CHAPTER

1 CHAPTER TWO
Wolaita Sodo University
College of Business and Economics
Department of Economics
Econometrics for Master of Project Management
(MPM 562)

Econometrics for MPM. By: Lambamo Arega(Assis't Prof.)

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CHAPTER TWO
Regression and Correlation Analysis

Econometrics for MPM. By: Lambamo Arega(Assis't Prof.)

 Linear Regression Basics
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 Linear regression analysis is often the starting point of an

empirical investigation.
 Because of its relative simplicity, it is useful for illustrating
different steps of modeling cycle that involve:
 Specification of the model followed by estimation

 Diagnostic checks, and

 Model re-specification

 To summarize data, generate conditional prediction, or

to test and evaluate regressors

Econometrics for MPM. By: Lambamo Arega(Assis't Prof.)

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Econometrics for MPM. By: Lambamo Arega(Assis't Prof.)

 Population and Sample Regression functions
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Econometrics for MPM. By: Lambamo Arega(Assis't Prof.)

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Econometrics for MPM. By: Lambamo Arega(Assis't Prof.)

 SLR model
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E ( y / x) = 0 + 1 x

E ( y / x) dE( y / x)
1 = =
x dx
0

The model: a linear relationship between average value of Y and X.

Econometrics for MPM. By: Lambamo Arega(Assis't Prof.)
 Sample regression function
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Econometrics for MPM. By: Lambamo Arega(Assis't Prof.)

 Reasons to include error term
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 Any other relevant factors affecting y (omitted

relevant variables, unobservable and/or
unimportant factors)
 Any approximation error due to the linear functional
form assumed
 Measurement error: inaccuracy in collection & measurement
of sample data.
 Sampling error: Consider a model relating consumption (Y)
with income (X) of households. The sample we randomly
choose to examine the relationship may turn out to be
predominantly poor households. In such cases, our estimation
of α and β from this sample may not be as good as that from
aEconometrics
balanced sample
for MPM. group.Arega(Assis't Prof.)
By: Lambamo
 Properties of error term(u)
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Econometrics for MPM. By: Lambamo Arega(Assis't Prof.)

 Assumptions of SLR
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 We assume that the dispersion of values of y about their mean

is the same for all levels of x
➔ Var ( y / x) = V ( y / x) =  , i.e., constant variance
2


 The constant variance assumption (homoscedasticity) ➔

 At each level of x we are equally uncertain about how far values
of y might fall from their mean value
 Additionally, the uncertainty does not depend on x or anything else
 Violation of it (i.e. V ( y / x)   2 ) is called heteroscedasticity
 Our sample is random ➔ the data are statistically independent
➔ cov( yi y j ) = 0

Econometrics for MPM. By: Lambamo Arega(Assis't Prof.)

 Estimating regression parameters:
Method of Least Squares
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Econometrics for MPM. By: Lambamo Arega(Assis't Prof.)

 Estimating regression parameters:
Method of Least Squares
13 
0
 
1
n  
e
i =1
2
i =  i 0 1 i
(Y −  −  X ) 2

 
0 1
Q    

= 0  2 (Y −  0 − 1 X )(−1) = 0   Yi = n  0 + 1  X i
 0

Q    
= 0  2 (Yi −  0 − 1 X i )(− X i ) = 0   X i Yi =  0  X i + 1  X i
2

 1 
 0 = Y − 1 X

n
 ( X i − X )(Yi − Y )
1 = i =1


n
Econometrics for MPM.
(X − X )
i =1By: Lambamo
i
2
Arega(Assis't Prof.)
 Least Square Estimators
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Econometrics for MPM. By: Lambamo Arega(Assis't Prof.)

 Assessing least squares estimators
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 The sampling properties of  0 and1 (Gauss-Markov Theorem)

 Given the assumptions of the linear regression model, the least-
squares estimators have the smallest variance of all linear and
unbiased estimators of ( i.e., BLUE).
 Linearity:  0 and1 are linear functions of the observed sample
 
values of Y  0 and 1
 
 Unbiasdness: E (1 ) = 1 and E (  0 ) =  0
 
Best (Minimum variance): Var (  ) , for i =
i OLS  Var (  i )Other

0,1
  e2   e2  X i2
Note that Var ( 1 ) = andVar ( 0 ) =
 xi2

n xi
2

 An unbiased estimator of  u2 is
 2
e =  ei2

n−2
Econometrics for MPM. By: Lambamo Arega(Assis't Prof.)
 Example 1:
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Econometrics for MPM. By: Lambamo Arega(Assis't Prof.)

 Example 2:
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Econometrics for MPM. By: Lambamo Arega(Assis't Prof.)

 Measure of Goodness of fit,
(Coefficient of determination, r2)
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Econometrics for MPM. By: Lambamo Arega(Assis't Prof.)

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Econometrics for MPM. By: Lambamo Arega(Assis't Prof.)

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Econometrics for MPM. By: Lambamo Arega(Assis't Prof.)

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 If R2 = 1, then all the sample data fall exactly on

the fitted least squares line, so RSS = 0, and the
model fits the data ‘‘perfectly.’’
 If the sample data for y and x are uncorrelated
and no linear association, then the fitted line is
‘‘horizontal,’’ and so that ESS = 0 and R2 = 0.
 Example: the survey on 40 households of Food
expenditure(y) and Income(x) generate the
following summary of data

Econometrics for MPM. By: Lambamo Arega(Assis't Prof.)

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Econometrics for MPM. By: Lambamo Arega(Assis't Prof.)

