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 CONTENTS

Preface xiii
Acknowledgments xvii
A personal message from the author xx
List of tables xxii
List of figures xxix

Part I: Basics of linear regression

1 The linear regression model: an overview 2

1.1 The linear regression model 2
1.2 The nature and sources of data 5
1.3 Estimation of the linear regression model 6
1.4 The classical linear regression model (CLRM) 8
1.5 Variances and standard errors of OLS estimators 10
1.6 Testing hypotheses about the true or population regression coefficients 11
1.7 R2: a measure of goodness of fit of the estimated regression 13
1.8 An illustrative example: the determinants of hourly wages 14
1.9 Forecasting 19
1.10 The road ahead 19
Exercises 22
Appendix: The method of maximum likelihood (ML) 25
2 Functional forms of regression models 28
2.1 Log-linear, double log or constant elasticity models 28
2.2 Testing validity of linear restrictions 32
2.3 Log-lin or growth models 33
2.4 Lin-log models 36
2.5 Reciprocal models 38
2.6 Polynomial regression models 40
2.7 Choice of the functional form 42
2.8 Comparing linear and log-linear models 43
2.9 Regression on standardized variables 44
2.10 Regression through the origin: the zero-intercept model 46
2.11 Measures of goodness of fit 49
2.12 Summary and conclusions 50
VIII CONTENTS

Exercises 51
3 Qualitative explanatory variables regression models 53
3.1 Wage function revisited 53
3.2 Refinement of the wage function 55
3.3 Another refinement of the wage function 56
3.4 Functional form of the wage regression 59
3.5 Use of dummy variables in structural change 61
3.6 Use of dummy variables in seasonal data 64
3.7 Expanded sales function 66
3.8 Piecewise linear regression 69
3.9 Summary and conclusions 73
Exercises 74

Part II: Regression diagnostics

4 Regression diagnostic I: multicollinearity 80

4.1 Consequences of imperfect collinearity 81
4.2 An example: married women’s hours of work in the labor market 84
4.3 Detection of multicollinearity 85
4.4 Remedial measures 87
4.5 The method of principal components (PC) 89
4.6 Summary and conclusions 92
Exercises 93
5 Regression diagnostic II: heteroscedasticity 96
5.1 Consequences of heteroscedasticity 96
5.2 Abortion rates in the USA 97
5.3 Detection of heteroscedasticity 100
5.4 Remedial measures 103
5.5 Summary and conclusions 110
Exercises 110
6 Regression diagnostic III: autocorrelation 113
6.1 US consumption function, 1947–2000 113
6.2 Tests of autocorrelation 115
6.3 Remedial measures 121
6.4 Model evaluation 126
6.5 Summary and conclusions 129
Exercises 129
7 Regression diagnostic IV: model specification errors 131
7.1 Omission of relevant variables 131
7.2 Tests of omitted variables 135
7.3 Inclusion of irrelevant or unnecessary variables 138
7.4 Misspecification of the functional form of a regression model 139
7.5 Errors of measurement 141
7.6 Outliers, leverage and influence data 142
7.7 Probability distribution of the error term 145
7.8 Random or stochastic regressors 147
 CONTENTS IX

7.9 The simultaneity problem 147

7.10 Dynamic regression models 153
7.11 Summary and conclusions 162
Exercises 163
Appendix: Inconsistency of the OLS estimators of the
consumption function 167 I
Part III: Topics in cross-section data

8 The logit and probit models 170

8.1 An illustrative example: to smoke or not to smoke 170
8.2 The linear probability model (LPM) 171
8.3 The logit model 172
8.4 The language of the odds ratio (OR) 180
8.5 The probit model 181
8.6 Summary and conclusions 184
Exercises 185
9 Multinomial regression models 190
9.1 The nature of multinomial regression models 190
9.2 Multinomial logit model (MLM): school choice 192
9.3 Conditional logit model (CLM) 198
9.4 Mixed logit (MXL) 201
9.5 Summary and conclusions 201
Exercises 203
10 Ordinal regression models 206
10.1 Ordered multinomial models (OMM) 207
10.2 Estimation of ordered logit model (OLM) 207
10.3 An illustrative example: attitudes toward working mothers 209
10.4 Limitation of the proportional odds model 212
10.5 Summary and conclusions 215
Exercises 216
Appendix: Derivation of Eq. (10.4) 218
11 Limited dependent variable regression models 219
11.1 Censored regression models 220
11.2 Maximum likelihood (ML) estimation of the censored regression
model: the Tobit model 223
11.3 Truncated sample regression models 227
11.4 A concluding example 229
11.5 Summary and conclusions 232
Exercises 233
Appendix: Heckman’s (Heckit) selection-bias model 234
12 Modeling count data: the Poisson and negative binomial regression models 236
12.1 An illustrative example 236
12.2 The Poisson regression model (PRM) 238
12.3 Limitation of the Poisson regression model 242
12.4 The Negative Binomial Regression Model (NBRM) 244
X CONTENTS

