1 Simple Linear Regression I – Least Squares Estimation

Textbook Sections: 18.1–18.3

Previously, we have worked with a random variable x that comes from a population that is
normally distributed with mean µ and variance σ 2 . We have seen that we can write x in terms
of µ and a random error component ε, that is, x = µ + ε. For the time being, we are going to
change our notation for our random variable from x to y. So, we now write y = µ + ε. We will now
find it useful to call the random variable y a dependent or response variable. Many times, the
response variable of interest may be related to the value(s) of one or more known or controllable
independent or predictor variables. Consider the following situations:

LR1 A college recruiter would like to be able to predict a potential incoming student’s first–year
GPA (y) based on known information concerning high school GPA (x1 ) and college entrance
examination score (x2 ). She feels that the student’s first–year GPA will be related to the
values of these two known variables.

LR2 A marketer is interested in the effect of changing shelf height (x1 ) and shelf width (x2 ) on
the weekly sales (y) of her brand of laundry detergent in a grocery store.

LR3 A psychologist is interested in testing whether the amount of time to become proficient in a
foreign language (y) is related to the child’s age (x).

In each case we have at least one variable that is known (in some cases it is controllable), and a
response variable that is a random variable. We would like to fit a model that relates the response
to the known or controllable variable(s). The main reasons that scientists and social researchers
use linear regression are the following:

1. Prediction – To predict a future response based on known values of the predictor variables
and past data related to the process.

2. Description – To measure the effect of changing a controllable variable on the mean value
of the response variable.

3. Control – To confirm that a process is providing responses (results) that we ‘expect’ under
the present operating conditions (measured by the level(s) of the predictor variable(s)).

1.1 A Linear Deterministic Model

Suppose you are a vendor who sells a product that is in high demand (e.g. cold beer on the beach,
cable television in Gainesville, or life jackets on the Titanic, to name a few). If you begin your day
with 100 items, have a profit of $10 per item, and an overhead of $30 per day, you know exactly
how much profit you will make that day, namely 100(10)-30=$970. Similarly, if you begin the day
with 50 items, you can also state your profits with certainty. In fact for any number of items you
begin the day with (x), you can state what the day’s profits (y) will be. That is,

y = 10 · x − 30.

This is called a deterministic model. In general, we can write the equation for a straight line as

y = β0 + β1 x,

1
where β0 is called the y–intercept and β1 is called the slope. β0 is the value of y when x = 0,
and β1 is the change in y when x increases by 1 unit. In many real–world situations, the response
of interest (in this example it’s profit) cannot be explained perfectly by a deterministic model. In
this case, we make an adjustment for random variation in the process.

1.2 A Linear Probabilistic Model

The adjustment people make is to write the mean response as a linear function of the predictor
variable. This way, we allow for variation in individual responses (y), while associating the mean
linearly with the predictor x. The model we fit is as follows:

E(y|x) = β0 + β1 x,

and we write the individual responses as

y = β0 + β1 x + ε,

We can think of y as being broken into a systematic and a random component:

y = β0 + β1 x + |{z}
ε
| {z }
systematic random

where x is the level of the predictor variable corresponding to the response, β0 and β1 are
unknown parameters, and ε is the random error component corresponding to the response whose
distribution we assume is N (0, σ), as before. Further, we assume the error terms are independent
from one another, we discuss this in more detail in a later chapter. Note that β0 can be interpreted
as the mean response when x=0, and β1 can be interpreted as the change in the mean response
when x is increased by 1 unit. Under this model, we are saying that y|x ∼ N (β0 +β1 x, σ). Consider
the following example.

Example 1.1 – Coffee Sales and Shelf Space

A marketer is interested in the relation between the width of the shelf space for her brand of
coffee (x) and weekly sales (y) of the product in a suburban supermarket (assume the height is
always at eye level). Marketers are well aware of the concept of ‘compulsive purchases’, and know
that the more shelf space their product takes up, the higher the frequency of such purchases. She
believes that in the range of 3 to 9 feet, the mean weekly sales will be linearly related to the
width of the shelf space. Further, among weeks with the same shelf space, she believes that sales
will be normally distributed with unknown standard deviation σ (that is, σ measures how variable
weekly sales are at a given amount of shelf space). Thus, she would like to fit a model relating
weekly sales y to the amount of shelf space x her product receives that week. That is, she is fitting
the model:
y = β0 + β1 x + ε,
so that y|x ∼ N (β0 + β1 x, σ).
One limitation of linear regression is that we must restrict our interpretation of the model to
the range of values of the predictor variables that we observe in our data. We cannot assume this
linear relation continues outside the range of our sample data.
We often refer to β0 + β1 x as the systematic component of y and ε as the random component.

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1.3 Least Squares Estimation of β0 and β1
We now have the problem of using sample data to compute estimates of the parameters β0 and
β1 . First, we take a sample of n subjects, observing values y of the response variable and x of the
predictor variable. We would like to choose as estimates for β0 and β1 , the values b0 and b1 that
‘best fit’ the sample data. Consider the coffee example mentioned earlier. Suppose the marketer
conducted the experiment over a twelve week period (4 weeks with 3’ of shelf space, 4 weeks with
6’, and 4 weeks with 9’), and observed the sample data in Table 1.

Shelf Space Weekly Sales Shelf Space Weekly Sales

x y x y
6 526 6 434
3 421 3 443
6 581 9 590
9 630 6 570
3 412 3 346
9 560 9 672

Table 1: Coffee sales data for n = 12 weeks

SALES
700

600

500

400

300
0 3 6 9 12
SPACE

Figure 1: Plot of coffee sales vs amount of shelf space

Now, look at Figure 1. Note that while there is some variation among the weekly sales at 3’,
6’, and 9’, respectively, there is a trend for the mean sales to increase as shelf space increases. If
we define the fitted equation to be an equation:

ŷ = b0 + b1 x,

we can choose the estimates b0 and b1 to be the values that minimize the distances of the data points
to the fitted line. Now, for each observed response yi , with a corresponding predictor variable xi ,
we obtain a fitted value ŷi = b0 + b1 xi . So, we would like to minimize the sum of the squared
distances of each observed response to its fitted value. That is, we want to minimize the error

3
sum of squares, SSE, where:
n
X n
X
SSE = (yi − ŷi )2 = (yi − (b0 + b1 xi ))2 .
i=1 i=1

A little bit of calculus can be used to obtain the estimates:

Pn
i=1 (xi − x)(yi − y) SSxy
b1 = Pn 2
= ,
i=1 (xi − x) SSxx

and Pn Pn
i=1 yi i=1 xi
b0 = y − β̂1 x = . − b1
n n
An alternative formula, but exactly the same mathematically, is to compute the sample
covariance of x and y, as well as the sample variance of x, then taking the ratio. This
is the the approach your book uses, but is extra work from the formula above.
Pn Pn
i=1 (xi − x)(yi − y) SSxy − x)2
i=1 (xi SSxx cov(x, y)
cov(x, y) = = s2x = = b1 =
n−1 n−1 n−1 n−1 s2x

Some shortcut equations, known as the corrected sums of squares and crossproducts, that while
not very intuitive are very useful in computing these and other estimates are:
Pn
Pn Pn ( xi )2
• SSxx = i=1 (xi − x)2 = 2
i=1 xi − i=1
n
Pn Pn
Pn Pn ( xi )( yi )
• SSxy = i=1 (xi − x)(yi − y) = i=1 xi yi − i=1
n
i=1

Pn
Pn Pn ( yi )2
• SSyy = i=1 (yi − y)2 = 2
i=1 yi − i=1
n

Example 1.1 Continued – Coffee Sales and Shelf Space

For the coffee data, we observe the following summary statistics in Table 2.

Week Space (x) Sales (y) x2 xy y2

1 6 526 36 3156 276676
2 3 421 9 1263 177241
3 6 581 36 3486 337561
4 9 630 81 5670 396900
5 3 412 9 1236 169744
6 9 560 81 5040 313600
7 6 434 36 2604 188356
8 3 443 9 1329 196249
9 9 590 81 5310 348100
10 6 570 36 3420 324900
11 3 346 9 1038 119716
12 9 672 81 6048 451584
P P P 2 P P 2
x = 72 y = 6185 x = 504 xy = 39600 y = 3300627

Table 2: Summary Calculations — Coffee sales data

From this, we obtain the following sums of squares and crossproducts.

4
 P
X X ( x)2 (72)2
2 2
SSxx = (x − x) = x − = 504 − = 72
n 12

P P
X X ( x)( y) (72)(6185)
SSxy = (x − x)(y − y) = xy − = 39600 − = 2490
n 12

P
X X ( y)2 (6185)2
2 2
SSyy = (y − y) = y − = 3300627 − = 112772.9
n 12
From these, we obtain the least squares estimate of the true linear regression relation (β0 +β1 x).

SSxy 2490
b1 = = = 34.5833
SSxx 72

P P
y x 6185 72
b0 = − b1 = − 34.5833( ) = 515.4167 − 207.5000 = 307.967.
n n 12 12

ŷ = b0 + b1 x = 307.967 + 34.583x

So the fitted equation, estimating the mean weekly sales when the product has x feet of shelf
space is ŷ = β̂0 + β̂1 x = 307.967 + 34.5833x. Our interpretation for b1 is “the estimate for the
increase in mean weekly sales due to increasing shelf space by 1 foot is 34.5833 bags of coffee”.
Note that this should only be interpreted within the range of x values that we have observed in the
“experiment”, namely x = 3 to 9 feet.

Example 1.2 – Computation of a Stock Beta

A widely used measure of a company’s performance is their beta. This is a measure of the firm’s
stock price volatility relative to the overall market’s volatility. One common use of beta is in the
capital asset pricing model (CAPM) in finance, but you will hear them quoted on many business
news shows as well. It is computed as (Value Line):

The “beta factor” is derived from a least squares regression analysis between weekly
percent changes in the price of a stock and weekly percent changes in the price of all
stocks in the survey over a period of five years. In the case of shorter price histories, a
smaller period is used, but never less than two years.

In this example, we will compute the stock beta over a 28-week period for Coca-Cola and
Anheuser-Busch, using the S&P500 as ’the market’ for comparison. Note that this period is only
about 10% of the period used by Value Line. Note: While there are 28 weeks of data, there are
only n=27 weekly changes.
Table 3 provides the dates, weekly closing prices, and weekly percent changes of: the S&P500,
Coca-Cola, and Anheuser-Busch. The following summary calculations are also provided, with x
representing the S&P500, yC representing Coca-Cola, and yA representing Anheuser-Busch. All
calculations should be based on 4 decimal places. Figure 2 gives the plot and least squares regression
line for Anheuser-Busch, and Figure 3 gives the plot and least squares regression line for Coca-Cola.

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 X X X
x = 15.5200 yC = −2.4882 yA = 2.4281
X X X
x2 = 124.6354 2
yC = 461.7296 2
yA = 195.4900
X X
xyC = 161.4408 xyA = 84.7527
a) Compute SSxx , SSxyC , and SSxyA .

b) Compute the stock betas for Coca-Cola and Anheuser-Busch.

Closing S&P A-B C-C S&P A-B C-C

Date Price Price Price % Chng % Chng % Chng
05/20/97 829.75 43.00 66.88 – – –
05/27/97 847.03 42.88 68.13 2.08 -0.28 1.87
06/02/97 848.28 42.88 68.50 0.15 0.00 0.54
06/09/97 858.01 41.50 67.75 1.15 -3.22 -1.09
06/16/97 893.27 43.00 71.88 4.11 3.61 6.10
06/23/97 898.70 43.38 71.38 0.61 0.88 -0.70
06/30/97 887.30 42.44 71.00 -1.27 -2.17 -0.53
07/07/97 916.92 43.69 70.75 3.34 2.95 -0.35
07/14/97 916.68 43.75 69.81 -0.03 0.14 -1.33
07/21/97 915.30 45.50 69.25 -0.15 4.00 -0.80
07/28/97 938.79 43.56 70.13 2.57 -4.26 1.27
08/04/97 947.14 43.19 68.63 0.89 -0.85 -2.14
08/11/97 933.54 43.50 62.69 -1.44 0.72 -8.66
08/18/97 900.81 42.06 58.75 -3.51 -3.31 -6.28
08/25/97 923.55 43.38 60.69 2.52 3.14 3.30
09/01/97 899.47 42.63 57.31 -2.61 -1.73 -5.57
09/08/97 929.05 44.31 59.88 3.29 3.94 4.48
09/15/97 923.91 44.00 57.06 -0.55 -0.70 -4.71
09/22/97 950.51 45.81 59.19 2.88 4.11 3.73
09/29/97 945.22 45.13 61.94 -0.56 -1.48 4.65
10/06/97 965.03 44.75 62.38 2.10 -0.84 0.71
10/13/97 966.98 43.63 61.69 0.20 -2.50 -1.11
10/20/97 944.16 42.25 58.50 -2.36 -3.16 -5.17
10/27/97 941.64 40.69 55.50 -0.27 -3.69 -5.13
11/03/97 914.62 39.94 56.63 -2.87 -1.84 2.04
11/10/97 927.51 40.81 57.00 1.41 2.18 0.65
11/17/97 928.35 42.56 57.56 0.09 4.29 0.98
11/24/97 963.09 43.63 63.75 3.74 2.51 10.75

Table 3: Weekly closing stock prices – S&P 500, Anheuser-Busch, Coca-Cola

Example 1.3 – Estimating Cost Functions of a Hosiery Mill

The following (approximate) data were published by Joel Dean, in the 1941 article: “Statistical
Cost Functions of a Hosiery Mill,” (Studies in Business Administration, vol. 14, no. 3).

6
 ya
5

-1

-2

-3

-4

-5
-4 -3 -2 -1 0 1 2 3 4 5
x

Figure 2: Plot of weekly percent stock price changes for Anheuser-Busch versus S&P 500 and least
squares regression line

ya
5

-1

-2

-3

-4

-5
-4 -3 -2 -1 0 1 2 3 4 5
x

Figure 3: Plot of weekly percent stock price changes for Coca-Cola versus S&P 500 and least
squares regression line

7
y — Monthly total production cost (in $1000s).

x — Monthly output (in thousands of dozens produced).

A sample of n = 48 months of data were used, with xi and yi being measured for each month.
The parameter β1 represents the change in mean cost per unit increase in output (unit variable
cost), and β0 represents the true mean cost when the output is 0, without shutting plant (fixed
cost). The data are given in Table 1.3 (the order is arbitrary as the data are printed in table form,
and were obtained from visual inspection/approximation of plot).

i xi yi i xi yi i xi yi
1 46.75 92.64 17 36.54 91.56 33 32.26 66.71
2 42.18 88.81 18 37.03 84.12 34 30.97 64.37
3 41.86 86.44 19 36.60 81.22 35 28.20 56.09
4 43.29 88.80 20 37.58 83.35 36 24.58 50.25
5 42.12 86.38 21 36.48 82.29 37 20.25 43.65
6 41.78 89.87 22 38.25 80.92 38 17.09 38.01
7 41.47 88.53 23 37.26 76.92 39 14.35 31.40
8 42.21 91.11 24 38.59 78.35 40 13.11 29.45
9 41.03 81.22 25 40.89 74.57 41 9.50 29.02
10 39.84 83.72 26 37.66 71.60 42 9.74 19.05
11 39.15 84.54 27 38.79 65.64 43 9.34 20.36
12 39.20 85.66 28 38.78 62.09 44 7.51 17.68
13 39.52 85.87 29 36.70 61.66 45 8.35 19.23
14 38.05 85.23 30 35.10 77.14 46 6.25 14.92
15 39.16 87.75 31 33.75 75.47 47 5.45 11.44
16 38.59 92.62 32 34.29 70.37 48 3.79 12.69

Table 4: Production costs and Output – Dean (1941)

.

