# Chapter 1 Introduction to Econometrics

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1 Chapter 1 Introduction to Econometrics Econometrics deals with the measurement of economic relationships. It is an integration of economics, mathematical economics and statistics with an objective to provide numerical values to the parameters of economic relationships. The relationships of economic theories are usually epressed in mathematical forms and combined with empirical economics. The econometrics methods are used to obtain the values of parameters which are essentially the coefficients of mathematical form of the economic relationships. The statistical methods which help in eplaining the economic phenomenon are adapted as econometric methods. The econometric relationships depict the random behaviour of economic relationships which are generally not considered in economics and mathematical formulations. It may be pointed out that the econometric methods can be used in other areas lie engineering sciences, biological sciences, medical sciences, geosciences, agricultural sciences etc. In simple words, whenever there is a need of finding the stochastic relationship in mathematical format, the econometric methods and tools help. The econometric tools are helpful in eplaining the relationships among variables. Econometric Models: A model is a simplified representation of a real world process. It should be representative in the sense that it should contain the salient features of the phenomena under study. In general, one of the objectives in modeling is to have a simple model to eplain a comple phenomenon. Such an objective may sometimes lead to oversimplified model and sometimes the assumptions made are unrealistic. In practice, generally all the variables which the eperimenter thins are relevant to eplain the phenomenon are included in the model. Rest of the variables are dumped in a baset called disturbances where the disturbances are random variables. This is the main difference between the economic modeling and econometric modeling. This is also the main difference between the mathematical modeling and statistical modeling. The mathematical modeling is eact in nature whereas the statistical modeling contains a stochastic term also. An economic model is a set of assumptions that describes the behaviour of an economy, or more general, a phenomenon. 1

2 An econometric model consists of - a set of equations describing the behaviour. These equations are derived from the economic model and have two parts observed variables and disturbances. - a statement about the errors in the observed values of variables. - a specification of the probability distribution of disturbances. Aims of econometrics: The three main aims econometrics are as follows: 1. Formulation and specification of econometric models: The economic models are formulated in an empirically testable form. Several econometric models can be derived from an economic model. Such models differ due to different choice of functional form, specification of stochastic structure of the variables etc.. Estimation and testing of models: The models are estimated on the basis of observed set of data and are tested for their suitability. This is the part of statistical inference of the modeling. Various estimation procedures are used to now the numerical values of the unnown parameters of the model. Based on various formulations of statistical models, a suitable and appropriate model is selected. 3. Use of models: The obtained models are used for forecasting and policy formulation which is an essential part in any policy decision. Such forecasts help the policy maers to judge the goodness of fitted model and tae necessary measures in order to re-adjust the relevant economic variables. Econometrics and statistics: Econometrics differs both from mathematical statistics and economic statistics. In economic statistics, the empirical data is collected recorded, tabulated and used in describing the pattern in their development over time. The economic statistics is a descriptive aspect of economics. It does not provide either the eplanations of the development of various variables or measurement of the parameters of the relationships.

3 Statistical methods describe the methods of measurement which are developed on the basis of controlled eperiments. Such methods may not be suitable for economic phenomenon as they don t fit in the framewor of controlled eperiments. For eample, in real world eperiments, the variables usually change continuously and simultaneously and so the set up of controlled eperiments are not suitable. Econometrics uses statistical methods after adapting them to the problems of economic life. These adopted statistical methods are usually termed as econometric methods. Such methods are adjusted so that they become appropriate for the measurement of stochastic relationships. These adjustments basically attempts to specify attempts to the stochastic element which operate in real world data and enters into the determination of observed data. This enables the data to be called as random sample which is needed for the application of statistical tools. The theoretical econometrics includes the development of appropriate methods for the measurement of economic relationships which are not meant for controlled eperiments conducted inside the laboratories. The econometric methods are generally developed for the analysis of non-eperimental data. The applied econometrics includes the application of econometric methods to specific branches of econometric theory and problems lie demand, supply, production, investment, consumption etc. The applied econometrics involves the application of the tools of econometric theory for the analysis of economic phenomenon and forecasting the economic behaviour. Types of data Various types of data is used in the estimation of the model. 1. Time series data Time series data give information about the numerical values of variables from period to period and are collected over time. For eample, the data during the years for monthly income constitutes a time series data.. Cross section data The cross section data give information on the variables concerning individual agents (e.g., consumers or produces) at a given point of time. For eample, a cross section of sample of consumers is a sample of family budgets showing ependitures on various commodities by each family, as well as information on family income, family composition and other demographic, social or financial characteristics. 3