12.5 Summary and conclusions 244

Exercises 245

Part IV: Time series econometrics

13 Stationary and nonstationary time series 250

13.1 Are exchange rates stationary? 250
13.2 The importance of stationary time series 251
13.3 Tests of stationarity 251
13.4 The unit root test of stationarity 255
13.5 Trend stationary vs. difference stationary time series 258
13.6 The random walk model (RWM) 262
13.7 Summary and conclusions 266
Exercises 267
14 Cointegration and error correction models 269
14.1 The phenomenon of spurious regression 269
14.2 Simulation of spurious regression 270
14.3 Is the regression of consumption expenditure on disposable income
spurious? 271
14.4 When a spurious regression may not be spurious 274
14.5 Tests of cointegration 275
14.6 Cointegration and error correction mechanism (ECM) 276
14.7 Are 3-month and 6-month Treasury Bill rates cointegrated? 278
14.8 Summary and conclusions 280
Exercises 281
15 Asset price volatility: the ARCH and GARCH models 283
15.1 The ARCH model 284
15.2 The GARCH model 290
15.3 Further extensions of the ARCH model 292
15.4 Summary and conclusions 294
Exercises 295
16 Economic forecasting 296
16.1 Forecasting with regression models 296
16.2 The Box–Jenkins methodology: ARIMA modeling 302
16.3 An ARMA model of IBM daily closing prices, 3 January 2000 to
31 October 2002 304
16.4 Vector autoregression (VAR) 310
16.5 Testing causality using VAR: the Granger causality test 315
16.6 Summary and conclusions 319
Exercises 320
Appendix: Measures of forecast accuracy 323

Part V: Selected topics in econometrics

17 Panel data regression models 326

17.1 The importance of panel data 326
17.2 An illustrative example: charitable giving 327
 CONTENTS XI

17.3 Pooled OLS regression of charity function 328

17.4 The fixed effects least squares dummy variable (LSDV) model 330
17.5 Limitations of the fixed effects LSDV model 332
17.6 The fixed effect within group (WG) estimator 333
17.7 The random effects model (REM) or error components model (ECM) 335
17.8 Fixed effects model vs. random effects model 336 I
17.9 Properties of various estimators 339
17.10 Panel data regressions: some concluding comments 339
17.11 Summary and conclusions 340
Exercises 341
18 Survival analysis 344
18.1 An illustrative example: modeling recidivism duration 344
18.2 Terminology of survival analysis 345
18.3 Modeling recidivism duration 348
18.4 Exponential probability distribution 348
18.5 Weibull probability distribution 351
18.6 The proportional hazard model 353
18.7 Summary and conclusions 355
Exercises 356
19 Stochastic regressors and the method of instrumental variables 358
19.1 The problem of endogeneity 359
19.2 The problem with stochastic regressors 360
19.3 Reasons for correlation between regressors and the error term 363
19.4 The method of instrumental variables 367
19.5 Monte Carlo simulation of IV 369
19.6 Some illustrative examples 370
19.7 A numerical example: earnings and educational attainment of
youth in the USA 373
19.8 Hypothesis testing under IV estimation 378
19.9 Test of endogeneity of a regressor 379
19.10 How to find whether an instrument is weak or strong 381
19.11 The case of multiple instruments 381
19.12 Regression involving more than one endogenous regressor 384
19.13 Summary and conclusions 385
Exercises 387
20 Beyond OLS: quantile regression 390
20.1 Quantiles 391
20.2 The quantile regression model (QRM) 392
20.3 The quantile wage regression model 392
20.4 Median wage regression 396
20.5 Wage regressions for 25%, 50% and 75% quantiles 397
20.6 Test of coefficient equality of different quantiles 400
20.7 Summary of OLS and 25th, 50th (median) and 75th quantile
regressions 401
20.8 Quantile regressions in Eviews 8 402
20.9 Summary and conclusions 403
XII CONTENTS

Exercises 404
Appendix: The mechanics of quantile regression 405
21 Multivariate regression models 407
21.1 Some examples of MRMs 407
21.2 Advantages of joint estimation 408
21.3 An illustrative example of MRM estimation with the same
explanatory variables 409
21.4 Estimation of MRM 410
21.5 Other advantages of MRM 413
21.6 Some technical aspects of MRM 414
21.7 Seemingly Unrelated Regression Equations (SURE) 417
21.8 Summary and conclusions 419
Exercises 422
Appendix 424

Appendices

1 Data sets used in the text 425

2 Statistical appendix 436
A.1 Summation notation 436
A.2 Experiments 437
A.3 Empirical definition of probability 438
A.4 Probabilities: properties, rules, and definitions 439
A.5 Probability distributions of random variables 439
A.6 Expected value and variance 442
A.7 Covariance and correlation coefficient 444
A.8 Normal distribution 445
A.9 Student’s t distribution 446
A.10 Chi-square (2) distribution 447
A.11 F distribution 447
A.12 Statistical inference 448
Exercises 451
Exponential and logarithmic functions 455

Index 460
 PREFACE

The primary objective of this second edition of Econometrics by Example, as in the

first edition, is to introduce the fundamentals of econometrics without complicated
mathematics and statistics. The emphasis throughout the book is on explaining
basic econometric theory with several worked examples using data from a variety
of fields. The intended audience is undergraduate students in economics, business,
marketing, finance, operations research and related disciplines. It is also intended
for students in MBA programs and for researchers in business, government and
research organizations.

