Dire Dawa University

College of Business and Economics

Department of Economics

Econometrics I

By Desalegn N.

1 April 3, 2023
Chapter One: Introduction to Econometrics

Outlines

 Introduction

 Definition and Scope of Econometrics

 Economic models and Econometric models

 Goals of econometrics

 Methodology of Econometrics

 Desirable properties of an econometric model

Introduction

Economic theories suggest the relationship of various economic variables. As

investigator(economist) we may interested in:

 If one variable changes in a certain magnitude, by how much will another variable

change?;

 Can we forecast or predict the corresponding value of another variable given that of the

know value of one variable(s)? So as to understand the real world.

This questions can be answered by econometrics.

Definition & Scope of Econometrics

Economy

Econo-metrics
Measure

Thus, econometrics means economic measurement. Measuring the unknown values

of theoretically defined parameters.

 Definition & Scope of Econometrics

Econometrics is the science which integrates economic theory, economic

statistics, and mathematical economics to investigate the empirical support of

the general schematic law established by economic theory.

It is a special type of economic analysis and research in which the general

economic theories, formulated in mathematical terms, is combined with

empirical measurements of economic phenomena.

April 3, 2023
 Definition & Scope of Econometrics

Econometrics is about how we can use economic, business or social science

theory, data and tools from statistics, to answer “how much” type questions.

It is the application of statistical and mathematical techniques to the analysis of

empirical data with the purpose of verifying or refuting theories.

Measurement is the crucial aspect of econometrics. But, the scope of

econometrics is beyond measurement.

April 3, 2023
 Definition & Scope of Econometrics

Econometrics is the science which integrates economic theory, economic

statistics, and mathematical economics to investigate the empirical support of

the general schematic law established by economic theory.

It is a special type of economic analysis and research in which the general

economic theories, formulated in mathematical terms, is combined with

empirical measurements of economic phenomena.

April 3, 2023
 Definition & Scope of Econometrics

Econometrics is about how we can use economic, business or social science

theory, data and tools from statistics, to answer “how much” type questions.

It is the application of statistical and mathematical techniques to the analysis of

empirical data with the purpose of verifying or refuting theories.

Measurement is the crucial aspect of econometrics. But, the scope of

econometrics is beyond measurement.

April 3, 2023
 Econometrics vs. mathematical economics

Economic theory state the relationship of variables by using verbal expression.

But, mathematical economics states economic theory in terms of mathematical

symbols. There is no essential difference between mathematical economics and

economic theory.

Both express economic relationships in an exact or deterministic form.

April 3, 2023
Economic theory

Econometrics

Mathematics

Statistics
 Econometrics vs. mathematical economics

On the contrary, econometrics state the relationship of economic variables by

assuming random disturbance term.

Econometrics method design to consider random relationships among economic

variables.

Furthermore, unlike both mathematical economics and economic theory, econometric

methods provide numerical values of the coefficients of economic relationships.

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 Econometrics vs. statistics

 Econometrics depart from statistics(economic and mathematical statistics).

 Economic statistics collect empirical data, records them, tabulates them or charts

them.

 Its descriptive aspect of research and try to detect some relationship between

various economic magnitudes.

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 Econometrics vs. statistics

 It does not provide numerical coefficients of economic relationships as

econometrics does.

 Mathematical (or inferential) statistics concern on measurement which are

developed on the basis of controlled experiments.

 However, inferential statistics must be adapted/adjust to real economic problem.

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 Economic models vs. econometric models

i. Economic Model

 Its an organized set of relationships that describes the functioning of an economic entity

under a set of simplifying assumptions.

 Economic model consists of three structural elements:

1.A set of variables

2.A list of fundamental relationships

3.A number of coefficients

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 Economic models vs. econometric models

i. Econometrics Model

Consists of behavioral equation derived from economic models and specification

of probability distribution of errors.

contains a disturbance term.

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 Economic models vs. econometric models

i. Economic Model

 Economic model postulates exact (deterministic) relationships among

variables and do not consider disturbance term.

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 Economic models vs. econometric models

Example: economic theory postulate that sales volume(SV) is depend

on advertising(AD), sales promotion(SP), and disposable income of

society(DI).