This dataset has n = 48 observations with a mean output (in 1000s of dozens) of x = 31.0673,
and a mean monthly cost (in $1000s) of y = 65.4329.
n
X n
X n
X n
X n
X
xi = 1491.23 x2i = 54067.42 yi = 3140.78 yi2 = 238424.46 xi yi = 113095.80
i=1 i=1 i=1 i=1 i=1

From these quantites, we get:

Pn
Pn 2 ( xi )2 (1491.23)2
• SSxx = i=1 xi −
i=1
n = 54067.42 − 48 = 54067.42 − 46328.48 = 7738.94
Pn Pn
Pn ( xi )( yi )
• SSxy = i=1 xi yi −
i=1
n
i=1
= 113095.80− (1491.23)(3140.78)
48 = 113095.80−97575.53 =
15520.27
Pn
Pn 2 ( yi )2 (3140.78)2
• SSyy = i=1 yi −
i=1
n = 238424.46 − 48 = 238424.46 − 205510.40 = 32914.06

Pn Pn
Pn ( xi )( i=1 yi )
i=1 xi yi −
i=1
SSxy 15520.27
b1 = Pn n = = = 2.0055
Pn 2 ( i=1 xi )2 SSxx 7738.94
i=1 xi − n

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 b0 = y − b1 x = 65.4329 − (2.0055)(31.0673) = 3.1274
ŷi = b 0 + b 1 xi = 3.1274 + 2.0055xi i = 1, . . . , 48
ei = yi − ŷi = yi − (3.1274 + 2.0055xi ) i = 1, . . . , 48
Table 1.3 gives the raw data, their fitted values, and residuals.
A plot of the data and regression line are given in Figure 4.

cost Y=Math Score X=Tissue LSD Concentration

100
score
80
90

8 07 0

70
60

60

50
50

40
40

30
30
20

1 02 0
01 21 0 3 20 4 30 5 40 6 5 07
scioznec

Figure 4: Estimated cost function for hosiery mill (Dean, 1941)

We have seen now, how to estimate β0 and β1 . Now we can obtain an estimate of the variance of
the responses at a given value of x. Recall from your previous statistics course, you estimated the
variance by taking the ‘average’ squared
P deviation of each measurement from the sample (estimated)
n
(yi −y)2
mean. That is, you calculated s2y = i=1n−1 . Now that we fit the regression model, we know
longer use y to estimate the mean for each yi , but rather ŷi = b0 + b1 xi to estimate the mean.
The estimate we use now looks similar to the previous estimate except we replace y with ŷi and
we replace n − 1 with n − 2 since we have estimated 2 parameters, β0 and β1 . The new estimate
(which we will refer as to the estimated error variance) is:
Pn (SS )2   !
SSE i=1 (yi− ŷi ) SSyy − SSxy n−1 [cov(x, y)]2
s2e = M SE = = = xx
= s2y −
n−2 n−2 n−2 n−2 s2x

9
 i xi yi ŷi ei
1 46.75 92.64 96.88 -4.24
2 42.18 88.81 87.72 1.09
3 41.86 86.44 87.08 -0.64
4 43.29 88.80 89.95 -1.15
5 42.12 86.38 87.60 -1.22
6 41.78 89.87 86.92 2.95
7 41.47 88.53 86.30 2.23
8 42.21 91.11 87.78 3.33
9 41.03 81.22 85.41 -4.19
10 39.84 83.72 83.03 0.69
11 39.15 84.54 81.64 2.90
12 39.20 85.66 81.74 3.92
13 39.52 85.87 82.38 3.49
14 38.05 85.23 79.44 5.79
15 39.16 87.75 81.66 6.09
16 38.59 92.62 80.52 12.10
17 36.54 91.56 76.41 15.15
18 37.03 84.12 77.39 6.73
19 36.60 81.22 76.53 4.69
20 37.58 83.35 78.49 4.86
21 36.48 82.29 76.29 6.00
22 38.25 80.92 79.84 1.08
23 37.26 76.92 77.85 -0.93
24 38.59 78.35 80.52 -2.17
25 40.89 74.57 85.13 -10.56
26 37.66 71.60 78.65 -7.05
27 38.79 65.64 80.92 -15.28
28 38.78 62.09 80.90 -18.81
29 36.70 61.66 76.73 -15.07
30 35.10 77.14 73.52 3.62
31 33.75 75.47 70.81 4.66
32 34.29 70.37 71.90 -1.53
33 32.26 66.71 67.82 -1.11
34 30.97 64.37 65.24 -0.87
35 28.20 56.09 59.68 -3.59
36 24.58 50.25 52.42 -2.17
37 20.25 43.65 43.74 -0.09
38 17.09 38.01 37.40 0.61
39 14.35 31.40 31.91 -0.51
40 13.11 29.45 29.42 0.03
41 9.50 29.02 22.18 6.84
42 9.74 19.05 22.66 -3.61
43 9.34 20.36 21.86 -1.50
44 7.51 17.68 18.19 -0.51
45 8.35 19.23 19.87 -0.64
46 6.25 14.92 15.66 -0.74
47 5.45 11.44 14.06 -2.62
48 3.79 12.69 10.73 1.96

Table 5: Approximated Monthly Outputs, total costs, fitted values and residuals – Dean (1941)
.

10
This estimated error variance s2e can be thought of as the ‘average’ squared distance from each
observed response to the fitted line. The word average is in quotes since we divide by n − 2 and not
n. The closer the observed responses fall to the line, the smaller s2e is and the better our predicted
values will be.

Example 1.1 (Continued) – Coffee Sales and Shelf Space

For the coffee data,
2
112772.9 − (2490) 112772.9 − 86112.5
s2e= 72
= = 2666.04,
12 − 2 10
√
and the estimated residual standard error (deviation) is Se = 2666.04 = 51.63. We now have
estimates for all of the parameters of the regression equation relating the mean weekly sales to the
amount of shelf space the coffee gets in the store. Figure 5 shows the 12 observed responses and
the estimated (fitted) regression equation.

SALES
700

600

500

400

300
0 3 6 9 12
SPACE

Figure 5: Plot of coffee data and fitted equation

Example 10.3 (Continued) – Estimating Cost Functions of a Hosiery Mill

For the cost function data:

Pn SS 2 2
• SSE = i=1 (yi − ŷi )
2 xy
= SSyy − SSxx = 32914.06− (15520.27)
7738.94 = 32914.06−31125.55 = 1788.51

• s2e = M SE = SSE
n−2 =
1788.51
48−2 = 38.88
√
• se = 38.88 = 6.24

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2 Simple Regression II — Inferences Concerning β1
Textbook Section: 18.5 (and some supplementary material)

Recall that in our regression model, we are stating that E(y|x) = β0 + β1 x. In this model, β1
represents the change in the mean of our response variable y, as the predictor variable x increases
by 1 unit. Note that if β1 = 0, we have that E(y|x) = β0 + β1 x = β0 + 0x = β0 , which implies
the mean of our response variable is the same at all values of x. In the context of the coffee sales
example, this would imply that mean sales are the same, regardless of the amount of shelf space, so
a marketer has no reason to purchase extra shelf space. This is like saying that knowing the level
of the predictor variable does not help us predict the response variable.
Under the assumptions stated previously, namely that y ∼ N (β0 + β1 x, σ), our estimator b1
has a sampling distribution that is normal with mean β1 (the true value of the parameter), and
standard error pPn σ 2
. That is:
i=1
(xi −x)

σ
b1 ∼ N (β1 , √ )
SSxx
We can now make inferences concerning β1 .

2.1 A Confidence Interval for β1

First, we obtain the estimated standard error of b1 (this is the standard deviation of its sampling
distibution:
se se
sb1 = √ =p
SSxx (n − 1)s2x
The interval can be written:
se
b1 ± tα/2,n−2 sb1 ≡ b1 ± tα/2,n−2 √ .
SSxx
se
√
Note that √SS is the estimated standard error of b1 since we use se = M SE to estimate σ.
xx
Also, we have n − 2 degrees of freedom instead of n − 1, since the estimate s2e has 2 estimated
paramters used in it (refer back to how we calculate it above).

Example 2.1 – Coffee Sales and Shelf Space

For the coffee sales example, we have the following results:

b1 = 34.5833, SSxx = 72, se = 51.63, n = 12.

So a 95% confidence interval for the parameter β1 is:

51.63
34.5833 ± t.025,12−2 √ = 34.5833 ± 2.228(6.085) = 34.583 ± 13.557,
72
which gives us the range (21.026, 48.140). We are 95% confident that the true mean sales increase
by between 21.026 and 48.140 bags of coffee per week for each extra foot of shelf space the brand

12
gets (within the range of 3 to 9 feet). Note that the entire interval is positive (above 0), so we are
confident that in fact β1 > 0, so the marketer is justified in pursuing extra shelf space.

Example 2.2 – Hosiery Mill Cost Function

b1 = 2.0055, SSxx = 7738.94, se = 6.24, n = 48.

For the hosiery mill cost function analysis, we obtain a 95% confidence interval for average unit
variable costs (β1 ). Note that t.025,48−2 = t.025,46 ≈ 2.015, since t.025,40 = 2.021 and t.025,60 = 2.000
(we could approximate this with z.025 = 1.96 as well).
6.24
2.0055 ± t.025,46 √ = 2.0055 ± 2.015(.0709) = 2.0055 ± 0.1429 = (1.8626, 2.1484)
7738.94
We are 95% confident that the true average unit variable costs are between $1.86 and $2.15 (this
is the incremental cost of increasing production by one unit, assuming that the production process
is in place.

2.2 Hypothesis Tests Concerning β1

Similar to the idea of the confidence interval, we can set up a test of hypothesis concerning β1 .
Since the confidence interval gives us the range of ‘believable’ values for β1 , it is more useful than
a test of hypothesis. However, here is the procedure to test if β1 is equal to some value, say β10 .

• H0 : β1 = β10 (β10 specified, usually 0)

• (1) Ha : β1 6= β10
(2) Ha : β1 > β10
(3) Ha : β1 < β10
b1 −β10 b1 −β10
• T S : tobs = √ se
= sb1
SSxx

• (1) RR : |tobs | ≥ tα/2,n−2

(2) RR : tobs ≥ tα,n−2
(3) RR : tobs ≤ −tα,n−2

• (1) P –value: 2 · P (t ≥ |tobs |)

(2) P –value: P (t ≥ tobs )
(3) P –value: P (t ≤ tobs )
Using tables, we can only place bounds on these p–values.

Example 2.1 (Continued) – Coffee Sales and Shelf Space

Suppose in our coffee example, the marketer gets a set amount of space (say 60 ) for free, and
she must pay extra for any more space. For the extra space to be profitable (over the long run),

13
the mean weekly sales must increase by more than 20 bags, otherwise the expense outweighs the
increase in sales. She wants to test to see if it is worth it to buy more space. She works under the
assumption that it is not worth it, and will only purchase more if she can show that it is worth it.
She sets α = .05.

1. H0 : β1 = 20 HA : β1 > 20
34.5833−20 14.5833
2. T.S.: tobs = 51.63
√
= 6.085 = 2.397
72

3. R.R.: tobs > t.05,10 = 1.812

4. p-value: P (T > 2.397) < P (T > 2.228) = .025 and P (T > 2.397) > P (T > 2.764) = .010, so
.01 < p − value < .025.

So, she has concluded that β1 > 20, and she will purchase the shelf space. Note also that the entire
confidence interval was over 20, so we already knew this.

Example 2.2 (Continued) – Hosiery Mill Cost Function

Suppose we want to test whether average monthly production costs increase with monthly
production output. This is testing whether unit variable costs are positive (α = 0.05).

• H0 : β1 = 0 (Mean Monthly production cost is not associated with output)

• HA : β1 > 0 (Mean monthly production cost increases with output)

2.0055−0 2.0055
• T S : tobs = √ 6.24
= 0.0709 = 28.29
7738.94

• RR : tobs > t0.05,46 ≈ 1.680 (or use z0.05 = 1.645)

• p-value: P (T > 28.29) ≈ 0

We have overwhelming evidence of positive unit variable costs.

2.3 The Analysis of Variance Approach to Regression

Consider the deviations of the individual responses, yi , from their overall mean y. We would
like to break these deviations into two parts, the deviation of the observed value from its fitted
value, ŷi = b0 + b1 xi , and the deviation of the fitted value from the overall mean. See Figure 6
corresponding to the coffee sales example. That is, we’d like to write:

yi − y = (yi − ŷi ) + (ŷi − y).

Note that all we are doing is adding and subtracting the fitted value. It so happens that
algebraically we can show the same equality holds once we’ve squared each side of the equation
and summed it over the n observed and fitted values. That is,
n
X n
X n
X
(yi − y)2 = (yi − ŷi )2 + (ŷi − y)2 .
i=1 i=1 i=1

14
 SALES
700

600

500

400

300
0 3 6 9 12
SPACE

Figure 6: Plot of coffee data, fitted equation, and the line y = 515.4167

These three pieces are called the total, error, and model sums of squares, respectively. We
denote them as SSyy , SSE, and SSR, respectively. We have already seen that SSyy represents the
total variation in the observed responses, and that SSE represents the variation in the observed
responses around the fitted regression equation. That leaves SSR as the amount of the total
variation that is ‘accounted for’ by taking into account the predictor variable X. We can use
this decomposition to test the hypothesis H0 : β1 = 0 vs HA : β1 6= 0. We will also find this
decomposition useful in subsequent sections when we have more than one predictor variable. We
first set up the Analysis of Variance (ANOVA) Table in Table 6. Note that we will have to
make minimal calculations to set this up since we have already computed SSyy and SSE in the
regression analysis.

ANOVA
Source of Sum of Degrees of Mean
Variation Squares Freedom Square F
Pn
MODEL SSR = i=1 (ŷi − y) 2 1 M SR = SSR
1 F =MM SR
SE
P
ERROR SSE = ni=1 (yi − ŷi )2 n−2 M SE = SSE
n−2
P
TOTAL SSyy = ni=1 (yi − y)2 n−1

Table 6: The Analysis of Variance Table for simple regression

The procedure of testing for a linear association between the response and predictor variables
using the analysis of variance involves using the F –distribution, which is given in Table 6 (pp
B-11–B-16) of your text book. This is the same distribution we used in the chapteron the 1-Way
ANOVA.
The testing procedure is as follows:

1. H0 : β1 = 0 HA : β1 6= 0 (This will always be a 2–sided test)

M SR
2. T.S.: Fobs = M SE

3. R.R.: Fobs > F1,n−2,α

15
 4. p-value: P (F > Fobs ) (You can only get bounds on this, but computer outputs report them
exactly)

Note that we already have a procedure for testing this hypothesis (see the section on Inferences
Concerning β1 ), but this is an important lead–in to multiple regression.

Example 2.1 (Continued) – Coffee Sales and Shelf Space

Referring back to the coffee sales data, we have already made the following calculations:

SSyy = 112772.9, SSE = 26660.4, n = 12.

We then also have that SSR = SSyy − SSE = 86112.5. Then the Analysis of Variance is given in
Table 7.
ANOVA
Source of Sum of Degrees of Mean
Variation Squares Freedom Square F
MODEL SSR = 86112.5 1 M SR = 86112.5
1 = 86112.5 F = 86112.5
2666.04 = 32.30
26660.4
ERROR SSE = 26660.4 12 − 2 = 10 M SE = 10 = 2666.04
TOTAL SSyy = 112772.9 12 − 1 = 11

Table 7: The Analysis of Variance Table for the coffee data example

To test the hypothesis of no linear association between amount of shelf space and mean weekly
coffee sales, we can use the F -test described above. Note that the null hypothesis is that there is
no effect on mean sales from increasing the amount of shelf space. We will use α = .01.

1. H0 : β1 = 0 HA : β1 6= 0
M SR 86112.5
2. T.S.: Fobs = M SE = 2666.04 = 32.30

3. R.R.: Fobs > F1,n−2,α = F1,10,.01 = 10.04

4. p-value: P (F > Fobs ) = P (F > 32.30) ≈ 0

We reject the null hypothesis, and conclude that β1 6= 0. There is an effect on mean weekly sales
when we increase the shelf space.

Example 2.2 (Continued) – Hosiery Mill Cost Function

For the hosiery mill data, the sums of squares for each source of variation in monthly production
costs and their corresponding degrees of freedom are (from previous calculations):
Pn
Total SS – SSyy = i=1 (yi − y)2 = 32914.06 dfT otal = n − 1 = 47
Pn
Error SS – SSE = i=1 (yi − ŷi )2 = 1788.51 dfE = n − 2 = 46
Pn
Model SS – SSR = i=1 (ŷi − y)2 = SSyy − SSE = 32914.06 − 1788.51 = 31125.55 dfR = 1

16
 ANOVA
Source of Sum of Degrees of Mean
Variation Squares Freedom Square F
MODEL SSR = 31125.55 1 M SR = 31125.55
1 = 31125.55 F = 31125.55
38.88 = 800.55
ERROR SSE = 1788.51 48 − 2 = 46 M SE = 1788.51
46 = 38.88
TOTAL SSyy = 32914.06 48 − 1 = 47

Table 8: The Analysis of Variance Table for the hosiery mill cost example

The Analysis of Variance is given in Table 8.

To test whether there is a linear association between mean monthly costs and monthly produc-
tion output, we conduct the F -test (α = 0.05).

1. H0 : β1 = 0 HA : β1 6= 0
M SR 31125.55
2. T.S.: Fobs = M SE = 38.88 = 800.55

3. R.R.: Fobs > F1,n−2,α = F1,46,.05 ≈ 4.06

4. p-value: P (F > Fobs ) = P (F > 800.55) ≈ 0

We reject the null hypothesis, and conclude that β1 6= 0.

2.3.1 Coefficient of Determination

A measure of association that has a clear physical interpretation is R2 , the coefficient of deter-
mination. This measure is always between 0 and 1, so it does not reflect whether y and x are
positively or negatively associated, and it represents the proportion of the total variation in the
response variable that is ‘accounted’ for by fitting the regression on x. The formula for R2 is:
SSE SSR [cov(x, y)]2
R2 = (R)2 = 1 − = = .
SSyy SSyy s2x s2y
P
Note that SSyy = ni=1 (yi − y)2 represents the total variation in the response variable, while
P
SSE = ni=1 (yi − ŷi )2 represents the variation in the observed responses about the fitted equation
(after taking into account x). This is why we sometimes say that R2 is “proportion of the variation
in y that is ‘explained’ by x.”

Example 2.1 (Continued) – Coffee Sales and Shelf Space

For the coffee data, we can calculate R2 using the values of SSxy , SSxx , SSyy , and SSE we have
previously obtained.
26660.4 86112.5
R2 = 1 − = = .7636
112772.9 112772.9
Thus, over 3/4 of the variation in sales is “explained” by the model using shelf space to predict
sales.

Example 2.2 (Continued) – Hosiery Mill Cost Function

17
 For the hosiery mill data, the model (regression) sum of squares is SSR = 31125.55 and the
total sum of squares is SSyy = 32914.06. To get the coefficient of determination:

31125.55
R2 = = 0.9457
32914.06
Almost 95% of the variation in monthly production costs is “explained” by the monthly production
output.

