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We consider the modeling between the dependent and one independent variable. When there is only one

independent variable in the linear regression model, the model is generally termed as simple linear

regression model. When there are more than one independent variables in the model, then the linear model

is termed as the multiple linear regression model.

Consider a simple linear regression model

y 0 1 X

where y is termed as the dependent or study variable and X is termed as independent or explanatory

variable. The terms 0 and 1 are the parameters of the model. The parameter 0 is termed as intercept

term and the parameter 1 is termed as slope parameter. These parameters are usually called as regression

coefficients. The unobservable error component accounts for the failure of data to lie on the straight line

and represents the difference between the true and observed realization of y . There can be several reasons

for such difference, e.g., the effect of all deleted variables in the model, variables may be qualitative, inherit

randomness in the observations etc. We assume that is observed as independent and identically

distributed random variable with mean zero and constant variance 2 . Later, we will additionally assume

that is normally distributed.

whereas y is viewed as a random variable with

E ( y ) 0 1 X

and

Var ( y ) 2 .

Sometimes X can also be a random variable. In such a case, instead of simple mean and simple variance of

y , we consider the conditional mean of y given X x as

E ( y | x) 0 1 x

1

and the conditional variance of y given X x as

Var ( y | x) 2 .

When the values of 0 , 1 and 2 are known, the model is completely described. The parameters 0 , 1 and

2 are generally unknown in practice and is unobserved. The determination of the statistical model

y 0 1 X depends on the determination (i.e., estimation ) of 0 , 1 and 2 . In order to know the

values of these parameters, n pairs of observations ( xi , yi )(i 1,..., n) on ( X , y ) are observed/collected and

Various methods of estimation can be used to determine the estimates of the parameters. Among them, the

methods of least squares and maximum likelihood are the popular methods of estimation.

Suppose a sample of n sets of paired observations ( xi , yi ) (i 1, 2,..., n) are available. These observations

are assumed to satisfy the simple linear regression model and so we can write

yi 0 1 xi i (i 1, 2,..., n).

The method of least squares estimates the parameters 0 and 1 by minimizing the sum of squares of

difference between the observations and the line in the scatter diagram. Such an idea is viewed from

different perspectives. When the vertical difference between the observations and the line in the scatter

diagram is considered and its sum of squares is minimized to obtain the estimates of 0 and 1 , the method

yi

(xi,

Y 0 1 X

(Xi,

xi

Direct regression

2

Alternatively, the sum of squares of difference between the observations and the line in horizontal direction

in the scatter diagram can be minimized to obtain the estimates of 0 and 1 . This is known as reverse (or

yi

Y 0 1 X

(xi, yi)

(Xi, Yi)

xi,

Instead of horizontal or vertical errors, if the sum of squares of perpendicular distances between the

observations and the line in the scatter diagram is minimized to obtain the estimates of 0 and 1 , the

yi

(xi

Y 0 1 X

(Xi

)

xi

Major axis regression method

3

Instead of minimizing the distance, the area can also be minimized. The reduced major axis regression

method minimizes the sum of the areas of rectangles defined between the observed data points and the

nearest point on the line in the scatter diagram to obtain the estimates of regression coefficients. This is

shown in the following figure:

yi

( x i y i)

Y 0 1 X

(Xi, Yi)

xi

Reduced major axis method

The method of least absolute deviation regression considers the sum of the absolute deviation of the

observations from the line in the vertical direction in the scatter diagram as in the case of direct regression to

obtain the estimates of 0 and 1 .

No assumption is required about the form of probability distribution of i in deriving the least squares

estimates. For the purpose of deriving the statistical inferences only, we assume that i ' s are random

variable with E ( i ) 0, Var ( i ) 2 and Cov ( i , j ) 0 for all i j (i, j 1, 2,..., n). This assumption is

needed to find the mean, variance and other properties of the least squares estimates. The assumption that

i ' s are normally distributed is utilized while constructing the tests of hypotheses and confidence intervals

of the parameters.

Based on these approaches, different estimates of 0 and 1 are obtained which have different statistical

properties. Among them the direct regression approach is more popular. Generally, the direct regression

estimates are referred as the least squares estimates or ordinary least squares estimates.

Econometrics | Chapter 2 | Simple Linear Regression Analysis | Shalabh, IIT Kanpur

4

Direct regression method

This method is also known as the ordinary least squares estimation. Assuming that a set of n paired

observations on ( xi , yi ), i 1, 2,..., n are available which satisfy the linear regression model y 0 1 X .

n n

S ( 0 , 1 ) i2 ( yi 0 1 xi ) 2

i 1 i 1

S ( 0 , 1 ) n

2 ( yt 0 1 xi )

0 i 1

S ( 0 , 1 ) n

2 ( yi 0 1 xi )xi .

1 i 1

S ( 0 , 1 )

0

0

S ( 0 , 1 )

0.

1

The solutions of these two equations are called the direct regression estimators, or usually called as the

ordinary least squares (OLS) estimators of 0 and 1 .

b0 y b1 x

sxy

b1

sxx

where

n n

1 n 1 n

sxy ( xi x )( yi y ), sxx ( xi x ) 2 , x i x , y yi .

i 1 i 1 n i 1 n i 1

5

Further, we have

2 S ( 0 , 1 ) n

02

2

i 1

(1) 2n,

2 S ( 0 , 1 ) n

12

2

i 1

xi2

2 S ( 0 , 1 ) n

2 xt 2nx .

0 1 i 1

The Hessian matrix which is the matrix of second order partial derivatives in this case is given as

2 S ( 0 , 1 ) 2 S ( 0 , 1 )

02 0 1

H* 2

S ( , ) 2 S ( 0 , 1 )

0 1

0 1 12

n nx

2 n

nx xi2

i 1

'

2 , x

x '

where (1,1,...,1) ' is a n -vector of elements unity and x ( x1 ,..., xn ) ' is a n -vector of observations on X .

