Topic 3a Correlation Theory

Dr. Olalekan Aworinde

Department of Economics
Babcock University
Ilishan-Remo

These presentation notes are based on Theory of Econometrics Second Edition by

A. Koutsoyiannis
De…nition of Correlation

It is de…ned as the degree of relationship existing between two or

more variables
The degree of relationship existing between two variables is called
simple correlation.
The degree of relationship connecting three or more variable is called
multiple correlation.
Correlation is said to be linear when all points (X, Y) on a scatter
diagram seem to cluster near a straight line, or nonlinear, when all
points seems to lie near a curve.
Two variables may have a positive correlation, negative correlation or
they may be uncorrleated and this holds for both linear and nonlinear
correlation.
Positive Correlation

Two variables are said to be positively correlated if they tend to

change together in the same direction, that is, if they tend to increase
or decrease together.
An example of positive correlation in economic theory is price and
quantity supplied. When the price increases the quantity supplied
increases and when price falls the quantity supplied decreases.
The scatter diagram of two variables positively correlated appears in
the Figure below.
All points in the scatter diagram seem to lie near a line or a curve
with a positive slope.
If all points lie on the line or curve the correlation is said to be perfect
positive.
Positive Correlation (Cont’d)

Positive Linear Correlation

Positive Nonlinear Correlation

Negative Correlation

Two variables are said to be negatively correlated if they tend to

change together in the opposite direction, that is, when X increases Y
decreases and vice versa.
An example of negative correlation in economic theory is price and
quantity demanded. When the price increases the quantity demanded
decreases and when price falls the quantity demanded increases.
The scatter diagram of two variables negatively correlated appears in
the Figure below.
All points in the scatter diagram seem to lie near a line or a curve
with a negative slope.
If all points lie on the line or curve the correlation is said to be perfect
negative.
Negative Correlation (Cont’d)

Negative Linear Correlation

Negative Nonlinear Correlation

Zero Correlation

Two variables are uncorrelated when they tend to change with no

connection to each other.
The scatter diagram shows that the points are dispersed all over the
surface of the XY plane.
For example one should expect zero correlation between the weight of
students and the colour of their hair.

X
Zero Correlation
Measure of Linear Correlation

For a precise quantitative measurement of the degree of correlation

between Y and X we use a parameter called the correlation coe¢ cient.
The sample correlation coe¢ cient is given as;
Σxi yi
rXY = r (1)
Σxi2 .Σyi2

where xi = Xi X̄ and yi = Yi Ȳ
If the sum of all products of the deviations of variables X and Y from
their means is positive, the correlation between X and Y will be
positive. Symbolically, if
n n
Σ (Xi X̄i ) (Yi Ȳi ) = Σxi yi > 0 (2)
i i
Measure of Linear Correlation (Cont’d)

If the sum of all products of the deviations of variables X and Y from

their means is negative, the correlation between X and Y will be
negative. Symbolically, if
n n
Σ (Xi X̄i ) (Yi Ȳi ) = Σxi yi < 0 (3)
i i

The sum of the products of the deviations Σxi yi provides a measure

of the association between X and Y .
The measure has two de…ciency, …rst, it is a¤ected by the number of
observations. Second, it is a¤ected by the units of measurement of
the variables X and Y .
To correct the …rst defect, we divide the sum Σxi yi by the number of
observations n;

Σxi yi
= SXY (4)
n
Measure of Linear Correlation (Cont’d)

Equation 4 is the covariance of X and Y and is obviously a better

measure of correlation than the sum of Σxi yi ,because it will not
change directly with the number of observations in the sample.
To correct the second defect, we divide the covariance by the
standard deviations of the variables and it is given as;
n
Σxi yi
i
r= (5)
nSX SY
where SXY = covariance of X and Y = Σxi yi /n
q 2
q
Σ(X i X̄ ) Σxi
SX = standard deviation of X , SX = n = n
q 2
q
Σ(Y i Ȳ )
SY = standard deviation of Y , SY = n = Σyn i
Measure of Linear Correlation (Cont’d)

Substituting the values of SX SY , SX and SY into equation 5 we have,

Σxi yi Σxi yi
r= q =q (6)
n (Σxi2 /n)(Σyi2 /n) (Σxi2 )(Σyi2 )

The expression in equation 6 is the deviations of the variables from

their means. The expression for the actual values is of the form;

nΣ(Xi Yi ) (ΣXi )(ΣYi )

r= r q (7)
nΣXi2 (ΣXi )2 nΣYi2 (ΣYi )2
Measure of Linear Correlation (Cont’d)

The numerator of equation 6 can be expanded as follows

Σxy = Σ(X X̄ )(Y Ȳ ) = Σ(XY Y X̄ X Ȳ + X̄ Ȳ )