18
3 Simple Regression III – Estimating the Mean and Prediction at
a Particular Level of x, Correlation
Textbook Sections: 18.7,18.8
We sometimes are interested in estimating the mean response at a particular level of the predic-
tor variable, say x = xg . That is, we’d like to estimate E(y|xg ) = β0 + β1 xg . The actual estimate
9point prediction) is just ŷ = b0 + b1 xg , which is simply where the fitted line crosses x = xg .
Under the previously stated normality assumptions, r the estimator ŷ0 is normally distributed with
2
mean β0 + β1 xg and standard error of estimate σ 1
n + Pn(xg (x
−x)
−x)2
. That is:
i=1 i

s
1 (xg − x)2
ŷ0 ∼ N (β0 + β1 xg , σ + Pn 2
).
n i=1 (xi − x)

Note that the standard error of the estimate is smallest at xg = x, that is at the mean of the
sampled levels of the predictor variable. The standard error increases as the value xg goes away
from this mean.
For instance, our marketer may wish to estimate the mean sales when she has 60 of shelf space,
or 70 , or 40 . She may also wish to obtain a confidence interval for the mean at these levels of x.

3.1 A Confidence Interval for E(y|xg ) = β0 + β1 xg

Using the ideas described in the previous section, we can write out the general form for a (1−α)100%
confidence interval for the mean response when xg .
s
1 (xg − x)2
(b0 + b1 xg ) ± tα/2,n−2 Se +
n SSxx

Example 3.1 – Coffee Sales and Shelf Space

Suppose our marketer wants to compute 95% confidence intervals for the mean weekly sales at
x=4,6, and 7 feet, respectively (these are not simultaneous confidence intervals as were computed
based on Bonferroni’s Method previously). Each of these intervals will depend on tα/2,n−2 =
t.05,10 = 2.228 and x = 6. These intervals are:
s
1 (4 − 6)2 √
(307.967 + 34.5833(4)) ± 2.228(51.63) + = 446.300 ± 115.032 .1389
12 72
= 446.300 ± 42.872 ≡ (403.428, 489.172)
s
1 (6 − 6)2 √
(307.967 + 34.5833(6)) ± 2.228(51.63) + = 515.467 ± 115.032 .0833
12 72
= 515.467 ± 33.200 ≡ (482.267, 548.667)
s
1 (7 − 6)2 √
(307.967 + 34.5833(7)) ± 2.228(51.63) + = 550.050 ± 115.032 .0972
12 72

19
 = 550.050 ± 35.863 ≡ (514.187, 585.913)
Notice that the interval is the narrowest at xg = 6. Figure 7 is a computer generated plot of the
data, the fitted equation and the confidence limits for the mean weekly coffee sales at each value
of x. Note how the limits get wider as x goes away from x = 6.
SALES
700

600

500

400

300
0 3 6 9 12
SPACE

Figure 7: Plot of coffee data, fitted equation, and 95% confidence limits for the mean

Example 3.2 – Hosiery Mill Cost Function

Suppose the plant manager is interested in mean costs among months where output is 30,000
items produced (xg = 30). She wants a 95% confidence interval for this true unknown mean.
Recall:

b0 = 3.1274 b1 = 2.0055 se = 6.24 n = 48 x = 31.0673 SSxx = 7738.94t.025,46 ≈ 2.015

Then the interval is obtained as:

r
1 (30 − 31.0673)2
3.1274 + 2.0055(30) ± 2.015(6.24) +
48 7738.94
√
≡ 63.29 ± 2.015(6.24) 0.0210 ≡ 63.29 ± 1.82 ≡ (61.47, 65.11)
We can be 95% confident that the mean production costs among months where 30,000 items are
produced is between $61,470 and $65,110 (recall units were thousands for x and thousands for y).
A plot of the data, regression line, and 95% confidence bands for mean costs is given in Figure 8.

3.2 Predicting a Future Response at a Given Level of x

In many situations, a researcher would like to predict the outcome of the response variable at a
specific level of the predictor variable. In the previous section we estimated the mean response,
in this section we are interested in predicting a single outcome. In the context of the coffee sales
example, this would be like trying to predict next week’s sales given we know that we will have 60
of shelf space.

20
 cost
100

90

80

70

60

50

40

30

20

10
0 10 20 30 40 50
size

Figure 8: Plot of hosiery mill cost data, fitted equation, and 95% confidence limits for the mean

21
 First, suppose you know the parameters β0 and β1 Then you know that the response variable,
for a fixed level of the predictor variable (x = xg ), is normally distributed with mean E(y|xg ) =
β0 + β1 xg and standard deviation σ. We know from previous work with the normal distribution
that approximately 95% of the measurements lie within 2 standard deviations of the mean. So if we
know β0 , β1 , and σ, we would be very confident that our response would lie between (β0 +β1 xg )−2σ
and (β0 + β1 xg ) + 2σ. Figure 9 represents this idea.
F2
0.040
0.035
0.030
0.025
0.020
0.015
0.010
0.005
0.000
50 60 70 80 90 100 110 120 130 140 150
X

Figure 9: Distribution of response variable with known β0 , β1 , and σ

We rarely, if ever, know these parameters, and we must estimate them as we have in previous
sections. There is uncertainty in what the mean response at the specified level, xg , of the response
variable. We do, however know how to obtain an interval that we are very confident contains the
true mean β0 + β1 xg . If we apply the method of the previous paragraph to all ‘believable’ values of
this mean we can obtain a prediction interval that we are very confident will contain our future
response. Since σ is being estimated as well, instead of 2 standard deviations, we must use tα/2,n−2
estimated standard deviations. Figure 10 portrays this idea.
F1
0.040
0.035
0.030
0.025
0.020
0.015
0.010
0.005
0.000
20 60 100 140 180
X

Figure 10: Distribution of response variable with estimated β0 , β1 , and σ

Note that all we really need are the two extreme distributions from the confidence interval for

22
the mean response. If we use the method from the last paragraph on each of these two distributions,
we can obtain the prediction interval by choosing the left–hand point of the ‘lower’ distribution
and the right–hand point of the ‘upper’ distribution. This is displayed in Figure 11.
F1
0.040
0.035
0.030
0.025
0.020
0.015
0.010
0.005
0.000
20 60 100 140 180
X

Figure 11: Upper and lower prediction limits when we have estimated the mean

The general formula for a (1 − α)100% prediction interval of a future response is similar to the
confidence interval for the mean at xg , except that it is wider to reflect the variation in individual
responses. The formula is:
s
1 (xg − x)2
(b0 + b1 xg ) ± tα/2,n−2 s 1 + + .
n SSxx

Example 3.1 (Continued) – Coffee Sales and Shelf Space

For the coffee example, suppose the marketer wishes to predict next week’s sales when the coffee
will have 50 of shelf space. She would like to obtain a 95% prediction interval for the number of
bags to be sold. First, we observe that t.025,10 = 2.228, all other relevant numbers can be found in
the previous example. The prediction interval is then:
r
1 (5 − 6)2 √
(307.967 + 34.5833(5)) ± 2.228(51.63) 1 + + = 480.883 ± 93.554 1.0972
12 72
= 480.883 ± 97.996 ≡ (382.887, 578.879).
This interval is relatively wide, reflecting the large variation in weekly sales at each level of x. Note
that just as the width of the confidence interval for the mean response depends on the distance
between xg and x, so does the width of the prediction interval. This should be of no surprise,
considering the way we set up the prediction interval (see Figure 10 and Figure 11). Figure 12
shows the fitted equation and 95% prediction limits for this example.
It must be noted that a prediction interval for a future response is only valid if conditions are
similar when the response occurs as when the data was collected. For instance, if the store is being
boycotted by a bunch of animal rights activists for selling meat next week, our prediction interval
will not be valid.

23
 SALES
700

600

500

400

300
0 3 6 9 12
SPACE

Figure 12: Plot of coffee data, fitted equation, and 95% prediction limits for a single response

Example 3.2 (Continued) – Hosiery Mill Cost Function

Suppose the plant manager knows based on purchase orders that this month, her plant will
produce 30,000 items (xg = 30.0). She would like to predict what the plant’s production costs will
be. She obtains a 95% prediction interval for this month’s costs.
r
1 (30 − 31.0673)2 √
3.1274 + 2.0055(30) ± 2.015(6.24) 1 + + ≡ 63.29 ± 2.015(6.24) 1.0210
48 7738.94
≡ 63.29 ± 12.70 ≡ (50.59, 75.99)
She predicts that the costs for this month will be between $50,590 and $75,990. This interval is
much wider than the interval for the mean, since it includes random variation in monthly costs
around the mean. A plot of the 95% prediction bands is given in Figure 13.

3.3 Coefficient of Correlation

In many situations, we would like to obtain a measure of the strength of the linear association
between the variables y and x. One measure of this association that is reported in research journals
from many fields is the Pearson product moment coefficient of correlation. This measure, denoted
by r, is a number that can range from -1 to +1. A value of r close to 0 implies that there is very
little association between the two variables (y tends to neither increase or decrease as x increases).
A positive value of r means there is a positive association between y and x (y tends to increase as
x increases). Similarly, a negative value means there is a negative association (y tends to decrease
as x increases). If r is either +1 or -1, it means the data fall on a straight line (SSE = 0) that has
either a positive or negative slope, depending on the sign of r. The formula for calculating r is:

SSxy cov(x, y)
r=p = .
SSxx SSyy sx sy

Note that the sign of r is always the same as the sign of b1 . We can test whether a population
coefficient of correlation is 0, but since the test is mathematically equivalent to testing whether
β1 = 0, we won’t cover this test.

24
 cost
100

90

80

70

60

50

40

30

20

10
0 10 20 30 40 50
size

Figure 13: Plot of hosiery mill cost data, fitted equation, and 95% prediction limits for an individual
outcome

25
 Example 3.1 (Continued) – Coffee Sales and Shelf Space

For the coffee data, we can calculate r using the values of SSxy , SSxx , SSyy we have previously
obtained.
2490 2490
r=p = = .8738
(72)(112772.9) 2849.5

Example 3.2 (Continued) – Hosiery Mill Cost Function

For the hosiery mill cost function data, we have:

15520.27 15520.27
r=p = = .9725
(7738.94)(32914.06) 15959.95

26
 Computer Output for Coffee Sales Example (SAS System)

Dependent Variable: SALES

Analysis of Variance

Sum of Mean
Source DF Squares Square F Value Prob>F
Model 1 86112.50000 86112.50000 32.297 0.0002
Error 10 26662.41667 2666.24167
C Total 11 112774.91667

Root MSE 51.63566 R-square 0.7636

Dep Mean 515.41667 Adj R-sq 0.7399

Parameter Estimates

Parameter Standard T for H0:

Variable DF Estimate Error Parameter=0 Prob > |T|
INTERCEP 1 307.916667 39.43738884 7.808 0.0001
SPACE 1 34.583333 6.08532121 5.683 0.0002

Dep Var Predict Std Err Lower95% Upper95% Lower95%

Obs SALES Value Predict Mean Mean Predict
1 421.0 411.7 23.568 359.2 464.2 285.2
2 412.0 411.7 23.568 359.2 464.2 285.2
3 443.0 411.7 23.568 359.2 464.2 285.2
4 346.0 411.7 23.568 359.2 464.2 285.2
5 526.0 515.4 14.906 482.2 548.6 395.7
6 581.0 515.4 14.906 482.2 548.6 395.7
7 434.0 515.4 14.906 482.2 548.6 395.7
8 570.0 515.4 14.906 482.2 548.6 395.7
9 630.0 619.2 23.568 566.7 671.7 492.7
10 560.0 619.2 23.568 566.7 671.7 492.7
11 590.0 619.2 23.568 566.7 671.7 492.7
12 672.0 619.2 23.568 566.7 671.7 492.7

Upper95% Upper95%
Obs Predict Residual Obs Predict Residual
1 538.1 9.3333 7 635.2 -81.4167
2 538.1 0.3333 8 635.2 54.5833
3 538.1 31.3333 9 745.6 10.8333
4 538.1 -65.6667 10 745.6 -59.1667
5 635.2 10.5833 11 745.6 -29.1667
6 635.2 65.5833 12 745.6 52.8333

27
4 Logistic Regression
Often, the outcome is nominal (or binary), and we wish to relate the probability that an outcome
has the characteristic of interest to an interval scale predictor variable. For instance, a local service
provider may be interested in the probability that a customer will redeem a coupon that is mailed
to him/her as a function of the amount of the coupon. We would expect that as the value of the
coupon increases, so does the proportion of coupons redeemed. An experiment could be conducted
as follows.

• Choose a range of reasonable coupon values (say x=$0 (flyer only), $1, $2, $5, $10)

• Identify a sample of customers (say 200 households)

• Randomly assign customers to coupon values (say 40 per coupon value level)

• Send out coupons, and determine whether each coupon was redeemed by the expiration date
(y = 1 if yes, 0 if no)

• Tabulate results and fit estimated regression equation.

Note that probabilities are bounded by 0 and 1, so we cannot fit a linear regression, since it will
provide fitted values outside this range (unless b0 is between 0 and 1 and b1 is 0). We consider the
following model, that does force fitted probabilities to lie between 0 and 1:

eβ0 +β1 x
p(x) = e = 2.71828 . . .
1 + eβ0 +β1 x
Unfortunately, unlike the case of simple linear regression, where there are close form equations
for least squares estimates of β0 and β1 , computer software must be used to obtain maximum
likelihood estimates of β0 and β1 , as well as their standard errors. Fortunately, many software
packages (e.g. SAS, SPSS, Statview) offer procedures to obtain the estimates, standard errors
and tests. We will give estimates and standard errors in this section, obtained from one of these
packages. Once the estimates of β0 and β1 are obtained, which we will label as b0 and b1 respectively,
we obtain the fitted equation:

eb0 +b1 x
P̂ (x) = e = 2.71828 . . .
1 + eb0 +b1 x

Example 4.1 – Viagra Clinical Trial

In a clinical trial for Viagra, patients suffering from erectile dysfunction were randomly assigned
to one of four daily doses (0mg, 25mg, 50mg, and 100mg). One measure obtained from the patients
was whether the patient had improved erections after 24 weeks of treatment (y = 1 if yes, y = 0 if
no). Table 9 gives the number of subjects with y = 1 an y = 0 for each dose level.
Source: I. Goldstein, et al, (1998), “Oral Sildenafil in the Treatment of Erectile Dysfunction”,
NEJM, 338:1397-1404.
Based on an analysis using SAS software, we obtain the following estimates and standard errors
for the logistic regression model:

b0 = −0.8311 sb0 = .1354 b1 = 0.0313 sb1 = .0034

28
 # Responding
Dose (x) n y=1 y=0
0 199 50 149
25 96 54 42
50 105 81 24
100 101 85 16

Table 9: Patients showing improvement (y = 1) and not showing improvement (y = 0) by Viagra

dose (x)

phatx
1.0

0.9

0.8

0.7

0.6

0.5

0.4

0.3

0.2

0.1

0.0
0 10 20 30 40 50 60 70 80 90 100
dose

Figure 14: Plot of estimated logistic regression equation - Viagra data

29
 A plot of the fitted equation (line) and the sample proportions at each dose (dots) are given in
Figure 14.

4.1 Testing for Association between Outcome Probabilities and x

Consider the logistic regression model:

eβ0 +β1 x
p(x) = e = 2.71828
1 + eβ0 +β1 x

Note that if β1 = 0, then the equation becomes p(x) = eβ0 /(1 + eβ0 ). That is, the probability
that the outcome is the characteristic of interest is not related to x, the predictor variable. In
terms of the Viagra example, this would mean that the probability a patient shows improvement
is independent of dose. This is what we would expect if the drug were not effective (still allowing
for a placebo effect).
Futher, note that if β1 > 0, the probability of the characteristic of interest occurring increases
in x, and if β1 < 0, the probability decreases in x. We can test whether β1 = 0 as follows:

• H0 : β1 = 0 (Probability of outcome is independent of x)

• HA : β1 6= 0 (Probability of outcome is associated with x)

2 = [b /s ]2
• Test Statistic: Xobs 1 b1

2 ≥ χ2
• Rejection Region: Xobs α,1 (=3.841, for α = 0.05).

• P -value: Area in χ21 distribution above Xobs

2

Note that if we reject H0 , we determine direction of association (positive/negative) by the sign

of b1 .

Example 4.1 (Continued) – Viagra Clinical Trial

For this data, we can test whether the probability of showing improvement is associated with
dose as follows:

• H0 : β1 = 0 (Probability of improvement is independent of dose)

• HA : β1 6= 0 (Probability of improvement is associated with dose)

2 = [b /s ]2 = [.0313/.0034]2 = (9.2059)2 = 84.75
• Test Statistic: Xobs 1 b1

2 ≥ χ2
• Rejection Region: Xobs α,1 (=3.841, for α = 0.05).

• P -value: Area in χ21 distribution above Xobs

2 (virtually 0)

Thus, we have strong evidence of a positive association (since b1 > 0 and we reject H0 ) between
probability of improvement and dose.

30
5 Multiple Linear Regression I
Textbook Sections: 19.1-19.3 and Supplement

In most situations, we have more than one independent variable. While the amount of math
can become overwhelming and involves matrix algebra, many computer packages exist that will
provide the analysis for you. In this chapter, we will analyze the data by interpreting the results
of a computer program. It should be noted that simple regression is a special case of multiple
regression, so most concepts we have already seen apply here.

