Wooldridge, Introductory Econometrics, 2d ed.

Chapter 1: Nature of Econometrics and Economic Data

What do we mean by econometrics? Econometrics is the
field of economics in which statistical methods are developed
and applied to estimate economic relationships, test economic
theories, and evaluate plans and policies implemented by
private industry, government, and supranational organizations.
Econometrics encompasses forecasting–not only the high-profile
forecasts of macroeconomic and financial variables, but also
forecasts of demand for a product, likely effects of a tax package,
or the interaction between the demand for health services and
welfare reform.
Why is econometrics separate from mathematical statistics?
Because most applications of statistics in economics and finance
are related to the use of non-experimental data, or observational
data. The fundamental techniques of statistics have been
developed for use on experimental data: that gathered from
controlled experiments, where the design of the experiment and
the reliability of measurements from its outcomes are primary
foci. In relying on observational data, economists are more like
astronomers, able to collect and analyse increasingly complete
measures on the world (or universe) around them, but unable to
influence the outcomes.
This distinction is not absolute; some economic policies
are in the nature of experiments, and economists have been
heavily involved in both their design and implementation. A
good example within the last five years is the implementation of
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welfare reform, limiting individuals’ tenure on the welfare rolls
to five years of lifetime experience. Many doubted that this would
be successful in addressing the needs of those welfare recipients
who have low job skills; but the reforms have been surprisingly
successful, as a recent article in The Economist states, at raising
the employment rate among this cohort. Economists are also
able to carefully examine the economic consequences of massive
regime changes in an economy, such as the transition from a
planned economy to a capitalist system in the former Soviet bloc.
But fundamentally applied econometricians observe the data, and
use sophisticated techniques to evaluate their meaning.
We speak of this work as empirical analysis, or empirical
research. The first step is the careful formulation of the
question of interest. This will often involve the application or
development of an economic model, which may be as simple
as noting that normal goods have negative price elasticities,
or exceedingly complex, involving a full-fledged description
of many aspects of a set of interrelated markets and the
supply/demand relationships for the products traded (as would,
for instance, an econometric analysis of an antitrust issue,
such as U.S. v Microsoft). Economists are often attacked
for their imperialistic tendencies–applying economic logic to
consider such diverse topics as criminal behavior, fertility, or
environmental issues–but where there is an economic dimension,
the application of economic logic and empirical research based on
econometric practice may yield valuable insights. Gary Becker,
who has made a career of applying economics to non-economic

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realms, won a Nobel Prize for his efforts.Crime, after all, is yet
another career choice, and for high school dropouts who don’t
see much future in flipping burgers at minimum wage, it is hardly
surprising that there are ample applicants for positions in a drug
dealer’s distribution network. In risk-adjusted terms (gauging the
risk of getting shot, or arrested and successfully prosecuted...)
the risk-adjusted hourly wage is many times the minimum wage.
Should we be surprised by the outcome?
Irregardless of whether empirical research is based on a for-
mal economic model or economic intuition, the hypotheses about
economic behavior must be transformed into an econometric
model that can be applied to the data. In an economic model, we
can speak of functions such as Q = Q (P, Y ) ; but if we are to
estimate the parameters of that relationship, we must have an ex-
plicit functional form for the Q function, and determine that it is
an appropriate form for the model we have in mind. For instance,
if we were trying to predict the efficiency of an automobile in
terms of its engine size (displacement, in in3 or liters), Ameri-
cans would likely rely on a measure like mpg – miles per gallon.
But the engineering relationship is not linear between mpg and
displacement; it is much closer to being a linear function if we
relate gallons per mile (gpm = 1/mpg ) to engine size. The re-
lationship will be curvilinear in mpg terms, requiring a more
complex model, but nearly linear in gpm vs displacement. An
econometric model will spell out the role of each of its variables:
for instance,
gpmi =
0 +
1displi + i