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Source SS df MS Number of obs = 40

F( 1, 38) = 23.79
Model 190626.984 1 190626.984 Prob > F = 0.0000
Residual 304505.176 38 8013.2941 R-squared = 0.3850
Adj R-squared = 0.3688
Total 495132.16 39 12695.6964 Root MSE = 89.517

food_exp Coef. Std. Err. t P>|t| [95% Conf. Interval]

income 10.20964 2.093264 4.88 0.000 5.972052 14.44723

_cons 83.416 43.41016 1.92 0.062 -4.463279 171.2953

Econometrics for MPM. By: Lambamo Arega(Assis't Prof.)

 Covariance and Correlation
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Econometrics for MPM. By: Lambamo Arega(Assis't Prof.)

 Correlation coefficient (rxy)
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Econometrics for MPM. By: Lambamo Arega(Assis't Prof.)

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Econometrics for MPM. By: Lambamo Arega(Assis't Prof.)

 Correlation coefficient(rxy) and
Coefficient of determination(R2)
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Econometrics for MPM. By: Lambamo Arega(Assis't Prof.)

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Econometrics for MPM. By: Lambamo Arega(Assis't Prof.)

 Pairwise correlation between
food expenditure and Income
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food_exp income

food_exp 1.0000
income 0.6205 1.0000

Econometrics for MPM. By: Lambamo Arega(Assis't Prof.)

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Econometrics for MPM. By: Lambamo Arega(Assis't Prof.)

 Hypothesis testing
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 Many business and economic decision problems require

a judgment as to whether or not a parameter is a
specific value.
 Hypothesis testing procedures compare a conjecture we
have about a population to the information contained in
a sample of data.
 Given an economic and statistical model, hypotheses are
formed about economic behavior
 Then they are represented as statements about model
parameters
Econometrics for MPM. By: Lambamo Arega(Assis't Prof.)
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 Steps in hypothesis testing:

 Determine the null and alternative hypotheses.

 Specify the test statistic and its distribution.

 Select α and determine the rejection region.

 Calculate the sample value of the test statistic.

 State your conclusion.

Econometrics for MPM. By: Lambamo Arega(Assis't Prof.)

 The null hypothesis(H0)
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 The null hypothesis specifies a value for a regression

parameter
 is stated as H0: βk = c, where c is a constant
 It is the belief we will maintain until we are convinced
by the sample evidence that it is not true, in which case
we reject the null hypothesis.
 Alternative Hypothesis(H1):
 is a logical alternative hypothesis H1 that we will accept if
the null hypothesis is rejected.
 is stated as H1: βk ≠ c

Econometrics for MPM. By: Lambamo Arega(Assis't Prof.)

 ❑ The test statistic
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Econometrics for MPM. By: Lambamo Arega(Assis't Prof.)

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One-sided test
 Besides our null, H0, we need an alternative
hypothesis, H1, and a significance level
 H1 may be one-sided, or two-sided
 H1: βj > 0 and H1: βj < 0 are one-sided
 H1: βj ≠0 is a two-sided alternative
 If we want to have only a 5% probability of
rejecting H0 when it is actually true, then we
say our significance level(α) is 5%

Econometrics for MPM. By: Lambamo Arega(Assis't Prof.)

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 Having picked a significance level, α, we look up the (1

– α)th percentile in a t distribution with (n – k – 1) df
and call this c, the critical value

 We can reject the null hypothesis(H0) if the t statistic is

greater than the critical value

 If the t statistic is less than the critical value then we fail

to reject the null (accept H0)

Econometrics for MPM. By: Lambamo Arega(Assis't Prof.)

 One- sided test
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Right tail test

Reject H0 if tcal>c
Accept H0 if tcal<c

Econometrics for MPM. By: Lambamo Arega(Assis't Prof.)

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 Because the t distribution is symmetric, hence,

testing H1: βj < 0 is straightforward.
 The critical value is just the negative of before
 We can reject the null if the t statistic < –c, and
 If the t statistic > –c then we fail to reject the null

 For a two-sided test, we set the critical value based on

α/2 and reject H0: βj = 0 if the absolute value of the t
statistic > c

Econometrics for MPM. By: Lambamo Arega(Assis't Prof.)

 Two-sided test
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Econometrics for MPM. By: Lambamo Arega(Assis't Prof.)

 Example of Hypothesis testing
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Econometrics for MPM. By: Lambamo Arega(Assis't Prof.)

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Econometrics for MPM. By: Lambamo Arega(Assis't Prof.)

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 Step6: Conclusion.
◼ We reject the hypothesis that there is no relationship
between income and food expenditure, and conclude that
there is a statistically significant positive relationship
between household income and food expenditure.

Econometrics for MPM. By: Lambamo Arega(Assis't Prof.)

 Practical using SPSS
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Indicate sig.
of Model
 Using ConsExp data

Intercept

P-value

Econometrics for MPM. By: Lambamo Arega(Assis't Prof.)

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Source SS df MS Number of obs = 40

F( 1, 38) = 23.79
Model 190626.984 1 190626.984 Prob > F = 0.0000
Residual 304505.176 38 8013.2941 R-squared = 0.3850
Adj R-squared = 0.3688
Total 495132.16 39 12695.6964 Root MSE = 89.517

food_exp Coef. Std. Err. t P>|t| [95% Conf. Interval]

income 10.20964 2.093264 4.88 0.000 5.972052 14.44723

_cons 83.416 43.41016 1.92 0.062 -4.463279 171.2953

Econometrics for MPM. By: Lambamo Arega(Assis't Prof.)

 Interpretation of output
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Econometrics for MPM. By: Lambamo Arega(Assis't Prof.)