5.1 The Multiple Regression Model and Least Squares Estimates

In general, if we have k predictor variables, we can write our response variable as:
y = β0 + β1 x1 + · · · + βk xk + ε.
Again, x is broken into a systematic and a random component:

y = β0 + β1 x1 + · · · + βk xk + |{z}
ε
| {z }
systematic random

We make the same assumptions as before in terms of ε, specifically that they are independent and
normally distributed with mean 0 and standard deviation σ. That is, we are assuming that y, at a
given set of levels of the k independent variables (x1 , . . . , xk ) is normal with mean E[y|x1 , . . . , xk ] =
β0 + β1 x1 + · · · + βk xk and standard deviation σ. Just as before, β0 , β1 , . . . , βk , and σ are unknown
parameters that must be estimated from the sample data. The parameters βi represent the change
in the mean response when the ith predictor variable changes by 1 unit and all other predictor
variables are held constant.
In this model:
• y — Random outcome of the dependent variable
• β0 — Regression constant (E(y|x1 = · · · = xk = 0) if appropriate)
• βi — Partial regression coefficient for variable xi (Change in E(y) when xi increases by 1 unit
0
and all other x s are held constant)
• ε — Random error term, assumed (as before) that ε ∼ N (0, σ)
• k — The number of independent variables
Pn
By the method of least squares (choosing the bi values that minimize SSE = i=1 (yi − ŷi )2 ),
we obtain the fitted equation:
Ŷ = b0 + b1 x1 + b2 x2 + · · · + bk xk
and our estimate of σ:
sP s
(y − ŷ)2 SSE
se = =
n−k−1 n−k−1
The Analysis of Variance table will be very similar to what we used previously, with the only
adjustments being in the degrees’ of freedom. Table 10 shows the values for the general case when
there are k predictor variables. We will rely on computer outputs to obtain the Analysis of Variance
and the estimates b0 , b1 , and bk .

31
 ANOVA
Source of Sum of Degrees of Mean
Variation Squares Freedom Square F
P
MODEL SSR = ni=1 (ŷi − y)2 k M SR = SSRk F =MM SR
SE
P
ERROR SSE = ni=1 (yi − ŷi )2 n−k−1 SSE
M SE = n−k−1
P
TOTAL SSyy = ni=1 (yi − y)2 n−1

Table 10: The Analysis of Variance Table for multiple regression

5.2 Testing for Association Between the Response and the Full Set of Predictor
Variables
To see if the set of predictor variables is useful in predicting the response variable, we will test
H0 : β1 = β2 = . . . = βk = 0. Note that if H0 is true, then the mean response does not depend
on the levels of the predictor variables. We interpret this to mean that there is no association
between the response variable and the set of predictor variables. To test this hypothesis, we use
the following method:

1. H0 : β1 = β2 = · · · = βk = 0

2. HA : Not every βi = 0
M SR
3. T.S.: Fobs = M SE

4. R.R.: Fobs > Fα,k,n−k−1

5. p-value: P (F > Fobs ) (You can only get bounds on this, but computer outputs report them
exactly)

The computer automatically performs this test and provides you with the p-value of the test, so
in practice you really don’t need to obtain the rejection region explicitly to make the appropriate
conclusion. However, we will do so in this course to help reinforce the relationship between the
test’s decision rule and the p-value. Recall that we reject the null hypothesis if the p-value is less
than α.

5.3 Testing Whether Individual Predictor Variables Help Predict the Response
If we reject the previous null hypothesis and conclude that not all of the βi are zero, we may wish
to test whether individual βi are zero. Note that if we fail to reject the null hypothesis that βi
is zero, we can drop the predictor xi from our model, thus simplifying the model. Note that this
test is testing whether xi is useful given that we are already fitting a model containing
the remaining k − 1 predictor variables. That is, does this variable contribute anything once
we’ve taken into account the other predictor variables. These tests are t-tests, where we compute
t = sbbi just as we did in the section on making inferences concerning β1 in simple regression. The
i
procedure for testing whether βi = 0 (the ith predictor variable does not contribute to predicting
the response given the other k − 1 predictor variables are in the model) is as follows:

• H0 : βi = 0 (y is not associated with xi after controlling for all other independent variables)

32
 • (1) HA : βi 6= 0
(2) HA : βi > 0
(3) HA : βi < 0
bi
• T.S.: tobs = S bi

• R.R.: (1) |tobs | > tα/2,n−k−1

(2) tobs > tα,n−k−1
(3) tobs < −tα,n−k−1

• (1) p–value: 2P (T > |tobs |)

(2) p–value: P (T > tobs )
(3) p–value: P (T < tobs )

Computer packages print the test statistic and the p-value based on the two-sided test, so to
conduct this test is simply a matter of interpreting the results of the computer output.

5.4 Testing for an Association Between a Subset of Predictor Variables and the
Response
We have seen the two extreme cases of testing whether all regression coefficients are simultaneously
0 (the F -test), and the case of testing whether a single regression coefficient is 0, controlling for
all other predictors (the t-test). We can also test whether a subset of the k regression coefficients
are 0, controlling for all other predictors. Note that the two extreme cases can be tested using this
very general procedure.
To make the notation as simple as possible, suppose our model consists of k predictor variables,
of which we’d like to test whether q (q ≤ k) are simultaneously not associated with y, after control-
ling for the remaining k − q predictor variables. Further assume that the k − q remaining predictors
are labelled x1 , x2 , . . . , xk−q and that the q predictors of interest are labelled xk−q+1 , xk−q+2 , . . . , xk .
This test is of the form:
H0 : βk−q+1 = βk−q+2 = · · · = βk = 0 HA : βk−q+1 6= 0 and/or βk−q+2 6= 0 and/or . . . and/or βk 6= 0

The procedure for obtaining the numeric elements of the test is as follows:

1. Fit the model under the null hypothesis (βk−q+1 = βk−q+2 = · · · = βk = 0). It will include
only the first k − q predictor variables. This is referred to as the Reduced model. Obtain
the error sum of squares (SSE(R)) and the error degrees of freedom dfE (R) = n − (k − q) − 1.

2. Fit the model with all k predictors. This is referred to as the Complete or Full model
(and was used for the F -test for all regression coefficients). Obtain the error sum of squares
(SSE(F )) and the error degrees of freedom (dfE (F ) = n − k − 1).

By definition of the least squares citerion, we know that SSE(R) ≥ SSE(F ). We now obtain the
test statistic:
SSE(R)−SSE(F )
(n−(k−q)−1)−(n−k−1) (SSE(R) − SSE(F ))/q
TS : Fobs = SSE(F )
=
M SE(F )
n−k−1

33
and our rejection region is values of Fobs ≥ Fα,q,n−k−1 .

Example 5.1 – Texas Weather Data

In this example, we will use regression in the context of predicting an outcome. A construction
company is making a bid on a project in a remote area of Texas. A certain component of the project
will take place in December, and is very sensitive to the daily high temperatures. They would like
to estimate what the average high temperature will be at the location in December. They believe
that temperature at a location will depend on its latitude (measure of distance from the equator)
and its elevation. That is, they believe that the response variable (mean daily high temperature in
December at a particular location) can be written as:

y = β0 + β1 x1 + β2 x2 + β3 x3 + ε,

where x1 is the latitude of the location, x2 is the longitude, and x3 is its elevation (in feet). As
before, we assume that ε ∼ N (0, σ). Note that higher latitudes mean farther north and higher
longitudes mean farther west.
To estimate the parameters β0 , β1 , β2 , β3 , and σ, they gather data for a sample of n = 16
counties and fit the model described above. The data, including one other variable are given in
Table 11.
COUNTY LATITUDE LONGITUDE ELEV TEMP INCOME
HARRIS 29.767 95.367 41 56 24322
DALLAS 32.850 96.850 440 48 21870
KENNEDY 26.933 97.800 25 60 11384
MIDLAND 31.950 102.183 2851 46 24322
DEAF SMITH 34.800 102.467 3840 38 16375
KNOX 33.450 99.633 1461 46 14595
MAVERICK 28.700 100.483 815 53 10623
NOLAN 32.450 100.533 2380 46 16486
ELPASO 31.800 106.40 3918 44 15366
COLLINGTON 34.850 100.217 2040 41 13765
PECOS 30.867 102.900 3000 47 17717
SHERMAN 36.350 102.083 3693 36 19036
TRAVIS 30.300 97.700 597 52 20514
ZAPATA 26.900 99.283 315 60 11523
LASALLE 28.450 99.217 459 56 10563
CAMERON 25.900 97.433 19 62 12931

Table 11: Data corresponding to 16 counties in Texas

The results of the Analysis of Variance are given in Table 12 and the parameter estimates,
estimated standard errors, t-statistics and p-values are given in Table 13. Full computer programs
and printouts are given as well.
We see from the Analysis of Variance that at least one of the variables, latitude and elevation,
are related to the response variable temperature. This can be seen by setting up the test H0 : β1 =
β2 = β3 = 0 as described previously. The elements of this test, provided by the computer output,
are detailed below, assuming α = .05.
1. H0 : β1 = β2 = β3 = 0

34
 ANOVA
Source of Sum of Degrees of Mean
Variation Squares Freedom Square F p-value
MODEL SSR = 934.328 k=3 M SR = 934.328
3 F = 311.443
0.634 .0001
=311.443 =491.235
ERROR SSE = 7.609 n−k−1 = M SE = 7.609
12
16 − 3 − 1 = 12 =0.634
TOTAL SSyy = 941.938 n − 1 = 15

Table 12: The Analysis of Variance Table for Texas data

t FOR H0 : STANDARD ERROR

PARAMETER ESTIMATE βi =0 P-VALUE OF ESTIMATE
INTERCEPT (β0 ) b0 =109.25887 36.68 .0001 2.97857
LATITUDE (β1 ) b1 = −1.99323 −14.61 .0001 0.13639
LONGITUDE (β2 ) b2 = −0.38471 −1.68 .1182 0.22858
ELEVATION (β3 ) b3 = −0.00096 −1.68 .1181 0.00057

Table 13: Parameter estimates and tests of hypotheses for individual parameters

2. HA : Not all βi = 0
M SR 311.443
3. T.S.: Fobs = M SE = 0.634 = 491.235

4. R.R.: Fobs > F2,13,.05 = 3.81 (This is not provided on the output, the p-value takes the place
of it).

5. p-value: P (F > 644.45) = .0001 (Actually it is less than .0001, but this is the smallest p-value
the computer will print).
We conclude that we are sure that at least one of these three variables is related to the response
variable temperature.
We also see from the individual t-tests that latitude is useful in predicting temperature, even
after taking into account the other predictor variables.
The formal test (based on α = 0.05 significance level) for determining wheteher temperature is
associated with latitude after controlling for longitude and elevation is given here:

• H0 : β1 = 0 (TEMP (y) is not associated with LAT (x1 ) after controlling for LONG (x2 ) and
ELEV (x3 ))

• HA : β1 6= 0 (TEMP is associated with LAT after controlling for LONG and ELEV)
b1 −1.99323
• T.S.: tobs = S b1 = 0.136399 = −14.614

• R.R.: |tobs | > tα/2,n−k−1 = t.025,12 = 2.179

• p–value: 2P (T > |tobs |) = 2P (T > 14.614) < .0001

Thus, we can conclude that there is an association between temperature and latitude, controlling
for longitude and elevation. Note that the coeficient is negative, so we conclude that temperature
decreases as latitude increases (given a level of longitude and elevation).

35
 Note from Table 13 that neither the coefficient for LONGITUDE (X2 ) or ELEVATION (X3 )
are significant at the α = 0.05 significance level (p-values are .1182 and .1181, respectively). Recall
these are testing whether each term is 0 controlling for LATITUDE and the other term.
Before concluding that neither LONGITUDE (x2 ) or ELEVATION (x3 ) are useful predictors,
controlling for LATITUDE, we will test whether they are both simultaneously 0, that is:

H0 : β2 = β3 = 0 vs HA : β2 6= 0 and/or β3 6= 0

First, note that we have:

n = 16 k = 3 q = 2 SSE(F ) = 7.609 dfE (F ) = 16 − 3 − 1 = 12 M SE(F ) = 0.634

dfE (R) = 16 − (3 − 2) − 1 = 14 F.05,2,12 = 3.89

Next, we fit the model with only LATITUDE (x1 ) and obtain the error sum of squares: SSE(R) =
60.935 and get the following test statistic:

(SSE(R) − SSE(F ))/q (60.935 − 7.609)/2 26.663

TS : Fobs = = = = 42.055
M SE(F ) 0.634 0.634

Since 42.055 >> 3.89, we reject H0 , and conclude that LONGITUDE (x2 ) and/or ELEVATION
(x3 ) are associated with TEMPERATURE (y), after controlling for LATITUDE (x1 ).

The reason we failed to reject H0 : β2 = 0 and H0 : β3 = 0 individually based on the t-tests is

that ELEVATION and LONGITUDE are highly correlated (Elevations rise as you go further west
in the state. So, once you control for LONGITUDE, we observe little ELEVATION effect, and vice
versa. We will discuss why this is the case later. In theory, we have little reason to believe that
temperatures naturally increase or decrease with LONGITUDE, but we may reasonably expect
that as ELEVATION increases, TEMPERATURE decreases.
We re–fit the more parsimonious (simplistic) model that uses ELEVATION (x1 ) and LATI-
TUDE (x2 ) to predict TEMPERATURE (y). Note the new symbols for ELEVATION and LATI-
TUDE. That is to show you that they are merely symbols. The results are given in Table 14 and
Table 15.
ANOVA
Source of Sum of Degrees of Mean
Variation Squares Freedom Square F p-value
MODEL SSR = 932.532 k=2 M SR = 932.532
2 F = 466.266
0.634 .0001
=466.266 =644.014
ERROR SSE = 9.406 n−k−1 = M SE = 9.406
13
16 − 2 − 1 = 13 =0.724
TOTAL SSyy = 941.938 n − 1 = 15

Table 14: The Analysis of Variance Table for Texas data – without LONGITUDE

We see this by observing that the t-statistic for testing H0 : β1 = 0 (no latitude effect on
temperature) is −17.65, corresponding to a p-value of .0001, and the t-statistic for testing H0 :
β2 = 0 (no elevation effect) is −8.41, also corresponding to a p-value of .0001. Further note
that both estimates are negative, reflecting that as elevation and latitude increase, temperature
decreases. That should not come as any big surprise.

36
 t FOR H0 : STANDARD ERROR
PARAMETER ESTIMATE βi =0 P-VALUE OF ESTIMATE
INTERCEPT (β0 ) b0 =63.45485 36.68 .0001 0.48750
ELEVATION (β1 ) b1 = −0.00185 −8.41 .0001 0.00022
LATITUDE (β2 ) b2 = −1.83216 −17.65 .0001 0.10380

Table 15: Parameter estimates and tests of hypotheses for individual parameters – without LON-
GITUDE

The magnitudes of the estimated coefficients are quite different, which may make you believe
that one predictor variable is more important than the other. This is not necessarily true, because
the ranges of their levels are quite different (1 unit change in latitude represents a change of
approximately 19 miles, while a unit change in elevation is 1 foot) and recall that βi represents the
change in the mean response when variable Xi is increased by 1 unit.
The data corresponding to the 16 locations in the sample are plotted in Figure 15 and the fitted
equation for the model that does not include LONGITUDE is plotted in Figure 16. The fitted
equation is a plane in three dimensions.

TEMP

62.00

53.33

44.67

36.00
36.35 3918
32.87 2618
L A T 12 9 . 3 8 1319 ELEV
25.90 19

Figure 15: Plot of temperature data in 3 dimensions

Example 5.2 – Mortgage Financing Cost Variation (By City)

A study in the mid 1960’s reported regional differences in mortgage costs for new homes. The
sampling units were n = 18 metro areas (SMSA’s) in the U.S. The dependent variable (y) is the
average yield (in percent) on a new home mortgage for the SMSA. The independent variables (xi )
are given below.
Source: Schaaf, A.H. (1966), “Regional Differences in Mortgage Financing Costs,” Journal of
Finance, 21:85-94.

x1 – Average Loan Value / Mortgage Value Ratio (Higher x1 means lower down payment and
higher risk to lender).

37
 YHAT

63.45

53.66

43.87

34.08
37 4000
33 2667
LAT 29 1333 ELEV
25 0

Figure 16: Plot of the fitted equation for temperature data

x2 – Road Distance from Boston (Higher x2 means further from Northeast, where most capital
was at the time, and higher costs of capital).

x3 – Savings per Annual Dwelling Unit Constructed (Higher x3 means higher relative credit surplus,
and lower costs of capital).

x4 – Savings per Capita (does not adjust for new housing demand).

x5 – Percent Increase in Population 1950–1960

x6 – Percent of First Mortgage Debt Controlled by Inter-regional Banks.