Major features
◆ In-depth examples illustrate major concepts in econometrics.
◆ Wherever essential, I have included figures and computer outputs from software
packages, such as Eviews (version 8), Stata (version 12) and Minitab (version 16).
◆ The data used in illustrative examples and in the exercises are posted on the book’s
website.
◆ Some of the exercises included are for classroom assignment.
◆ A full list of the data sets and the descriptions of the variables used in analysis is
provided in Appendix 1.
◆ Appendix 2 provides the basics of statistics that are necessary to follow this book.

New for the second edition

◆ There are two brand new chapters on quantile regression modeling and multi-
variate regression models. Two further chapters on hierarchical linear regression
models and bootstrapping are available on the book’s website.
◆ There are new illustrated examples in several chapters.
◆ I have considerably expanded the data-based exercises. In all there are about 70
data-based examples and exercises.
The book is now divided into five parts.
Part I discusses the classical linear regression model, the workhorse of economet-
rics, in considerable detail. These chapters form the foundation for the rest the
book. Some of the new topics discussed relate to the regression through the origin,
XIV PREFACE

or zero-intercept model, which is illustrated by the well-known capital asset pricing

model (CAPM) of financial theory, using UK stock market data. Another topic
included is the piecewise linear regression, in which linear segments of a regression
line are joined at certain break points, known as knots.
Part II examines critically the assumptions of the classical linear regression
model. Specifically, we discuss the topics of multicollinearity, heteroscedasticity,
autocorrelation, and model specification errors. We also discuss the topics of simul-
taneous equation bias and dynamic regression models. All these topics are discussed
with concrete economic data, some of which are new to this edition. The chapter
on heteroscedasticity discusses some technical aspects of robust standard errors and
introduces the concepts of the heteroscedastic robust t statistic and heteroscedastic
robust Wald statistic. The chapter on autocorrelation discusses both the standard
and alternative Durbin tests of autocorrelation. It also discusses the limitations of the
popularly used Jarque–Bera test of normality in small samples. Several data-based
exercises are added in this part.
Part III deals with what are known as the Generalized Linear Models (GLM). As
the name indicates, they are generalizations of the classical linear regression model.
Recall that the classical model assumes that the dependent variable is a linear func-
tion of the regression parameters, that it is continuous, that it is normally distributed,
and that it has a constant variance. The assumption of normal distribution for the
error term is for obtaining the probability distributions of the regression coefficients
and for the purpose of hypothesis testing. This assumption is very crucial in small
samples.
GLMs are useful in situations where the mean of the dependent variable is a non-
linear function of the regression parameters, the dependent variable is not normally
distributed, and the error variance may be non-constant. The GLMs discussed in this
part are: logit and probit models, multinomial regression models, ordinal regression
models, limited dependent variable regression models, and models of count data
using Poisson and negative binomial regression models. All these models are illus-
trated with several concrete examples
Some chapter specific changes include a discussion of the odds ratios in logit and
probit models and the bivariate probit model that involves two yes/no type depen-
dent variables that may be correlated. Chapter 11, on limited dependent variable
regression models, includes a discussion of Heckman’s sample selection model,
popularly known as the Heckit model. This part of the text includes several new
exercises, including a project for classroom assignment.
Part IV discusses several topics frequently encountered in time series data. The
concepts of stationary and nonstationary time series, cointegrated time series, and
asset price volatility are illustrated with several sets of economic and financial data.
The topic of economic forecasting is of great interest to business and economic fore-
casters. Various methods of forecasting are discussed and illustrated. As in the other
parts of this text, new examples and exercises are interspersed throughout this part
of the book.
Part V, which includes two chapters that are new to this edition, deals with some
advanced topics in econometrics.
Chapter 17 on panel data regression models shows how one can study the behav-
ior of cross-sectional units (e.g. firms in a given industry) over a period of time and
some of the estimation problems in such an analysis. One example is the impact of
 PREFACE XV

