LECTURE 2
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Introduction to Econometrics
INTRODUCTION TO LINEAR
REGRESSION ANALYSIS I
Dali Laxton
October 16, 2020
PREVIOUS LECTURE...
e Introduction, organization, review of statistical
background
▪ random variables
▪ mean, variance, standard deviation
▪ covariance, correlation, independence
▪ normal distribution
▪ standardized random variables
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WARM-UP EXERCISE
► What is the correlation between X andY?
► Correlation: Corr(X, Y) = Cov(X,Y)
σXσY
► Covariance:
Cov(X,Y) = E [(X − E[X])(Y − E[Y])] = E [XY] − E[X]E[Y]
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LECTURE 2.
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e Introduction to simple linear regressionanalysis
Sampling and estimation
OLS principle
e Readings:
Studenmund, A. H., Using Econometrics: A Practical
Guide, Chapters 1, 2.1, 16.1, 16.2
Wooldridge, J. M., Introductory Econometrics: A Modern
Approach, Chapters 2.1, 2.2
SAMPLING
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e Population: the entire group of items that interestsus
e Sample: the part of the population that we actually
observe
e Statistical inference: use of the sample to draw conclusion
about the characteristics of the population from which the
sample came
e Examples: medical experiments, opinionpolls
RANDOM SAMPLING VS SELECTION BIAS
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e Correct statistical inference can be performed only on a
random sample - a sample that reflects the true
distribution of the population
e Biased sample: any sample that differs systematically
from the population that it is intended to represent
e Selection bias: occurs when the selection of the sample
systematically excludes or under represents certaingroups
Example: opinion poll about tuition payments among
undergraduate students vs all citizens
e Self-selection bias: occurs when we examine data for a
group of people who have chosen to be in that group
Example: accident records of people who buy collision
insurance
EXERCISE 1
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e American Express and the French tourist office sponsored
a survey that found that most visitors to France do not
consider the French to be especially unfriendly.
e The sample consisted of 1,000 Americans who have visited
France more than once for pleasure over the past two
years.
e Is this surveyunbiased?
ESTIMATION
e Parameter: a true characteristic of the distribution of a variable,
whose value is unknown, but can be estimated
Example: population mean E[X]
e Estimator: a sample statistic that is used to estimate the value of
the parameter
Example: sample mean
Note that the estimator is a random variable (it has a probability
distribution, mean, variance,...)
e Estimate: the specific value of the estimator that is obtained
on a specific sample
PROPERTIES OF AN ESTIMATOR
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e An estimator is unbiased if the mean of its distribution is
equal to the value of the parameter it is estimating
e An estimator is consistent if it converges to the value of
the true parameter as the sample size increases
e An estimator is efficient if the variance of its sampling
distribution is the smallest possible
EXERCISE 2
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e A young econometrician wants to estimate the relationship
between foreign direct investments (FDI) in her country
and firm profitability.
e Her reasoning is that better managerial skills introduced
by foreign owners increases firms’ profitability.
e She collects a random sample of 8,750 firms and finds that
one sixth of the firms were entered within last few yearsby
foreign investors. The rest of the firms are owned
domestically.
e When she compares indicators of profitability, such as
ROA and ROE, between the domestic and foreign-owned
firms, she finds significantly better outcomes for
foreign-owned firms.
e She concludes that FDI increases firms’ profitability. Is this
conclusion correct?
ECONOMETRIC MODELS
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e Econometric model is an estimable formulation of a
theoretical relationship
e Theory says: Q = f(P,Ps, Y)
Q . . . quantity demanded
P . . . commodity’s price
Ps . . . price of substitutegood
Y . . . disposable income
e We simplify: Q = β0 + β1P + β2Ps + β3Y
e We estimate: Q = 31.50 − 0.73P + 0.11Ps + 0.23Y
ECONOMETRIC MODELS
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e Today’s econometrics deals with different, even very
general models
e During this course we will cover just linear regression
models
e Wewill see how these models are estimatedby
Ordinary Least Squares (OLS)
Generalized Least Squares (GLS)
Instrumental Variables (IV)
e Wewill perform estimation on different types ofdata
DATA USED IN ECONOMETRICS
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cross-section
sample of units
(eg. firms, individuals)
taken at a given point in time
repeated cross-section
several independent
samples of units
(eg. firms, individuals)
taken at different points in time
time-series
observations of variable(s)
in different points in time
(eg. GDP)
paneldata
time series for each
cross-sectional unit
in the data set
(eg. GDP of
various countries)
DATA USED IN ECONOMETRICS -EXAMPLES
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e Country’s macroeconomic indicators (GDP, inflation rate,
net exports, etc.) month by month
e Data about firms’ employees or financial indicators as of
the end of the year
e Records of bank clients who were given aloan