The data, fitted values, and residuals are given in Table 16. The Analysis of Variance is given
in Table 17. The regression coefficients, test statistics, and p-values are given in Table 18.
Show that the fitted value for Los Angeles is 6.19, based on the fitted equation, and that the
residual is -0.02.
Based on the large F -statistic, and its small corresponding P -value, we conclude that this set of
predictor variables is associated with the mortgage rate. That is, at least one of these independent
variables is associated with y.
Based on the t-tests, while none are strictly significant at the α = 0.05 level, there is some
evidence that x1 (Loan Value/Mortgage Value, P = .0515), x3 (Savings per Unit Constructed,
P = .0593), and to a lesser extent, x4 (Savings per Capita, P = .1002) are helpful in predicting
mortgage rates. We can fit a reduced model, with just these three predictors, and test whether we
can simultaneously drop x2 , x5 , and x6 from the model. That is:

H0 : β2 = β5 = β6 = 0 vs HA : β2 6= 0 and/or β5 6= 0 and/or β6 6= 0

First, we have the following values:

n = 18 k=6 q=3

SSE(F ) = 0.10980 dfE (F ) = 18 − 6 − 1 = 11 M SE(F ) = 0.00998

dfE (R) = 18 − (6 − 3) − 1 = 14 F.05,3,11 = 3.59

38
 SMSA y x1 x2 x3 x4 x5 x6 ŷ e = y − ŷ
Los Angeles-Long Beach 6.17 78.1 3042 91.3 1738.1 45.5 33.1 6.19 -0.02
Denver 6.06 77.0 1997 84.1 1110.4 51.8 21.9 6.04 0.02
San Francisco-Oakland 6.04 75.7 3162 129.3 1738.1 24.0 46.0 6.05 -0.01
Dallas-Fort Worth 6.04 77.4 1821 41.2 778.4 45.7 51.3 6.05 -0.01
Miami 6.02 77.4 1542 119.1 1136.7 88.9 18.7 6.04 -0.02
Atlanta 6.02 73.6 1074 32.3 582.9 39.9 26.6 5.92 0.10
Houston 5.99 76.3 1856 45.2 778.4 54.1 35.7 6.02 -0.03
Seattle 5.91 72.5 3024 109.7 1186.0 31.1 17.0 5.91 0.00
New York 5.89 77.3 216 364.3 2582.4 11.9 7.3 5.82 0.07
Memphis 5.87 77.4 1350 111.0 613.6 27.4 11.3 5.86 0.01
New Orleans 5.85 72.4 1544 81.0 636.1 27.3 8.1 5.81 0.04
Cleveland 5.75 67.0 631 202.7 1346.0 24.6 10.0 5.64 0.11
Chicago 5.73 68.9 972 290.1 1626.8 20.1 9.4 5.60 0.13
Detroit 5.66 70.7 699 223.4 1049.6 24.7 31.7 5.63 0.03
Minneapolis-St Paul 5.66 69.8 1377 138.4 1289.3 28.8 19.7 5.81 -0.15
Baltimore 5.63 72.9 399 125.4 836.3 22.9 8.6 5.77 -0.14
Philadelphia 5.57 68.7 304 259.5 1315.3 18.3 18.7 5.57 0.00
Boston 5.28 67.8 0 428.2 2081.0 7.5 2.0 5.41 -0.13

Table 16: Data and fitted values for mortgage rate multiple regression example.

ANOVA
Source of Sum of Degrees of Mean
Variation Squares Freedom Square F p-value
MODEL SSR = 0.73877 k=6 M SR = 0.73877
6 F = 0.12313
0.00998 .0003
=0.12313 =12.33
ERROR SSE = 0.10980 n−k−1 = M SE = 0.10980
11
18 − 6 − 1 = 11 =0.00998
TOTAL SSyy = 0.84858 n − 1 = 17

Table 17: The Analysis of Variance Table for Mortgage rate regression analysis

STANDARD
PARAMETER ESTIMATE ERROR t-statistic P -value
INTERCEPT (β0 ) b0 =4.28524 0.66825 6.41 .0001
x1 (β1 ) b1 = 0.02033 0.00931 2.18 .0515
x2 (β2 ) b2 = 0.000014 0.000047 0.29 .7775
x3 (β3 ) b3 = −0.00158 0.000753 -2.10 .0593
x4 (β4 ) b4 = 0.000202 0.000112 1.79 .1002
x5 (β5 ) b5 = 0.00128 0.00177 0.73 .4826
x6 (β6 ) b6 = 0.000236 0.00230 0.10 .9203

Table 18: Parameter estimates and tests of hypotheses for individual parameters – Mortgage rate
regression analysis

39
 ANOVA
Source of Sum of Degrees of Mean
Variation Squares Freedom Square F p-value
MODEL SSR = 0.73265 k−q =3 M SR = 0.73265
3 F = 0.24422
0.00828 .0001
=0.24422 =29.49
ERROR SSE = 0.11593 n − (k − q) − 1 = M SE = 0.11593
14
18 − 3 − 1 = 14 =0.00828
TOTAL SSyy = 0.84858 n − 1 = 17

Table 19: The Analysis of Variance Table for Mortgage rate regression analysis (Reduced Model)

STANDARD
PARAMETER ESTIMATE ERROR t-statistic P -value
INTERCEPT (β0 ) b0 =4.22260 0.58139 7.26 .0001
x1 (β1 ) b1 = 0.02229 0.00792 2.81 .0138
x3 (β3 ) b3 = −0.00186 0.00041778 -4.46 .0005
x4 (β4 ) b4 = 0.000225 0.000074 3.03 .0091

Table 20: Parameter estimates and tests of hypotheses for individual parameters – Mortgage rate
regression analysis (Reduced Model)

Next, we fit the reduced model, with β2 = β5 = β6 = 0. We get the Analysis of Variance in
Table 19 and parameter estimates in Table 20.
Note first, that all three regression coefficients
√ are significant now at the α = 0.05 significance
level. Also, our residual standard error, Se = M SE has also decreased (0.09991 to 0.09100). This
implies we have lost very little predictive ability by dropping x2 , x5 , and x6 from the model. Now
to formally test whether these three predictor variables’ regression coefficients are simultaneously
0 (with α = 0.05):

• H0 : β2 = β5 = β6 = 0

• HA : β2 6= 0 and/or β5 6= 0 and/or β6 6= 0
(0.11593−0.10980)/2 .00307
• T S : Fobs = 0.00998 = .00998 = 0.307

• RR : Fobs ≥ F0.05,3,11 = 3.59

We fail to reject H0 , and conclude that none of x2 , x5 , or x6 are associated with mortgage rate,
after controlling for x1 , x3 , and x4 .

Example 5.3 – Store Location Characteristics and Sales

A study proposed using linear regression to describe sales at retail stores based on location
characteristics. As a case study, the authors modelled sales at n = 16 liquor stores in Charlotte,
N.C. Note that in North Carolina, all stores are state run, and do not practice promotion as liquor
stores in Florida do. The response was SALES volume (for the individual stores) in the fiscal year
7/1/1979-6/30/1980. The independent variables were: POP (number of people living within 1.5
miles of store), MHI (mean household income among households within 1.5 miles of store), DIS,
(distance to the nearest store), TFL (daily traffic volume on the street the store was located), and

40
EMP (the amount of employment within 1.5 miles of the store. The regression coefficients and
standard errors are given in Table 5.4.

Source: Lord, J.D. and C.D. Lynds (1981), “The Use of Regression Models in Store Location
Research: A Review and Case Study,” Akron Business and Economic Review, Summer, 13-19.

Variable Estimate Std Error

POP 0.09460 0.01819
MHI 0.06129 0.02057
DIS 4.88524 1.72623
TFL -2.59040 1.22768
EMP -0.00245 0.00454

Table 21: Regression coefficients and standard errors for liquor store sales study

a) Do any of these variables fail to be associated with store sales after controlling for the others?

b) Consider the signs of the significant regression coefficients. What do they imply?

5.5 R2 and Adjusted–R2

As was discussed in the previous chapter, the coefficient of multiple determination represents the
proportion of the variation in the dependent variable (y) that is “explained” by the regression on
the collection of independent variables: (x1 ,. . . ,xk ). R2 is computed exactly as before:
SSR SSE
R2 = = 1−
SSyy SSyy

One problem with R2 is that when we continually add independent variables to a regression
model, it continually increases (or at least, never decreases), even when the new variable(s) add
little or no predictive power. Since we are trying to fit the simplest (most parsimonious) model
that explains the relationship between the set of independent variables and the dependent variable,
we need a measure that penalizes models that contain useless or redundant independent variables.
This penalization takes into account that by including useless or redundant predictors, we are
decreasing error degrees of freedom (dfE = n − k − 1). A second measure, that does not carry the
proportion of variation explained criteria, but is useful for comparing models of varying degrees of
complexity, is Adjusted-R2 :
!
2 SSE/(n − k − 1) n−1 SSE
Adjusted − R = 1− = 1−
SSyy /(n − 1) n−k−1 SSyy

Example 5.1 (Continued) – Texas Weather Data

Consider the two models we have fit:

Full Model — I.V.’s: LATITUDE, LONGITUDE, ELEVATION

41
Reduced Model — I.V.’s: LATITUDE, ELEVATION

For the Full Model, we have:

n = 16 k=3 SSE = 7.609 SSyy = 941.938

and, we obtain RF2 and Adj-RF2 :
 
7.609 15 7.609
RF2 = 1− = 1 − .008 = 0.992 Adj − RF2 = 1− = 1 − 1.25(.008) = 0.9900
941.938 12 941.938
For the Reduced Model, we have:

n = 16 k=2 SSE = 9.406 SSyy = 941.938

2 and Adj-R2 :
and, we obtain RR R
 
2 9.406 2 15 9.406
RR = 1− = 1 − .010 = 0.990 Adj − RR = 1− = 1 − 1.15(.010) = 0.9885
941.938 13 941.938
Thus, by both measures the Full Model “wins”, but it should be added that both appear to fit
the data very well!

Example 5.2 (Continued) – Mortgage Financing Costs

For the mortgage data (with Total Sum of Squares SSyy = 0.84858 and n = 18), when we
include all 6 independent variables in the full model, we obtain the following results:
SSR = 0.73877 SSE = 0.10980 k=6
From this full model, we compute R2 and Adj-R2 :
!  
SSRF 0.73877 n−1 SSEF 17 0.10980
RF2 = = = 0.8706 Adj−RF2 = 1− = 1− = 0.8000
SSyy 0.84858 n−k−1 SSyy 11 0.84858

Example 5.3 (Continued) – Store Location Characteristics and Sales

In this study, the authors reported that R2 = 0.69. Note that although we are not given the
Analysis of Variance, we can still conduct the F test for the overall model:
SSR
M SR SSR/k SSyy /k R2 /k
F = = = SSE
=
M SE SSE/(n − k − 1) SSyy /(n − k − 1) (1 − R2 )/(n − k − 1)

For the liquor store example, there were n = 16 stores and k = 5 variables in the full model. To
test:
H0 : β1 = β2 = β3 = β4 = β5 = 0 vs HA : Not all βi = 0
we get the following test statistic and rejection region (α = 0.05):
0.69/5 0.138
T S : Fobs = = = 4.45 RR : Fobs ≥ Fα,k,n−k−1 = F0.05,5,10 = 3.33
(1 − 0.69)/(16 − 5 − 1) 0.031
Thus, at least one of these variables is associated with store sales.

What is Adjusted-R2 for this analysis?

42
5.6 Multicollinearity
Textbook: Section 19.4, Supplement
Multicollinearity refers to the situation where independent variables are highly correlated
among themselves. This can cause problems mathematically and creates problems in interpreting
regression coefficients.
Some of the problems that arise include:

• Difficult to interpret regression coefficient estimates

• Inflated std errors of estimates (and thus small t–statistics)
• Signs of coefficients may not be what is expected.
• However, predicted values are not adversely affected

It can be thought that the independent variables are explaining “the same” variation in y, and it
is difficult for the model to attribute the variation explained (recall partial regression coefficients).
Variance Inflation Factors provide a means of detecting whether a given independent variable
is causing multicollinearity. They are calculated (for each independent variable) as:
1
V IFi =
1 − Ri2
where Ri2 is the coefficient of multiple determination when xi is regressed on the k − 1 other
independent variables. One rule of thumb suggests that severe multicollinearity is present if V IFi >
10 (Ri2 > .90).

Example 5.1 Continued

First, we run a regression with ELEVATION as the dependent variable and LATITUDE and
LONGITUDE as the independent variables. We then repeat the process with LATITUDE as the
dependent variable, and finally with LONGITUDE as the dependent variable. Table ?? gives R2
and V IF for each model.
Variable R2 V IF
ELEVATION .9393 16.47
LATITUDE .7635 4.23
LONGITUDE .8940 9.43

Table 22: Variance Inflation Factors for Texas weather data

Note how large the factor is for ELEVATION. Texas elevation increases as you go West and as
you go North. The Western rise is the more pronounced of the two (the simple correlation between
ELEVATION and LONGITUDE is .89).
Consider the effects on the coefficients in Table 23 and Table 24 (these are subsets of previously
shown tables).
Compare the estimate and estimated standard error for the coefficient for ELEVATION and
LATITUDE for the two models. In particular, the ELEVATION coefficient doubles in absolute
value and its standard error decreases by a factor of almost 3. The LATITUDE coefficient and
standard error do not change very much. We choose to keep ELEVATION, as opposed to LONGI-
TUDE, in the model due to theoretical considerations with respect to weather and climate.

43
 STANDARD ERROR
PARAMETER ESTIMATE OF ESTIMATE
INTERCEPT (β0 ) b0 =109.25887 2.97857
LATITUDE (β1 ) b1 = −1.99323 0.13639
LONGITUDE (β2 ) b2 = −0.38471 0.22858
ELEVATION (β3 ) b3 = −0.00096 0.00057

Table 23: Parameter estimates and standard errors for the full model

STANDARD ERROR
PARAMETER ESTIMATE OF ESTIMATE
INTERCEPT (β0 ) b0 =63.45485 0.48750
ELEVATION (β1 ) b1 = −0.00185 0.00022
LATITUDE (β2 ) b2 = −1.83216 0.10380

Table 24: Parameter estimates and standard errors for the reduced model

5.7 Autocorrelation
Textbook Section: 19.5

Recall a key assumption in regression: Error terms are independent. When data are collected
over time, the errors are often serially correlated (Autocorrelated). Under first–Order Autocorre-
lation, consecutive error terms are linealy related:

εt = ρεt−1 + νt
where ρ is the correlation between consecutive error terms, and νt is a normally distributed
independent error term. When errors display a positive correlation, ρ > 0 (Consecutive error
terms are associated). We can test this relation as follows, note that when ρ = 0, error terms
are independent (which is the assumption in the derivation of the tests in the chapters on linear
regression).

Durbin–Watson Test for Autocorrelation

H0 : ρ = 0 No autocorrelation Ha : ρ > 0 Postive Autocorrelation

Pn 2
D= t=2 P(ent −et−1
2
)
e
t=1 t
D ≥ dU =⇒ Don’t Reject H0
D ≤ dL =⇒ Reject H0
dL ≤ D ≤ dU =⇒ Withhold judgement
Values of dL and dU (indexed by n and k (the number of predictor variables)) are given in Table
11(a), p. B-22.

“Cures” for Autocorrelation:

44
 • Additional independent variable(s) — A variable may be missing from the model that will
eliminate the autocorrelation.

• Transform the variables — Take “first differences” (yt+1 −yt ) and (yt+1 −yt ) and run regression
with transformed y and x.

Example 5.4 Spirits Sales and Income and Prices in Britain

A study was conducted relating annual spirits (liquor) sales (y) in Britain to per capita income
(x1 ) and prices (x2 ), where all monetary values were in constant (adjusted for inflation) dollars
for the years 1870-1938. The following output gives the results from the regression analysis and
the Durbin-Watson statistic. Note that there are n = 69 observations and k = 2 predictors, and
the approximate lower and upper bounds for the rejection region are dL = 1.55 and dU = 1.67
for an α = 0.05 level test. Since the test statistic is d = 0.247 (see output below), we reject the
null hypothesis of no autocorrelation among the residuals, and conclude that they are positively
correlated. See Figure 17 for a plot of the residuals versus year.
Source: Durbin J., and Watson, G.S. (1950), “Testing for Serial Correlation in Least Squares
Regression, I”, Biometrika, 37:409-428.