4 3. Panel data: The panel data are the data from repeated survey of a single (cross-section) sample in different periods of time. 4. Dummy variable data When the variables are qualitative in nature, then the data is recorded in the form of indicator function. The values of the variables do not reflect the magnitude of data. They reflect only the presence/absence of a characteristic. For eample, the variables lie religion, se, taste, etc. are qualitative variables. The variable `se taes two values male or female, the variable `taste taes values-lie or dislie etc. Such values are denoted by dummy variable. For eample, these values can be represented as 1 represents male and 0 represents female. Similarly, 1 represents the liing of taste and 0 represents the disliing of taste. Aggregation problem: The aggregation problems arise when aggregative variables are used in functions. Such aggregative variables may involve. 1. Aggregation over individuals: For eample the total income may comprise the sum of individual incomes.. Aggregation over commodities: The quantity of various commodities may be aggregated over e.g., price or group of commodities. This is done by using suitable inde. 3. Aggregation over time periods Sometimes the data is available for shorter or longer time periods than required to be used in the functional form of economic relationship. In such cases, the data needs to be aggregated over time period. For eample, the production of most of the manufacturing commodities is completed in a period shorter than a year. If annual figures are to be used in the model then there may be some error in the production function. 4. Spatial aggregation: Sometimes the aggregation is related to spatial issues. For eample, the population of towns, countries, or the production in a city or region etc.. Such sources of aggregation introduces aggregation bias in the estimates of the coefficients. It is important to eamine the possibility of such errors before estimating the model. 4

5 Econometrics and regression analysis: One of the very important role of econometrics is to provide the tools for modeling on the basis of given data. The regression modeling technique helps a lot in this tas. The regression models can be either linear or non-linear based on which we have linear regression analysis and non-linear regression analysis. We will consider only the tools of linear regression analysis and our main interest will be the fitting of linear regression model to a given set of data. Linear regression model Suppose the outcome of any process is denoted by a random variable y, called as dependent (or study) variable, depends on independent (or eplanatory) variables denoted by X 1, X,..., X. Suppose the behaviour of y can be eplained by a relationship given by y = f( X, X,..., X, β, β,..., β ) + ε 1 1 where f is some well defined function and β1, β,..., β are the parameters which characterize the role and contribution of X1, X,..., X, respectively. The term ε reflects the stochastic nature of the relationship between y and X1, X,..., X and indicates that such a relationship is not eact in nature. When ε = 0, then the relationship is called the mathematical model otherwise the statistical model. The term model is broadly used to represent any phenomenon in a mathematical frame wor. A model or relationship is termed as linear if it is linear in parameters and nonlinear, if it is not linear in parameters. In other words, if all the partial derivatives of y with respect to each of the parameters β, β,..., β are independent of the parameters, then the model is called as a linear model. If any of the 1 partial derivatives of y with respect to any of the β1, β,..., β is not independent of the parameters, the model is called as nonlinear. Note that the linearity or non-linearity of the model is not described by the linearity or nonlinearity of eplanatory variables in the model. For eample y = β X + β X + β log X + ε is a linear model because y/ β, ( i = 1,, 3) are independent of the parameters β, ( i = 1,, 3). On the other hand, y = β X + β X + β X + ε log i i 5

6 is a nonlinear model because y/ β1 = β1x1 depends on β 1 although y / β and y / β3 are independent of any of the β1, β or β 3. When the function f is linear in parameters, then y = f( X1, X,..., X, β1, β,..., β) + ε is called a linear model and when the function f is nonlinear in parameters, then it is called a nonlinear model. In general, the function f is chosen as f( X, X,..., X, β, β..., β ) = β X + β X β X to describe a linear model. Since X1, X,..., X are pre-determined variables and y is the outcome, so both are nown. Thus the nowledge of the model depends on the nowledge of the parameters β1, β,..., β. The statistical linear modeling essentially consists of developing approaches and tools to determine β1, β,..., β in the linear model y = β X + β X + + β X + ε given the observations on y and X1, X,..., X. Different statistical estimation procedures, e.g., method of maimum lielihood, principle of least squares, method of moments etc. can be employed to estimate the parameters of the model. The method of maimum lielihood needs further nowledge of the distribution of y whereas the method of moments and the principle of least squares do not need any nowledge about the distribution of y. The regression analysis is a tool to determine the values of the parameters given the data on y and X1, X,..., X. The literal meaning of regression is to move in the bacward direction. Before discussing and understanding the meaning of bacward direction, let us find which of the following statements is correct: S 1: model generates data or S : data generates model. Obviously, S 1 is correct. It can be broadly thought that the model eists in nature but is unnown to the eperimenter. When some values to the eplanatory variables are provided, then the values for the output or study variable are generated accordingly, depending on the form of the function f and the nature of phenomenon. So ideally, the pre-eisting model gives rise to the data. Our objective is to determine the 6

