Econometrics: Combines

Overview
I Econometrics combines:
I Economic Theory
I Math and Statistics
I Data
I Statistical/Econometrics Software
I Primary course objective:
I Provide tools to analyze data
I Provide foundation for the interpretation of the resulting empirical
evidence
I This class:
I Develop theoretical background
I Real-world examples from business and financial economics
I Practical experience working with data
I Centerpiece of the course:
I The multiple regression model
Overview
I Economic Theory
I Data
evidence
I This class:
Overview
I Economic Theory
I Data
evidence
I This class:
Overview
I Economic Theory
I Data
evidence
I This class:
Overview
I Economic Theory
I Data
evidence
I This class:
Materials
I “Introductory Econometrics: A Modern Approach” by J. M.

Wooldridge, 7th Edition, South-Western Cengage Learning
I Optional: Using R for Introductory Econometrics, Florian Heiss,
2nd edition
I Data: Included with the textbook
I Software: R
What is Econometrics?
I Quantitative methods of analyzing and interpreting economic

data: bring economic theory to the data.
I Need to combine:
1. Economic Theory
2. Math and Statistics
3. Data
4. Statistical/Econometrics Software

I Need to combine:
1. Economic Theory
3. Data

I Need to combine:
1. Economic Theory
3. Data
Focus of the class
1. Estimating economic relationships
Hi
2. Testing Hypotheses involving economic behaviours
Of
i
Q o
3. Forecasting the behaviour of economic variables
Focus of the class

Estimating Economic Relationships
I What is the e↵ect of technological change on growth?

I Growth theory
I Data on GDP, capital stock, population, some measure of
technology etc of many countries over time
I What is the return to college education?

I Labor economics
I Data on degree, earning, age, gender, family background etc of
many individuals (possibly over time)

I Growth theory

I Labor economics

I Growth theory

I Labor economics

I Growth theory

I Labor economics
I What is the e↵ect of advertising on sales and profits?

I Marketing/Consumer Behaviour
I Data on history of demand, past advertisement levels, average
income, population, prices of competitors etc
I What is the impact of gas tax rates on the automobile industry?

I Industrial Organization/Environmental Economics
I Data on past prices, taxes, history of demand for gas, income, etc








I What are the impacts of monetary and fiscal policies on
unemployment, income, imports, exports, interest rates, inflation
rates, and budget deficits?
I Macroeconomics
I Data on the above variables
I What are the impacts of a job training program on employment

and wage?
I Theory of job search
I Data on individual characteristics, earnings, unemployment length
etc.
I What is a most profitable auto insurance contract design?

I Expected utility theory, adverse selection theory
I Data on number (frequency, amount) of claims, amount of
deductible, type of cars, marriage status, age, income etc
I Macroeconomics

and wage?
etc.

I Macroeconomics

and wage?
etc.

I Macroeconomics

and wage?
etc.

I Macroeconomics

and wage?
etc.

I Macroeconomics

and wage?
etc.

Focus of the class

Testing
Sale
Otto
flagging
I Has the new advertising campaign of Toyota’s been e↵ective in
increasing sales?
I Is the demand for cars elastic with respect to price?
I Has the monetary policy increased inflation?
I Has the government training program reduced unemployment
duration?
I Has the government investments in police force reduced crime?
I Are moral hazard and adverse selection present in insurance
markets?
Testing
Theta Hig
increasing sales?
pricey demand of far
duration?
markets?
Testing

increasing sales?
inflation Ifmonetary
poling
ftp
f
duration?
markets?
Testing

increasing sales?
70
duration?
markets?
Testing

increasing sales?
duration?
I
Épolia H
Has the government investments in police force reduced crime?
markets?
Testing

increasing sales?
duration?
markets?
Testing

increasing sales?
duration?
markets?
Focus of the class

Forecasting
I The federal government forecasts inflation, unemployment,

budget, and trade deficits
I Analysts on the Wall Street forecast stock prices
I Commercial banks forecast default on loans
I Insurance companies forecast probability of loss
I Firms forecast sales, profits, cost of production, and inventory
requirements
I Infrastructure projects need to estimate future demand (road
building, e.g.)
I Investment banks forecast future interest rates
Forecasting