income and beer tax on the sales of beer in 50 US states and Washington, DC, over
the period 1985–2000.
Chapter 18 on survival analysis considers the time until an event occurs, such
as the time until an unemployed worker finds employment, the time that a patient
diagnosed with leukemia survives until death, and the time between divorce and
remarriage. We discuss in this chapter how econometric techniques handle these I
situations.
Chapter 19 on stochastic regressors and the method of instrumental variables
addresses a thorny problem in regression analysis, which is the correlation between
the regression error term and one or more explanatory variables in the model. If such
a correlation exists, the OLS estimates of the regression parameters are not even
consistent; that is, they do not converge to their true values, no matter how large
the sample is. Instrumental, or proxy, variables are designed to solve this problem.
The instrumental variables (IV) must satisfy two criteria: First, they must be highly
correlated with the variables for which they are a proxy but are not correlated with
the error term. Second, the IVs themselves must not be possible explanatory vari-
ables in their own right in the model for which they are acting as instruments. These
requirements are often not easy to meet, but in some situations IVs can be found.
Chapter 20 on quantile regression (QR) is new to this edition. Unlike the OLS focus
on estimating the mean value of the dependent variable in relation to one or more
explanatory variables, QR looks at the entire (probability) distribution of a random
variable by dividing the distribution into various segments, such as deciles, quartiles,
and percentiles. In skewed distributions or in distribution with several outliers, it
may be better to estimate the median of the distribution rather than the mean, for
the latter may be affected by outlying or extreme observations. In this chapter, I show
how QR estimates various quantiles and some of the merits of examining the whole
distribution. As a concrete example, we revisit the wage data and related variables
discussed in Chapter 1.
Chapter 21 on multivariate regression models (MRM) is also new to this edition.
MRMs are useful in situations in which we have more than one dependent variable
but each dependent variable has the same explanatory variables. An example is the
scholastic aptitude test (SAT) ,which most high school students in the US take. It has
two components: verbal and quantitative skills. One can estimate an OLS regression
of the test score on each skill separately, but it may be advantageous to estimate them
jointly, for the variables that affect each test scores are the same. It is thus quite likely
that the scores on the two tests are correlated. Therefore, joint estimation of the two
scores that takes into account the possible correlation between them will produce
estimators that are more efficient than if they are estimated separately by OLS.
However, if the errors are not correlated, joint estimation has no advantage over OLS
estimation of each equation singly.
A broader class of MRM is the seemingly unrelated regressions equations (SURE).
A classic example is the investment functions of several different companies in the
same industry group. Since these companies face a common regulatory atmosphere,
the investment decisions made by the individual companies may be estimated more
efficiently if we estimate them jointly rather than estimating each equation singly,
because it is quite likely that the error terms in individual regressions are correlated.
Note that, unlike the SAT example, in which the same individual takes both the
verbal and quantitative part of the SAT examination, in SURE that is not the case. In
XVI PREFACE

addition, in SURE the explanatory variables may be different for different companies.
Interestingly, if each company has identical explanatory variables, each taking identi-
cal values across every company, SURE estimates will be identical to those obtained
by estimating an OLS regression for each company individually. Also, if the error
terms across equations are not correlated, joint estimations of the equations has no
advantage over individual OLS estimation of each equation.

Companion website
The book’s companion website can be found at www.palgrave.com/companion/
gujarati-econometrics-by-example-2e/ and includes sources for both students and
instructors.
For the student, there are chapter summaries and conclusions, and all data sets in
Excel and Stata formats. Students are encouraged to use these data in several end-of-
chapter exercises to practice applying what they have learned to different scenarios.
A password-protected lecturers’ zone includes a collection of PowerPoint pre-
sentations that correspond to each chapter, and a Solution Manual with solutions to
all the end-of-chapter exercises. Because of their specialized nature, I have put two
additional chapters on the book’s website for those lecturers who wish to use them in
teaching: Chapter 22, Elements of hierarchical linear regression models, also known
as multilevel linear regression analysis (MLR), and Chapter 23, Bootstrapping: learn-
ing from the sample.

Hierarchical linear regression models

The primary objective of MLR is to predict the values of some dependent variable
as a function of explanatory variables at more than one level. A frequently studied
example is a child’s score on a standardized reading examination. It is influenced by
the characteristics of the child (e.g. the amount of study time) as well as features of
the child’s classroom (e.g. class size). This is a two-level analysis. If we include the
type of school, parochial or non-parochial, in the analysis, it would be a three-level
analysis. The actual level at which the analysis is done depends on the type of the
problem studied, availability of the data and computing facilities. As you can imag-
ine, the analysis becomes quickly more complex if we study a problem at many levels.
The point of this example is that we must consider the context in which the anal-
ysis is done. That is why MLR models are also known as contextual models. The
standard classical linear regression model is not adequate to deal with such multilev-
el analyses. The chapter on MLR explains the reasons for this and shows how such
multilevel regression models are estimated and interpreted.

Bootstrapping
In the classical linear regression model with the added assumption that the regression
error term is normally distributed we were able to estimate the parameters of the mod-
el, estimate their standard errors and establish confidence interval for the true param-
eter values. But what happens if the normality assumption is not valid or we have a
sample whose true population is unknown to us? In the chapter on bootstrapping, we
show how we can obtain the estimators of the parameters of interest, their standard
errors and the confidence intervals based on the computed standard errors.
 ACKNOWLEDGEMENTS

In preparing the second edition of Econometrics by Example, I have received invalu-

able help from Inas Kelly, Associate Professor of Economics, Queens College of
the City University of New York, and Professor Michael Grossman, Distinguished
Professor of Economics at the Graduate Center of the City University of New York.
I am indebted to them. I am also grateful to the following reviewers for their very
helpful comments and suggestions.

