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You are on page 1of 26

Dougherty

Introduction to Econometrics,

5th edition

Chapter heading

Chapter 1: Simple Regression

Analysis

Y

Y 1 2 X

X1

X2

X3

X4

parameters 1 and 2 that we wish to estimate.

1

Y

Y 1 2 X

X1

X2

X3

X4

Y

Y 1 2 X

Q1

X1

Q2

X2

Q3

X3

Q4

X4

If the relationship were an exact one, the observations would lie on a straight line and we

would have no trouble obtaining accurate estimates of 1 and 2.

3

P4

Y 1 2 X

P1

Q1

X1

Q2

P2

X2

Q3

Q4

P3

X3

X4

In practice, most economic relationships are not exact and the actual values of Y are

different from those corresponding to the straight line.

4

P4

Y 1 2 X

P1

Q1

X1

Q2

P2

X2

Q3

Q4

P3

X3

X4

disturbance term.

5

P4

Y 1 2 X

u1

P1

Q1

Q2

P2

Q3

Q4

P3

u = disturbance term

1 2 X1

X1

X2

X3

X4

Each value of Y thus has a nonrandom component, 1 + 2X, and a random component, u.

The first observation has been decomposed into these two components.

6

P4

P1

P2

X1

X2

P3

X3

X4

P4

Y 1 2 X

P1

P2

X1

X2

P3

X3

X4

Obviously, we can use the P points to draw a line which is an approximation to the line

Y = 1 + 2X. If we write this line Y 1 2 X , 1 is an estimate of 1 and2 is an estimate of

2.

Y (actual value)

Y (fitted value)

P4

Y 1 2 X

P1

R1

X1

R2

P2

X2

R3

R4

P3

X3

X4

The line is called the fitted model and the values of Y predicted by it are called the fitted

values of Y. They are given by the heights of the R points.

9

Y (actual value)

Y (fitted value)

P4

Y 1 2 X

u 4

u1 P1

R1

X1

R2

u 2

P2

X2

R3

R4

u 3

P3

X3

Y Y u (residual)

X4

The discrepancies between the actual and fitted values of Y are known as the residuals

denoted u .

10

Y (actual value)

Y (fitted value)

P4

Y 1 2 X

P1

1

1

R1

X1

R2

P2

X2

R3

R4

Y 1 2 X

P3

X3

X4

Note that the values of the residuals are not the same as the values of the disturbance term.

The diagram now shows the true unknown relationship as well as the fitted line.

11

Y (actual value)

Y (fitted value)

P4

Y 1 2 X

Y 1 2 X

P1

1

1

Q1

X1

Q2

P2

X2

Q3

Q4

P3

X3

X4

The disturbance term in each observation is responsible for the divergence between the

nonrandom component of the true relationship and the actual observation.

12

Y (actual value)

Y (fitted value)

P4

Y 1 2 X

P1

1

1

R1

X1

R2

P2

X2

R3

R4

Y 1 2 X

P3

X3

X4

The residuals are the discrepancies between the actual and the fitted values.

13

Y (actual value)

Y (fitted value)

P4

Y 1 2 X

P1

1

1

R1

X1

R2

P2

X2

R3

R4

Y 1 2 X

P3

X3

X4

If the fit is a good one, the residuals and the values of the disturbance term will be similar,

but they must be kept apart conceptually.

14

Y (actual value)

Y (fitted value)

P4

Y 1 2 X

u4

Y 1 2 X

Q4

1 2 X 4

1

1

u = disturbance term

X1

X2

X3

X4

Both of these lines will be used in our analysis. Each permits a decomposition of the value

of Y. The decompositions will be illustrated with the fourth observation.

15

Y (actual value)

Y (fitted value)

P4

Y 1 2 X

u4

Y 1 2 X

Q4

1 2 X 4

1

1

u = disturbance term

X1

X2

X3

X4

Using the theoretical relationship, Y can be decomposed into its nonstochastic component

1 + 2X and its random component u.

16

Y (actual value)

Y (fitted value)

P4

Y 1 2 X

u4

Y 1 2 X

Q4

1 2 X 4

1

1

u = disturbance term

X1

X2

X3

X4

values of the disturbance term. We shall use it in our analysis of the properties of the

regression coefficients.

17

Y (actual value)

Y (fitted value)

P4

u 4

Y 1 2 X

R4

Y 1 2 X

1 2 X 4

1

1

Y Y u (residual)

X1

X2

X3

X4

The other decomposition is with reference to the fitted line. In each observation, the actual

value of Y is equal to the fitted value plus the residual. This is an operational

decomposition which we will use for practical purposes.

18

Minimize RSS (residual sum of squares), where

n

i 1

To begin with, we will draw the fitted line so as to minimize the sum of the squares of the

residuals, RSS. This is described as the least squares criterion.

19

Minimize RSS (residual sum of squares), where

n

i 1

n

u

i 1

u1 ... u n

Why the squares of the residuals? Why not just minimize the sum of the residuals?

20

P4

P1

P2

X1

X2

P3

X3

X4

The answer is that you would get an apparently perfect fit by drawing a horizontal line

through the mean value of Y. The sum of the residuals would be zero.

21

P4

P1

P2

X1

X2

P3

X3

X4

You must prevent negative residuals from cancelling positive ones, and one way to do this

is to use the squares of the residuals.

22

P4

P1

P2

X1

X2

P3

X3

X4

Of course there are other ways of dealing with the problem. The least squares criterion has

the attraction that the estimators derived with it have desirable properties, provided that

certain conditions are satisfied.

23

P4

P1

P2

X1

X2

P3

X3

X4

The next sequence shows how the least squares criterion is used to calculate the

coefficients of the fitted line.

24

These slideshows may be downloaded by anyone, anywhere for personal use.

Subject to respect for copyright and, where appropriate, attribution, they may be

used as a resource for teaching an econometrics course. There is no need to

refer to the author.

The content of this slideshow comes from Section 1.2 of C. Dougherty,

Introduction to Econometrics, fifth edition 2016, Oxford University Press.

Additional (free) resources for both students and instructors may be

downloaded from the OUP Online Resource Centre

http://www.oxfordtextbooks.co.uk/orc/dougherty5e/

Individuals studying econometrics on their own who feel that they might benefit

from participation in a formal course should consider the London School of

Economics summer school course

EC212 Introduction to Econometrics

http://www2.lse.ac.uk/study/summerSchools/summerSchool/Home.aspx

or the University of London International Programmes distance learning course

EC2020 Elements of Econometrics

www.londoninternational.ac.uk/lse.

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