The REG Procedure

Model: MODEL1
Dependent Variable: consume

Analysis of Variance

Sum of Mean
Source DF Squares Square F Value Pr > F

Model 2 4.80557 2.40278 712.27 <.0001

Error 66 0.22264 0.00337
Corrected Total 68 5.02821

Root MSE 0.05808 R-Square 0.9557

Dependent Mean 1.76999 Adj R-Sq 0.9544
Coeff Var 3.28143

Parameter Estimates

Parameter Standard
Variable DF Estimate Error t Value Pr > |t|

Intercept 1 4.61171 0.15262 30.22 <.0001

income 1 -0.11846 0.10885 -1.09 0.2804
price 1 -1.23174 0.05024 -24.52 <.0001

Durbin-Watson D 0.247
Number of Observations 69
1st Order Autocorrelation 0.852

45
Obs consume income price yhat e
1 1.9565 1.7669 1.9176 2.04042 -0.08392
2 1.9794 1.7766 1.9059 2.05368 -0.07428
3 2.0120 1.7764 1.8798 2.08586 -0.07386
4 2.0449 1.7942 1.8727 2.09249 -0.04759
5 2.0561 1.8156 1.8984 2.05830 -0.00220
6 2.0678 1.8083 1.9137 2.04032 0.02748
7 2.0561 1.8083 1.9176 2.03552 0.02058
8 2.0428 1.8067 1.9176 2.03571 0.00709
9 2.0290 1.8166 1.9420 2.00448 0.02452
10 1.9980 1.8041 1.9547 1.99032 0.00768
11 1.9884 1.8053 1.9379 2.01087 -0.02247
12 1.9835 1.8242 1.9462 1.99841 -0.01491
13 1.9773 1.8395 1.9504 1.99142 -0.01412
14 1.9748 1.8464 1.9504 1.99060 -0.01580
15 1.9629 1.8492 1.9723 1.96330 -0.00040
16 1.9396 1.8668 2.0000 1.92709 0.01251
17 1.9309 1.8783 2.0097 1.91378 0.01712
18 1.9271 1.8914 2.0146 1.90619 0.02091
19 1.9239 1.9166 2.0146 1.90321 0.02069
20 1.9414 1.9363 2.0097 1.90691 0.03449
21 1.9685 1.9548 2.0097 1.90472 0.06378
22 1.9727 1.9453 2.0097 1.90585 0.06685
23 1.9736 1.9292 2.0048 1.91379 0.05981
24 1.9499 1.9209 2.0097 1.90874 0.04116
25 1.9432 1.9510 2.0296 1.88066 0.06254
26 1.9569 1.9776 2.0399 1.86482 0.09208
27 1.9647 1.9814 2.0399 1.86437 0.10033
28 1.9710 1.9819 2.0296 1.87700 0.09400
29 1.9719 1.9828 2.0146 1.89537 0.07653
30 1.9956 2.0076 2.0245 1.88024 0.11536
31 2.0000 2.0000 2.0000 1.91131 0.08869
32 1.9904 1.9939 2.0048 1.90612 0.08428
33 1.9752 1.9933 2.0048 1.90619 0.06901
34 1.9494 1.9797 2.0000 1.91372 0.03568
35 1.9332 1.9772 1.9952 1.91993 0.01327
36 1.9139 1.9924 1.9952 1.91813 -0.00423
37 1.9091 2.0117 1.9905 1.92163 -0.01253
38 1.9139 2.0204 1.9813 1.93193 -0.01803
39 1.8886 2.0018 1.9905 1.92280 -0.03420
40 1.7945 2.0038 1.9859 1.92823 -0.13373
41 1.7644 2.0099 2.0518 1.84634 -0.08194
42 1.7817 2.0174 2.0474 1.85087 -0.06917
43 1.7784 2.0279 2.0341 1.86601 -0.08761
44 1.7945 2.0359 2.0255 1.87565 -0.08115
45 1.7888 2.0216 2.0341 1.86675 -0.07795
46 1.8751 1.9896 1.9445 1.98091 -0.10581
47 1.7853 1.9843 1.9939 1.92069 -0.13539
48 1.6075 1.9764 2.2082 1.65766 -0.05016
49 1.5185 1.9965 2.2700 1.57916 -0.06066
50 1.6513 2.0652 2.2430 1.60428 0.04702
51 1.6247 2.0369 2.2567 1.59075 0.033946
52 1.5391 1.9723 2.2988 1.54655 -0.007450
53 1.4922 1.9797 2.3723 1.45514 0.037059
54 1.4606 2.0136 2.4105 1.40407 0.056527
55 1.4551 2.0165 2.4081 1.40669 0.048415
56 1.4425 2.0213 2.4081 1.40612 0.036383
57 1.4023 2.0206 2.4367 1.37097 0.031328
58 1.3991 2.0563 2.4284 1.37697 0.022134

46
59 1.3798 2.0579 2.4310 1.37357 0.006226
60 1.3782 2.0649 2.4363 1.36622 0.011983
61 1.3366 2.0582 2.4552 1.34373 -0.007131
62 1.3026 2.0517 2.4838 1.30927 -0.006673
63 1.2592 2.0491 2.4958 1.29480 -0.035600
64 1.2365 2.0766 2.5048 1.28046 -0.043957
65 1.2549 2.0890 2.5017 1.28281 -0.027906
66 1.2527 2.1059 2.4958 1.28807 -0.035372
67 1.2763 2.1205 2.4838 1.30112 -0.024823
68 1.2906 2.1205 2.4636 1.32600 -0.035404
69 1.2721 2.1182 2.4580 1.33317 -0.061074

Residual
0.12
0.11
0.10
0.09
0.08
0.07
0.06
0.05
0.04
0.03
0.02
0.01
0.00
-0.01
-0.02
-0.03
-0.04
-0.05
-0.06
-0.07
-0.08
-0.09
-0.10
-0.11
-0.12
-0.13
-0.14
1870 1880 1890 1900 1910 1920 1930 1940
year

Figure 17: Plot of the residuals versus year for British spirits data

47
6 Special Cases of Multiple Regression
Textbook Sections: 20.2,20.3

In this section, we will look at three special cases that are frequently used methods of multiple
regression. The ideas such as the Analysis of Variance, tests of hypotheses, and parameter estimates
are exactly the same as before and we will concentrate on their interpretation through specific
examples. The four special cases are:

1. Polynomial Regression

2. Regression Models with Nominal (Dummy) Variables

3. Regression Models Containing Interaction Terms

6.1 Polynomial Regression

While certainly not restricted to this case, it is best to describe polynomial regression in the case
of a model with only one predictor variable. In many real–world settings relationships will not be
linear, but will demonstrate nonlinear associations. In economics, a widely described phenomenon
is “diminishing marginal returns”. In this case, y may increase with x, but the rate of increase
decreases over the range of x. By adding quadratic terms, we can test if this is the case. Other
situations may show that the rate of increase in y is increasing in x.

Example 6.1 – Health Club Demand

y = β0 + β1 x + β2 x2 + ε.

Again, we assume that ε ∼ N (0, σ). In this model, the number of people attending in a day when
there are x machines is nomally distributed with mean β0 + β1 x + β2 x2 and standard deviation
σ. Note that we are no longer saying that the mean is linearly related to x, but rather that
it is approximately quadratically related to x (curved). Suppose she leases varying numbers of
machines over a period of n = 12 Wednesdays (always advertising how many machines will be
there on the following Wednesday), and observes the number of people attending the club each day,
and obtaining the data in Table 25.
In this case, we would like to fit the multiple regression model:

y = β0 + β1 x + β2 x2 + ε,

which is just like our previous model except instead of a second predictor variable x2 , we are using
the variable x2 , the effect is that the fitted equation ŷ will be a curve in 2 dimensions, not a
plane in 3 dimensions as we saw in the weather example. First we will run the regression on the
computer, obtaining the Analysis of Variance and the parameter estimates, then plot the data and
fitted equation. Table 26 gives the Analysis of Variance for this example and Table 27 gives the
parameter estimates and their standard errors. Note that even though we have only one predictor
variable, it is being used twice and could in effect be treated as two different predictor variables,
so k = 2.
The first test of hypothesis is whether the attendance is associated with the number of machines.
This is a test of H0 : β1 = β2 = 0. If the null hypothesis is true, that implies mean daily attendance

48
 Week # Machines (x) Attendance (y)
1 3 555
2 6 776
3 1 267
4 2 431
5 5 722
6 4 635
7 1 218
8 5 692
9 3 534
10 2 459
11 6 810
12 4 671

Table 25: Data for health club example

ANOVA
Source of Sum of Degrees of Mean
Variation Squares Freedom Square F p-value
MODEL SSR = 393933.12 k=2 M SR = 393933.12
2 F = 196966.56
776.06 .0001
=196966.56 =253.80
ERROR SSE = 6984.55 n − k − 1 = M SE = 6984.55
9
=12-2-1=9 =776.06
TOTAL SSyy = 400917.67 n − 1 = 11

Table 26: The Analysis of Variance Table for health club data

t FOR H0 : STANDARD ERROR

PARAMETER ESTIMATE βi =0 P-VALUE OF ESTIMATE
INTERCEPT (β0 ) b0 =72.0500 2.04 .0712 35.2377
MACHINES (β1 ) b1 = 199.7625 8.67 .0001 23.0535
MACHINES SQ (β2 ) b2 = −13.6518 −4.23 .0022 3.2239

Table 27: Parameter estimates and tests of hypotheses for individual parameters

49
is unrelated to the number of machines, thus the club owner would purchase very few (if any) of the
machines. As before this test is the F -test from the Analysis of Variance table, which we conduct
here at α = .05.

1. H0 : β1 = β2 = 0

2. HA : Not both βi = 0
M SR 196966.56
3. T.S.: Fobs = M SE = 776.06 = 253.80

4. R.R.: Fobs > F2,9,.05 = 4.26 (This is not provided on the output, the p-value takes the place
of it).

5. p-value: P (F > 253.80) = .0001 (Actually it is less than .0001, but this is the smallest p-value
the computer will print).

Another test with an interesting interpretation is H0 : β2 = 0. This is testing the hypothesis

that the mean increases linearly with x (since if β2 = 0 this becomes the simple regression model
(refer back to the coffee data example)). The t-test in Table 27 for this hypothesis has a test
statistic tobs = −4.23 which corresponds to a p-value of .0022, which since it is below .05, implies
we reject H0 and conclude β2 6= 0. Since b2 is is negative, we will conclude that β2 is negative,
which is in agreement with her theory that once you get to a certain number of machines, it does
not help to keep adding new machines. This is the idea of ‘diminishing returns’. Figure 18 shows
the actual data and the fitted equation ŷ = 72.0500 + 199.7625x − 13.6518x2 .
YHAT
900
800
700
600
500
400
300
200
100
0
0 1 2 3 4 5 6 7
X

Figure 18: Plot of the data and fitted equation for health club example

6.2 Regression Models With Nominal (Dummy) Variables

All of the predictor variables we have used so far were numeric or what are often called quantitative
variables. Other variables also can be used that are called qualitative variables. Qualitative vari-
ables measure characteristics that cannot be described numerically, such as a person’s sex, race,
religion, or blood type; a city’s region or mayor’s political affiliation; the list of possibilities is
endless. In this case, we frequently have some numeric predictor variable(s) that we believe is (are)

50
related to the response variable, but we believe this relationship may be different for different levels
of some qualitative variable of interest.
If a qualitative variable has m levels, we create m−1 indicator or dummy variables. Consider
an example where we are interested in health care expenditures as related to age for men and women,
separately. In this case, the response variable is health care expenditures, one predictor variable is
age, and we need to create a variable representing sex. This can be done by creating a variable x2
that takes on a value 1 if a person is female and 0 if the person is male. In this case we can write
the mean response as before:

E[y|x1 , x2 ] = β0 + β1 x1 + β2 x2 + ε.

Note that for women of age x1 , the mean expenditure is E[y|x1 , 1] = β0 +β1 x1 +β2 (1) = (β0 +β2 )+
β1 x1 , while for men of age x1 , the mean expenditure is E[y|x1 , 0] = β0 + β1 x1 + β0 (0) = β0 + β1 x1 .
This model allows for different means for men and women, but requires they have the same slope
(we will see a more general case in the next section). In this case the interpretation of β2 = 0 is
that the means are the same for both sexes, this is a hypothesis a health care professional may wish
to test in a study. In this example the variable sex had two variables, so we had to create 2 − 1 = 1
dummy variable, now consider a second example.

Example 6.2
We would like to see if annual per capita clothing expenditures is related to annual per capita
income in cities across the U.S. Further, we would like to see if there is any differences in the means
across the 4 regions (Northeast, South, Midwest, and West). Since the variable region has 4 levels,
we will create 3 dummy variables x2 , x3 , and x4 as follows (we leave x1 to represent the predictor
variable per capita income): (
1 if region=South
x2 =
0 otherwise
(
1 if region=Midwest
x3 =
0 otherwise
(
1 if region=West
x4 =
0 otherwise
Note that cities in the Northeast have x2 = x3 = x4 = 0, while cities in other regions will have
either x2 , x3 , or x4 being equal to 1. Northeast cities act like males did in the previous example.
The data are given in Table 28.
The Analysis of Variance is given in Table 29, and the parameter estimates and standard errors
are given in Table 30.
Note that we would fail to reject H0 : β1 = β2 = β3 = β4 = 0 at α = .05 significance level if
we looked only at the F -statistic and it’s p-value (Fobs = 2.93, p-value=.0562). This would lead us
to conclude that there is no association between the predictor variables income and region and the
response variable clothing expenditures. This is where you need to be careful when using multiple
regression with many predictor variables. Look at the test of H0 : β1 = 0, based on the t-test in
Table 30. Here we observe tobs =3.11, with a p-value of .0071. We thus conclude β1 6= 0, and that
clothing expenditures is related to income, as we would expect. However, we do fail to reject H0 :
β2 = 0, H0 : β3 = 0,and H0 : β4 = 0, so we fail to observe any differences among the regions in terms
of clothing expenditures after ‘adjusting’ for the variable income. Figure 19 and Figure 20 show the
original data using region as the plotting symbol and the 4 fitted equations corresponding to the 4

51
 PER CAPITA INCOME & CLOTHING EXPENDITURES (1990)
Income Expenditure
Metro Area Region x1 y x2 x3 x4
New York City Northeast 25405 2290 0 0 0
Philadelphia Northeast 21499 2037 0 0 0
Pittsburgh Northeast 18827 1646 0 0 0
Boston Northeast 24315 1659 0 0 0
Buffalo Northeast 17997 1315 0 0 0
Atlanta South 20263 2108 1 0 0
Miami/Ft Laud South 19606 1587 1 0 0
Baltimore South 21461 1978 1 0 0
Houston South 19028 1589 1 0 0
Dallas/Ft Worth South 19821 1982 1 0 0
Chicago Midwest 21982 2108 0 1 0
Detroit Midwest 20595 1262 0 1 0
Cleveland Midwest 19640 2043 0 1 0
Minneapolis/St Paul Midwest 21330 1816 0 1 0
St Louis Midwest 20200 1340 0 1 0
Seattle West 21087 1667 0 0 1
Los Angeles West 20691 2404 0 0 1
Portland West 18938 1440 0 0 1
San Diego West 19588 1849 0 0 1
San Fran/Oakland West 25037 2556 0 0 1

Table 28: Clothes Expenditures and income example

ANOVA
Source of Sum of Degrees of Mean
Variation Squares Freedom Square F p-value
MODEL 1116419.0 4 279104.7 2.93 .0562
ERROR 1426640.2 15 95109.3
TOTAL 2543059.2 19

Table 29: The Analysis of Variance Table for clothes expenditure data

t FOR H0 : STANDARD ERROR

PARAMETER ESTIMATE βi =0 P-VALUE OF ESTIMATE
INTERCEPT (β0 ) −657.428 −0.82 .4229 797.948
x1 (β1 ) 0.113 3.11 .0071 0.036
x2 (β2 ) 237.494 1.17 .2609 203.264
x3 (β3 ) 21.691 0.11 .9140 197.536
x4 (β4 ) 254.992 1.30 .2130 196.036

Table 30: Parameter estimates and tests of hypotheses for individual parameters

52
regions. Recall that the fitted equation is ŷ = −657.428+0.113x1 +237.494x2 +21.691x3 +254.992x4 ,
and each of the regions has a different set of levels of variables x2 , x3 , and x4 .
Y
2600 W
2500
2400 W
2300 S
2200
2100 M N
2000 N S
M M
1900 W
1800 N
1700 S W S
1600 M M
1500
1400 W
1300 S N
N
1200
16000 18000 20000 22000 24000 26000
X1
REGION N N N Midwest S S S Northeast
M M M South W W W West

Figure 19: Plot of clothing data, with plotting symbol region

YN
2600
2500
2400
2300
2200
2100
2000
1900
1800
1700
1600
1500
1400
1300
1200
16000 18000 20000 22000 24000 26000
X1

Figure 20: Plot of fitted equations for each region

6.3 Regression Models With Interactions

In some situations, two or more predictor variables may interact in terms of their effects on the
mean response. That is, the effect on the mean response of changing the level of one predictor
variable depends on the level of another predictor variable. This idea is easiest understood in the
case where one of the variables is qualitative.

Example 6.3 – Truck and SUV Safety Ratings

Several years ago, The Wall Street Journal reported safety scores on 33 models of SUV’s and

53
trucks. Safety scores (y) were reported, as well as the vehicle’s weight (x1 ) and and indicator of
whether the vehicle has side air bags (x2 = 1 if it does, 0 if not). We fit a model, relating safety
scores to weight, presence of side airbags, and an interaction term that allows the effect of weight
to depend on whether side airbags are present:

y = β0 + β1 x1 + β2 x2 + β3 x1 x2 + ε.

We can write the equations for the two side airbag types as follows:

Side airbags: y = β0 + β1 x1 + β2 (1) + β3 x1 (1) + ε = (β0 + β2 ) + (β1 + β3 )x1 + ε,

and
No side airbags: y = β0 + β1 x1 + β2 (0) + β3 x1 (0) + ε = β0 + β1 x1 + ε.
The data for years the 33 models are given in Table 31.
The Analysis of Variance table for this example is given in Table 32. Note that R2 = .5518.
Table 33 provides the parameter estimates, standard errors, and individual t-tests. Note that the
F -test for testing H0 : β1 = β2 = β3 = 0 rejects the null hypothesis (F =11.90, P -value=.0001), but
none of the individual t-tests are significant (all P -values exceed 0.05). This can happen due to the
nature of the partial regression coefficients. It can be seen that weight is a very good predictor,
and that the presence of side airbags and the interaction term do not contribute much to the model
(SSE for a model containing only Weight (x1 ) is 3493.7, use this to test H0 : β2 = β3 = 0).
For vehicles with side airbags the fitted equation is:

ŷairbags = (b0 + b2 ) + (b1 + b3 )x1 = 44.18 + 0.02162x1 ,

while for vehicles without airbags, the fitted equation is:

ŷnoairbags = b0 + b1 x1 = 76.09 + 0.01262x1 .

