as the main tool of econometrics (step 5).
NOW: the nature of this tool

I.1 HISTORICAL ORIGIN OF THE TERM REGRESSION?
 The term regression by Francis Galton: tendency for tall/short parents to
have tall/short children – however (….). Law of universal regression.
 Karl Pearson: confirmed this law. ‘regression to mediocrity’.

I.2 THE MODERN INTERPRETATION OF REGRESSION

Regression analysis is concerned with the study of the dependence of one
variable, the dependent variable, on one or more other variables, the
explanatory variables,
with a view to estimating and/or predicting the (population) mean or
average value of the former in terms of the known or fixed values of the
latter.
Y = β1 + β2 X + u

(I. 3.2)

Examples to make the concepts clear:
1) Galton’s law of universal regression
Figure 1.1: scatter diagram – hypothetical distribution of sons’ heights
corresponding to given heights of fathers

2: .2) The distribution in a hypothetical population of heights of boys measured at fixed ages. Figure 1.

3) Interested in: the dependence of personal consumption expenditure on after-tax or disposable income  What to be estimated? – slope coefficient ?  What are the dependent and independent variables here?  Its functional form?  Causality from what to what? Check the other examples listed in your book (Gujarati. 2003: 20-21) .

STATISTICAL DEPENDENCE AMONG VARIABLES: - The one we are concerned with in regression analysis.I. sunshine. - Example: Newton’s law of gravity. .Example: the dependence of crop yield on temperature. .  2.3 STATISTICAL VERSUS DETERMINISTIC RELATIONSHIPS  1. FUNCTIONAL OR DETERMINISTIC DEPENDENCE AMONG VARIABLES: - We deal with the variables that are not random or stochastic. rainfall. and fertilizer. - We deal with random or stochastic variables: variables that have probability distributions.

e. it does not necessarily imply causation. ULTIMATELY FROM SOME THEORY OR OTHER (i. .4 REGRESSION VERSUS CAUSATION • Although regression analysis deals with the dependence of one variable on other variables. Keynesian consumption theory).I. OUR IDEAS OF CAUSATION MUST COME FROM OUTSIDE STATISTICS.

- Correlation coefficient: measuring the strength of (linear) association. i. - The primary objective: to measure the strength or degree of linear association between two variables.e. . The correlation (coefficient) between smoking and lung cancer.5 REGRESSION VERSUS CORRELATION  Correlation analysis: - Closely related to but conceptually different from regression analysis.I.

I.e. height: measured at these levels. random or stochastic – that has a probability distribution – - The explanatory variable(s): fixed values (in repeated sampling) – that is.2: age: fixed.5 REGRESSION VERSUS CORRELATION (cont’d)  Regression analysis: - The dependent variable: statistical. Figure 1. - Both variables: random . X assumes the same values in various samples -. i.  Correlation analysis: - No distinction between the dependent and independent variables.

6 TERMINOLOGY AND NOTATION .I.

weekly.7 THE NATURE AND SOURCES OF DATA FOR ECONOMIC ANALYSIS  THREE TYPES OF DATA: time series.I. - Special problems with the time series data: assumption of stationarity – a time series is stationary if its mean and variance do not vary systematically over time. monthly. daily. .  Time series data: - A set of observations on the values that a variable takes at different times. etc. - Collected at regular time intervals. cross-section. pooled (others as well).

Figure I.5: a steady upward trend as well as variability over the years. . (chapter 21). the M1 time series is not stationary.

- Table 1.e. - The problem with this type of data: heterogeneity. HLFS.1: US egg production: egg production and egg prices for the 50 states for 1990 AND 1991. - For each year: cross-sectional data - If considered as total: two cross-sectional samples. censuses. etc. - WHY DO WE NEED THIS TYPE OF DATA? – through an example - .I.7 THE NATURE AND SOURCES OF DATA FOR ECONOMIC ANALYSIS (cont’d)  Cross-section data: - Data on one or more variables collected at the same point in time. i.

EGG PRODUCTION state AL AK AZ AR CA CO CT DE (….8 106.) Y1 172 1...) X1 92.0 104.029 168 (….7 104.) X2 91.9 52.7 74 3.8 49 491 302 987 3.0 117.0 68.0 50.) Y1 2.0 48..8 58.0 86.) Y2 2.472 788 1.TABLE 1.0 113. p.620 7.7 (….S.0 56.0 64..206 0. Department of Agriculture..4 149. 1993. The data are from the Economic Research Service..S..202 2.033 (….0 74.2 43 442 283 975 3.9 109. Y2 164 1.0 (…. 119.0 70.4 77.1 U.) X2 66.3 63..186 0.0 (….0 61.) Y1: eggs produced in 1990 (millions) Y2: eggs produced in 1991 (millions) X1: price per dozen (cents) in 1990 X2: price per dozen (cents) in 1991 Source: World Almanac.3 53.0 91.737 7..8 (….045 (…..1 82.0 85.) X1 68.0 83.400 1.0 78.444 873 948 164 (….7 151.) .7 73 3. U.) state MT NE NV NH NJ NM NY NC (….4 73.