Accordingly the economic and econometrics model can be specified by:

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 Economic models vs. econometric models

Economic model

𝑆𝑉 = α0 + α1AD + α2SP + α3DI -------------------------------(1)

Econometrics Model

 𝑆𝑉 = α0 + α1AD + α2SP + α3DI + ℇi---------------------- (2)

April 3, 2023
 The three Basic main goals of Econometrics

1. Analysis - testing the implication of a theory. verifying how well economic

theories explain the observed behavior of economic units.

2. Policy making - Obtaining numerical estimates of the coefficients of economic

relationships for policy simulations.

3. Forecasting- using the numerical estimates of the coefficients in order to

forecast the future values of economic magnitudes .

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 Methodology Of Econometrics
Econometric research is focused on measurement of the parameters of economic

relationships and predication of the values of economic variables.

Generally, econometrics research follow the following step:

1. Specification the model

2. Estimation of the model

3. Evaluation of the estimates

4. Evaluation of he forecasting power of the estimated model

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 1. Specification of the model
This is the stage of expressing the relationships between economic variables in

mathematical form.

Basically in this step the ff activities have been done:

1. Identification of dependent and independent variables

2. priori theoretical expectations about the size and sign of the parameters of the

function.

3. Specifying the mathematical form of the model

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 1. Specification of the model
The specification of the econometric model based on economic theory

and other information and the investigator require the know how of

them.

It’s the weakest point of most econometrics research.

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 1. Specification of the model
Econometrics model may incorrectly specified due to:

 The imperfections, looseness of statements in economic theories.

 limitation of our knowledge about factor in particular case.

 Data related problem.

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 1. Specification of the model
The most common errors of specification are:

 Omissions of some important variables from the function.

 The omissions of some equations (for example, in simultaneous

equations model).
 The mistaken mathematical form of the functions.

April 3, 2023
 1. Specification of the model
The most common errors of specification are:

 Omissions of some important variables from the function.

 The omissions of some equations (for example, in simultaneous

equations model).
 The mistaken mathematical form of the functions.

April 3, 2023
2. Estimation of the model
Estimation of the model requires knowledge of the various econometric methods, their

assumptions and the economic implications for the estimates of the parameters.

This stage includes the following activities.

Gathering of the data

Examination of the identification conditions of the function

Examination of the aggregations problems

Examination of the degree of correlation

Choice of appropriate economic techniques(OLS, MLM, Logit, and Probit).

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 3. Evaluation of the estimates
In this step we are going to check whether parameters are theoretically

meaningful and statistically satisfactory or not.

In this step the econometrician is expected to evaluate the reliability of

result.

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 3. Evaluation of the estimates
As a result the econometrician expected to check the following criteria:

1. Economic a priori criteria: evaluate by economic theory and refer to the size

and sign of the parameters.

2. Statistical criteria (first-order tests): determined by statistical theory and

aim at the evaluation of the statistical reliability of the estimates of the

parameters of the model. by using standard error test, t-test, F-test, and R2 –

test.
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 3. Evaluation of the estimates
3. Econometric criteria (second-order tests): in this test the

econometrician is expected to check the fulfillment of the assumption of

the employed econometrics techniques/detection of the violation of the

assumptions.

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 4. Evaluation of the forecasting power of the model:
In this stage the sensitivity of the result to the change like sample size a

and econometrics techniques is checked.

If the result is insensitive to the change in sample size and econometrics

techniques we can accept the result of the study and used to forecast the

future value of the concerned variable.

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 Desirable properties of an econometric model
The ‘goodness’ of an econometric model is judged customarily according

to the following desirable properties:

1. Theoretical plausibility: econometric model should compatible

with economic theory.

2. Explanatory ability: econometrics model should explain the real

world.
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 Desirable properties of an econometric model
3. Accuracy of the estimates of the parameters: the estimated coefficients

should the best approximate of the true parameters.

4. Forecasting ability: The model should forecast the future values of

the dependent variable.

5. Simplicity: econometrics model should specify the relationship of

variables with a maximum simplicity.

April 3, 2023