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would express the relationship between the fuel consumption
of the ith automobile to its engine size, or displacement, as a
linear function, with an additive error term i which encompasses
all factors not included in the model. The parameters of the
model are the
terms, which must be estimated via statistical
methods. Once that estimation has been done, we may test
specific hypotheses on their values: for instance, that
1 is
positive (larger engines use more fuel), or that
1 takes on a
certain value. Estimating this relationship for Stata’s auto.dta
dataset of 74 automobiles, the predicted relationship is

i = 0.029 + 0.011displi
gpm
where displacement is measured in hundreds of in3. This
estimated relationship has an “R2” value of 0.59, indicating that
59% of the variation of gpm around its mean is “explained” by
displacement, and a root-mean-squared error of 0.008 (which can
be compared to gpm’s mean of 0.050, corresponding to about 21
mpg ).
The structure of economic data
We must acquaint ourselves with some terminology to
describe the several forms in which economic and financial data
may appear. A great deal of the work we will do in this course
will relate to cross-sectional data: a sample of units (individuals,
families, firms, industries, countries...) taken at a given point
in time, or in a particular time frame. The sample is often
considered to be a random sample of some sort when applied to
microdata such as that gathered from individuals or households.
For instance, the official estimates of the U.S. unemployment
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rate are gathered from a monthly survey of individuals, in which
each is asked about their employment status. It is not a count,
or census, of those out of work. Of course, some cross sections
are not samples, but may represent the population: e.g. data
from the 50 states do not represent a random sample of states. A
cross-sectional dataset can be conceptualized as a spreadsheet,
with variables in the columns and observations in the rows.
Each row is uniquely identified by an observation number, but
in a cross-sectional datasets the ordering of the observations is
immaterial. Different variables may correspond to different time
periods; we might have a dataset containing municipalities, their
employment rates, and their population in the 1990 and 2000
censuses.
The other major form of data considered in econometrics
is the time series: a series of evenly spaced measurements
on a variable. A time-series dataset may contain a number
of measures, each measured at the same frequency, including
measures derived from the originals such as lagged values,
differences, and the like. Time series are innately more difficult
to handle in an econometric context because their observations
almost surely are interdependent across time. Most economic
and financial time series exhibit some degree of persistence.
Although we may be able to derive some measures which should
not, in theory, be explainable from earlier observations (such as
tomorrow’s stock return in an efficient market), most economic
time series are both interrelated and autocorrelated–that is,
related to themselves across time periods. In a spreadsheet

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context, the variables would be placed in the columns, and the
rows labelled with dates or times. The order of the observations
in a time-series dataset matters, since it denotes the passage of
equal increments of time. We will discuss time-series data and
some of the special techniques that have been developed for its
analysis in the latter part of the course.
Two combinations of these data schemes are also widely
used: pooled cross-section/time series (CS/TS) datasets and
panel, or longitudinal, data sets. The former (CS/TS) arise
in the context of a repeated survey–such as a presidential
popularity poll–where the respondents are randomly chosen. It is
advantageous to analyse multiple cross-sections, but not possible
to link observations across the cross-sections. Much more useful
are panel data sets, in which we have timeseries of observations
on the same unit: for instance, Ci,t might be the consumption
level of the ith household at time t. Many of the datasets we
commonly utilize in economic and financial research are of this
nature: for instance, a great deal of research in corporate finance
is carried out with Standard and Poor’s COMPUSTAT, a panel
data set containing 20 years of annual financial statements for
thousands of major U.S. corporations. There is a wide array of
specialized econometric techniques that have been developed to
analyse panel data; we will not touch upon them in this course.
Causality and ceteris paribus
The hypotheses tested in applied econometric analysis are
often posed to make inferences about the possible causal effects
of one or more factors on a response variable: that is, do changes

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in consumers’ incomes “cause” changes in their consumption
of beer? At some level, of course, we can never establish
causation–unlike the physical sciences, where the interrelations
of molecules may follow well-established physical laws, our
observed phenomena represent innately unpredictable human
behavior. In economic theory, we generally hold that individuals
exhibit rational behavior; but since the econometrician does
not observe all of the factors that might influence behavior,
we cannot always make sensible inferences about potentially
causal factors. Whenever we “operationalize” an econometric
model, we implicitly acknowledge that it can only capture a few
key details of the behavioral relationship, and is leaving many
additional factors (which may or may not be observable) in the
“pound of ceteris paribus.” ceteris paribus–literally, other things
equal–always underlies our inferences from empirical research.
Our best hope is that we might control for many of the factors,
and be able to use our empirical findings to ascertain whether
systematic factors have been omitted. Any econometric model
should be subjected to diagnostic testing to determine whether
it contains obvious flaws. For instance, the relationship between
mpg and displ in the automobile data is strictly dominated by
a model containing both displ and displ 2, given the curvilinear
relation between mpg and displ. Thus the original linear
model can be viewed as unacceptable in comparison to the
polynomial model; this conclusion could be drawn from analysis
of the model’s residuals, coupled with an understanding of the
engineering relationship that posits a nonlinear function between

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mpg and displ.