Reviewers of the first edition:

◆ Professor Michael P. Clements, University of Warwick
◆ Professor Brendan McCabe, University of Liverpool
◆ Professor Timothy Park, University of Georgia
◆ Professor Douglas G. Steigerwald, University of California Santa Barbara
◆ Associate Professor Heino Bohn Nielsen, University of Copenhagen
◆ Assistant Professor Pedro André Cerqueira, University of Coimbra
◆ Doctor Peter Moffatt, University of East Anglia
◆ Doctor Jiajing (Jane) Sun, University of Liverpool

Reviewers of the second edition:

◆ Professor Genaro Sucarrat, Norwegian Business School
◆ Doctor Jouni Sohkanen, University of St. Andrews
◆ Doctor Jin Suk Park, Durham University
◆ Professor Linus Yamane, Pitzer College
◆ Professor Doctor Horst Rottman, University of Applied Sciences Amberg Weiden
◆ Associate Professor Paul Solano, University of Delaware
◆ Professor Anh Nguyen, Ichec Brussels Management School
◆ Professor Frank J. Fabozzi, EDHEC Business School
◆ Professor Robert Duval, University of West Virginia
◆ Professor Robert Bickel, Marshall University
◆ Professor Nicholas Stratis, Florida State University
◆ Professor Giovanni Urga, Cass Business School and Bergamo University
XVIII ACKNOWLEDGEMENTS

and to the other anonymous reviewers whose comments were invaluable. Of course,
I alone am responsible for any errors that remain.
I am grateful to Jaime Marshall, Managing Director at Palgrave Macmillan Higher
Education for initiating this book and to Lauren Zimmerman, Development Editor
at Palgrave Macmillan, for her very constructive suggestions and for her meticulous
attention to detail in the preparation of the second edition. In addition, I am thankful
to Aléta Bezuidenhout and Amy Grant for their behind-the-scenes help.

The author and publishers are grateful to the following for kindly granting their
permission:
◆ Doctor Laurits R. Christensen and Doctor Douglas W. Caves for Table 21.6
Estimate of SURE airlines cost functions.
◆ Doctor Singfat Chu for Table 3.20 Diamond pricing.
◆ Professor Philip Cook for Table 17.11 The effect of beer tax on beer sales in 50 US
states and Washington DC, 1985–2000.
◆ Elsevier for Table 19.15 David Card’s OLS and IV wage regressions.
◆ Professor Ray Fair for Table 11.7 Data on extramarital affairs.
◆ Professor Philip Hans Franses, Professor Christiaan Heij, and Oxford University
Press for Table 8.13 Direct marketing of investment product.
◆ Edward W. Frees for Table 17.1 Charitable giving.
◆ Professor Jeremy Freese, Professor J. Scott Long and Stata Press for Table 12.7
Productivity of scholars.
◆ Professor James W. Hardin, Professor Joseph M. Hilbe and Stata Press for Table
8.12 Heart attack within 48 hours of myocardial infarction onset.
◆ John Wiley & Sons for: Table 7.22 Family planning, social setting, and decline in
birth rate in 20 Latin American countries, 1965–1975; the data used in Exercise
8.8; Table 8.9 The number of coupons redeemed and the price discount; Table
12.1 Data on R&D expenditure for 181 firms.
◆ Professor Leo Kahane for Table 5.1 Data on abortion rates in 50 US states for 1992.
◆ McGraw-Hill for the data used in Exercise 12.5.
◆ Professor Michael J. Kahn for Table 1.5 Data on 654 Boston youth.
◆ MIT Press for: Table 8.1 Data on smoking and other variables; Table 18.1
Modeling recidivism.
◆ Professor Tom Mroz for Table 4.4/Table 11.1 Married women’s hours of work and
related data.
◆ Professor Alicia Munnell for Table 17.9 Role of public investment in productivity
growth in 48 US states.
◆ NORC at the University of Chicago for the General Society Survey data used in
Exercise 9.1.
◆ Norton Company for Table 7.8 Consumption of cigarettes and death from lung
cancer.
◆ Professor Alan Reifman for Table 8.14 President Clinton’s impeachment trial.
 ACKNOWLEDGEMENTS XIX

◆ Professor Germán Rodríguez for the data used in Exercise 9.3.

◆ Sage Publications for the results reproduced in Exercise 8.8.
◆ Professor Allen L. Shoemaker for Table 3.21 Body temperature and heart rate.
◆ Professor C. F. Sirman, J. Shilling, U. Dhillon and John Wiley & Sons for Table 8.10
Fixed vs. adjustable rate mortgages.
I
◆ Standard and Poor for Table 10.8 Data on credit ratings of 92 US companies.
◆ Stata Press for Figure 19.1.
◆ Thomson Reuters DataStream for Table 2.15 CAPM of the UK stock market.
◆ Transparency.org and the World Bank for Table 2.18 GDP and corruption index.
◆ The UCLA IDRE Statistical Consulting Group for: Table 8.11 Admission to gradu-
ate school; Table 9.9 High school students’ curriculum choice; Table 12.8 Poisson
model of student absenteeism.
◆ The World Bank for Table 2.19 Fertility and related data for 64 countries.
 A PERSONAL MESSAGE FROM
THE AUTHOR