I
I
O
Analysts on the Wall Street forecast stock prices
Commercial banks forecast default on loans
requirements
building, e.g.)
Forecasting

requirements
building, e.g.)
Forecasting

requirements
building, e.g.)
Forecasting

requirements
building, e.g.)
Forecasting

requirements
building, e.g.)
Forecasting

requirements
building, e.g.)
Data
I Di↵erent data structures:

I Cross-section
I Time series
I Repeated cross-section
I Panel (or longitudinal) data
I The nature of the data significantly a↵ects the econometric

issues that need to be considered
Data

I Cross-section
I Time series

Data

I Cross-section
I Time series

Cross-Section
I Consists of a sample of individuals, households, firms, countries,

etc, taken at a given point in time
I Observations are generally independent draws from the

population (random sample)
I Commonly indexed by i, as xi
Cross-Section
t
Time-Series
stockprice
I Consists of observations on a variable or several variables over
time
I Time series observations are almost never independent of each

other
I Monthly unemployment rate; housing prices; annual GDP
I
o
Commonly indexed by t, as xt
Xxii T periods of
observations
Time-Series
910500
7 38
Repeated Cross-Section
I Consists of two or more cross-sectional data in di↵erent points in

time
I Di↵erent units in di↵erent periods
I Useful for before/after analysis of policy changes
I Commonly indexed by it, as in xit

Repeated Cross-Section
t
Panel Data
I Consists of a time series for each cross-sectional unit in the data

set
I Observations are independent among units, and dependent over

time for each unit
O
I Many survey are of this nature: census, Canadian Household
Panel Survey (CHPS)
I
O
Commonly indexed by it, as in xit
Panel Data
04800
i 2,2
1 2
If
Econometric Methodology
1. Ask a question - Statement of Theory or Hypothesis
2. Specification of Economic Model
3. Specification of Econometric Model
4. Collection of Data
5. Estimation of the Econometric Model
6. Hypothesis Testing
7. Prediction or Forecasting
O
00
An Example
I Ask a Question: What is the e↵ect of Law Enforcement on City

Crime Levels?
I By how much does total crime decrease if number of police

officers increases?
An Example
I Ask a Question: What is the e↵ect of Law Enforcement on City

Crime Levels?
I By how much does total crime decrease if number of police

officers increases?
Economic Model
I A simplification of complex reality

I Individual decides whether or not to commit a crime
I Commit a crime if
U (W0 )  pU (Wc ) + (1 p) U (Wnc )
where
U (.) = utility function
W0 = income if legal activity
p = probability of being caught;
Wc = income if illegal activity and caught
Wnc = income if illegal activity and not caught
I The total number of crimes is denoted by y . Then,
y = f (p, W0 , Wc , Wnc , other factors)

Economic Model

I Commit a crime if
U (W0 )  pU (Wc ) + (1 p) U (Wnc )
where

Economic Model

I Commit a crime if
U (W0 )  pU (Wc ) + (1 p) U (Wnc )
where

Economic Model

I Commit a crime if
U (W0 )  pU (Wc ) + (1 p) U (Wnc )
where

Econometric Model
I Some factors a↵ecting crime decisions are observed, or

measurable, or can be proxied for, like
I The number of police officers (that a↵ects p)
I Average wage in legal work, W0
I Income from other legal sources
I Frequency of conviction
I Average sentence length after conviction
I Other factors are not observable, like

I Income for illegal activities, Wc , Wnc
I Risk-aversion, moral character, family background, etc
Econometric Model
I Some factors a↵ecting crime decisions are observed, or

measurable, or can be proxied for, like
I The number of police officers (that a↵ects p)
I Average wage in legal work, W0
I Income from other legal sources
I Frequency of conviction
I Average sentence length after conviction
I Other factors are not observable, like

I Income for illegal activities, Wc , Wnc
I Risk-aversion, moral character, family background, etc
Econometric Model
I Let x1 , x2 , ..., xk denote all the observables in the data