ΣX ΣY ΣX ΣY
= ΣXY X̄ ΣY Ȳ ΣX + nX̄ Ȳ = ΣXY ΣY ΣX + n
n n n n

nΣXY ΣX ΣY
= (8)
n
The denominator of equation 6 can also be expanded as follows
Measure of Linear Correlation (Cont’d)

Σx 2 = Σ(X X̄ )2 = Σ(X 2 2X X̄ + X̄ 2 ) = ΣX 2 2X̄ ΣX + nX̄ 2

ΣX
= ΣX 2 2X̄ ΣX + nX
n

= ΣX 2 X̄ ΣX

(ΣX )2
= ΣX 2
n

nΣX 2 (ΣX )2
= (9)
n
Measure of Linear Correlation (Cont’d)

Similarly
nΣY 2 (ΣY )2
Σy 2 = (10)
n
Substituting equations 8, 9 and 10 into equation 6 we get

fnΣXY (ΣX )(ΣY )g/n

r= p p
fnΣX 2 (ΣX )2 g/n fnΣY 2 (ΣY )2 g/n

nΣXY (ΣX )(ΣY )

r= p p (11)
nΣX 2 (ΣX )2 nΣY 2 (ΣY )2
Numerical Values of the Correlation Coe¢ cient

The values for the correlation coe¢ cient is between 1 and +1.
When r is positive, it implies X and Y increase or decrease together.
If r = +1 it implies that there is perfect positive correlation between
X and Y.
Similarly, when r is negative, it implies X and Y move in opposite
direction
If r = 1 it implies that there is perfect negative correlation between
X and Y.
When r = 0 it implies that X and Y are uncorrelated.
The …gure below shows perfect positive and negative correlation.
Numerical Values of the Correlation Coe¢ cient (Cont’d)

Y Y

X X
r = +1 r = -1
Perfect Positive Correlation Perfect Negative Correlation
Proof that Numerical Values of the Correlation Coe¢ cient
is Unity
We can proof that r = 1 when the two variables are perfectly linearly
correlated.

Y X

y=Y-Y

Y θ

x=X- X

X
Proof that Numerical Values of the Correlation Coe¢ cient
is Unity (Cont’d)

In the above …gure we can picture a case of perfect positive

correlation between X and Y.
The line depicting the relation forms an angle θ with the parallel Ȳ Ȳ
to the horizontal axis. From elementary trigonometry tan θ = y /x.
Therefore f(x ).(tan θ )g = y . Substituting this into equation 6 we
…nd;
Σxy Σx (x ).(tan θ )
r= p =p
Σx Σy
2 2 Σx 2 Σf(x ).(tan θ )g2
(tan θ ).(Σx 2 ) (tan θ )(Σx 2 )
r= p =p =1 (12)
(Σx 2 ).(tan θ )2 .(Σx 2 ) (tan θ )2 .(Σx 2 )2
Measure of Linear Correlation (Cont’d)

Sample Correlation Coe¢ cient rYX

n Yi Xi xi yi xi2 yi2 xi yi Xi Yi Xi2 Yi2
1 10 2 -9 -51 81 2601 459 20 4 100
2 20 4 -7 -41 49 1681 287 80 16 400
3 50 6 -5 -11 25 121 55 300 36 2500
4 40 8 -3 -21 9 441 63 320 64 1600
5 50 10 -1 -11 1 121 11 500 100 2500
6 60 12 1 -1 1 1 -1 720 144 3600
7 80 14 3 19 9 361 57 1120 196 6400
8 90 16 5 29 25 841 145 1440 256 8100
9 90 18 7 29 49 841 203 1620 324 8100
10 120 20 9 59 81 3481 531 2400 400 14400
n=10 610 110 0 0 330 10490 1810 8520 1540 47700
Measure of Linear Correlation (Cont’d)

Similarly
nΣY 2 (ΣY )2
Σy 2 = (13)
n
Substituting equations 8, 9 and 10 into equation 6 we get

fnΣXY (ΣX )(ΣY )g/n

r= p p
fnΣX 2 (ΣX )2 g/n fnΣY 2 (ΣY )2 g/n

nΣXY (ΣX )(ΣY )

r= p p (14)
nΣX 2 (ΣX )2 nΣY 2 (ΣY )2
Measure of Linear Correlation (Cont’d)

Similarly
nΣY 2 (ΣY )2
Σy 2 = (15)
n
Substituting equations 8, 9 and 10 into equation 6 we get

fnΣXY (ΣX )(ΣY )g/n

r= p p
fnΣX 2 (ΣX )2 g/n fnΣY 2 (ΣY )2 g/n

nΣXY (ΣX )(ΣY )

r= p p (16)
nΣX 2 (ΣX )2 nΣY 2 (ΣY )2