What is econometrics?

The study of econometrics has become an essential part of every undergraduate course

in economics, and it is not an exaggeration to say that it is also an essential part of

every economist’s training. This is because the importance of applied economics is

constantly increasing, and the ability to quantify and evaluate economic theories and

hypotheses constitutes now, more than ever, a bare necessity. Theoretical economics

may suggest that there is a relationship between two or more variables, but applied

economics demands both evidence that this relationship is a real one, observed in

everyday life, and quantification of the relationship between the variables. The study

of the methods that enable us to quantify economic relationships using actual data is

known as econometrics.

Literally, econometrics means ‘measurement [the meaning of the Greek word metrics]

in economics’. However, econometrics includes all those statistical and mathemat-

ical techniques that are utilized in the analysis of economic data. The main aim

of using these tools is to prove or disprove particular economic propositions and

models.

The stages of applied econometric work

Applied econometric work always takes (or, at least, should take) as its starting point a

model or an economic theory. From this theory, the first task of the applied econome-

trician is to formulate an econometric model that can be tested empirically. The next

tasks are to collect data that can be used to perform the test and, after that, to proceed

with the estimation of the model.

After this estimation of the model, the applied econometrician performs specification

tests to ensure that the model used was appropriate and to check the performance and

accuracy of the estimation procedure. If these tests suggest that the model is adequate,

hypothesis testing is applied to check the validity of the theoretical predictions, and

then the model can be used to make predictions and policy recommendations. If the

specification tests and diagnostics suggest that the model used was not appropriate,

the econometrician must go back to the formulation stage and revise the econometric
model, repeating the whole procedure from the beginning.

The purpose of this textbook

This book provides students with the basic mathematical and analytical tools they

require to carry out applied econometric work of this kind.

For the first task, formulating an econometric theory, the book adopts a very anal-

ytical and simplified approach. For the subsequent tasks, it explains all the basic

commands for obtaining the required results from economic data sets using econo-

metric software.

The use and level of mathematics

The use of mathematics in econometrics is unavoidable, but the book tries to satisfy

both those students who do not have a solid mathematical background and those who

prefer the use of mathematics for a more thorough understanding. To achieve this

aim, the book provides, when required, both a general and a mathematical treatment

of the subject, in separate sections. Thus students who do not want to get involved

with proofs and mathematical manipulations can concentrate on the general (verbal)

approach, skipping the more mathematical material, without any loss of continuity. On

the other hand, readers who want to go through the mathematics involved in every

topic can study these mathematical sections in each chapter. To accommodate this

choice, the text uses matrix algebra to prove some important concepts mathematically,

while the main points of the analysis are also presented in a simplified manner to make

the concept accessible to those who have not taken a course in matrix algebra.

Another important feature of the text is that it presents all the calculations required

to get the student from one equation to another, as well as providing explanations of

the mathematical techniques used to derive these equations. Students with a limited

background in mathematics will find some of the mathematical proofs quite accessible,

and should therefore not be disheartened when progressing through them.

The use of econometric software and real data examples

From the practical or applied econometrics point of view, this book is innovative in two

ways: (1) it presents all the statistical tests analytically (step by step), and (2) it explains
how each test can be carried out using econometric software such as EViews, Stata

and Microfit. We think this approach is one of the strongest features of the book, and

hope that students will find it useful when they apply these techniques to real data.

It was chosen because, from our teaching experience, we realized that students find

econometrics a relatively hard course simply because they cannot see the ‘beauty’ of it,

which emerges only when they are able to obtain results from actual data and know

how to interpret those results to draw conclusions. Applied econometric analysis is the

essence of econometrics, and we hope that using EViews, Stata and Microfit will make

the study of econometrics fascinating and its practice more satisfying and enjoyable.

Readers who need a basic introduction to EViews, Stata and Microfit should first read the final chapter
(Chapter 23), which discusses the practicalities of using these three

econometric packages.

Why Study Econometrics?

Econometrics is fundamental for economic measurement. However, its importance extends far

beyond the discipline of economics. Econometrics is a set of research tools also employed in

the business disciplines of accounting, finance, marketing, and management. It is used by social

scientists, specifically researchers in history, political science, and sociology. Econometrics plays

an important role in such diverse fields as forestry and agricultural economics. This breadth of

interest in econometrics arises in part because economics is the foundation of business analysis

and is the core social science. Thus, research methods employed by economists, which includes

the field of econometrics, are useful to a broad spectrum of individuals.

Econometrics plays a special role in the training of economists. As a student of economics,

you are learning to “think like an economist.” You are learning economic concepts such as oppor-

tunity cost, scarcity, and comparative advantage. You are working with economic models of

supply and demand, macroeconomic behavior, and international trade. Through this training you

become a person who better understands the world in which we live; you become someone who

understands how markets work, and the way in which government policies affect the marketplace.

If economics is your major or minor field of study, a wide range of opportunities is open to

you upon graduation. If you wish to enter the business world, your employer will want to know
the answer to the question, “What can you do for me?” Students taking a traditional economics

curriculum answer, “I can think like an economist.” While we may view such a response to be

powerful, it is not very specific and may not be very satisfying to an employer who does not

understand economics.

The problem is that a gap exists between what you have learned as an economics student

and what economists actually do. Very few economists make their livings by studying economic

theory alone, and those who do are usually employed by universities. Most economists, whether

they work in the business world or for the government, or teach in universities, engage in economic

analysis that is in part “empirical.” By this we mean that they use economic data to estimate

economic relationships, test economic hypotheses, and predict economic outcomes.

Studying econometrics fills the gap between being “a student of economics” and being

“a practicing economist.” With the econometric skills you will learn from this book, including

how to work with econometric software, you will be able to elaborate on your answer to the

employer’s question above by saying “I can predict the sales of your product.” “I can estimate the

effect on your sales if your competition lowers its price by $1 per unit.” “I can test whether your

new ad campaign is actually increasing your sales.” These answers are music to an employer’s

ears, because they reflect your ability to think like an economist and to analyze economic data.

Such pieces of information are keys to good business decisions. Being able to provide your

employer with useful information will make you a valuable employee and increase your odds of

getting a desirable job.

On the other hand, if you plan to continue your education by enrolling in graduate school or

law school, you will find that this introduction to econometrics is invaluable. If your goal is to earn

a master’s or Ph.D. degree in economics, finance, data analytics, data science, accounting, mar-

keting, agricultural economics, sociology, political science, or forestry, you will encounter more

econometrics in your future. The graduate courses tend to be quite technical and mathematical,

and the forest often gets lost in studying the trees. By taking this introduction to econometrics

you will gain an overview of what econometrics is about and develop some “intuition” about how

things work before entering a technically oriented course.