Econometrics

Gujarati & Porter

Chapter 1
What is econometrics?
•Literally speaking, the word Econometrics means
measurement in economics.
•However, this is a too broad definition to be of any use
because most of the subject economics is concerned with
measurement.
•In general, what we mean by the term econometrics is as
follows:
The application of statistical and mathematical
methods to analyze economic data, with a purpose of
to validate economic theories.
Why do we need to study econometrics?
•Economic theory makes statements or hypotheses that are
mostly qualitative in nature. For example, macroeconomic
theory states that, ceteris paribus, increase in the price of a
commodity is expected to decrease its demand.
•This theory does not tell us by how much the quantity
demanded of a certain commodity will go up or down as a
result of a certain change in the price of the commodity
•It is the job of an econometrician to provide such numerical
estimates. Put differently, econometrics gives the empirical
content to most economic theory.
Why do we need to study econometrics?
•Suppose, we find in an econometric study that when the price of a
commodity increases by one Tk., its quantity demanded goes down
by, say 10 units.
•That is, by doing this study, we have not only confirmed the law of
demand but also have provided a numerical estimate of the
relationship between two variables  price and quantity demanded.
•For students majoring in economics and business, there is a
practical reason for studying econometrics.
•After graduation, in their employment, they may be called upon to
forecast sales, interest rates, and money supply, or to estimate
demand and supply functions, price elasticities for products, or to
provide empirical evidence on various finance theories, etc. This is
where their econometric background will help them from falling flat.
Steps in an Econometric Study
•Suppose that a manufacturer hired you as an econometrician. Your
employer asks you to determine the effect of price increase on the
demand for its product, say, coffee. As an econometrician you need to
follow the steps above to conduct an econometric study.
•Statement of theory or hypotheses
•Collection of data
•Specification of the mathematical model
•Specification of the statistical or econometric model
•Estimation of the parameters of the chosen econometric model
•Checking for model adequacy
•Tests of hypotheses derived from the model
•Using the model for forecasting or prediction
Statement of theory or hypotheses
•In any econometric study, an econometrician first tries to find
out what economic theory says about the relationship he
wants to model.
•According to the law of demand, when the price of a
commodity increases (and other things are held constant),
buyers tend to buy less of the commodity and, vice versa.
•Keep in mind that this law holds only when all other things
such as taste of the consumer, there income, prices of other
goods, etc., are held constant or inoperative.
Collecting data
•Before turning to the estimation of the model (finding the
values of the model parameters), we must first obtain
the relevant data on quantity demanded (Q) and price (P)
of the commodity whose demand function we are
studying.

1. Time Series
2. Cross-sectional &
3. Pooled (combination of time series & cross-sectional
data) and panel
 Time series

Time series data are collected

over a period of time at certain
intervals, e.g., daily (e.g., stock
prices), weekly (e.g., money
supply), monthly (e.g.,
unemployment rate), quarterly
(e.g., GNP) or annually (e.g.,
government budget).
Cross-sectional

Cross-sectional data are the

data on one or more variables
collected at one point of time,
such as census of population,
surveys on consumer
expenditure, opinion polls.
 Pooled and panel
In pooled data, we have
elements of both time-series
and cross-sectional data.
For example, if we were to
collect data on
unemployment rate for 10
countries for a period of 20
years, the data will be an
example of pooled data.
Pooled and panel
There is special type of pooled data known as the panel, or
longitudinal, or micropanel data, in which the same cross-
sectional unit, say, a family or firm, is surveyed over time.
Specification of the Mathematical Model
The law of demand postulates an inverse relationship between price
and quantity demanded, it does not indicate the precise form of the
relationship.
[1]
1 intercept  it gives the value of Q when P is zero.
 2 slope  which measures the rate of change in Q for per unit
change in P.
If the law of demand holds, we would expect  2 to be negative , that
is,  2  0 and 1  0 (who wouldn’t demand a good when its price
is zero).
In a mathematical model, the variable appearing on the left-hand side
is called the dependent variable and the variable on the right-hand
side is called as independent or explanatory variable.
Specification of the Statistical or Economic Model
P Q
0 78
90
1 70 80
70
2 69 60
50

uantity
3 63 40
30
20
4 60

Q
10
0
5 58 0 1 2 3 4 5 6

Price

Why do all the 6 points not lie on the single straight line as specified by the
mathematical model?
In deriving the demand curve, we held all other forces affecting the quantity
demanded constant except price. However, from a certain set of data we
have no way to know whether all these other influences are held constant.
 Specification of the Statistical or Economic Model
•If the ceteris paribus condition does not hold, factors other than P are
likely to exert some influence on Q, even though the impact of P on Q
is more dominant. Observed relationship between P and Q becomes
inexact.
•Let us denote the effect of all other factors on Q except P as ‘u’ and
re-write the demand function as follows:
[2]

• ‘u’ is called as a random or stochastic (in statistical lingo) error term.

‘u’ captures all those forces (besides price) that might affect Q but not
explicitly introduced in the model.
Estimation of the Parameters of the Chosen Econometric
Model
• How we do find the numerical values (known as estimates) of
1  2 and ? We shall start knowing this a couple of classes
later

[3]

•Note that we have put a hat “” on Q to remind us that EQ [3] is the
𝛽1
estimated demand equation. As equation𝛽 2EQ [3] shows, the
estimated values of is 76 and that of is 3.9.
The Fitted line
Checking model adequacy
•Demand is affected by several factors.

Q  1   2 P   3 I  u
Q  1   2 P  u

•Which model do we choose? First one is better because it

includes income of the consumer.
•But can we (or should we) choose all factors affecting
demand?
•Model chosen should be a reasonable representation of
reality.
 Test of Hypothesis/Hypotheses Derived from the Models
•The law of demand and thus the demand function indicates that
the coefficient of the price variable is expected to be negative.

•We need to look whether the observed value of the coefficient,  2 ,

is negative or not. In statistical lingo, we need to test the
hypothesis that  2  0

•This test provides us the statistical/empirical evidence on the law

of demand (the testing procedure will be discussed later).
Forecasting or Prediction
Suppose the manufacturer wants to know what the quantity
demanded be if he were to charge TK. 4.50, a price not
shown in the Table. Plug the value of TK. 4.50 for P on the
right-hand side of EQ [3]

That is, the forecasted value of Q is about 59 units if the

price were TK. 4.50.