The matrix H * is positive definite if its determinant and the element in the first row and column of H * are

positive. The determinant of H is given by

n

H * 2 n xi2 n 2 x 2

i 1

n

2n ( xi x ) 2

i 1

0.

n

The case when (x x )

i 1

i

2

0 is not interesting because all the observations in this case are identical, i.e.

xi c (some constant). In such a case there is no relationship between x and y in the context of regression

n

analysis. Since (x x )

i 1

i

2

0, therefore H * 0. So H * is positive definite for any ( 0 , 1 ); therefore

6

The fitted line or the fitted linear regression model is

y b0 b1 x.

The predicted values are

yˆi b0 b1 xi (i 1, 2,..., n).

The difference between the observed value yi and the fitted (or predicted) value yˆi is called as a residual.

ˆi yi ~ yˆi (i 1, 2,..., n) .

We consider it as

ˆi yi yˆi

yi (b0 b1 xi ).

Unbiased property:

sxy

Note that b1 and b0 y b1 x are the linear combinations of yi (i 1,..., n).

sxx

Therefore

n

b1 ki yi

i 1

n n

where ki ( xi x ) / sxx . Note that ki 0 and

i 1

k x

i 1

i i 1, so

n

E (b1 ) ki E ( yi )

i 1

n

ki ( 0 1 xi ) .

i 1

1.

E (b0 ) E y b1 x

E 0 1 x b1 x

0 1 x 1 x

0 .

Econometrics | Chapter 2 | Simple Linear Regression Analysis | Shalabh, IIT Kanpur

7

Variances:

Using the assumption that yi ' s are independently distributed, the variance of b1 is

n

Var (b1 ) ki2Var ( yi ) ki k j Cov( yi , y j )

i 1 i j i

(x x ) i

2

2 i

(Cov( yi , y j ) 0 as y1 ,..., yn are independent)

sxx2

2 sxx

=

sxx2

2

= .

sxx

The variance of b0 is

First we find that

Cov( y , b1 ) E y E ( y )b1 E (b1 )

E ( ki yi 1 )

i

1

E ( i )( 0 ki 1 ki xi ki i ) 1 i

n i i i i i

1

0 0 0 0

n

0

So

1 x2

Var (b0 ) 2 .

n sxx

Covariance:

The covariance between b0 and b1 is

x 2

.

sxx

8

It can further be shown that the ordinary least squares estimators b0 and b1 possess the minimum variance

in the class of linear and unbiased estimators. So they are termed as the Best Linear Unbiased Estimators

(BLUE). Such a property is known as the Gauss-Markov theorem which is discussed later in multiple

linear regression model.

The residual sum of squares is given as

n

SSres ei2

i 1

n

( yi yˆi ) 2

i 1

n

( yi b0 b1 xi ) 2

i 1

n

yi y b1 x b1 xi

2

i 1

n

( yi y ) b1 ( xi x )

2

i 1

n n n

( yi y ) 2 b12 ( xi x ) 2 2b1 ( xi x )( yi y )

i 1 i 1 i 1

s yy b s 2b s

2

1 xx

2

1 xx

s yy b12 sxx

2

s

s yy xy sxx

sxx

sxy2

s yy

sxx

s yy b1sxy .

n

1 n

where s yy ( yi y ) 2 , y yi .

i 1 n i 1

9

Estimation of 2

The estimator of 2 is obtained from the residual sum of squares as follows. Assuming that yi is normally

SSres

~ 2 (n 2).

2

Thus using the result about the expectation of a chi-square random variable, we have

E ( SSres ) (n 2) 2 .

SSres

s2 .

n2

Note that SSres has only (n 2) degrees of freedom. The two degrees of freedom are lost due to estimation

The estimators of variances of b0 and b1 are obtained by replacing 2 by its estimate ˆ 2 s 2 as follows:

(b ) s 2 1 x

2

Var 0

n sxx

and

2

(b ) s .

Var 1

sxx

n n

It is observed that since ( yi yˆi ) 0, so

i 1

e

i 1

i 0. In the light of this property, ˆi can be regarded as an

estimate of unknown i (i 1,..., n) . This helps in verifying the different model assumptions on the basis of

n

(i) xe

i 1

i i 0,

n

(ii) yˆ e

i 1

i i 0,

10

n n

(iii) y yˆ

i 1

i

i 1

i and

Centered Model:

Sometimes it is useful to measure the independent variable around its mean. In such a case, model

yi 0 1 X i i has a centered version as follows:

yi 0 1 ( xi x ) 1 x (i 1, 2,..., n)

0* 1 ( xi x ) i

n n 2

S ( , 1 ) yi 1 ( xi x ) .

*

0 i

2 *

0

i 1 i 1

Now solving

S ( 0* , 1 )

0

0*

S ( 0* , 1 )

0,

1*

b0* y

and

sxy

b1

sxx

respectively.

Thus the form of the estimate of slope parameter 1 remains same in usual and centered model whereas the

form of the estimate of intercept term changes in the usual and centered models.

Further, the Hessian matrix of the second order partial derivatives of S ( 0* , 1 ) with respect to 0* and 1

is positive definite at 0* b0* and 1 b1 which ensures that S ( 0* , 1 ) is minimized at 0* b0* and

1 b1 .

11

Under the assumption that E ( i ) 0,Var ( i ) 2 and Cov( i j ) 0 for all i j 1, 2,..., n , it follows that

E (b0* ) 0* , E (b1 ) 1 ,

2 2

Var (b0* ) , Var (b1 ) .

n sxx

y y b1 ( x x ),

and the predicted values are

yˆi y b1 ( xi x ) (i 1,..., n).