e Annual social security or tax records of individual workers
STEPS OF AN ECONOMETRIC ANALYSIS
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1. Formulation of an economic model (rigorous or intuitive)
2. Formulation of an econometric model based on the
economic model
3. Collection of data
4. Estimation of the econometric model
5. Interpretation of results
EXAMPLE - ECONOMIC MODEL
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e Denote:
p
c
.. . price of the good
. . . firm’s average cost per one unit of output
q(p) .. . demand for firm’soutput
Demand for good:
q(p) = a − b ·p
Firm profit:
π= q(p) ·(p −c)
e Derive:
bq =
a
− ·c
2 2
e Wecall q dependent variable and c explanatoryvariable
EXAMPLE - ECONOMETRIC MODEL
e Write the relationship in a simple linearform
q = β0 +β1c
0 1
a b
2 2
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(have in mind that β = and β = −
e There are other (unpredictable) things that influence firms’
sales ⇒ add disturbance term
q = β0 + β1c +ε
e Find the value of parameters β1 (slope) and β0(intercept)
EXAMPLE - DATA
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e Ideally: investigate all firms in theeconomy
e Reality: investigate a sample offirms
Weneed a random (unbiased) sample of firms
e Collect data:
Firm 1 2 3 4 5 6
q 15 32 52 14 37 27
c 294 247 153 350 173 218
EXAMPLE - DATA
10204050
Outpu
t30
150 200 250 300 350
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Average cost
EXAMPLE - ESTIMATION
10204050
Outpu
t30
150 200 250 300 350
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Average cost
EXAMPLE - ESTIMATION1050
Output
203040
150 200 300 350
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rageAve
250
cost
OLS method:
Make the fit as good as possible
⇓
Make the misfit as low as
possible
Minimize the (vertical)distance
between data points and
regression line
Minimize the sum of
ssquared deviations
TERMINOLOGY
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yi = β0 + β1xi + εi . .. regression line
yi . . . dependent/explained variable (i-thobservation)
xi . . .independent/explanatory variable (i-th observation)
εi . . .random error term/disturbance (of i-th observation)
β0 ... intercept parameter ( β^0... estimate of this parameter)
β1 ... slope parameter ( β^1... estimate of this parameter)
ORDINARY LEAST SQUARES
e OLS = fitting the regression line by minimizing the sum of
vertical distance between the regression line and the
observed points
104050
Output
2030
150 200 300 350
rageAve
250
cost
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ORDINARY LEAST SQUARES - PRINCIPLE
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e Take the squared differences between observed point yi
and regression line β0 + β1xi:
𝜀𝑖
2
=(yi − β0 −β1xi)2
e Sum them over all n observations:
e ^0
^1Find β and β such that they minimize this
sum
ORDINARY LEAST SQUARES - DERIVATION
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RESIDUAL
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e Residual is the vertical difference between the estimated
regression line and the observation points
e OLS minimizes the sum of squares of allresiduals
e It is the difference between the true value yi and the
estimated value
e Wedefine:
e Residual ei (observed) is not the same as the disturbance εi
(unobserved)!!!
e Residual is an estimate of the disturbance:
^
RESIDUAL VS. DISTURBANCE
10204050
Outpu
t30
150 200 250 300 350
Average cost
True relationship
Estimated relationship
Disturbance
Residual
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GETTING BACK TO THE EXAMPLE
e Wehave the economicmodel
bq =
a
− ·c
2 2
e Weestimate
qi = β0 + β1ci +εi
0
a
2(having in mind that β = and β1
b
2
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= − )
e Over data:
Firm 1 2 3 4 5 6
q 15 32 52 14 37 27
c 294 247 153 350 173 218
GETTING BACK TO THE EXAMPLE
e When we plug in the formula:
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-0.177
GETTING BACK TO THE EXAMPLE
e When we plug in the formula:
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-0.177
-0.177c
0.353
MEANING OF REGRESSION COEFFICIENT
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e Consider themodel
q = β0 + β1c
^q = 71.74 −1.77cestimated as
q . . . demand forfirm’s
output
c . . . firm’s average costper
unit of output
e Meaning of β1 is the impact of a one unit increase in c on
the dependent variable q
e When average costs increase by 1 unit, quantity demanded
decreases by 1.77 units
- 0.177c
BEHIND THE ERROR TERM
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e The stochastic error term must be present in a regression
equation because of:
1. omission of many minor influences (unavailable data)
2. measurement error
3. possibly incorrect functional form
4. stochastic character of unpredictable human behavior
e Remember that all of these factors are included in the error
term and may alter its properties
e The properties of the error term determine the properties
of the estimates
SUMMARY
e Wehave learned that an econometric analysis consistsof
1. definition of the model
2. estimation
3. interpretation
e Wehave explained the principle of OLS: minimizing the
sum of squared differences between the observations and
the regression line
e Wehave derived the formulas of theestimates:
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WHAT’S NEXT
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e In the next lectures, wewill
▪ derive estimation formulas for multivariate models
▪ specify properties of the OLS estimator
▪ start using Gretl for data description and estimation