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BEC2044 ECONOMETRICS 1
LECTURE 1:
INTRODUCTION
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What is Econometrics?
• Econometrics literally means “economic measurement”
• It is the quantitative measurement and analysisof actual economic and business phenomena—
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of actual economic and business phenomena—and so involves:
– economic theory
– Statistics
– Math
– observation/data collection
What is Econometrics? (cont.)
• Three major uses of econometrics:
– Describing economic reality
– Testing hypotheses about economic theory
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– Forecasting future economic activity
• So econometrics is all about questions: the researcher (YOU!) first asks questions and then uses econometrics to answer them
Example
• Consider the general and purely theoretical relationship:
Q = f(P, Ps, Yd) (1.1)
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Q = f(P, Ps, Yd) (1.1)
• Econometrics allows this general and purely theoretical relationship to become explicit:
Q = 27.7 – 0.11P + 0.03Ps + 0.23Yd (1.2)
What is Regression Analysis?
• Economic theory can give us the direction of a change, e.g. the change in the demand for dvd’s following a price decrease (or price increase)
• But what if we want to know not just “how?” but also “how much?”
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• But what if we want to know not just “how?” but also “how much?”
• Then we need:
– A sample of data
– A way to estimate such a relationship
• one of the most frequently ones used is regression analysis
What is Regression Analysis? (cont.)
• Formally, regression analysis is a statistical technique that attempts to “explain” movements in one variable, the dependent
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variable, as a function of movements in a set of other variables, the independent (or explanatory) variables, through the quantification of a single equation
Example
• Return to the example from before:
Q = f(P, Ps, Yd) (1.1)
• Here, Q is the dependent variable and P, Ps, Yd are the independent variables
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• Don’t be deceived by the words dependent and independent, however
– A statistically significant regression result does not necessarily imply causality
– We also need:
• Economic theory
• Common sense
Single-Equation Linear Models
• The simplest example is:
Y = β0 + β1X (1.3)
• The βs are denoted “coefficients”
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– β0 is the “constant” or “intercept” term
– β1 is the “slope coefficient”: the amount that Y will change when X increases by one unit; for a linear model, β1 is constant over the entire function
Figure 1.1Graphical Representation of the
Coefficients of the Regression Line
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Single-Equation Linear Models (cont.)
• Application of linear regression techniques requires that the equation be linear—such as (1.3)
• By contrast, the equation
Y = β0 + β1X2 (1.4)
is not linear
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is not linear
• What to do? First define
Z = X2 (1.5)
• Substituting into (1.4) yields:
Y = β0 + β1Z (1.6)
• This redefined equation is now linear (in the coefficients β0 and β1
and in the variables Y and Z)
Single-Equation Linear Models (cont.)
• Is (1.3) a complete description of origins of variation in Y?
• No, at least four sources of variation in Y other than the variation in the included Xs:
• Other potentially important explanatory variables may be missing (e.g., X2 and X3)
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• Measurement error
• Incorrect functional form
• Purely random and totally unpredictable occurrences
• Inclusion of a “stochastic error term” (ε) effectively “takes care” of all these other sources of variation in Y that are NOT captured by X, so that (1.3) becomes:
Y = β0 + β1X + ε (1.7)
Single-Equation Linear Models (cont.)
• Two components in (1.7):
– deterministic component (β0 + β1X)
– stochastic/random component (ε)
• Why “deterministic”?
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• Why “deterministic”?
– Indicates the value of Y that is determined by a given value of X (which is assumed to be non-stochastic)
– Alternatively, the det. comp. can be thought of as the expected value of Y given X—namely E(Y|X)—i.e. the mean (or average) value of the Ys associated with a particular value of X
– This is also denoted the conditional expectation (that is, expectation of Y conditional on X)
Extending the Notation
• Include reference to the number of observations
– Single-equation linear case:
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– Single-equation linear case:
Yi = β0 + β1Xi + εi (i = 1,2,…,N) (1.10)
• So there are really N equations, one for each observation
• the coefficients, β0 and β1, are the same
• the values of Y, X, and ε differ across observations
Extending the Notation (cont.)