Note that in centered model

Cov(b0* , b1 ) 0.

Sometimes in practice, a model without an intercept term is used in those situations when xi 0 yi 0 for

yi 1 xi i (i 1, 2,.., n).

For example, in analyzing the relationship between the illumination of bulb ( y ) and electric current ( X ) ,

the illumination is zero when current is zero.

Using the data ( xi , yi ), i 1, 2,..., n, the direct regression least squares estimate of 1 is obtained by

n n

minimizing S ( 1 ) i2 ( yi 1 xi ) 2 and solving

i 1 i 1

S ( 1 )

0

1

n

yx i i

b

*

1

i 1

n

.

xi2

i 1

The second order partial derivative of S ( 1 ) with respect to 1 at 1 b1 is positive which insures that b1

minimizes S ( 1 ).

12

Using the assumption that E ( i ) 0,Var ( i ) 2 and Cov( i j ) 0 for all i j 1, 2,..., n , the properties

n

x E( y ) i i

E (b ) *

1

i 1

n

x

i 1

2

i

x 2

i 1

i 1

n

x i 1

2

i

1

n

x Var ( y ) 2

i i

Var (b1* ) i 1

2

n 2

xi

i 1

n

x 2

i

2 i 1

2

n 2

xi

i 1

2

n

xi 1

2

i

n n

y

i 1

2

i b1 yi xi

i 1

.

n 1

Econometrics | Chapter 2 | Simple Linear Regression Analysis | Shalabh, IIT Kanpur

13

We assume that i ' s (i 1, 2,..., n) are independent and identically distributed following a normal

distribution N (0, 2 ). Now we use the method of maximum likelihood to estimate the parameters of the

linear regression model

yi 0 1 xi i (i 1, 2,..., n),

the observations yi (i 1, 2,..., n) are independently distributed with N ( 0 1 xi , 2 ) for all i 1, 2,..., n.

The likelihood function of the given observations ( xi , yi ) and unknown parameters 0 , 1 and 2 is

1/ 2

n

1 1

L( xi , yi ; 0 , 1 , 2 ) 2

exp 2 ( yi 0 1 xi ) 2 .

i 1 2 2

The maximum likelihood estimates of 0 , 1 and 2 can be obtained by maximizing L( xi , yi ; 0 , 1 , 2 ) or

equivalently ln L( xi , yi ; 0 , 1 , 2 ) where

n n 1 n

ln L( xi , yi ; 0 , 1 , 2 ) ln 2 ln 2 2 ( yi 0 1 xi ) 2 .

2 2 2 i 1

The normal equations are obtained by partial differentiation of log-likelihood with respect to 0 , 1 and 2

and equating them to zero as follows:

ln L( xi , yi ; 0 , 1 , 2 ) 1 n

0

2

(y

i 1

i 0 1 xi ) 0

ln L( xi , yi ; 0 , 1 , 2 ) 1 n

1

2

(y

i 1

i 0 1 xi )xi 0

and

ln L( xi , yi ; 0 , 1 , 2 ) n 1 n

2

2 4

2 2

(y

i 1

i 0 1 xi ) 2 0.

The solution of these normal equations give the maximum likelihood estimates of 0 , 1 and 2 as

b0 y b1 x

n

( x x )( y y )

i i

sxy

b1 i 1

n

(x x ) 2 sxx

i

i 1

and

n

( y b i 0 b1 xi ) 2

s 2 i 1

n

respectively.

14

It can be verified that the Hessian matrix of second order partial derivation of ln L with respect to 0 , 1 ,

and 2 is negative definite at 0 b0 , 1 b1 , and 2 s 2 which ensures that the likelihood function is

maximized at these values.

Note that the least squares and maximum likelihood estimates of 0 and 1 are identical. The least squares

and maximum likelihood estimates of 2 are different. In fact, the least squares estimate of 2 is

1 n

s2 ( yi y )2

n 2 i 1

so that it is related to maximum likelihood estimate as

n2 2

s 2 s .

n

Thus b0 and b1 are unbiased estimators of 0 and 1 whereas s 2 is a biased estimate of 2 , but it is

asymptotically unbiased. The variances of b0 and b1 are same as of b0 and b1 respectively but the mean

Now we consider the tests of hypothesis and confidence interval estimation for the slope parameter of the

model under two cases, viz., when 2 is known and when 2 is unknown.

Consider the simple linear regression model yi 0 1 xi i (i 1, 2,..., n) . It is assumed that i ' s are

First we develop a test for the null hypothesis related to the slope parameter

H 0 : 1 10

15

2

Assuming 2 to be known, we know that E (b1 ) 1 , Var (b1 ) and b1 is a linear combination of

sxx

2

b1 ~ N 1 ,

sxx

b1 10

Z1

2

sxx

Reject H 0 if Z1 Z / 2

Similarly, the decision rule for one sided alternative hypothesis can also be framed.

The 100 (1 )% confidence interval for 1 can be obtained using the Z1 statistic as follows:

P z /2 Z1 z /2 1

b1 1

P z /2 z /2 1

2

sxx

2 2

P b1 z /2 1 b1 z /2 1.

sxx sxx

2 2

b1 z / 2 , b1 z / 2

sxx sxx

16

Case 2: When 2 is unknown:

When 2 is unknown then we proceed as follows. We know that

SSres

~ 2 (n 2)

2

and

SS

E res 2 .

n2

Further, SSres / 2 and b1 are independently distributed. This result will be proved formally later in next

module on multiple linear regression. This result also follows from the result that under normal distribution,

the maximum likelihood estimates, viz., the sample mean (estimator of population mean) and the sample

variance (estimator of population variance) are independently distributed, so b1 and s 2 are also

independently distributed.

