Chapter 1

The Nature of Econometrics

and Economic Data
Overview
• What is econometrics?
• Steps in empirical economic analysis
• The structure of economic data
• Causality and the notion of ceteris paribus in econometric analysis
What is econometrics?
• Ragnar Frisch (Nobel prize 1969) defines econometrics as follows
(Econometrica, 1933, vol.1, nr.1, p. 2):
What is econometrics?
• In fact, on the same page, Ragnar Frisch also warned that even
Big Data cannot do without econometrics (1933):
What is econometrics?
• Econometrics combines economic theory and mathematical
statistics to
• analyze economic relationships
• test economic theories
• evaluate government or business policies
• A distinguishing feature of econometrics is that it focuses on the
problems associated with analyzing nonexperimental
(observational) data
• Sometimes, policy changes can be considered a (natural)
experiment
Steps in empirical economic analysis
• An empirical analysis uses data to test a theory or to estimate a
relationship
• Steps in empirical economic analysis
• Step 1: Careful formulation of the question of interest
• Step 2: Formulation of an econometric model (sometimes, but not
always, based on a formal economic model)
• Step 3: Formulation of hypotheses in terms of unknown model
parameters
• Step 4: Data collection and use of econometric methods to estimate
the parameters in the econometric model and formally test hypotheses
of interest
• Step 5: Carefully interpret the results. Are they economically meaningful?
Steps in empirical economic analysis
• Step 1: Careful formulation of the question of interest
• Does an increase of the VAT on gasoline have an impact on gasoline
consumption?
• Does job training have an impact on worker productivity?
• Does an additional year of schooling have an impact on one’s wage?
• Is there an impact of legalized abortion on crime?
Steps in empirical economic analysis
• Step 1: Careful formulation of the question of interest
• Sometimes a formal economic model is constructed
• Demand theory assumes that individuals allocate their budget to a set of
goods such that they maximize their utility for a given set of prices
Steps in empirical economic analysis
• Step 1: Careful formulation of the question of interest
• This implies a system of demand equations that relate the quantity
consumed of goods to the consumer’s budget, prices and individual
characteristics that affect taste

• This system of equations may form the basis for an econometric analysis
of the impact of an increase in the VAT on gasoline on the consumption
of gasoline and other goods
Steps in empirical economic analysis
• Step 1: Careful formulation of the question of interest
• In many cases, empirical analyses make use of economic theory in
a less formal way or even rely on intuition
• A labor economist is interested in the effect of job training on worker
productivity
• Basic economic understanding is sufficient to realize that factors like
education, experience and training affect worker productivity
• Moreover, workers are paid according to their productivity
• This leads to a model such as
wage = f (educ,exper,training)
Steps in empirical economic analysis
• Step 2: Formulation of an econometric model
• Form of the demand equations or the wage equation has to be specified
• One must decide how to deal with unobserved variables
• An econometric model to analyze the impact of training on worker
productivity may look like