I Let x1 = number of police officers
I Let u contain all the unobservable factors

I We can NEVER eliminate u entirely
I Then,
y = f (x1 , x2 , ..., xk , u)
= 0 + 1 x1 + 2 x2 + ... + k xk +u
Econometric Model


I Then,
y = f (x1 , x2 , ..., xk , u)
= 0 + 1 x1 + 2 x2 + ... + k xk +u
Econometric Model


I Then,
y = f (x1 , x2 , ..., xk , u)
= 0 + 1 x1 + 2 x2 + ... + k xk +u
Econometric Model


I Then,
y = f (x1 , x2 , ..., xk , u)
= 0 + 1 x1 + 2 x2 + ... + k xk +u
Econometric Model


I Then,
y = f (x1 , x2 , ..., xk , u)
= 0 + 1 x1 + 2 x2 + ... + k xk +u
Data
I Example:
I Cross-section of cities in Canada in 2010
I We have {yi , xi1 , xi2 , ..., xik }, for cities i = 1, ..., N

Data
I Example:

Data
I Example:

Estimation, testing, and forecasting
I Model:
y= 0 + 1 x1 + 2 x2 + ... + k xk +u
I Interest may be on:
I Estimating 1
I Testing if < 0 or 0
1 1
I Forecasting y for some level of x1 .

I Model:
y= 0 + 1 x1 + 2 x2 + ... + k xk +u
I Estimating 1
1 1

I Model:
y= 0 + 1 x1 + 2 x2 + ... + k xk +u
I Estimating 1
1 1

I Model:
y= 0 + 1 x1 + 2 x2 + ... + k xk +u
I Estimating 1
1 1

I Model:
y= 0 + 1 x1 + 2 x2 + ... + k xk +u
I Estimating 1
1 1

Causality and Ceteris Paribus in Econometrics
I How can we infer causality from data?
I Ideally:
I Observe same city with x1 = 90 and x1 = 100 police officers
I Then you have all other things equal (in latin: “ceteris paribus”)
I And check the di↵erence in crime levels
I Impossible!
I Next best:
I Police level force should be assigned independently of the factors
that a↵ect crime
I Eg, randomly assign x1 = 90 and x1 = 100 across cities and check
the di↵erences in crime level
I Yeah, right...
I Ideally:
I Impossible!
I Next best:
that a↵ect crime
I Yeah, right...
I Ideally:
I Impossible!
I Next best:
that a↵ect crime
I Yeah, right...
I Ideally:
I Impossible!
I Next best:
that a↵ect crime
I Yeah, right...
I Ideally:
I Impossible!
I Next best:
that a↵ect crime
I Yeah, right...
I Ideally:
I Impossible!
I Next best:
that a↵ect crime
I Yeah, right...
I Ideally:
I Impossible!
I Next best:
that a↵ect crime
I Yeah, right...
I Problem:
I The size of police force depends on other factors that a↵ect
crime.
I Actually, policy size force and crime level rates are determined
simultaneously.
I Similar problem when estimating demand and supply!
I Estimating causal relationship with nonexperimental data

requires more sophisticated techniques.
I Developing such techniques is one of the main objectives of

Econometrics!
I Problem:
crime.
simultaneously.


Econometrics!
I Problem:
crime.
simultaneously.


Econometrics!
I Problem:
crime.
simultaneously.


Econometrics!
I Problem:
crime.
simultaneously.


Econometrics!
Framework for the Class
I Start with simple regression model:
y= 0 + 1 x1 +u
I Assume:
1. The model is linear
2. We have a random sample
3. Sample x’s are not all of the same value
4. Error u has mean zero, conditional on x
5. The error u is homoskedastic
I How to use regressions to estimate the model?
I Why do we need each assumption?
I When assumptions fail, what can we do?
I You need math to get the intuition
I You need to work with data to understand how to use it
y= 0 + 1 x1 +u
I Assume:
y= 0 + 1 x1 +u
I Assume:
y= 0 + 1 x1 +u
I Assume:
y= 0 + 1 x1 +u
I Assume:
y= 0 + 1 x1 +u
I Assume:
y= 0 + 1 x1 +u
I Assume:
y= 0 + 1 x1 +u
I Assume:
y= 0 + 1 x1 +u
I Assume:
y= 0 + 1 x1 +u
I Assume:
y= 0 + 1 x1 +u
I Assume:
y= 0 + 1 x1 +u
I Assume:
y= 0 + 1 x1 +u
I Assume:
Syllabus
Week Lecture Chapters