Thus the following statistic can be constructed:

b1 1

t0

ˆ 2

sxx

b1 1

SSres

(n 2) sxx

reject H 0 if t0 tn 2, / 2

where tn 2, / 2 is the / 2 percent point of the t -distribution with (n 2) degrees of freedom. Similarly, the

decision rule for one sided alternative hypothesis can also be framed.

The 100 (1 )% confidence interval of 1 can be obtained using the t0 statistic as follows:

17

Consider

P t /2 t0 t /2 1

b1 1

P t /2 t /2 1

ˆ 2

sxx

ˆ 2 ˆ 2

P b1 t /2 1 b1 t / 2 1.

sxx sxx

SSres SS res

b1 tn 2, /2 , b1 tn 2, /2 .

(n 2) sxx (n 2) sxx

Now, we consider the tests of hypothesis and confidence interval estimation for intercept term under two

cases, viz., when 2 is known and when 2 is unknown.

Suppose the null hypothesis under consideration is

H 0 : 0 00 ,

1 x2

where 2 is known, then using the result that E (b0 ) 0 , Var (b0 ) 2 and b0 is a linear

n sx

combination of normally distributed random variables, the following statistic

b0 00

Z0

1 x2

2

n sxx

Reject H 0 if Z 0 Z /2

where Z /2 is the / 2 percentage points on normal distribution. Similarly, the decision rule for one sided

alternative hypothesis can also be framed.

Econometrics | Chapter 2 | Simple Linear Regression Analysis | Shalabh, IIT Kanpur

18

The 100 (1 )% confidence intervals for 0 when 2 is known can be derived using the Z 0 statistic as

follows:

P z /2 Z 0 z /2 1

b0 0

P z /2 z /2 1

1 x2

2

n s xx

21 x2 21 x2

P b0 z /2

0 b0 z /2 1.

n sxx n sxx

1 x2 1 x2

b0 z / 2 2 , b0 z / 2 2 .

n sxx n sxx

When 2 is unknown, then the following statistic is constructed

b0 00

t0

SSres 1 x 2

n 2 n sxx

where tn 2, / 2 is the / 2 percentage point of the t -distribution with (n 2) degrees of freedom. Similarly,

the decision rule for one sided alternative hypothesis can also be framed.

19

Consider

P tn 2, /2 t0 tn 2, /2 1

b0 0

P tn 2, /2 tn 2, /2 1

SS res 1 x 2

n 2 n sxx

SSres 1 x 2 SS res 1 x 2

P b0 tn 2, /2 0 b0 t n 2, /2 1.

n 2 n sxx n 2 n sxx

SS res 1 x 2 SSres 1 x 2

b0 tn 2, / 2 , b0 tn 2, / 2 .

n 2 n sxx n 2 n sxx

We have considered two types of test statistics for testing the hypothesis about the intercept term and slope

parameter- when 2 is known and when 2 is unknown. While dealing with the case of known 2 , the

value of 2 is known from some external sources like past experience, long association of the experimenter

with the experiment, past studies etc. In such situations, the experimenter would like to test the hypothesis

like H 0 : 2 02 against H 0 : 2 02 where 02 is specified. The test statistic is based on the result

SS r es

~ n2 2 . So the test statistic is

2

SS r es

C0 ~ n2 2 under H 0 .

02

20

Confidence interval for 2

A confidence interval for 2 can also be derived as follows. Since SSres / 2 ~ n2 2 , thus consider

SS

P n2 2, /2 res n2 2,1 /2 1

2

SS SS

P 2 res 2 2 res 1 .

n 2,1 / 2 n 2, / 2

SSres SS

2 , 2 res .

n 2,1 / 2 n 2, / 2

A joint confidence region for 0 and 1 can also be found. Such region will provide a 100(1 )%

confidence that both the estimates of 0 and 1 are correct. Consider the centered version of the linear

regression model

yi 0* 1 ( xi x ) i

sxy

b0* y and b1 ,

sxx

respectively.

E (b0* ) 0* ,

E (b1 ) 1 ,

2

Var (b0* ) ,

n

2

Var (b1 ) .

sxx

b0* 0* b1 1

~ N (0,1) and ~ N (0,1).

2

2

n sxx

Econometrics | Chapter 2 | Simple Linear Regression Analysis | Shalabh, IIT Kanpur

21

Moreover, both the statistics are independently distributed. Thus

2

2

* *

b0 0 ~ 12 and b1 1 ~ 2

2 2 1

s

n xx

are also independently distributed because b0* and b1 are independently distributed. Consequently, the sum

of these two

n(b0* o* ) 2 sxx (b1 1 ) 2

~ 22 .

2

2

Since

SSres

~ n2 2

2

2

2 2 ~ F2, n 2 .

SSres

2 (n 2)

Substituting b0* b0 b1 x and 0* 0 1 x , we get

n 2 Qf

2 SSres

where

n n

Q f n(b0 0 ) 2 2 xt (b0 1 )(b1 1 ) xi2 (b1 1 ) 2 .

i 1 i 1

Since

n 2 Q f

P F2, n 2 1

2 SSres

holds true for all values of 0 and 1 , so the 100 (1 ) % confidence region for 0 and 1 is

n 2 Qf

. F2, n 2;1 . .

2 SSres

This confidence region is an ellipse which gives the 100 (1 )% probability that 0 and 1 are contained

Econometrics | Chapter 2 | Simple Linear Regression Analysis | Shalabh, IIT Kanpur

22

Analysis of variance:

The technique of analysis of variance is usually used for testing the hypothesis related to equality of more

than one parameters, like population means or slope parameters. It is more meaningful in case of multiple

regression model when there are more than one slope parameters. This technique is discussed and

illustrated here to understand the related basic concepts and fundamentals which will be used in developing

the analysis of variance in the next module in multiple linear regression model where the explanatory

variables are more than two.