Figure 21 shows the two fitted equations for the safety data.

yhatsa
170
160 Side Airbag
150
140
130 No Side Airb
120
110
3000 4000 5000 6000
weight

Figure 21: Plot of fitted equations for each vehicle type

54
 SUV/Truck Safety Ratings
Make Model Safety (y) Weight (x1 ) Airbag (x2 )
TOYOTA AVALON 111.34 3437 1
CHEVROLET IMPALA 119.22 3454 1
FORD RANGER 113.39 3543 0
BUICK LESABRE 124.6 3610 1
MAZDA MPV 117.13 3660 1
PLYMOUTH VOYAGER 117.29 3665 0
VOLVO S80 136.66 3698 1
AUDI A8 138.62 3751 1
DODGE DAKOTA 120.49 3765 0
ACURA RL 113.05 3824 1
PONTIAC TRANSPORT 118.83 3857 1
CHRYSLER TOWN&COUNTRY 122.62 3918 0
FORD F-150 118.7 3926 0
TOYOTA 4RUNNER 130.96 3945 0
MERCURY GRAND MARQUIS 136.37 3951 0
ISUZU RODEO 126.92 3966 0
TOYOTA SIENNA 138.54 3973 0
MERCURY VILLAGER 123.07 4041 0
LINCOLN TOWN CAR 120.83 4087 1
FORD F-150X 132.01 4125 0
FORD WINDSTAR 152.48 4126 1
NISSAN PATHFINDER 137.67 4147 1
OLDSMOBILE BRAVADO 117.61 4164 0
HONDA ODYSSEY 156.84 4244 0
MERCURY MOUNTAINEER 136.27 4258 1
TOYOTA TUNDRA 118.27 4356 0
MERCEDES-BENZ ML320 140.57 4396 1
FORD ECONOLINE 140.72 4760 0
DODGE RAM 120.08 4884 0
LINCOLN NAVIGATOR 144.57 4890 1
DODGE RAM 144.75 4896 0
CADILLAC ESCALANTE 158.82 5372 1
CHEVROLET SUBURBAN 170.26 5759 1

Table 31: Safety ratings for trucks and SUV’s

ANOVA
Source of Sum of Degrees of Mean
Variation Squares Freedom Square F p-value
MODEL 3838.03 3 1279.34 11.90 .0001
ERROR 3116.88 29 107.48
TOTAL 6954.91 32

Table 32: The Analysis of Variance Table for truck/SUV safety data

55
 STANDARD ERROR t FOR H0 :
PARAMETER ESTIMATE OF ESTIMATE βi =0 P-VALUE
INTERCEPT (β0 ) 76.09 27.04 2.81 .0087
x1 (β1 ) 0.01262 0.0065 1.93 .0629
x2 (β2 ) -31.91 31.78 -1.00 .3236
x3 (β3 ) 0.0090 .0076 1.18 .2487

Table 33: Parameter estimates and tests of hypotheses for individual parameters – Safety data

7 Introduction to Time Series and Forecasting

Textbook Sections: 21.1-21.6

In the remainder of the course, we consider data that are collected over time. Many economic
and financial models are based on time series. First, we will describe means of smoothing series,
then some simple ways to decompose a series, then we will describe some simple methods used to
predict future outcomes based on past values.

7.1 Time Series Components

Textbook Section: 21.2

Time series can be broken into five components: level, long-term trend, Cyclical variation,
seasonal variation, and random variation. A brief description of each is given below:

Level – Horizontal sales history in absence of other sources of variation (long run average).
Trend – Continuing pattern of increasing/decreasing values in the form of a line or curve.
Cyclical – Wavelike patterns that represent business cycles over multiple periods such as economic
expansions and recessions.
Seasonal – Patterns that occur over repetitive calendar periods such as quarters, months, weeks,
or times of the day.
Random – Short term irregularities that cause variation in individual outcomes above and beyond
the other sources of variation.

Example 7.1 - U.S. Cotton Production - 1978-2001

Figure 22 represents a plot of U.S. cotton production from 1978 to 2001 (Source: Cotton
association web site). We can see that there has been a trend to higher production over time, with
cyclical patterns arising as well along the way. Since the data are annual production, we cannot
observe seasonal patterns.

Example 7.2 - Texas in-state Finance/Insurance/Real Estate Sales - 1989-2002

56
 yrkbales
20000
18000
16000
14000
12000
10000
8000
6000
1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 2 2
9 9 9 9 9 9 9 9 9 9 9 9 9 9 9 9 9 9 9 9 9 9 0 0
7 7 8 8 8 8 8 8 8 8 8 8 9 9 9 9 9 9 9 9 9 9 0 0
8 9 0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9 0 1
year

Figure 22: Plot of U.S. cotton production 1978-2001

Table 34 gives in-state gross sales for the Finance, Insurance, and Real Estate (FIRE) for the
state of Texas for the 4 quarters of years 1989-2002 in hundreds of millions of dollars (Source: State
of Texas web site). A plot of the data (with vertical lines delineating years) is shown in Figure 23.
There is a clear positive trend in the series, and the fourth quarter tends to have much larger sales
than the other three quarters. We will use the variables in the last two columns in a subsequent
section.

Gross_Sales
11
10
9
8
7
6
5
4
3
2
1
0 10 20 30 40 50 60
quarter1

Figure 23: Plot of quarterly Texas in-state FIRE gross sales 1989-2002

7.2 Smoothing Techniques

Textbook Section: 21.3

Moving Averages are averages of values at a particular time period, and values that are near
it in time. We will focus on odd numbered moving averages, as they are simpler to describe and

57
 t year quarter gross sales (yt ) fitted sales (ŷt ) ratio (yt /ŷt )
1 1989 1 1.567 1.725 0.908
2 1989 2 1.998 1.813 1.102
3 1989 3 1.929 1.900 1.015
4 1989 4 3.152 1.988 1.586
5 1990 1 2.108 2.075 1.016
6 1990 2 2.004 2.163 0.926
7 1990 3 1.965 2.250 0.873
8 1990 4 3.145 2.338 1.345
9 1991 1 1.850 2.425 0.763
10 1991 2 2.303 2.513 0.916
11 1991 3 2.209 2.600 0.850
12 1991 4 4.030 2.688 1.499
13 1992 1 2.455 2.776 0.884
14 1992 2 2.536 2.863 0.886
15 1992 3 2.800 2.951 0.949
16 1992 4 4.733 3.038 1.558
17 1993 1 2.666 3.126 0.853
18 1993 2 3.256 3.213 1.013
19 1993 3 3.050 3.301 0.924
20 1993 4 5.307 3.388 1.566
21 1994 1 2.950 3.476 0.849
22 1994 2 3.190 3.563 0.895
23 1994 3 3.025 3.651 0.829
24 1994 4 4.847 3.738 1.297
25 1995 1 3.005 3.826 0.785
26 1995 2 3.297 3.913 0.843
27 1995 3 3.301 4.001 0.825
28 1995 4 4.607 4.089 1.127
29 1996 1 3.333 4.176 0.798
30 1996 2 3.352 4.264 0.786
31 1996 3 3.430 4.351 0.788
32 1996 4 5.552 4.439 1.251
33 1997 1 3.297 4.526 0.728
34 1997 2 3.637 4.614 0.788
35 1997 3 3.909 4.701 0.832
36 1997 4 6.499 4.789 1.357
37 1998 1 4.047 4.876 0.830
38 1998 2 4.621 4.964 0.931
39 1998 3 4.509 5.051 0.893
40 1998 4 6.495 5.139 1.264
41 1999 1 4.334 5.226 0.829
42 1999 2 4.557 5.314 0.858
43 1999 3 4.596 5.401 0.851
44 1999 4 7.646 5.489 1.393
45 2000 1 4.596 5.577 0.824
46 2000 2 5.282 5.664 0.933
47 2000 3 5.158 5.752 0.897
48 2000 4 7.834 5.839 1.342
49 2001 1 5.155 5.927 0.870
50 2001 2 5.312 6.014 0.883
51 2001 3 5.331 6.102 0.874
52 2001 4 10.42 6.189 1.684
53 2002 1 5.397 6.277 0.860
54 2002 2 5.832 6.364 0.916
55 2002 3 5.467 6.452 0.847
56 2002 4 8.522 6.539 1.303

Table 34: Quarterly in-state gross sales for Texas FIRE firms

58
implement (the textbook also covers even numbered MA’s as well). A 3-period moving averge
involves averaging the value directly prior to the current time point, the current value, and the
value directly after the current time point. There will not be values for either the first or last
periods of the series. Similarly, a 5-period moving average will include the current time point, and
the two prior time points and the two subsequent time points.

Example 7.3 - U.S. Internet Retail Sales - 1999q4-2003q1

The data in Table 35 gives the U.S. e-commerce sales for n = 14 quarters (quarter 1 is the 4th
quarter of 1999 and quarter 14 is preliminary reported sales for the 1st quarter of 2003) in millions
of dollars (Source: U.S. Census Bureau).

Quarter Sales (yt ) MA(3) ES(0.1) ES(0.5)

1 5393 . 5393 5393
2 5722 5788 5426 5558
3 6250 6350 5508 5904
4 7079 7526 5665 6491
5 9248 8112 6024 7870
6 8009 8387 6222 7939
7 7904 7936 6390 7922
8 7894 8862 6541 7908
9 10788 9384 6965 9348
10 9470 10006 7216 9409
11 9761 9899 7470 9585
12 10465 11332 7770 10025
13 13770 12052 8370 11897
14 11921 . 8725 11909

Table 35: Quarterly e-commerce sales and smoothed values for U.S. 1999q4-2003q1

To obatain the three period moving average (MA(3)) for the second quarter, we average the
first, second, and third period sales:
5393 + 5722 + 6250 17365
= = 5788.3 ≈ 5788
3 3
We can similarly obtain the three period moving average for quarters 3-13. The data and three
period moving averages are given in Figure 24. The moving average is the dashed line, while the
original series is the solid line.
Exponential Smoothing is an alternative means of smoothing the series. It makes use of
all prior time points, with higher weights on more recent time points, and exponentially decaying
weights on more distance time points. One advantage is that we have smoothed values for all time
points. One drawback is that we must select a tuning parameter (although we would also have to
choose the length of a moving average as well, for that method). One widely used convention is
to set the first period’s smoothed value to the first observation, then make subsequent smoothed
values as a weighted average of the current observation and the previous value of the smoothed
series. We use the notation St for the smoothed value at time t.

59
 sales
14000
13000
12000
11000
10000
9000
8000
7000
6000
5000
1 2 3 4 5 6 7 8 9 10 11 12 13 14
quarter

Figure 24: Plot of quarterly U.S. internet retail sales and 3-Period moving average

S 1 = y1 St = wyt + (1 − w)St−1 t≥2

Example 7.3 (Continued)

Thus, for quarter 4 of 1999, we set S1 = y1 = 5393. In Table 35, we include smoothed values
based on w = 0.1 and w = 0.5, respectively:

w = 0.1 : S2 = 0.1 ∗ y2 + 0.9 ∗ S1 = 0.1(5722) + 0.9(5393) = 572.2 + 4853.7 = 5425.9 ≈ 5426

w = 0.5 : S2 = 0.5 ∗ y2 + 0.5 ∗ S1 = 0.5(5722) + 0.5(5393) = 2861.0 + 2696.5 = 5557.5 ≈ 5558

The smoothed values are given in Table 35, as well as in Figure 25. The solid line is the original
series, the smoothest line is w = 0.1, and the intermediate line is w = 0.5.

7.3 Estimating Trend and Seasonal Effects

Textbook Section: 21.4

While the cyclical patterns are difficult to predict and estimate, we can estimate linear trend
and seasonal indexes fairly simply. Further, there is no added difficulty if the trend is nonlinear
(quadratic), but we will consider only the linear case here.
First, we must identify seasons, these can be weeks, months, or quarters (or even times of the
day or days of the week). Then we fit a linear trend for the entire series. This is followed by taking
the ratio of the actual to the fitted value (from the regression equation) for each period. Next, we
average these ratios for each season, and adjust so that the averages sum to 1.0.

Example 7.2 (Continued)

60
 sales
14000
13000
12000
11000
10000
9000
8000
7000
6000
5000
1 2 3 4 5 6 7 8 9 10 11 12 13 14
quarter

Figure 25: Plot of quarterly U.S. internet retail sales and 32 Exponentially smoothed series

Consider the Texas gross (in-state) sales for the FIRE industry. The seasons are the four
quarters. Fitting a simple linear regression, relating sales to time period, we get:

ŷt = b0 + b1 t = 1.6376 + 0.08753t

The fitted values (as well as the observed values) have been shown previously in Table 34. Also for
each outcome, we obtain the ratio of the observed to fitted value, also given in the table. Consider
the first and last cases:
y1 1.567
t=1: y1 = 1.567 ŷ1 = 1.6376 + 0.08753(1) = 1.725 = = 0.908
ŷ1 1.725
y1 8.522
t = 56 : y56 = 8.522 ŷ1 = 1.6376 + 0.08753(56) = 6.539 = = 1.303
ŷ1 6.539
Next, we take the mean of the observed-to-fitted ratio for each quarter. There are 14 years of data:
0.908 + 1.016 + 0.763 + 0.884 + 0.853 + 0.849 + 0.785 + 0.798 + 0.728 + 0.830 + 0.829 + 0.824 + 0.870 + 0.860
Q1 : = 0.84
14
The means for the remaining three quarters are:

Q2 : 0.906 Q3 : 0.875 Q4 : 1.398

The means sum to 4.022, and have a mean of 4.022/4=1.0055. If we divide each mean by 1.0055,
the indexes will sum to 1:

Q1 : 0.838 Q2 : 0.901 Q3 : 0.870 Q4 : 1.390

The seasonally adjusted time series is given by dividing each observed value by its seasonal index.
This way, we can determine when there are real changes in the series, beyond seasonal fluctuations.
Table 36 contains all components as well as the seasonally adjusted values.

61
 t year quarter gross sales (yt ) fitted sales (ŷt ) ratio (yt /ŷt ) season adjusted
1 1989 1 1.567 1.725 0.908 1.870
2 1989 2 1.998 1.813 1.102 2.218
3 1989 3 1.929 1.900 1.015 2.218
4 1989 4 3.152 1.988 1.586 2.268
5 1990 1 2.108 2.075 1.016 2.515
6 1990 2 2.004 2.163 0.926 2.224
7 1990 3 1.965 2.250 0.873 2.259
8 1990 4 3.145 2.338 1.345 2.263
9 1991 1 1.850 2.425 0.763 2.207
10 1991 2 2.303 2.513 0.916 2.556
11 1991 3 2.209 2.600 0.850 2.540
12 1991 4 4.030 2.688 1.499 2.899
13 1992 1 2.455 2.776 0.884 2.929
14 1992 2 2.536 2.863 0.886 2.815
15 1992 3 2.800 2.951 0.949 3.218
16 1992 4 4.733 3.038 1.558 3.405
17 1993 1 2.666 3.126 0.853 3.182
18 1993 2 3.256 3.213 1.013 3.614
19 1993 3 3.050 3.301 0.924 3.506
20 1993 4 5.307 3.388 1.566 3.818
21 1994 1 2.950 3.476 0.849 3.521
22 1994 2 3.190 3.563 0.895 3.540
23 1994 3 3.025 3.651 0.829 3.477
24 1994 4 4.847 3.738 1.297 3.487
25 1995 1 3.005 3.826 0.785 3.585
26 1995 2 3.297 3.913 0.843 3.660
27 1995 3 3.301 4.001 0.825 3.794
28 1995 4 4.607 4.089 1.127 3.314
29 1996 1 3.333 4.176 0.798 3.977
30 1996 2 3.352 4.264 0.786 3.720
31 1996 3 3.430 4.351 0.788 3.942
32 1996 4 5.552 4.439 1.251 3.994
33 1997 1 3.297 4.526 0.728 3.934
34 1997 2 3.637 4.614 0.788 4.037
35 1997 3 3.909 4.701 0.832 4.493
36 1997 4 6.499 4.789 1.357 4.675
37 1998 1 4.047 4.876 0.830 4.829
38 1998 2 4.621 4.964 0.931 5.129
39 1998 3 4.509 5.051 0.893 5.183
40 1998 4 6.495 5.139 1.264 4.672
41 1999 1 4.334 5.226 0.829 5.171
42 1999 2 4.557 5.314 0.858 5.058
43 1999 3 4.596 5.401 0.851 5.282
44 1999 4 7.646 5.489 1.393 5.501
45 2000 1 4.596 5.577 0.824 5.485
46 2000 2 5.282 5.664 0.933 5.862
47 2000 3 5.158 5.752 0.897 5.928
48 2000 4 7.834 5.839 1.342 5.636
49 2001 1 5.155 5.927 0.870 6.152
50 2001 2 5.312 6.014 0.883 5.896
51 2001 3 5.331 6.102 0.874 6.128
52 2001 4 10.42 6.189 1.684 7.498
53 2002 1 5.397 6.277 0.860 6.440
54 2002 2 5.832 6.364 0.916 6.473
55 2002 3 5.467 6.452 0.847 6.283
56 2002 4 8.522 6.539 1.303 6.131

Table 36: Quarterly in-state gross sales for Texas FIRE firms and seasonally adjusted series

62
7.4 Introduction to Forecasting
Textbook Section: 21.5

There are unlimited number of possibilities of ways of forecasting future outcomes, so we need
means of comparing the various methods. First, we introduce some notation:
• yt — Actual (random) outcome at time t, unknown prior to t
• Ft — Forecast of yt , made prior to t
• et — Forecast error et = yt − Ft (Book does not use this notation).
Two commonly used measures of comparing forecasting methods are given below:
P Pn
t |e | |yt −Ft |
Mean Absolute Deviation (MAD) — MAD= number of forecasts = t=1
n
P Pn
Sum of Square Errors (SSE) — SSE= e2t = t=1 (yt − F t )2

When comparing forecasting methods, we wish to minimize one or both of these quantities.

7.5 Simple Forecasting Techniques

Textbook Section: 21.6 and Supplement

In this section, we describe some simple methods of using past data to predict future outcomes.
Most forecasts you hear reported are generally complex hybrids of these techniques.

