Why Econometrics?

- Review Session

Why do we need Econometrics? Discussion and examples.

1. The number of minutes on the phone spent by a student while in

class is a function (i.e. relation) of class length, income, ] of friends, ]
of students present in class, age (i.e. assume a non linear effect), and
other factors observed or unobserved (i.e. can you think of some?)
2. Can we simplify the statement without losing content? Yes we can !!!

y = f (x1 , x2 , x3 , x4 , x5 , u) (1)

where: y = The number of minutes on the phone spent by a student

while in class, x1 = class length, x2 = income, x3 = ] of friends, x4 =
] of students present in class, x5 = age, and u = error term.
3 What now?

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Guiding Principles
Given the previous research question, how do we proceed?
We need some guiding principles or assumptions to be able to
estimate (the estimation method will be introduced later) the effects
of xj (i.e. independent variables) on y (dependent variable).

Assumption MLR.1: Linear in Parameters (i.e. β(s), not xj (s))

y = β0 + β1 x1 + β2 log (x2 ) + β3 x3 + β4 x4 + β5 x5 + β6 x52 + u (2)

Non linearity is not acceptable(e.g. βj2 , e βj and others).

We need data to estimate the eq. (2) (i.e. the population model), hence:

Assumption MLR.2: Random Sampling (i.e. Why random? Hint:

How do you taste if a soup is done?)
We have a random sample of n obs. {(xi1 , . . . , xi5 , yi )}, i = 1, . . . , n.

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Guiding Principles - continued

Does it make sense to include the same explanatory variable twice in the
model ?
For example, income in NZD (i.e. 50.000 NZD) and income in
thousands of NZD (i.e. 50K NDZ)? Hint: try constructing a sentence
with both incomes. Does it sound naturally?
Another example: including the wife’s salary, husband’s salary and the
household’s income (calculated as the sum of the two salaries) to
explain household consumption.

Assumption MLR.3: No Perfect Collinearity

In the sample (and therefore in the population), none of the independent
variables is constant (e.g. xij = 5 ∀i = 1, . . . n and j = 1, . . . , 5), and there
are no exact linear relationships among the independent variables (e.g.
x1 = 3x2 + 5x4 ).

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Intermission - The Estimation Method
How do we estimate the population parameters β1 , β2 , . . . , β5 ?
Well, let’s rewrite our model in eq. (2):

u = y − β0 − β1 x1 − β2 log (x2 ) − β3 x3 − β4 x4 − β5 x5 − β6 x52

The term, u, represents a difference between what we want to

explain, y , and what we can explain, the independent variables
xj , j = 1, . . . , 5. Naturally, we want to minimize this difference. Why?
Hence, we want our estimators β̂1 , . . . , β̂5 of population parameters
β1 , . . . , β5 to minimize the difference
n
X
2 2
min (yi − b0 − b1 xi1 − b2 log (xi2 ) − b3 xi3 − b4 xi4 − b5 xi5 − b6 xi5 )
i=1

Solved by calculus (see Appendix A-5 in the textbook ). This is an

applied class, so we do not review it. However this is not a reason to
be lazy and not to glance at the Appendix !!!
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Intermission - An Example

Ordinary Least Square (OLS) estimation method

ˆ = 0.500 + 0.167classL + 50log (income) + 0.333]friends

]mins
(3)
+ 0.453]students + 0.298age − 0.006age 2

If classL ↑ by 1 ⇒ ] mins ↑ by 0.167 minutes or 10 seconds.

If ] friends ↑ by 1 ⇒ ] mins ↑ by 0.333 minutes or 20 seconds.
If income ↑ by 1% ⇒ ] mins ↑ by 0.5 minutes or 30 seconds. How?
dx1 100 β1
y = β0 + β1 log (x1 ) ⇒ dy = β1 = %dx1
x1 100 100
If age ↑ by 1 year ⇒ ] mins ↑ by 0.298 − 2 ∗ 0.006 ∗ age mins. How?

y = β0 + β1 x1 + β2 x12 ⇒ dy = (β1 + 2β2 x1 )dx1

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Intermission - Are we happy?

Clearly, the question in the title is rhetorical. We are not happy!!! Why?
At this point, we can not claim much about the population. Only
about the sample of students.
We have the β̂j , j = 0, . . . , 6, but we are interested in the population
parameters βj , j = 0, . . . , 6 and we do not know much about them.
For example, just because βˆ1 = 0.167, it does not mean β1 = 0.167!!!
What would happen if we collect another sample of students and
estimate β1 again? Would βˆ1 still be equal to 0.167?
We want some assumptions that allow us to claim that our β̂j are
“closed” to βj . Hence, this is what we will be doing next.

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Guiding Principles - continued

Change of pace. What happens if we want to estimate wage as a function

of education and ability, but we do not observe ability?

wage = β0 + β1 Educ. + β2 x2 + · · · + βk xk + u + ability (4)

Intuition:
1. An additional year of Education should increase the wage received.
2. Ability is correlated with Wage. People with higher ability likely to
have higher wages everything else constant. Do you agree?
3. Ability is correlated to education. People with higher ability more
likely to have more years of education.