A test statistic for testing H 0 : 1 0 can also be formulated using the analysis of variance technique as

follows.

yi yˆi ( yi y ) ( yˆi y ),

the sum of squared residuals is

n

S (b) ( yi yˆi ) 2

i 1

n n n

( yi y ) 2 ( yˆi yi ) 2 2 ( yi y )( yˆi y ).

i 1 i 1 i 1

Further consider

n n

( yi y )( yˆi y ) ( yi y )b1 ( xi x )

i 1 i 1

n

b12 ( xi x ) 2

i 1

n

( yˆi y ) 2 .

i 1

Thus we have

n n n

i 1

( yi y ) 2 ( yi yˆi ) 2 ( yˆi y ) 2 .

i 1 i 1

n

The term ( y y)

i 1

i

2

is called the sum of squares about the mean, corrected sum of squares of y (i.e.,

23

n

The term ( y yˆ )

i 1

i i

2

describes the deviation: observation minus predicted value, viz., the residual sum of

n

squares, i.e., SS res ( yi yˆi ) 2

i 1

n

whereas the term ( yˆ y )

i 1

i

2

describes the proportion of variability explained by regression,

n

SS r e g ( yˆi y ) 2 .

i 1

n

If all observations yi are located on a straight line, then in this case ( y yˆ )

i 1

i i

2

0 and thus

SScorrected SSr e g .

Note that SSr e g is completely determined by b1 and so has only one degrees of freedom. The total sum of

n n

squares s yy ( yi y ) 2 has (n 1) degrees of freedom due to constraint ( y y) 0i and SS res has

i 1 i 1

All sums of squares are mutually independent and distributed as df2 with df degrees of freedom if the

SS r e g

MS r e g

1

and mean square due to residuals is

SS res

MSE .

n2

The test statistic for testing H 0 : 1 0 is

MS r e g

F0 .

MSE

If H 0 : 1 0 is true, then MSr e g and MSE are independently distributed and thus

F0 ~ F1, n 2 .

Econometrics | Chapter 2 | Simple Linear Regression Analysis | Shalabh, IIT Kanpur

24

The decision rule for H1 : 1 0 is to reject H 0 if

F0 F1,n 2;1

at level of significance. The test procedure can be described in an Analysis of variance table.

Total s yy n 1

sxy

rxy .

sxx s yy

Moreover, we have

sxy s yy

b1 rxy .

sxx sxx

1 n 2

s2 ei

n 2 i 1

1

SS res .

n2

Various alternative formulations for SS res are in use as well:

n

SSres [ yi (b0 b1 xi )]2

i 1

n

[( yi y ) b1 ( xi x )]2

i 1

s yy b12 sxx

( sxy ) 2

s yy .

sxx

25

Using this result, we find that

SScorrected s yy

and

SSr e g s yy SS res

( sxy ) 2

sxx

b s 2

1 xx

b1sxy .

It can be noted that a fitted model can be said to be good when residuals are small. Since SSres is based on

residuals, so a measure of quality of fitted model can be based on SSres . When intercept term is present in the

model, a measure of goodness of fit of the model is given by

SS res

R2 1

s yy

SS r e g

.

s yy

This is known as the coefficient of determination. This measure is based on the concept that how much

variation in y ’s stated by s yy is explainable by SSreg and how much unexplainable part is contained in

SS res . The ratio SS r e g / s yy describes the proportion of variability that is explained by regression in relation

to the total variability of y . The ratio SSres / s yy describes the proportion of variability that is not covered

by the regression.

R 2 rxy2

where rxy is the simple correlation coefficient between x and y. Clearly 0 R 2 1 , so a value of R 2 closer

to one indicates the better fit and value of R 2 closer to zero indicates the poor fit.

26

Prediction of values of study variable

An important use of linear regression modeling is to predict the average and actual values of study variable.

The term prediction of value of study variable corresponds to knowing the value of E ( y ) (in case of

average value) and value of y (in case of actual value) for a given value of explanatory variable. We

consider both the cases.

Under the linear regression model y 0 1 x , the fitted model is y b0 b1 x where b0 and b1 are the

Suppose we want to predict the value of E ( y ) for a given value of x x0 . Then the predictor is given by

E ( y | x0 ) ˆ y / x0 b0 b1 x0 .

Predictive bias

Then the prediction error is given as

ˆ y| x E ( y ) b0 b1 x0 E ( 0 1 x0 )

0

b0 b1 x0 ( 0 1 x0 )

(b0 0 ) (b1 1 ) x0 .

Then

E ˆ y| x0 E ( y ) E (b0 0 ) E (b1 1 ) x0

00 0

Thus the predictor y / x0 is an unbiased predictor of E ( y ).

Predictive variance:

The predictive variance of ˆ y| x0 is

PV ( ˆ y| x0 ) Var (b0 b1 x0 )

Var y b1 ( x0 x )

Var ( y ) ( x0 x ) 2 Var (b1 ) 2( x0 x )Cov( y , b1 )

2 2 ( x0 x ) 2

0

n sxx

1 ( x x )2

2 0 .

n sxx

27

Estimate of predictive variance

The predictive variance can be estimated by substituting 2 by ˆ 2 MSE as

( ˆ ) ˆ 2 1 ( x0 x )

2

PV y| x0

n sxx

1 ( x0 x ) 2

MSE .

n sxx

The 100(1- )% prediction interval for E ( y / x0 ) is obtained as follows:

The predictor ˆ y| x0 is a linear combination of normally distributed random variables, so it is also normally

distributed as

ˆ y| x ~ N 0 1 x0 , PV ˆ y| x

0 0

.