I. For each year: we have 50 cross-sectional observations For each state: we have two time series observations on prices and output of eggs. .1 (if both years are considered together).7 THE NATURE AND SOURCES OF DATA FOR ECONOMIC ANALYSIS (cont’d)  Pooled data: - Having elements of both time series and cross-section data. - The one in Table 1.

. i.I.7 THE NATURE AND SOURCES OF DATA FOR ECONOMIC ANALYSIS (cont’d)  Panel.e. A family or a firm) is surveyed over time. (Chapter 16).e. the same household is interviewed at each period survey to find out whether there is any change in the housing conditions of that household. A census of housing at periodic intervals. longitudinal or micropanel data: - A special type of pooled data where the same cross-sectional unit (i.

Nonexperimental data: data that are not subject to the control of reseracher.???? . i. 2) Even if experimental: data errors of measurement due to approximations and roundoffs. i.e. .THE SOURCES OF DATA: .e.????  THE ACCURACY OF DATA: The quality of data: 1) Most data are nonexperimental in nature: possibility of observational errors.Experimental data: Collecting the data while holding certain factors constant.

aggregated in sectors. cannot reveal the dynamics of the behaviour of the microunits.e. thus not being able to reach information on individuals or microunits. Turkey: firm statistics – no firm names. certain data can be published only in highly aggregate form. + not all questions answered leading to additional selectivity bias. 4) The difference in the sampling methods used in obtaining the data – difficult to compare the results obtained from various samples. THE ACCURACY OF DATA: (con’d) 3) The problem of non-response in questionnaire-type surveys. . i. Selectivity bias where analysis based on such partial response. 5) Economic data generally being available at a highly aggerate level. 6) Because of confidentially. GNP. sometimes even aggergation in sectors. inflation. unemployment – available for the economy as a whole/broad geographical regions.

. - But that the poor quality of the data.THE ACCURACY OF DATA: (con’d)  The reseracher should always keep in mind that the results of research are only as good as the quality of data – have no choice but to depend on the available data:  The results of the research are ‘unsatisfactory’: - The reason may not be the wrong model used.

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

1: for 60 families (a total population of 60 families). . - weekly family income (X) AND - weekly family consumption expenditure (Y) are provided in dollars.2.1 A HYPOTHETICAL EXAMPLE  Remember the concern of regression analysis: estimating and/or predicting the (population) mean value of the dependent variable on the basis of the known or fixed values of the explanatory variable(s). Consider Table 2.

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

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

It is the curve connecting the means of the subpopulations of Y corresponding to the given values of the regressor X. It is the locus of the conditional means of the dependent variable for the fixed values of the explanatory variable(s).Definition of ‘population regression curve’:  Geometrically.1) . See Figure 2.  More simply.2: Population regression line (data of Table 2.

𝟐.  So. Assume that consumption expenditure is linearly related to income.e. 𝐸 𝑌 𝑋𝑖 is assumed to be a linear function of 𝑋𝑖 : 𝐸 𝑌 𝑋𝑖 = β1 + β2 𝑋𝑖 (𝟐. 𝟐) . 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. The relationship btw consumption expenditure and income. so the PRF.2. its functional form is an empirical question.

1) .Figure 2.2 Population regression line (data of Table 2.

(2. X. In our example: 𝐸 𝑌 𝑋𝑖 is a linear function of 𝑋𝑖 . linear function. . 𝟏 𝑓 𝑋𝑖 : some function of the explanatory variable. (2.1): how the mean or average response of Y varies with X.2. – here.2.1): the expected value of the distribution of Y given 𝑋𝑖 is functionally related to 𝑋𝑖 . 𝟐. (2. 𝐸 𝑌 𝑋𝑖 = 𝑓 𝑋𝑖 𝟐.2.2 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.1): conditional expectation function (CEF) or population regression function (PRF) or population regression (PR).2.

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

the parameters are raised to the first power only). It may or may not be linear in the explanatory variables. the β’s (that is. the X’s.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.

that is. too.1: the values.  What about the consumption expenditure of an individual family in relation to its (fixed) level of income? Table 2. . an individual family’s consumption expenditure is clustered around the average consumption of all families at that 𝑋𝑖 .1: given the income level of 𝑋𝑖 .4 STOCHASTIC SPECIFICATION OF PRF  Figure 2. around its conditional expectation. family consumption expenditure on the average increases.1: as family income increases.2.1 + Figure 2. Figure 2.