Assumption MLR.4: Zero Conditional Mean

E (u|x1 , . . . xk ) = 0 (5)

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Guiding Principles: MLR.1 to MLR.4 ⇒ Unbiasedness
Under assumptions MLR.1 through MLR.4, we have:
Unbiasedness
E (β̂j ) = βj , j = 1, . . . k, (6)
where β̂j is the sample estimate, and βj is the population parameter.

1 Why should we care? Hint: We are interested in the population and

not the sample.
2 When we use a random sample, we obtain a sample estimate β̂j which
is not necessary equal to the population βj . Example, our estimate of
class length on number of minutes could be β̂1 = 0.167. It does not
mean that β1 = 0.167.
3 However the procedure of obtaining β̂j across all possible random
samples, assures us that “on average” our estimate is equal to the
population parameter.
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Guiding Principles - another one

Now, we have a measure of the central tendencies of our estimates β̂j .

However, we also want a measure of the spread in their sampling
distribution. Why?
Hint: what is the simple average of 1 and −1? How about 100 and
−100?
Hence another assumption:
MLR.5: Homoskedasticity
The error u has the same variance give any value of the explanatory
variables.
Var (u|x1 , . . . xk ) = σ 2 (7)

Do not get to attached to this assumption because it is the first

assumption to relax. Hint: Heteroskedasticy !!!

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Guiding Principles: Variance and Standard Deviation

Under assumptions MLR.1 through MLR.5, we have:

Sampling Variance
σ2
Var (β̂j ) = (8)
SSTj (1 − Rj2 )
where SSTj = ni=1 (xij − x̄j )2 and Rj2 is the R - squared from regressing
P
xj on all other independent variables and an intercept.

and the standard deviation (do not confuse with the standard error) is
q
sd(β̂j ) = Var (β̂j ) (9)

A low sd(β̂j ) indicates our estimates are closed to the population mean.
However, we do not know σ 2 ⇒ need to estimate it !!!

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Guiding Principle at work: Standard Error
We have σ 2 = E (u 2 ) − E (u)2 = E (u 2 ). Why? We do not observe u.
Why? (Hint: do we know βj ?).
Then we use second best: ûi = yi − β̂0 − β̂1 xi1 − · · · − β̂j xij
Hence, σ̂ 2 = ni=1 ûi2 /(n − k − 1)
P

From where,
σ̂
se(β̂j ) =
[SSTj (1 − Rj2 )]1/2

A low se(β̂j ) indicates our estimates are closed to the population mean.
But, can we “trust” σ̂ and se(β̂j )?

Unbiased Estimation of σ 2
MLR.1 through MLR.5 ⇒ E (σ̂ 2 ) = σ 2

NOTE: MLR.5 (Homoskedasticity) is crucial. Without MLR.5 se(β̂j )

is not a valid estimator of sd(β̂j ).
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Guiding Principles: MLR.1 to MLR.5 ⇒ BLUE

Under assumptions MLR.1 through MLR.5, we have:

Gauss-Markov Theorem
Our sample estimates β̂0 , β̂0 , . . . β̂k are the best linear unbiased estimators
(BLUEs) of β0 , β1 , . . . , βk respectively.

We have a measure of centrality and dispersion (good for describing the

precision of our estimates). But, we would like to perform statistical
inference. Hence:
Assumption MLR.6: Normality
The population error u is independent of the explanatory variables
x1 , . . . , xj and is normally distributed with zero mean and variance σ 2 :
u ∼ Normal(0, σ 2 ).

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Statistical Inference

Normal Sampling Distributions

MLR.1 through MLR.6 ⇒ β̂j ∼ Normal(βj , Var (β̂j )). Hence,
(β̂j − βj )/sd(β̂j ) ∼ Normal(0, 1)

from where
t Distribution for the Standardized Estimators
MLR.1 through MLR.6 ⇒ (β̂j − βj )/se(β̂j ) ∼ tn−k−1

Again, why should we care? Because now we can test hypothesis such as:

H0 : βj = 0 (10)

What happened if we can not reject the null hypothesis?

How do we test the hypothesis? tβ̂j ≡ β̂j /se(β̂j ). See Table G.2.
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Final Example - For now

ˆ = 0.500 + 0.167 classL + 50.000 log (income) + 0.333 ]friends

]mins
(0.128) (0.083) (1.247) (0.113)
+ 0.453 ]stud + 0.298 age − 0.006 age 2
(0.230) (0.041) (0.0009)
(11)

Some information: R 2 = 0.723, n = 500, j + 1 = 7, F = 188.826.

H0 : β 1 = 0 (12)

tβ̂1 = 0.167/0.083 = 2.019 > 1.96 = c

We say β̂1 is statistically significant at 5% significance level.

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