7.5.1 Moving Averages

This method, which is not included in the tesxt, is a slight adjustment to the centered moving
averages in the smoothing section. At time point t, we use the previous k observations to forecast
yt . We use the mean of the last k observations to forecast outcome at t:
Xt−1 + Xt−2 + · · · + Xt−k
Ft =
k
Problem: How to choose k?
Example 7.4 - Anhueser-Busch Annual Dividend Yields 1952-1995
Table 37 gives average dividend yields for Anheuser–Busch for the years 1952–1995 (Source:Value
Line), forecasts and errors based on moving averages based on lags of 1, 2, and 3. Note that we
don’t have early year forecasts, and the longer the lag, the longer we must wait until we get our
first forecast.
Here we compute moving averages for year=1963:
1–Year: F1963 = y1962 = 3.2
y1962 +y1961 3.2+2.8
2–Year: F1963 = 2 = 2 = 3.0
y1962 +y1961 +y1960 3.2+2.8+4.4
3–Year: F1963 = 3 = 3 = 3.47
Figure 26 displays raw data and moving average forecasts.

63
 t Year yt F1,t e1,t F2,t e2,t F3,t e3,t
1 1952 5.30 . . . . . .
2 1953 4.20 5.30 -1.10 . . . .
3 1954 3.90 4.20 -0.30 4.75 -0.85 . .
4 1955 5.20 3.90 1.30 4.05 1.15 4.47 0.73
5 1956 5.80 5.20 0.60 4.55 1.25 4.43 1.37
6 1957 6.30 5.80 0.50 5.50 0.80 4.97 1.33
7 1958 5.60 6.30 -0.70 6.05 -0.45 5.77 -0.17
8 1959 4.80 5.60 -0.80 5.95 -1.15 5.90 -1.10
9 1960 4.40 4.80 -0.40 5.20 -0.80 5.57 -1.17
10 1961 2.80 4.40 -1.60 4.60 -1.80 4.93 -2.13
11 1962 3.20 2.80 0.40 3.60 -0.40 4.00 -0.80
12 1963 3.10 3.20 -0.10 3.00 0.10 3.47 -0.37
13 1964 3.10 3.10 0.00 3.15 -0.05 3.03 0.07
14 1965 2.60 3.10 -0.50 3.10 -0.50 3.13 -0.53
15 1966 2.00 2.60 -0.60 2.85 -0.85 2.93 -0.93
16 1967 1.60 2.00 -0.40 2.30 -0.70 2.57 -0.97
17 1968 1.30 1.60 -0.30 1.80 -0.50 2.07 -0.77
18 1969 1.20 1.30 -0.10 1.45 -0.25 1.63 -0.43
19 1970 1.20 1.20 0.00 1.25 -0.05 1.37 -0.17
20 1971 1.10 1.20 -0.10 1.20 -0.10 1.23 -0.13
21 1972 0.90 1.10 -0.20 1.15 -0.25 1.17 -0.27
22 1973 1.40 0.90 0.50 1.00 0.40 1.07 0.33
23 1974 2.00 1.40 0.60 1.15 0.85 1.13 0.87
24 1975 1.90 2.00 -0.10 1.70 0.20 1.43 0.47
25 1976 2.30 1.90 0.40 1.95 0.35 1.77 0.53
26 1977 3.10 2.30 0.80 2.10 1.00 2.07 1.03
27 1978 3.50 3.10 0.40 2.70 0.80 2.43 1.07
28 1979 3.80 3.50 0.30 3.30 0.50 2.97 0.83
29 1980 3.70 3.80 -0.10 3.65 0.05 3.47 0.23
30 1981 3.10 3.70 -0.60 3.75 -0.65 3.67 -0.57
31 1982 2.60 3.10 -0.50 3.40 -0.80 3.53 -0.93
32 1983 2.40 2.60 -0.20 2.85 -0.45 3.13 -0.73
33 1984 3.00 2.40 0.60 2.50 0.50 2.70 0.30
34 1985 2.40 3.00 -0.60 2.70 -0.30 2.67 -0.27
35 1986 1.80 2.40 -0.60 2.70 -0.90 2.60 -0.80
36 1987 1.70 1.80 -0.10 2.10 -0.40 2.40 -0.70
37 1988 2.20 1.70 0.50 1.75 0.45 1.97 0.23
38 1989 2.10 2.20 -0.10 1.95 0.15 1.90 0.20
39 1990 2.40 2.10 0.30 2.15 0.25 2.00 0.40
40 1991 2.10 2.40 -0.30 2.25 -0.15 2.23 -0.13
41 1992 2.20 2.10 0.10 2.25 -0.05 2.20 0.00
42 1993 2.70 2.20 0.50 2.15 0.55 2.23 0.47
43 1994 3.00 2.70 0.30 2.45 0.55 2.33 0.67
44 1995 2.80 3.00 -0.20 2.85 -0.05 2.63 0.17

Table 37: Dividend yields, Forecasts, errors — 1, 2, and 3 year moving Averages

64
 DIV_YLD
7

6 Actual
MA(1)
MA(2)
5 MA(3)

0
1950 1960 1970 1980 1990 2000
CAL_YEAR

Figure 26: Plot of the data moving average forecast for Anheuser–Busch dividend data

7.5.2 Exponential Smoothing

Exponential smoothing is a method of forecasting that weights data from previous time periods
with exponentially decreasing magnitudes. Forecasts can be written as follows, where the forecast
for period 2 is traditionally (but not always) simply the outcome from period 1:

Ft+1 = St = wyt + (1 − w)St−1 = wyt + (1 − w)Ft

where :

• Ft+1 is the forecast for period t + 1

• yt is the outcome at t

• St is the smoothed value for period t (St−1 = Ft )

• w is the smoothing constant (0 ≤ w ≤ 1)

Forecasts are “smoother” than the raw data and weights of previous observations decline expo-
nentially with time.

Example 7.4 (Continued)

3 smoothing constants (allowing decreasing amounts of smoothness) for illustration:

• w = 0.2 — Ft+1 = 0.2yt + 0.8St−1 = 0.2yt + 0.8Ft

• w = 0.5 — Ft+1 = 0.5yt + 0.5St−1 = 0.5yt + 0.5Ft

• w = 0.8 — Ft+1 = 0.8yt + 0.2St−1 = 0.8yt + 0.2Ft

Year 2 (1953) — set F1953 = X1952 , then cycle from there.

65
 t Year yt Fw=.2,t ew=.2,t Fw=.5,t ew=.5,t Fw=.8,t ew=.8,t
1 1952 5.30 . . . . . .
2 1953 4.20 5.30 -1.10 5.30 -1.10 5.30 -1.10
3 1954 3.90 5.08 -1.18 4.75 -0.85 4.42 -0.52
4 1955 5.20 4.84 0.36 4.33 0.88 4.00 1.20
5 1956 5.80 4.92 0.88 4.76 1.04 4.96 0.84
6 1957 6.30 5.09 1.21 5.28 1.02 5.63 0.67
7 1958 5.60 5.33 0.27 5.79 -0.19 6.17 -0.57
8 1959 4.80 5.39 -0.59 5.70 -0.90 5.71 -0.91
9 1960 4.40 5.27 -0.87 5.25 -0.85 4.98 -0.58
10 1961 2.80 5.10 -2.30 4.82 -2.02 4.52 -1.72
11 1962 3.20 4.64 -1.44 3.81 -0.61 3.14 0.06
12 1963 3.10 4.35 -1.25 3.51 -0.41 3.19 -0.09
13 1964 3.10 4.10 -1.00 3.30 -0.20 3.12 -0.02
14 1965 2.60 3.90 -1.30 3.20 -0.60 3.10 -0.50
15 1966 2.00 3.64 -1.64 2.90 -0.90 2.70 -0.70
16 1967 1.60 3.31 -1.71 2.45 -0.85 2.14 -0.54
17 1968 1.30 2.97 -1.67 2.03 -0.73 1.71 -0.41
18 1969 1.20 2.64 -1.44 1.66 -0.46 1.38 -0.18
19 1970 1.20 2.35 -1.15 1.43 -0.23 1.24 -0.04
20 1971 1.10 2.12 -1.02 1.32 -0.22 1.21 -0.11
21 1972 0.90 1.91 -1.01 1.21 -0.31 1.12 -0.22
22 1973 1.40 1.71 -0.31 1.05 0.35 0.94 0.46
23 1974 2.00 1.65 0.35 1.23 0.77 1.31 0.69
24 1975 1.90 1.72 0.18 1.61 0.29 1.86 0.04
25 1976 2.30 1.76 0.54 1.76 0.54 1.89 0.41
26 1977 3.10 1.86 1.24 2.03 1.07 2.22 0.88
27 1978 3.50 2.11 1.39 2.56 0.94 2.92 0.58
28 1979 3.80 2.39 1.41 3.03 0.77 3.38 0.42
29 1980 3.70 2.67 1.03 3.42 0.28 3.72 -0.02
30 1981 3.10 2.88 0.22 3.56 -0.46 3.70 -0.60
31 1982 2.60 2.92 -0.32 3.33 -0.73 3.22 -0.62
32 1983 2.40 2.86 -0.46 2.96 -0.56 2.72 -0.32
33 1984 3.00 2.77 0.23 2.68 0.32 2.46 0.54
34 1985 2.40 2.81 -0.41 2.84 -0.44 2.89 -0.49
35 1986 1.80 2.73 -0.93 2.62 -0.82 2.50 -0.70
36 1987 1.70 2.54 -0.84 2.21 -0.51 1.94 -0.24
37 1988 2.20 2.38 -0.18 1.96 0.24 1.75 0.45
38 1989 2.10 2.34 -0.24 2.08 0.02 2.11 -0.01
39 1990 2.40 2.29 0.11 2.09 0.31 2.10 0.30
40 1991 2.10 2.31 -0.21 2.24 -0.14 2.34 -0.24
41 1992 2.20 2.27 -0.07 2.17 0.03 2.15 0.05
42 1993 2.70 2.26 0.44 2.19 0.51 2.19 0.51
43 1994 3.00 2.35 0.65 2.44 0.56 2.60 0.40
44 1995 2.80 2.48 0.32 2.72 0.08 2.92 -0.12

Table 38: Dividend yields, Forecasts, and errors based on exponential smoothing with w =
0.2, 0.5, 0.8

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 Table 38 gives average dividend yields for Anheuser–Busch for the years 1952–1995 (Source:Value
Line), forecasts and errors based on exponential smoothing based on lags of 1, 2, and 3.

Here we obtain Forecasts based on Exponential Smoothing, beginning with year 2 (1953):
1953: Fw=.2,1953 = y1952 = 5.30 Fw=.5,1952 = y1952 = 5.30 Fw=.8,1952 = y1952 = 5.30
1954 (w = 0.2): Fw=.2,1954 = .2y1953 + .8Fw=.2,1953 = .2(4.20) + .8(5.30) = 5.08
1954 (w = 0.5): Fw=.5,1954 = .5y1953 + .5Fw=.5,1953 = .5(4.20) + .5(5.30) = 4.75
1954 (w = 0.8): Fw=.8,1954 = .8y1953 + .2Fw=.5,1953 = .8(4.20) + .2(5.30) = 4.42
Which level of w appears to be “discounting” more distant observations at a quicker rate? What
would happen if w = 1? If w = 0? Figure 27 gives raw data and exponential smoothing forecasts.
DIV_YLD
7

6 Actual
ES(a=.2)
ES(a=.5)
5 ES(a=.8)

0
1950 1960 1970 1980 1990 2000
CAL_YEAR

Figure 27: Plot of the data and Exponential Smoothing forecasts for Anheuser–Busch dividend
data

Table 39 gives measures of forecast errors for three moving average, and three exponential
smoothing methods.

Moving Average Exponential Smoothing

Measure 1–Period 2–Period 3–Period w = 0.2 w = 0.5 w = 0.8
MAE 0.43 0.53 0.62 0.82 0.58 0.47
MSE 0.30 0.43 0.57 0.97 0.48 0.34

Table 39: Relative performances of 6 forecasting methods — Anheuser–Busch data

Note that M SE is SSE/n where n is the number of forecasts.

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7.6 Forecasting with Seasonal Indexes
After trend and seasonal indexes have been estimated, future outcomes can be forecast by the
equation:
Ft = [b0 + b1 t] × SIt
where b0 + b1 t is the linear trend and SIt is the seasonal index for period t.

Example 7.2 (Continued)

For the Texas FIRE gross sales data, we have:

b0 = 1.6376 b1 = .08753 SIQ1 = .838 SIQ2 = .901 SIQ3 = .870 SIQ4 = 1.390

Thus for the 4 quarters of 2003 (t = 57, 58, 59, 60), we have:

Q1 : F57 = [1.6376 + 0.08753(57)](.838) = 5.553 Q2 : F58 = [1.6376 + 0.08753(58)](.901) = 6.050

Q3 : F59 = [1.6376 + 0.08753(59)](.870) = 5.918 Q4 : F60 = [1.6376 + 0.08753(60)](1.390) = 9.576

7.6.1 Autoregression
Sometimes regression is run on past or “lagged” values of the dependent variable (and possibly
other variables). An Autoregressive model with independent variables corresponding to k periods
can be written as follows:

ŷt = b0 + b1 yt−1 + b2 yt−2 + · · · + bk yt−k

Note that the regression cannot be run for the first k responses in the series. Technically forecasts
can be given for only periods after the regression has been fit, since the regression model depends
on all periods used to fit it.

Example 7.4 (Continued)

From Computer software, autoregressions based on lags of 1, 2, and 3 periods are fit:
1–Period: ŷt = 0.29 + 0.88yt−1
2–Period: ŷt = 0.29 + 1.18yt−1 − 0.29yt−2
3–Period: ŷt = 0.28 + 1.21yt−1 − 0.37yt−2 + 0.05yt−3
Table 40 gives raw data and forecasts based on three autoregression models. Figure 28 displays
the actual outcomes and predictions.

68
 t Year yt FAR(1),t eAR(1),t FAR(2),t e(AR(2),t FAR(3),t eAR(3),t
1 1952 5.3 . . . . . .
2 1953 4.2 4.96 -0.76 . . . .
3 1954 3.9 3.99 -0.09 3.72 0.18 . .
4 1955 5.2 3.72 1.48 3.68 1.52 3.72 1.48
5 1956 5.8 4.87 0.93 5.30 0.50 5.35 0.45
6 1957 6.3 5.40 0.90 5.64 0.66 5.58 0.72
7 1958 5.6 5.84 -0.24 6.06 -0.46 6.03 -0.43
8 1959 4.8 5.22 -0.42 5.09 -0.29 5.03 -0.23
9 1960 4.4 4.52 -0.12 4.34 0.06 4.35 0.05
10 1961 2.8 4.16 -1.36 4.10 -1.30 4.12 -1.32
11 1962 3.2 2.75 0.45 2.33 0.87 2.29 0.91
12 1963 3.1 3.11 -0.01 3.26 -0.16 3.35 -0.25
13 1964 3.1 3.02 0.08 3.03 0.07 3.00 0.10
14 1965 2.6 3.02 -0.42 3.06 -0.46 3.05 -0.45
15 1966 2 2.58 -0.58 2.47 -0.47 2.44 -0.44
16 1967 1.6 2.05 -0.45 1.90 -0.30 1.90 -0.30
17 1968 1.3 1.70 -0.40 1.60 -0.30 1.61 -0.31
18 1969 1.2 1.43 -0.23 1.36 -0.16 1.37 -0.17
19 1970 1.2 1.35 -0.15 1.33 -0.13 1.34 -0.14
20 1971 1.1 1.35 -0.25 1.36 -0.26 1.36 -0.26
21 1972 0.9 1.26 -0.36 1.24 -0.34 1.23 -0.33
22 1973 1.4 1.08 0.32 1.03 0.37 1.03 0.37
23 1974 2 1.52 0.48 1.68 0.32 1.70 0.30
24 1975 1.9 2.05 -0.15 2.25 -0.35 2.23 -0.33
25 1976 2.3 1.96 0.34 1.96 0.34 1.92 0.38
26 1977 3.1 2.31 0.79 2.46 0.64 2.47 0.63
27 1978 3.5 3.02 0.48 3.29 0.21 3.28 0.22
28 1979 3.8 3.37 0.43 3.53 0.27 3.49 0.31
29 1980 3.7 3.64 0.06 3.77 -0.07 3.75 -0.05
30 1981 3.1 3.55 -0.45 3.56 -0.46 3.54 -0.44
31 1982 2.6 3.02 -0.42 2.88 -0.28 2.86 -0.26
32 1983 2.4 2.58 -0.18 2.47 -0.07 2.47 -0.07
33 1984 3 2.40 0.60 2.37 0.63 2.39 0.61
34 1985 2.4 2.93 -0.53 3.14 -0.74 3.16 -0.76
35 1986 1.8 2.40 -0.60 2.26 -0.46 2.20 -0.40
36 1987 1.7 1.87 -0.17 1.72 -0.02 1.73 -0.03
37 1988 2.2 1.79 0.41 1.78 0.42 1.80 0.40
38 1989 2.1 2.23 -0.13 2.40 -0.30 2.41 -0.31
39 1990 2.4 2.14 0.26 2.13 0.27 2.10 0.30
40 1991 2.1 2.40 -0.30 2.52 -0.42 2.53 -0.43
41 1992 2.2 2.14 0.06 2.08 0.12 2.05 0.15
42 1993 2.7 2.23 0.47 2.28 0.42 2.29 0.41
43 1994 3 2.67 0.33 2.84 0.16 2.85 0.15
44 1995 2.8 2.93 -0.13 3.05 -0.25 3.03 -0.23

Table 40: Average dividend yields and Forecasts/errors based on autoregression with lags of 1, 2,
and 3 periods

69
 DIV_YLD
7

6 Actual
AR(1)
AR(2)
5 AR(3)

0
1950 1960 1970 1980 1990 2000
CAL_YEAR

Figure 28: Plot of the data and Autoregressive forecasts for Anheuser–Busch dividend data

70