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 (𝟐.4. 𝟏) The deviation 𝑢𝑖 is an unobservable random variable – positive or negative values-.1)? The sum of two components: systematic (or deterministic) component AND random (or nonsystematic) component. HOW DO WE INTERPRET (2. 𝑢𝑖 : the stochastic disturbance OR stochastic error term.2. 𝟒. .

2. 𝟐 − that we are familiar with.3) . 𝟒.2. consider the individual consumption expenditures when 𝑋 = \$80: the following 5 equations constitute(2.1): 𝑌𝑖 = 𝐸 𝑌 𝑋𝑖 + 𝑢𝑖 𝑡𝑢𝑟𝑛𝑠 𝑜𝑢𝑡 𝑡𝑜 𝑏𝑒 𝑌𝑖 = β1 + β2 𝑋𝑖 + 𝑢𝑖 𝟐.4 STOCHASTIC SPECIFICATION OF PRF (cont’d) If 𝑬 𝒀 𝑿𝒊 is linear in 𝑿𝒊 : 𝑬 𝒀 𝑿𝒊 = β𝟏 + β𝟐 𝑿𝒊 𝒂𝒔 𝒊𝒏 (𝟐. 𝟐. 𝟐)  Substitute (2.4.4.2) into (2. NOW.

.4 STOCHASTIC SPECIFICATION OF PRF (cont’d)  Take the expected value of (2.4.because the expected value of a constant is that constant 𝐸 𝑌𝑖 𝑋𝑖 = 𝐸 𝑌 𝑋𝑖 + 𝐸 𝑢𝑖 𝑋𝑖 (𝟐. 𝟒.2. 𝟒. 𝟒) AND since 𝐸 𝑌𝑖 𝑋𝑖 = 𝐸 𝑌 𝑋𝑖 . 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. 𝟓) Thus.1) on both sides: 𝐸 𝑌𝑖 𝑋𝑖 = 𝐸 𝐸 𝑌 𝑋𝑖 Since 𝐸 𝐸 𝑌 𝑋𝑖 itself: + 𝐸 𝑢𝑖 𝑋𝑖 = 𝐸 𝑌 𝑋𝑖 . then 𝐸 𝑢𝑖 𝑋𝑖 = 0 (𝟐.

𝑢𝑖 . Unavailability of data Even if we know what some of the excluded variables are.5 THE SIGNIFICANCE OF THE STOCHASTIC DISTURBANCE TERM 1. captured in 𝑢𝑖 . 2. we may not have quantitative information about them. combined effect being treated as a random variable. 3. Vagueness of theory ignorant or unsure about the other variables affecting Y. 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. .2. 𝑢𝑖 : as a substitute for all the excluded or omitted variables from the model.

𝑢𝑖 ’s reflecting this randomness. 𝑢𝑖 representing the errors of measurement. Principle of parsimony To keep the as simple as possible. Wrong functional form Correct variables explaining a phenomenon but not sure about the functional form. .2. Poor proxy variables Errors in measurement where data may not be measured accurately. 5. 7. 𝑢𝑖 representing all other variables. some ‘intrinsic’ randomness in individual Y’s that cannot be explained.5 THE SIGNIFICANCE OF THE STOCHASTIC DISTURBANCE TERM (cont’d) 4. 6. The scattergram: helpful if two-variable model is concerned. Intrinsic randomness in human behavior Even if we succeed in introducing all the relevant variables into the model.

4 AND 2.1: presenting the population. OUESTION: From the sample of Table 2.2.4.5: a randomly selected sample of Y values for the fixed X’s. 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? .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. not a sample  Table 2.  Table 2.

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

5: .6 THE SAMPLE REGRESSION FUNCTION (SRF) (cont’d) Plotting tha data of Tables 2.2.4 and 2.

2) may be written as: 𝑌𝑖 = β1 + β2 𝑋𝑖 (𝟐. 𝟔.6 THE SAMPLE REGRESSION FUNCTION (SRF) (cont’d) the concept of the sample regression function (SRF):  The sample counterpart of (2. 𝟏) A particular numerical value obtained by the estimatır in an application is known as an estimate.2.2. .

2) may be written as: 𝑌𝑖 = β1 + β2 𝑋𝑖 + 𝑢𝑖 (𝟐. 𝟔.4. which is an estimate of 𝑢𝑖 .1).2): the stochastic form of SRF given in (2. 𝟐) (2.6.2.6 THE SAMPLE REGRESSION FUNCTION (SRF) (cont’d) the concept of the sample regression function (SRF):  The sample counterpart of (2.6. 𝑢𝑖 : the (sample) residual term. .

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

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

FIGURE 2.5 SAMPLE AND POPULATION REGRESSION LINES .

THE CRITICAL QUESTION  Granted that the SRF is but an approximation of the PRF. 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. .