So if 2 is known, then the distribution of

ˆ y| x E ( y | x0 )

0

PV ( ˆ y| x0 )

ˆ y| x0 E ( y | x0 )

P z /2 z /2 1

PV ( ˆ y| x0 )

1 ( x x )2 ( x0 x ) 2

2 1

ˆ y| x0 z /2 2 0 ,

ˆ

y| x0 /2

z .

n sxx n sxx

When 2 is unknown, it is replaced by ˆ 2 MSE and in this case the sampling distribution of

ˆ y|x E ( y | x0 )

0

1 ( x x )2

MSE 0

n sxx

28

The 100(1- )% prediction interval in this case is

ˆ y| x0 E ( y | x0 )

P t /2,n 2 t 1 .

1 ( x x )2 2

,n2

MSE 0

n s

xx

which gives the prediction interval as

1 ( x x )2 1 ( x0 x ) 2

ˆ y| x0 t /2, n 2 MSE 0 ,

ˆ y| x0 t /2, n 2 MSE .

n sxx n sxx

Note that the width of prediction interval E ( y | x0 ) is a function of x0 . The interval width is minimum for

x0 x and widens as x0 x increases. This is expected also as the best estimates of y to be made at x -

values lie near the center of the data and the precision of estimation to deteriorate as we move to the

boundary of the x -space.

If x0 is the value of the explanatory variable, then the actual value predictor for y is

ŷ0 b0 b1 x0 .

The true value of y in the prediction period is given by y0 0 1 x0 0 where 0 indicates the value that

would be drawn from the distribution of random error in the prediction period. Note that the form of

predictor is the same as of average value predictor but its predictive error and other properties are different.

This is the dual nature of predictor.

Predictive bias:

The predictive error of ŷ0 is given by

yˆ 0 y0 b0 b1 x0 ( 0 1 x0 0 )

(b0 0 ) (b1 1 ) x0 .

Thus, we find that

E ( yˆ 0 y0 ) E (b0 0 ) E (b1 1 ) x0 E ( 0 )

000 0

29

Predictive variance

Because the future observation y0 is independent of ŷ0 , the predictive variance of ŷ0 is

PV ( yˆ 0 ) E ( yˆ 0 y0 ) 2

E[(b0 0 ) ( x0 x )(b1 1 ) (b1 1 ) x 0 ]2

Var (b0 ) ( x0 x ) 2 Var (b1 ) x 2Var (b1 ) Var ( 0 ) 2( x0 x )Cov(b0 , b1 ) 2 xCov(b0 , b1 ) 2( x0 x )Var (b1 )

[rest of the terms are 0 assuming the independence of 0 with 1 , 2 ,..., n ]

Var (b0 ) [( x0 x ) 2 x 2 2( x0 x )]Var (b1 ) Var ( ) 2[( x0 x ) 2 x ]Cov(b0 , b1 )

Var (b0 ) x02Var (b1 ) Var ( 0 ) 2 x0Cov(b0 , b1 )

1 x2 2 x 2

2 x02 2 2 x0

n sxx sxx sxx

1 ( x x )2

2 1 0 .

n sxx

The estimate of predictive variance can be obtained by replacing 2 by its estimate ˆ 2 MSE as

1 ( x x )2

PV ( yˆ 0 ) ˆ 2 1 0

n sxx

1 ( x x )2

MSE 1 0 .

n sxx

Prediction interval:

If 2 is known, then the distribution of

yˆ 0 y0

PV ( yˆ 0 )

yˆ y0

P z /2 0 z /2 1

PV ( yˆ 0 )

which gives the prediction interval for y0 as

1 ( x x )2 1 ( x0 x ) 2

2

yˆ 0 z /2 2 1 0 , ˆ

0 /2

y z 1 .

n sxx n sxx

30

When 2 is unknown, then

yˆ 0 y0

( yˆ )

PV 0

follows a t -distribution with (n 2) degrees of freedom. The 100(1- )% prediction interval for ŷ0 in this

case is obtained as

yˆ y0

P t /2,n 2 0 t /2, n 2 1

( yˆ )

PV

0

which gives the prediction interval

1 ( x x )2 1 ( x0 x ) 2

yˆ 0 t /2,n 2 MSE 1 0 , ˆ

0 /2,n 2

y t MSE 1 .

n s xx n s xx

The prediction interval for ŷ0 is wider than the prediction interval for ˆ y / x0 because the prediction interval

for ŷ0 depends on both the error from the fitted model as well as the error associated with the future

observations.

The reverse (or inverse) regression approach minimizes the sum of squares of horizontal distances between

the observed data points and the line in the following scatter diagram to obtain the estimates of regression

parameters.

yi

Y 0 1 X

(xi, yi)

(Xi, Yi)

x,

Econometrics | Chapter 2 | Simple Linear

Reverse Regression

regression Analysis | Shalabh, IIT Kanpur

method

31

The reverse regression has been advocated in the analysis of sex (or race) discrimination in salaries. For

example, if y denotes salary and x denotes qualifications and we are interested in determining if there is a sex

discrimination in salaries, we can ask:

“Whether men and women with the same qualifications (value of x) are getting the same salaries

(value of y). This question is answered by the direct regression.”

“Whether men and women with the same salaries (value of y) have the same qualifications (value of

x). This question is answered by the reverse regression, i.e., regression of x on y.”

xi 0* 1* yi i (i 1, 2,..., n)

where i ’s are the associated random error components and satisfy the assumptions as in the case of usual

simple linear regression model. The reverse regression estimates ˆOR of 0* and ˆ1R of 1* for the model

are obtained by interchanging the x and y in the direct regression estimators of 0 and 1 . The estimates are

obtained as

ˆOR x ˆ1R y

and

sxy

ˆ1R

s yy

sxy2

SS res sxx

*

.

s yy

Note that

ˆ sxy2

1Rb1 rxy2

sxx s yy

where b1 is the direct regression estimator of slope parameter and rxy is the correlation coefficient between x

and y. Hence if rxy2 is close to 1, the two regression lines will be close to each other.