1 What is econometrics? Ch 1
2 Review of Statistics Appendix A-D
3 Simple Regression Ch 2
4 Multiple Regression: Introduction Ch 3
5 Multiple Regression: Finite Sample Ch 4 (& Appen
6 Multiple Regression: Asymptotics Ch 5
7 Reading Week ( no class)
8 Midterm
9 Further Issues and Dummy Variables, Heteroskedasticity Ch 6.1-6.2, 7.1-
10 Endogenity: instrumental variables (simple) Ch 15.1, 2, 3, 5
11 Endogenity: instrumental variables (general) Ch 15.1, 2, 3, 5
12 Endogenity: instrumental variables (general) Ch 15.1, 2, 3, 5
13 Review

Econometrics: Combines

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Overview

I “Introductory Econometrics: A Modern Approach” by J. M.

I Quantitative methods of analyzing and interpreting economic

I Quantitative methods of analyzing and interpreting economic

I Quantitative methods of analyzing and interpreting economic

1. Estimating economic relationships

1. Estimating economic relationships

2. Testing Hypotheses involving economic behaviours

3. Forecasting the behaviour of economic variables

I What is the e↵ect of technological change on growth?

I What is the return to college education?

I What is the e↵ect of technological change on growth?

I What is the return to college education?

I What is the e↵ect of technological change on growth?

I What is the return to college education?

I What is the e↵ect of technological change on growth?

I What is the return to college education?

I What is the e↵ect of advertising on sales and profits?

I What is the impact of gas tax rates on the automobile industry?

I What is the e↵ect of advertising on sales and profits?

I What is the impact of gas tax rates on the automobile industry?

I What is the e↵ect of advertising on sales and profits?

I What is the impact of gas tax rates on the automobile industry?

I What is the e↵ect of advertising on sales and profits?

I What is the impact of gas tax rates on the automobile industry?

I What is the e↵ect of advertising on sales and profits?

I What is the impact of gas tax rates on the automobile industry?

I What are the impacts of a job training program on employment

I What is a most profitable auto insurance contract design?

I What are the impacts of a job training program on employment

I What is a most profitable auto insurance contract design?

I What are the impacts of a job training program on employment

I What is a most profitable auto insurance contract design?

I What are the impacts of a job training program on employment

I What is a most profitable auto insurance contract design?

I What are the impacts of a job training program on employment

I What is a most profitable auto insurance contract design?

I What are the impacts of a job training program on employment

I What is a most profitable auto insurance contract design?

1. Estimating economic relationships

2. Testing Hypotheses involving economic behaviours

3. Forecasting the behaviour of economic variables

I Has the new advertising campaign of Toyota’s been e↵ective in

I Has the new advertising campaign of Toyota’s been e↵ective in

I Has the new advertising campaign of Toyota’s been e↵ective in

I Has the new advertising campaign of Toyota’s been e↵ective in

I Has the new advertising campaign of Toyota’s been e↵ective in

1. Estimating economic relationships

2. Testing Hypotheses involving economic behaviours

3. Forecasting the behaviour of economic variables

I The federal government forecasts inflation, unemployment,

I The federal government forecasts inflation, unemployment,

I The federal government forecasts inflation, unemployment,

I The federal government forecasts inflation, unemployment,

I The federal government forecasts inflation, unemployment,

I The federal government forecasts inflation, unemployment,

I The federal government forecasts inflation, unemployment,

I Di↵erent data structures:

I The nature of the data significantly a↵ects the econometric

I Di↵erent data structures:

I The nature of the data significantly a↵ects the econometric

I Di↵erent data structures: