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Module 3

Regression

Dependent variable

Independent variable (x)

Regression is the attempt to explain the variation in a dependent variable using the variation in independent variables.

**Regression is thus an explanation of causation.
**

If the independent variable(s) sufficiently explain the variation in the dependent variable, the model can be used for prediction.

Simple Linear Regression

Dependent variable (y)

є

y’ = b0 + b1X ± є

b0 (y intercept)

B1 = slope = ∆y/ ∆x

Independent variable (x)

The output of a regression is a function that predicts the dependent variable based upon values of the independent variables.

Simple regression fits a straight line to the data.

Simple Linear Regression

Dependent variable

Observation: y ^ Prediction: y

Zero

Independent variable (x)

**The function will make a prediction for each observed data point.
**

^ The observation is denoted by y and the prediction is denoted by y.

Simple Linear Regression

Prediction error: ε Observation: y ^ Prediction: y Zero

For each observation, the variation can be described as:

y=^ +ε y Actual = Explained + Error

Regression

Dependent variable Independent variable (x) A least squares regression selects the line with the lowest total sum of squared prediction errors. This value is called the Sum of Squares of Error, or SSE.

Calculating SSR

Dependent variable

Population mean: y

Independent variable (x)

The Sum of Squares Regression (SSR) is the sum of the squared differences between the prediction for each observation and the population mean.

Regression Formulas The Total Sum of Squares (SST) is equal to SSR + SSE.

Mathematically, SSR = ∑ ( ^ – y ) 2 (measure of explained variation) y ^ SSE = ∑ ( y – y )

**(measure of unexplained variation)
**

2

SST = SSR + SSE = ∑ ( y – y ) (measure of total variation in y)

The Coefficient of Determination

The proportion of total variation (SST) that is explained by the regression (SSR) is known as the Coefficient of Determination, and is often referred to as R 2.

2

R

=

SSR = SST

SSR SSR + SSE

The value of R 2 can range between 0 and 1, and the higher its value the more accurate the regression model is. It is often referred to as a percentage.

Standard Error of Regression

The Standard Error of a regression is a measure of its variability. It can be used in a similar manner to standard deviation, allowing for prediction intervals. y ± 2 standard errors will provide approximately 95% accuracy, and 3 standard errors will provide a 99% confidence interval.

Standard Error is calculated by taking the square root of the average prediction error. Standard Error =

√

SSE n-k

Where n is the number of observations in the sample and k is the total number of variables in the model

The output of a simple regression is the coefficient β and the constant A. The equation is then: y=A+β*x+ε where ε is the residual error. β is the per unit change in the dependent variable for each unit change in the independent variable. Mathematically: β= ∆y ∆x

Multiple Linear Regression

More than one independent variable can be used to explain variance in the dependent variable, as long as they are not linearly related.

A multiple regression takes the form: y = A + β 1 X 1 + β 2 X 2 + … + β k Xk + ε where k is the number of variables, or parameters.

Multicollinearity

Multicollinearity is a condition in which at least 2 independent variables are highly linearly correlated. It will often crash computers.

Example table of Correlations Y Y X1 X2 1.000 0.802 0.848 1.000 0.578 1.000 X1 X2

A correlations table can suggest which independent variables may be significant. Generally, an ind. variable that has more than a .3 correlation with the dependent variable and less than .7 with any other ind. variable can be included as a possible predictor.

Nonlinear Regression

Nonlinear functions can also be fit as regressions. Common choices include Power, Logarithmic, Exponential, and Logistic, but any continuous function can be used.

Regression Output in Excel

SUMMARY OUTPUT Regression Statistics Multiple R 0.982655 R Square 0.96561 Adjusted R Square 0.959879 Standard Error 26.01378 Observations 15 ANOVA df Regression Residual Total SS MS F Significance F 2 228014.6 114007.3 168.4712 1.65E-09 12 8120.603 676.7169 14 236135.2

Y = B0 + B1 X1 + B2X2 + B3X3 - - - +/- Error Total = Estimated/Predicted +/- Error

Intercept Temperature Insulation

Coefficients Standard Error t Stat P-value Lower 95%Upper 95% 562.151 21.0931 26.65094 4.78E-12 516.1931 608.1089 -5.436581 0.336216 -16.1699 1.64E-09 -6.169133 -4.704029 -20.01232 2.342505 -8.543127 1.91E-06 -25.1162 -14.90844

Estimated Heating Oil = 562.15 - 5.436 (Temperature) - 20.012 (Insulation)

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