Dear student,
First, I am thankful to the students and teachers who used the first edition of
Econometrics by Example (EBE). Encouraged by their helpful comments and
suggestions, I have now written the second edition. It retains the user-friendly and
example-oriented approach to econometrics of the first edition. The changes I have
incorporated in this edition relate to some expository refinements of the topics cov-
ered in the first edition. I have added two new chapters in this edition and have put
two additional chapters on the book’s website. I have added several data-based new
exercises to the new edition.
As noted in the first edition, econometrics is no longer confined to economics
departments. Econometric techniques are used in a variety of fields, such as finance,
law, political science, international relations, sociology, psychology, medicine, and
agricultural science. Some techniques specifically developed for solving economic
problems have now found use in several of these disciplines. Newer econometric
techniques to address specific economic situations and refinements of old econo-
metric techniques are what keep the econometrics field an active field of study.
Students who acquire a thorough grounding in econometrics have a head start in
making careers in these areas. Major corporations, banks, brokerage houses, gov-
ernments at all levels, and international organizations like the IMF and the World
Bank employ a vast number of people who can use econometrics to estimate demand
functions and cost functions, and to conduct economic forecasting of key national
and international economic variables. There is also a great demand for econometri-
cians by colleges and universities all over the world.
There are now several textbooks that discuss econometrics from very elementary
to very advanced levels to help you along the way. I have contributed to this growing
industry with two introductory and intermediate level texts and this third book based
on a clear need for a new approach. Having taught econometrics for several years at
both undergraduate and graduate levels in Australia, India, Singapore, the USA, and
the UK, I came to realize that there was clearly a need for a book that explains this
often-complex discipline in straightforward, practical terms by considering several
interesting examples, such as charitable giving, fashion sales, pricing of diamond
stones, and exchange rates, in depth. This need has now been met with Econometrics
by Example.
What has made econometrics even more exciting to study these days is the
availability of user-friendly software packages. Although there are several software
packages, in this book I primarily use Eviews and Stata, as they are widely available
 A PERSONAL MESSAGE FROM THE AUTHOR XXI

and easy to get started with. Student versions of these packages are available at rea-
sonable cost and I have presented outputs from them throughout the book so you
can see the results of the analysis very clearly.
I have also made this text easy to navigate by dividing it into five parts, which are
described in detail in the Preface. Each chapter follows a similar structure, ending
with a summary and conclusions section to draw together the main points in an I
easy-to-remember format. I have put the data sets used in the examples in the book
up on the companion website, which you can find at www.palgrave.com/compan-
ion/gujarati-econometrics-by-example-2e/. Several data archives maintained by
academic journals and universities provide researchers a vast amount of data for
further research.
I hope you enjoy my hands-on approach to learning and that this textbook will be
a valuable companion to your further education in economics and related disciplines
and your future career.
I would welcome any feedback on the text; please contact me via my email address
on the companion website. Such feedback is extremely valuable to me in planning
future editions of this book.
 LIST OF TABLES

Tables marked with an * are available on the companion website: www.palgrave.com/companion/

gujarati-econometrics-by-example-2e/
Table 1.1 Wages and related data*
Table 1.2 Wage regression 15
Table 1.3 Stata output of the wage function 17
Table 1.4 The AOV table 17
Table 1.5 Data on 654 Boston youth*

Table 2.1 Production data for the USA, 2005*

Table 2.2 Cobb–Douglas function for USA, 2005 30
Table 2.3 Linear production function 31
Table 2.4 Cobb–Douglas production function with linear restriction 33
Table 2.5 Data on real GDP USA, 1960–2007*
Table 2.6 Rate of growth of real GDP, USA 1960–2007 35
Table 2.7 Trend in real US GDP, 1960–2007 36
Table 2.8 Food expenditure and total expenditure for 869 US households in 1995*
Table 2.9 Lin-log model of expenditure on food 38
Table 2.10 Reciprocal model of food expenditure 39
Table 2.11 Polynomial model of US GDP, 1960–2007 41
Table 2.12 Polynomial model of log US GDP, 1960–2007 42
Table 2.13 Summary of functional forms 43
Table 2.14 Linear production function using standardized variables 45
Table 2.15 CAPM of the UK stock market, monthly data for 1980–1999*
Table 2.16 Market model of the UK stock market 48
Table 2.17 The market model with intercept 48
Table 2.18 GDP and corruption index*
Table 2.19 Fertility and related data for 64 countries*

Table 3.1 A model of wage determination 54

Table 3.2 Wage function with interactive dummies 56
Table 3.3 Wage function with differential intercept and slope dummies 57
Table 3.4 Reduced wage function 58
Table 3.5 Semi-log model of wages 61
Table 3.6 Gross private investment and gross private savings, USA, 1959–2007*
Table 3.7 Regression of GPI on GPS, 1959–2007 62
Table 3.8 Regression of GPI on GPS with 1981 recession dummy 63
 LIST OF TABLES XXIII