7 functional form of this model. Now we move in the bacward direction. We propose to first collect the data on study and eplanatory variables. Then we employ some statistical techniques and use this data to now the form of function f. Equivalently, the data from the model is recorded first and then used to determine the parameters of the model. The regression analysis is a technique which helps in determining the statistical model by using the data on study and eplanatory variables. The classification of linear and nonlinear regression analysis is based on the determination of linear and nonlinear models, respectively. Consider a simple eample to understand the meaning of regression. Suppose the yield of crop ( y ) depends linearly on two eplanatory variables, viz., the quantity of a fertilizer ( X 1) and level of irrigation ( X ) as y = β X + β X + ε 1 1. There eist the true values of β1 and β in nature but are unnown to the eperimenter. Some values on y are recorded by providing different values to X 1 and X. There eists some relationship between y and X1, X which gives rise to a systematically behaved data on y, X1 and X. Such relationship is unnown to the eperimenter. To determine the model, we move in the bacward direction in the sense that the collected data is used to determine the unnown parameters β1 and β of the model. In this sense such an approach is termed as regression analysis. The theory and fundamentals of linear models lay the foundation for developing the tools for regression analysis that are based on valid statistical theory and concepts. Steps in regression analysis Regression analysis includes the following steps: Statement of the problem under consideration Choice of relevant variables Collection of data on relevant variables Specification of model Choice of method for fitting the data Fitting of model Model validation and criticism Using the chosen model(s) for the solution of the posed problem. 7

8 These steps are eamined below. 1. Statement of the problem under consideration: The first important step in conducting any regression analysis is to specify the problem and the objectives to be addressed by the regression analysis. The wrong formulation or the wrong understanding of the problem will give the wrong statistical inferences. The choice of variables depends upon the objectives of study and understanding of the problem. For eample, height and weight of children are related. Now there can be two issues to be addressed. (i) Determination of height for given weight, or (ii) determination of weight for given height. In the case 1, the height is response variable whereas weight is response variable in case. The role of eplanatory variables are also interchanged in the cases 1 and.. Choice of relevant variables: Once the problem is carefully formulated and objectives have been decided, the net question is to choose the relevant variables. It has to ept in mind that the correct choice of variables will determine the statistical inferences correctly. For eample, in any agricultural eperiment, the yield depends on eplanatory variables lie quantity of fertilizer, rainfall, irrigation, temperature etc. These variables are denoted by X1, X,..., X as a set of eplanatory variables. 3. Collection of data on relevant variables: Once the objective of study is clearly stated and the variables are chosen, the net question arises is to collect data on such relevant variables. The data is essentially the measurement on these variables. For eample, suppose we want to collect the data on age. For this, it is important to now how to record the data on age. Then either the date of birth can be recorded which will provide the eact age on any specific date or the age in terms of completed years as on specific date can be recorded. Moreover, it is also important to decide that whether the data has to be collected on variables as quantitative variables or qualitative variables. For eample, if the ages (in years) are 15,17,19,1,3, then these are quantitative values. If the ages are defined by a variable that taes value 1 if ages are less than 18 years and 0 if the ages are more than 18 years, then the earlier recorded data is converted to 1,1,0,0,0. Note that there is a loss of information in converting the quantitative data into qualitative data. The methods and approaches for qualitative and quantitative data are also different. If the study variable is binary, then logistic and probit 8

