Correlation

In theory of demand, the quantity demand of a commodity is related to its own price.
Similarly, the income of the consumers and the prices of related goods are related. A
firm's production function is a technical relation showing how inputs are transformed
into outputs. It measures in terms of relationship between outputs and inputs such as land,
labour and capital. Therefore, the numerical measurement for the relationship
between/among two or more variables is called correlation. It is also called Coefficient of
Correlation, r for sample observation and p for population.

Let us consider n pairs of observations (x1 , yi), i : 1,2,3, ......, n. Then the coefficient of
correlation r between x and v is defined as

I(', -"Xv,-v)

where i and y are the means of x

ffi
and y respectively. The numerator is called the Sum
(1)

of Products, S.P.(xy), between x and y. Thus,

I(", - "Xy, - y)= I(", -*)y, - r>,(*, - *)

=I(*, _x)y, _y"O
= I(r, _*)y,
Similarly, IG, -xXy, - y) = I(V, -Vb,
and I(*, -xXv, -y) = Z*,y, - I*'IY'
n

Therefbre, r- ,Z*,v, -Z*,}v,

l{,2. :- (r,, )'Y\,>,r / - Ev,r F'

r is often known as the product moment or Pearsonian coefficient of correlation. Further,
S.P.(x,y)

o The coefficient of correlation lies between -l and l.

o When it is positive, one variable tends to increase as the other increases.
o When it is negative, one variable tends to decrease as the other increases.
o When r: 0 the variables are said to be uncorrelated.
/

a When r : + l. the correlation is said to be perf-ect.

a The closer the value of r to either +1 or -1" the stronger is the relationship between x
and y. and the closer it is to zero. the weaker is the relationship.
It measurcs the strength of Iirrear relationship only.

Partial and Multiple Correlation

The coefficient of correlation r,, between x, and .rr2 measures the intensity of linear
relationship between these variables. This coefficient, however, ignores other variables
that may influence either or both of these variables. Thus we may ask whether an
observed value r,, is merely due to the fact that both x, and x2 are influenced by a third
variable JU3, or whether there is net association between x, and x, after the effect of x,
has been eliminated. For this purpose we require partial correlation coefficients. The
partial correlation coefficient between x, and x, eliminating the effect of x, is denoted
by frz.: or 121.3. For the number of n variables partial correlation coefficient is denoted
bY rrz.(:+...,.,) .

A partial correlation of the first order can be expressed in terms of total correlation
coefficients. The fundamental formula in this respect is
r0
t12.3 =
W - \3 r23

Similarly, tt2.34_ffi
\2.q - \z.q rzs.q

Thus, starting with the total correlation coefficients we can calculate successively partial
coefficients of any order.

To find the correlation between a dependent variable y and its estimate Y obtained from a
multiple regression equation containing n independent variables. This coefficient of
correlation is known as the coefficient of multiple Correlation and is often denoted by
Ry.(12.....n) or simply R. Therefore,

2
 R11t:...n) = ,s..s.(1,)

to y' from the regression eqllation'

where Yi is the estimate correspollding
coefllcient R1123)is expressed in terms
of simple
Similarly. the mr-rltiple correlation
coffelation as

t',.2 *Ii-.1 - 2rr. t'rrr.a

Ri(zr) =
7 - r'zt'

o Test of Correlation Coefficient

Ho:P=Po
H,: p+Po -
We define
l. l+r
-7 = -2los
-'1-r'
-
l. l+pn
and * = ,log'1-p.

Then the test statistic is

as a standard normal variate'
a = Q - fiJ, 'Z which is treated
This is an approximate test and as
usual + l'96 are the critical values at 5o/o level of
significace.

Example:
Samplesize, n=30, r:0j2 and p: 0.50.

Ho:P=Po=0.50
Hr: P+0.50
We define

, =:,o*"I#=o'33
and ,, = :,o*"fffi = o'55 '

a
J
Then the test statistic is

d= (r- m)Jl

r:ti:j?f
Since iO] is tess than 1.96, it is consider insignificant at 5%o level. Herrce the hypothesia
is accepted.

4
 I

The coef llcient of correlation lies betrveen -l and +1.

r Proof :

Since the coefllcient of correlation betu,een trvo variables is independent of origin.

we can assume u,ithout any loss of generality that the variables are rleasured from
their means. l'hat is, x : y = 0.

: I Q, * y)' . n here c is an arbitrary number.

Consider the expression S

Then s = I b' *' * 2cxy +t' )> 0 for all values of c.

or, ,'Zr' _ zrZx.], + Z y2 >o for all c. (l)

Purting
" . = I+
Ir'
in 1l). $e have

tr4+F,2*r(I".)'=o
-
I" L" \'*'
Multiplying both sides by Ir', we get

E rY *(I,'YZr')-zg,v)' >o
or, (I,,XIrr)r (I,r)'
(}.
or. l> '4-""")' (2)
f ,, L,,,
(5-
But yt" -_)4'-L"r)2 ^_.rvhen 1: y=0.
Z*'Zr'
From (2) ,2 .l
Or, - I < r < +l