Econometrics | Chapter 2 | Simple Linear Regression Analysis | Shalabh, IIT Kanpur

32

Orthogonal regression method (or major axis regression method)

The direct and reverse regression methods of estimation assume that the errors in the observations are either

in x -direction or y -direction. In other words, the errors can be either in dependent variable or independent

variable. There can be situations when uncertainties are involved in dependent and independent variables

both. In such situations, the orthogonal regression is more appropriate. In order to take care of errors in both

the directions, the least squares principle in orthogonal regression minimizes the squared perpendicular

distance between the observed data points and the line in the following scatter diagram to obtain the

estimates of regression coefficients. This is also known as major axis regression method. The estimates

obtained are called as orthogonal regression estimates or major axis regression estimates of regression

coefficients.

yi

(xi, yi)

Y 0 1 X

(Xi, Yi)

xi

If we assume that the regression line to be fitted is Yi 0 1 X i , then it is expected that all the

observations ( xi , yi ), i 1, 2,..., n lie on this line. But these points deviate from the line and in such a case,

the squared perpendicular distance of observed data ( xi , yi ) (i 1, 2,..., n) from the line is given by

di2 ( X i xi ) 2 (Yi yi ) 2

where ( X i , Yi ) denotes the i th pair of observation without any error which lie on the line.

33

n

The objective is to minimize the sum of squared perpendicular distances given by i 1

di2 to obtain the

estimates of 0 and 1 . The observations ( xi , yi ) (i 1, 2,..., n) are expected to lie on the line

Yi 0 1 X i ,

so let

Ei Yi 0 1 X i 0.

n

The regression coefficients are obtained by minimizing d

i 1

i

2

under the constraints Ei ' s using the

n n

L0 di2 2 i Ei

i 1 i 1

where 1 ,..., n are the Lagrangian multipliers. The set of equations are obtained by setting

L0 L L L

0, 0 0, 0 0 and 0 0 (i 1, 2,..., n).

X i Yi 0 1

Thus we find

L0

( X i xi ) i 1 0

X i

L0

(Yi yi ) i 0

Yi

L0 n

0

i 1

i 0

L0 n

1

X

i 1

i i 0.

Since

X i xi i 1

Yi yi i ,

Ei ( yi i ) 0 1 ( xi i 1 ) 0

0 1 xi yi

i .

1 12

n

Also using this i in the equation

i 1

i 0 , we get

34

n

( 0 1 xi yi )

i 1

0

1 12

n

and using ( X i xi ) i 1 0 and X

i 1

i i 0 , we get

( x ) 0.

i 1

i i i 1

n n

( x x 0 i

2

1 i yi xi ) 1 ( 0 1 xi yi ) 2

i 1

i 1

0. (1)

(1 12 ) (1 12 ) 2

n

Using i in the equation and using the equation

i 1

i 0 , we solve

( 0 1 xi yi )

i 1

0.

1 12

ˆ0OR y ˆ1OR x

2

) yxi 1 xxi x xi yi 1 y 1 x 1 xi yi 0

n n

(1

i 1

1

2 2

1 i

i 1

or

n n 2

(1 12 ) xi yi y 1 ( xi x ) 1 ( yi y ) 1 ( xi x ) 0

i 1 i 1

or

n n

(1 12 ) (ui x )(vi 1ui ) 1 (vi 1ui ) 2 0

i 1 i 1

where ui xi x ,

vi yi y .

35

n n

Since u v

i 1

i

i 1

i 0, so

n

i 1

u v 1 (ui2 vi2 ) ui vi 0

2

1 i i

or

12 sxy 1 ( sxx s yy ) sxy 0.

ˆ1OR

yy

2 sxy

where sign( sxy ) denotes the sign of sxy which can be positive or negative . So

1 if sxy 0

sign( sxy ) .

1 if sxy 0.

n

Notice that this gives two solutions for ˆ1OR . We choose the solution which minimizes d

i 1

i

2

. The other

n

solution maximizes d

i 1

i

2

and is in the direction perpendicular to the optimal solution. The optimal

36

Reduced major axis regression method:

The direct, reverse and orthogonal methods of estimation minimize the errors in a particular direction which

is usually the distance between the observed data points and the line in the scatter diagram. Alternatively,

one can consider the area extended by the data points in certain neighbourhood and instead of distances, the

area of rectangles defined between corresponding observed data point and nearest point on the line in the

following scatter diagram can also be minimized. Such an approach is more appropriate when the

uncertainties are present in study as well as explanatory variables. This approach is termed as reduced major

axis regression.

yi

(xi yi)

Y 0 1 X

(Xi, Yi)

xi

Suppose the regression line is Yi 0 1 X i on which all the observed points are expected to lie. Suppose

the points ( xi , yi ), i 1, 2,..., n are observed which lie away from the line. The area of rectangle extended

Ai ( X i ~ xi )(Yi ~ yi ) (i 1, 2,..., n)

where ( X i , Yi ) denotes the i th pair of observation without any error which lie on the line.

n n

A (X

i 1

i

i 1

i ~ xi )(Yi ~ yi ).

All observed data points ( xi , yi ), (i 1, 2,..., n) are expected to lie on the line

Yi 0 1 X i

37

and let

Ei* Yi 0 1 X i 0.

So now the objective is to minimize the sum of areas under the constraints Ei* to obtain the reduced major

axis estimates of regression coefficients. Using the Lagrangian multiplies method, the Lagrangian function is

n n

LR Ai i Ei*

i 1 i 1

n n

( X i xi )(Yi yi ) i Ei*

i 1 i 1

where 1 ,..., n are the Lagrangian multipliers. The set of equations are obtained by setting

LR L L L

0, R 0, R 0, R 0 (i 1, 2,..., n).