9 regressions etc. are used. If all eplanatory variables are qualitative, then analysis of variance technique is used. If some eplanatory variables are qualitative and others are quantitative, then analysis of covariance technique is used. The techniques of analysis of variance and analysis of covariance are the special cases of regression analysis. Generally, the data is collected on n subjects, then y on data, then y denotes the response or study variable and y1, y,..., y n are the n values. If there are eplanatory variables X 1, X,.., X then ij denotes the i th value of following table: th j variable 1,,..., ; 1,,..., i = n j =. The observation can be presented in the Notation for the data used in regression analysis Observation Response Eplanatory variables number y X 1 X X 1 y y 1 3 y n y n n1 n n 4. Specification of model: The eperimenter or the person woring in the subject usually help in determining the form of the model. Only the form of the tentative model can be ascertained and it will depend on some unnown parameters. For eample, a general form will be lie y = f( X, X,..., X ; β, β,..., β ) + ε 1 1 where ε is the random error reflecting mainly the difference in the observed value of y and the value of y obtained through the model. The form of f( X1, X,..., X; β1, β,..., β ) can be linear as well as nonlinear depending on the form of parameters β1, β,..., β. A model is said to be linear if it is linear in parameters. For eample, 9

10 y = β X + β X + β X + ε y = β + β ln X + ε 1 are linear models whereas y = β X + β X + β X + ε ( ln ) y = β X + β X + ε 1 1 are non-linear models. Many times, the nonlinear models can be converted into linear models through some transformations. So the class of linear models is wider than what it appears initially. If a model contains only one eplanatory variable, then it is called as simple regression model. When there are more than one independent variables, then it is called as multiple regression model. When there is only one study variable, the regression is termed as univariate regression. When there are more than one study variables, the regression is termed as multivariate regression. Note that the simple and multiple regressions are not same as univariate and multivariate regressions. The simple and multiple regression are determined by the number of eplanatory variables whereas univariate and multivariate regressions are determined by the number of study variables. 5. Choice of method for fitting the data: After the model has been defined and the data have been collected, the net tas is to estimate the parameters of the model based on the collected data. This is also referred to as parameter estimation or model fitting. The most commonly used method of estimation is the least squares method. Under certain assumptions, the least squares method produces estimators with desirable properties. The other estimation methods are the maimum lielihood method, ridge method, principal components method etc. 6. Fitting of model: The estimation of unnown parameters using appropriate method provides the values of the parameter. Substituting these values in the equation gives us a usable model. This is termed as model fitting. The estimates of parameters β1, β,..., β in the model y = f( X, X,..., X, β, β,..., β ) + ε 1 1 are denoted by ˆ β ˆ ˆ 1, β,..., β which gives the fitted model as y = f( X, X,..., X, ˆ β, ˆ β,..., ˆ β )

11 When the value of y is obtained for the given values of X1, X,..., X, it is denoted as ŷ and called as fitted value. The fitted equation is used for prediction. In this case, ŷ is termed as predicted value. Note that the fitted value is where the values used for eplanatory variables correspond to one of the n observations in the data whereas predicted value is the one obtained for any set of values of eplanatory variables. It is not generally recommended to predict the y -values for the set of those values of eplanatory variables which lie outside the range of data. When the values of eplanatory variables are the future values of eplanatory variables, the predicted values are called forecasted values. 7. Model criticism and selection The validity of statistical method to be used for regression analysis depends on various assumptions. These assumptions become essentially the assumptions for the model and the data. The quality of statistical inferences heavily depends on whether these assumptions are satisfied or not. For maing these assumptions to be valid and to be satisfied, care is needed from beginning of the eperiment. One has to be careful in choosing the required assumptions and to decide as well to determine if the assumptions are valid for the given eperimental conditions or not? It is also important to decide that the situations is which the assumptions may not meet. The validation of the assumptions must be made before drawing any statistical conclusion. Any departure from validity of assumptions will be reflected in the statistical inferences. In fact, the regression analysis is an iterative process where the outputs are used to diagnose, validate, criticize and modify the inputs. The iterative process is illustrated in the following figure. Inputs Outputs Theories Model Assumptions Data Statistocal methods Estimate Diagnosis, validation and criticism Estimation of parameters Confidence regions Tests of hypotheses Graphical displays 11

12 8. Objectives of regression analysis The determination of eplicit form of regression equation is the ultimate objective of regression analysis. It is finally a good and valid relationship between study variable and eplanatory variables. The regression equation helps is understanding the interrelationships of variables among them. Such regression equation can be used for several purposes. For eample, to determine the role of any eplanatory variable in the joint relationship in any policy formulation, to forecast the values of response variable for given set of values of eplanatory variables. 1

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