Table 3.9 Regression of GPI on GPS with interactive dummy 63

Table 3.10 Quarterly retail fashion sales 1986-I–1992-IV*
Table 3.11 Results of regression (3.10) 65
Table 3.12 Sales, forecast sales, residuals, and seasonally adjusted sales 67
Table 3.13 Expanded model of fashion sales 68
Table 3.14 Actual sales, forecast sales, residuals, and seasonally adjusted sales 69 I
Table 3.15 Fashion sales regression with differential intercept and slope dummies 70
Table 3.16 Hypothetical data on production lot size and average cost (AC,$) 72
Table 3.17 Relationship between average cost and lot size 72
Table 3.18 Lot size and average cost relationship disregarding the threshold value 73
Table 3.19 Effects of ban and sugar consumption on diabetes*
Table 3.20 Diamond pricing*
Table 3.21 Body temperature, gender, and heart rate*
Table 3.22 A sample of 528 wage earners*

Table 4.1 The effect of increasing r23 on the variance of OLS estimator b2 82
Table 4.2 Hypothetical data on expenditure, income, and wealth for 10 consumers 83
Table 4.3 Regression results (t values in parentheses) 83
Table 4.4 Mroz data on married women’s hours of work*
Table 4.5 Women’s hours worked regression 85
Table 4.6 The VIF and TOL factors 87
Table 4.7 Revised women’s hours worked regression 88
Table 4.8 VIF and TOL for coefficients in Table 4.7 89
Table 4.9 Principal components of the hours-worked example 90
Table 4.10 Principal components regression 91
Table 4.11 Manpower needs of the US Navy*
Table 4.12 Data on blood pressure and related variables for 20 patients*
Table 4.13 Longley classic data*

Table 5.1 Data on abortion rates in the 50 US states for 1992*

Table 5.2 OLS estimation of the abortion rate function 98
Table 5.3 The Breusch–Pagan test of heteroscedasticity 101
Table 5.4 Abridged White test 103
Table 5.5 Transformed Eq. (5.1) 104
Table 5.6 Logarithmic regression of the abortion rate 105
Table 5.7 Robust standard errors of the abortion rate regression 106
Table 5.8 Heteroscedasticity-corrected robust standard errors of the wage function 109
Table 5.9 Heteroscedasticity-corrected robust standard errors of the hours function 109
Table 5.10 GDP growth rate and related data for 106 countries*
Table 5.11 Data for 455 US manufacturing industries, 1994*

Table 6.1 US consumption function, 1947–2000*

Table 6.2 Regression results of the consumption function 114
Table 6.3 BG test of autocorrelation of the consumption function 120
Table 6.4 First difference transform of the consumption function 122
Table 6.5 Transformed consumption function using = 0.3246 124
Table 6.6 HAC standard errors of the consumption function 125
Table 6.7 Autoregressive consumption function 126
XXIV LIST OF TABLES

Table 6.8 BG test of autocorrelation for autoregressive consumption function 127

Table 6.9 HAC standard errors of the autoregressive consumption function 128
Table 6.10 Housing starts and related data for USA, 1973–2011*

Table 7.1 Determinants of hourly wage rate 133

Table 7.2 Expanded wage function 133
Table 7.3 Refinement of the wage model 134
Table 7.4 RESET test of the wage model 136
Table 7.5 The LM test of the wage model 137
Table 7.6 Regression of experience on age 139
Table 7.7 Determinants of log of wages 140
Table 7.8 Consumption of cigarettes and death rate from lung cancer in 11 countries 143
Table 7.9 Deaths from lung cancer and consumption of cigarettes (all countries) 143
Table 7.10 Deaths from lung cancer and consumption of cigarettes (USA excluded) 144
Table 7.11 Calculated p-value equivalents to true alpha levels at given sample sizes 146
Table 7.12 Aggregate consumption function for the USA, 1960–2009*
Table 7.13 Reduced form regression of PCE on GDPI 151
Table 7.14 Reduced form regression of income on GDPI 151
Table 7.15 OLS results of the regression of PCE on income 152
Table 7.16 OLS results of regression (7.22) 157
Table 7.17 Results of regression with robust standard errors 157
Table 7.18 The results of regression (7.23) using HAC standard errors 158
Table 7.19 OLS estimates of model (7.26) 161
Table 7.20 OLS estimates of model (7.26) with HAC standard errors 161
Table 7.21 Cigarette smoking and deaths from various types of cancer in 43 US states and
Washington, DC, 1960*
Table 7.22 Family planning, social setting, and decline in birth rate in 20 Latin American
countries, 1965–1975 165

Table 8.1 Data on smoking and other variables*

Table 8.2 LPM model of to smoke or not to smoke 171
Table 8.3 Logit model of to smoke or not to smoke 176
Table 8.4 The effect of a unit change in the mean value of the explanatory variables on the
probability of smoking 178
Table 8.5 The logit model of smoking with interaction 179
Table 8.6 Odds ratios for smoking versus non-smoking 181
Table 8.7 Probit model of smoking 182
Table 8.8 The probit model of smoking with interaction 183
Table 8.9 The number of coupons redeemed and the price discount 185
Table 8.10 Fixed vs. adjustable rate mortgages*
Table 8.11 Admission to graduate school*
Table 8.12 Heart attack within 48 hours of myocardial infarction onset*
Table 8.13 Direct marketing of an investment product*
Table 8.14 President Clinton’s impeachment trial*

