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Dougherty

Introduction to Econometrics,
5th edition
Chapter heading
Chapter 1: Simple Regression
Analysis

Christopher Dougherty, 2016. All rights reserved.

SIMPLE REGRESSION MODEL

Y
Y 1 2 X

X1

X2

X3

X4

Suppose that a variable Y is a linear function of another variable X, with unknown


parameters 1 and 2 that we wish to estimate.
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SIMPLE REGRESSION MODEL

Y
Y 1 2 X

X1

X2

X3

X4

Suppose that we have a sample of 4 observations with X values as shown.

SIMPLE REGRESSION MODEL

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.
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SIMPLE REGRESSION MODEL

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.
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SIMPLE REGRESSION MODEL

P4

Y 1 2 X
P1

Q1

X1

Q2
P2

X2

Q3

Q4

P3

X3

X4

To allow for such divergences, we will write the model as Y = 1 + 2X + u, where u is a


disturbance term.
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SIMPLE REGRESSION MODEL

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.
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SIMPLE REGRESSION MODEL

P4

P1
P2

X1

X2

P3

X3

X4

In practice we can see only the P points.

SIMPLE REGRESSION MODEL

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.

SIMPLE REGRESSION MODEL

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.
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SIMPLE REGRESSION MODEL

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 .
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SIMPLE REGRESSION MODEL

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.
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SIMPLE REGRESSION MODEL

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.
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SIMPLE REGRESSION MODEL

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

SIMPLE REGRESSION MODEL

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.
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SIMPLE REGRESSION MODEL

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.
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SIMPLE REGRESSION MODEL

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.
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SIMPLE REGRESSION MODEL

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

This is a theoretical decomposition because we do not know the values of 1 or 2, or the


values of the disturbance term. We shall use it in our analysis of the properties of the
regression coefficients.
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SIMPLE REGRESSION MODEL

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.
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SIMPLE REGRESSION MODEL

Least squares criterion:


Minimize RSS (residual sum of squares), where
n

RSS u i2 u12 ... u n2


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.
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SIMPLE REGRESSION MODEL

Least squares criterion:


Minimize RSS (residual sum of squares), where
n

RSS u i2 u12 ... u n2


i 1

Why not minimize


n

u
i 1

u1 ... u n

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

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SIMPLE REGRESSION MODEL

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.
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SIMPLE REGRESSION MODEL

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.
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SIMPLE REGRESSION MODEL

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.
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SIMPLE REGRESSION MODEL

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.
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Copyright Christopher Dougherty 2016.


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Introduction to Econometrics, fifth edition 2016, Oxford University Press.
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2015.12.18