• The general case: multivariate regression
Yi = β0 + β1X1i + β2X2i + β3X3i + εi (i = 1,2,…,N) (1.11)
• Each of the slope coefficients gives the impact of a one-unit
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increase in the corresponding X variable on Y, holding the other included independent variables constant (i.e., ceteris paribus)
• As an (implicit) consequence of this, the impact of variables that are not included in the regression are not held constant (we return to this in Ch. 6)
Example: Wage Regression
• Let wages (WAGE) depend on:
– years of work experience (EXP)
– years of education (EDU)
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– years of education (EDU)
– gender of the worker (GEND: 1 if male, 0 if female)
• Substituting into equation (1.11) yields:
WAGEi = β0 + β1EXPi + β2EDUi + β3GENDi + εi (1.12)
Indexing Conventions
• Subscript “i” for data on individuals (so called “cross section” data)
• Subscript “t” for time series data (e.g., series of
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• Subscript “t” for time series data (e.g., series of years, months, or days—daily exchange rates, for example )
• Subscript “it” when we have both (for example, “panel data”)
The Estimated Regression Equation
• The regression equation considered so far is the “true”—but unknown—theoretical regression equation
• Instead of “true,” might think about this as the populationregression vs. the sample/estimated regression
• How do we obtain the empirical counterpart of the theoretical
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• How do we obtain the empirical counterpart of the theoretical regression model (1.14)?
• It has to be estimated
• The empirical counterpart to (1.14) is:
(1.16)
• The signs on top of the estimates are denoted “hat,” so that we have “Y-hat,” for example
iiXY
10
ˆˆˆ ββ +=
The Estimated Regression Equation (cont.)
• For each sample we get a different set of estimated regression coefficients
• Y is the estimated value of Yi (i.e. the dependent variable for observation i); similarly it is the prediction of E(Y |X ) from the regression equation
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variable for observation i); similarly it is the prediction of E(Yi|Xi) from the regression equation
• The closer Y is to the observed value of Yi, the better is the “fit” of the equation
• Similarly, the smaller is the estimated error term, ei, often denoted the “residual,” the better is the fit
The Estimated Regression Equation (cont.)
• This can also be seen from the fact that
(1.17)
• Note difference with the error term, εi, given as
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• Note difference with the error term, εi, given as
(1.18)
• This all comes together in Figure 1.3
Figure 1.3 True and Estimated Regression Lines
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Example: Using Regression to Explain Housing prices
• Houses are not homogenous products, like corn or gold, that have generally known market prices
• So, how to appraise a house against a given asking price?
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asking price?
• Yes, it’s true: many real estate appraisers actually use regression analysis for this!
• Consider specific case: Suppose the asking price was $230,000
Example: Using Regression to Explain Housing prices (cont.)
• Is this fair / too much /too little?
• Depends on size of house (higher size, higher price)
• So, collect cross-sectional data on prices (in thousands of $) and sizes (in square feet)
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(in thousands of $) and sizes (in square feet) for, say, 43 houses
• Then say this yields the following estimated regression line:
(1.23)ii
SIZECEIPR 138.00.40ˆ +=
Figure 1.5 A Cross-Sectional Model of Housing Prices
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Example: Using Regression to Explain Housing prices (cont.)
• Note that the interpretation of the intercept term is problematic in this case (we’ll get back to this later, in Section 7.1.2)
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• The literal interpretation of the intercept here is the price of a house with a size of zero square feet…
Example: Using Regression to Explain Housing prices (cont.)
• How to use the estimated regression line / estimated regression coefficients to answer the question?
– Just plug the particular size of the house, you are interested in (here, 1,600 square feet) into (1.23)
– Alternatively, read off the estimated price using Figure 1.5
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– Alternatively, read off the estimated price using Figure 1.5
• Either way, we get an estimated price of $260.8 (thousand, remember!)
• So, in terms of our original question, it’s a good deal—go ahead and purchase!!
• Note that we simplified a lot in this example by assuming that only size matters for housing prices
Table 1.1a Data for and Results of the Weight-Guessing Equation
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Table 1.1b Data for and Results of the Weight-Guessing Equation
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Key Terms from Chapter 1
• Regression analysis
• Dependent variable
• Independent (or
explanatory) variable(s)
• Slope coefficient
• Multivariate regression model
• Expected value
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explanatory) variable(s)
• Causality
• Stochastic error term
• Linear
• Intercept term
• Residual
• Time series
• Cross-sectional data set