X i Yi 0 1

Thus

LR

(Yi yi ) 1i 0

X i

LR

( X i xi ) i 0

Yi

LR n

i 0

0 i 1

LR n

i X i 0.

1 i 1

Now

X i xi i

Yi yi 1i

0 1 X i yi 1i

0 1 ( xi i ) yi 1i

y 0 1 xi

i i .

2 1

n

Substituting i in

i 1

i 0 , the reduced major axis regression estimate of 0 is obtained as

ˆ0 RM y ˆ1RM x

where ˆ1RM is the reduced major axis regression estimate of 1 . Using X i xi i , i and ˆ0 RM in

n

X

i 1

i i 0 , we get

38

n

yi y 1 x 1 xi yi y 1 x 1 xi

i 1 21

xi

21

0.

Let ui xi x and vi yi y , then this equation can be re-expressed as

n

(v u )(v u 2 x ) 0.

i 1

i 1 i i 1 i 1

n n

Using u V

i 1

i

i 1

i 0, we get

n n

v

i 1

2

i 12 ui2 0.

i 1

Solving this equation, the reduced major axis regression estimate of 1 is obtained as

s yy

ˆ1RM sign( sxy )

sxx

1 if sxy 0

where sign ( sxy )

1 if sxy 0.

We choose the regression estimator which has same sign as of sxy .

The least squares principle advocates the minimization of sum of squared errors. The idea of squaring the

errors is useful in place of simple errors because the random errors can be positive as well as negative. So

consequently their sum can be close to zero indicating that there is no error in the model which can be

misleading. Instead of the sum of random errors, the sum of absolute random errors can be considered

which avoids the problem due to positive and negative random errors.

In the method of least squares, the estimates of the parameters 0 and 1 in the model

n

yi 0 1 xi i . (i 1, 2,..., n) are chosen such that the sum of squares of deviations

i 1

i

2

is minimum. In

the method of least absolute deviation (LAD) regression, the parameters 0 and 1 are estimated such that

n

the sum of absolute deviations

i 1

i is minimum. It minimizes the absolute vertical sum of errors as in the

39

yi

(xi,

Y 0 1 X

(Xi,

)

xi

Least absolute deviation

The LAD estimates ˆ0 L and ˆ1L are the estimates of 0 and 1 , respectively which minimize

n

LAD( 0 , 1 ) yi 0 1 xi

i 1

Conceptually, LAD procedure is simpler than OLS procedure because e (absolute residuals) is a more

straightforward measure of the size of the residual than e 2 (squared residuals). The LAD regression

estimates of 0 and 1 are not available in closed form. Rather they can be obtained numerically based on

algorithms. Moreover, this creates the problems of non-uniqueness and degeneracy in the estimates. The

concept of non-uniqueness relates to that more than one best lines pass through a data point. The degeneracy

concept describes that the best line through a data point also passes through more than one other data points.

The non-uniqueness and degeneracy concepts are used in algorithms to judge the quality of the estimates.

The algorithm for finding the estimators generally proceeds in steps. At each step, the best line is found that

passes through a given data point. The best line always passes through another data point, and this data point

is used in the next step. When there is non-uniqueness, then there are more than one best lines. When there

is degeneracy, then the best line passes through more than one other data point. When either of the problem

is present, then there is more than one choice for the data point to be used in the next step and the algorithm

may go around in circles or make a wrong choice of the LAD regression line. The exact tests of hypothesis

and confidence intervals for the LAD regression estimates can not be derived analytically. Instead they are

derived analogous to the tests of hypothesis and confidence intervals related to ordinary least squares

estimates.

Econometrics | Chapter 2 | Simple Linear Regression Analysis | Shalabh, IIT Kanpur

40

Estimation of parameters when X is stochastic

In a usual linear regression model, the study variable is supped to be random and explanatory variables are

assumed to be fixed. In practice, there may be situations in which the explanatory variable also becomes

random.

Suppose both dependent and independent variables are stochastic in the simple linear regression model

y 0 1 X

where is the associated random error component. The observations ( xi , yi ), i 1, 2,..., n are assumed to be

jointly distributed. Then the statistical inferences can be drawn in such cases which are conditional on X .

are the means of X and y; x2 and y2 are the variances of X and y; and is the correlation coefficient

between X and y . Then the conditional distribution of y given X x is univariate normal conditional

mean

E ( y | X x) y| x 0 1 x

Var ( y | X x) y2| x y2 (1 2 )

where

0 y x 1

and

y

1 .

x

When both X and y are stochastic, then the problem of estimation of parameters can be reformulated as

follows. Consider a conditional random variable y | X x having a normal distribution with mean as

conditional mean y| x and variance as conditional variance Var ( y | X x) y2| x . Obtain n independently

distributed observation yi | xi , i 1, 2,..., n from N ( y| x , y2| x ) with nonstochastic X . Now the method of

maximum likelihood can be used to estimate the parameters which yields the estimates of 0 and 1 as

earlier in the case of nonstochastic X as

41

b y b1 x

and

s

b1 xy

sxx

respectively.

E ( y y )( X x )

y x

can be estimated by the sample correlation coefficient

n

( y y )( x x )

i i

ˆ i 1

n n

( xi x )2

i 1

( y y)

i 1

i

2

sxy

sxx s yy

s

b1 xx .

s yy

Thus

sxx

ˆ 2 b12

s yy

sxy

b1

s yy

n

s yy ˆi2

i 1

s yy

R2

which is same as the coefficient of determination. Thus R 2 has the same expression as in the case when X

is fixed. Thus R 2 again measures the goodness of fitted model even when X is stochastic.

42

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