Table 9.1 Data on school choice*

Table 9.2 Multinomial logistic model of school choice 195
Table 9.3 Raw data for mode of travel*
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Balfour (Andrew). VENGEANCE IS MINE.
TO ARMS.
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DOMITIA.
THE FROBISHERS.
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A CREEL OF IRISH STORIES.
THE FOUNDING OF FORTUNES.
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Bartram (George). THIRTEEN EVENINGS.
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THE CLASH OF ARMS.
DENOUNCED.
FORTUNE’S MY FOE.
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Chesney (Weatherby). THE BAPTIST RING.
THE BRANDED PRINCE.
THE FOUNDERED GALLEON.
JOHN TOPP.
Clifford (Mrs. W. K.). A FLASH OF SUMMER.
Collingwood (Harry). THE DOCTOR OF THE ‘JULIET.’
Cornford (L. Cope). SONS OF ADVERSITY.
Crane (Stephen). WOUNDS IN THE RAIN.
Denny (C. E.). THE ROMANCE OF UPFOLD MANOR.
Dickson (Harris). THE BLACK WOLF’S BREED.
Dickinson (Evelyn). THE SIN OF ANGELS.
Duncan (Sara J.). THE POOL IN THE DESERT.
A VOYAGE OF CONSOLATION.
Embree (C. F.). A HEART OF FLAME.
Fenn (G. Manville). AN ELECTRIC SPARK.
Findlater (Jane H.). A DAUGHTER OF STRIFE.
Findlater (Mary). OVER THE HILLS.
Forrest (R. E.). THE SWORD OF AZRAEL.
Francis (M. E.). MISS ERIN.
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Gerard (Dorothea). THINGS THAT HAVE HAPPENED.
Gilchrist (R. Murray). WILLOWBRAKE.
Glanville (Ernest). THE DESPATCH RIDER.
THE LOST REGIMENT.
THE KLOOF BRIDE.
THE INCA’S TREASURE.
Gordon (Julien). MRS. CLYDE. WORLD’S PEOPLE.
Goss (C. F.). THE REDEMPTION OF DAVID CORSON.
Gray (E. M‘Queen). MY STEWARDSHIP
Hales (A. G.). JAIR THE APOSTATE.
Hamilton (Lord Ernest). MARY HAMILTON.
Harrison (Mrs. Burton). A PRINCESS OF THE HILLS.
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Hooper (I.). THE SINGER OF MARLY.
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GARNERED.
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Norris (W. E.). AN OCTAVE.
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SIR ROBERT’S FORTUNE.
THE TWO MARY’S.
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FANCY FREE.
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BARBARA’S MONEY.
THE ENTHUSIAST.
A GREAT LADY.
THE LOVE THAT OVERCAME.
THE MASTER OF BEECHWOOD.
UNDER SUSPICION.
THE YELLOW DIAMOND.
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Levett-Yeats (S. K.). THE TRAITOR’S WAY.
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A COUNSEL OF PERFECTION.
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A LOST ESTATE.
THE CEDAR STAR.
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A MOMENT’S ERROR.
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THE JOSS.
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Mathers (Helen). HONEY.
GRIFF OF GRIFFITHSCOURT.
SAM’S SWEETHEART.
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Morrison (Arthur). THE HOLE IN THE WALL.
Nesbit (E.). THE RED HOUSE.
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GILES INGILBY.
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LORD LEONARD.
MATTHEW AUSTIN.
CLARISSA FURIOSA.
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SIR ROBERTS FORTUNE.
THE PRODIGALS.
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Parker (Gilbert). THE POMP OF THE LAVILETTES.
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THE TRAIL OF THE SWORD.
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I CROWN THEE KING.
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CHILDREN OF THE MIST.
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LOST PROPERTY.
GEORGE AND THE GENERAL.
Russell (W. Clark). A MARRIAGE AT SEA.
ABANDONED.
MY DANISH SWEETHEART.
Sergeant (Adeline). THE MASTER OF BEECHWOOD.
BARBARA’S MONEY.
THE YELLOW DIAMOND.
Surtees (R. S.). HANDLEY CROSS. Illustrated.
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ASK MAMMA. Illustrated.
Valentine (Major E. S.). VELDT AND LAAGER.
Walford (Mrs. L. B.). MR. SMITH.
THE BABY’S GRANDMOTHER.
Wallace (General Lew). BEN-HUR.
THE FAIR GOD.
Watson (H. B. Marriot). THE ADVENTURERS.
Weekes (A. B.). PRISONERS OF WAR.
Wells (H. G.). THE STOLEN BACILLUS.
White (Percy). A PASSIONATE PILGRIM.
 TRANSCRIBER’S NOTES
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