• The constants 𝛽0 , 𝛽1 , 𝛽2 and 𝛽3 are called the parameters (of the model)
• The term u is the error term or disturbance term and contains factors
such as innate ability, quality of education and all other unobserved
factors that influence one’s wage
Steps in empirical economic analysis
• Step 3: Formulation of hypotheses in terms of unknown model
parameters
• We may hypothesize that an increase of VAT on gasoline decreases
gasoline consumption
• We may hypothesize that training increases a worker’s wage
• The latter hypothesis is equivalent to 𝛽3 > 0 in the wage equation
Steps in empirical economic analysis
• Step 4: Data collection and use of econometric methods to
estimate the parameters in the econometric model and formally
test hypotheses of interest
• Data on relevant variables have to be collected
• Data on individuals’ consumption of a set of goods, prices, budgets and
characteristics
• Data on workers’ wages, education, experience and training
• Econometric methods can then be used to estimate the econometric
model’s parameters and to formally test hypotheses of interest
• In many cases, econometric models are used to make predictions
• Change in consumption due to impact of VAT increase
• Forecasts of unemployment, GDP, inflation, etc.
Steps in empirical economic analysis
• Step 5: Carefully interpret the results. Are they economically
meaningful?
• Always check that estimated parameters make sense. What does the
magnitude of the estimate mean?
• It is not sufficient just to conclude that an effect is (statistically) significant
• Often, a better interpretation is obtained considering confidence intervals
of estimates
The structure of economic data
• The most important economic data structures are
• Cross-sectional data
• Time series data
• Pooled cross sections
• Panel or longitudinal data
The structure of economic data
• Cross-sectional data
• A cross-sectional data set consists of a sample of individuals,
households, firms, countries, etc. taken at a given point in time
• We will often assume that these data have been obtained by random
sampling from the underlying population
• Sometimes, this assumption is not appropriate
• Suppose that we want to analyze families’ wealth levels
• Survey a sample of families
• If wealthier people are more reluctant to disclose their wealth level, then the
resulting sample is not a random sample from the population of all families
• Ordering of the data does not matter for the analysis
The structure of economic data
The structure of economic data
The structure of economic data
• Time series data
• A time series data set consists of observations on a variable or several
variables over time (like stock prices, money supply, gross domestic
product, annual homicide rates, automobile sales, etc.)
• Difficulty: observations can rarely be assumed to be independent across
time (e.g. GDP of last quarter is very similar to that of this quarter)
• A simple model predicting next quarter GDP growth to be equal to this quarter’s
usually works very well...
• Data frequency can be daily, weekly, monthly, quarterly, annually, etc
The structure of economic data
The structure of economic data
• Couples breaking up (measured by Facebook updates)
The structure of economic data
• Pooled cross sections
• Such data have both cross-sectional and time series features
• For example:
• Random sample of households in 1985 with variables like income, savings, family
size, etc.
• New random sample of households in 1990 with the same variables as in 1985
• Pooled cross section combines both years
• In a pooled cross section, the households observed are different
The structure of economic data
The structure of economic data
• Panel data
• A panel data set consists of a time series for each cross-sectional
member in the data set
• For example:
• Random sample of older individuals in 2004 with variables like income, savings,
health, etc.
• The same set of older individuals is surveyed again in 2006, 2008, 2010, etc.
• Key distinction with pooled cross sections is that the same cross-
sectional units (individuals, firms, countries, etc.) are followed over a
given time period
• Specific econometric techniques exist to analyze panel data
The structure of economic data
The structure of economic data
Causality and ceteris paribus in econometric
analysis
• The economist’s goal often is to infer the causal effect of one variable
(such as education) on another (such as worker productivity)
• An association between two or more variables may suggest, but does
not establish, a causal effect (correlation does not imply causality)
• Ceteris paribus (other factors held constant; all else equal) plays a key
role in a causal analysis
• E.g. demand analysis focuses on the effect of a price increase of a good on the
quantity demanded, holding income, other prices, etc. fixed
• If other factors are not held fixed, then we cannot isolate the causal effect of a
price change on the quantity demanded
Causality and ceteris paribus in econometric
analysis
Causality and ceteris paribus in econometric
analysis
• Key question in most empirical studies will be whether enough
other factors have been held fixed to establish causality
• Econometric methods can “emulate” a ceteris paribus experiment
• Useful to make a link with experiments
Causality and ceteris paribus in econometric
analysis
• Experimental data
• Suppose we are interested in the effect of a training program for the
unemployed on future earnings
• Apart from training, earnings may depend on education, ability,
experience, social skills, etc.
• One way to determine training’s impact is to conduct a (social)
experiment:
• Select a group of unemployed (from the population of interest)
• Assign each one of them to either the training program or not
• Measure their earnings in some period of interest after training
• Use statistical methods to measure the association between training and earnings
Causality and ceteris paribus in econometric
analysis
• Experimental data
• We said nothing about selecting individuals who are identical in all
respects except for training (cf. ceteris paribus notion)
• The usefulness of the experiment will depend on the exact way training
was assigned
• If training is assigned to individuals independently of other individual
characteristics that affect earnings (like ability), then the experiment is
useful
• Do you expect any practical problems with such a social
experiment?
Causality and ceteris paribus in econometric
analysis
• Observational data
• Experimental data for measuring the return to education cannot be
obtained (ethical issues, economic costs,...)
• Nonexperimental (or observational) data on education levels and
wages can be obtained for a large group by sampling randomly from the
population of working individuals
• Similar independence condition as before
• Possibly problematic. Examples:
• Those with more education have usually less experience
• People with more innate ability often choose more education
• First example is easier to deal with (still hard); second one is more difficult