Chapter One: Introduction to Econometrics

1.1. Definition and Scope of Econometrics

What is Econometrics?
 Econometrics means economic measurement. The “metric” part of the word signifies
measurement and econometrics is concerned with the measuring of economic relationships.
 It is a social science in which the tools of economic theory, mathematics and statistical
inference are applied to the analysis of economic phenomena.
 It is the application of statistical and mathematical methods to the analysis of economic
data, with a purpose of giving empirical content to economic theories and verifying them or
refuting them.
 It is a special type of economic analysis and research in which the general economic theory
formulated in mathematical form (i.e. mathematical economics) is combined with empirical
measurement (i.e. statistics) of economic phenomena.

Why a Separate Discipline?

A distinction has to be made between Econometrics and economic theory, statistics and
mathematics.
Econometrics vs. Economic theory
Economic theory makes statements or hypotheses that are mostly of qualitative nature.
Example: Other things remaining constant (ceteris paribus) a reduction in the price of a
commodity is expected to increase the quantity demanded. And Economic theory postulates an
inverse relationship between price and quantity demanded of a commodity. But the theory does
not provide numerical value as the measure of the relationship between the two. Here comes the
task of the econometrician to provide the numerical value by which the quantity will go up or
down as a result of changes in the price of the commodity.

Econometrics vs. Mathematical Economics

Mathematical economics states economic theory in terms of mathematical symbols. There is
no essential difference between mathematical economics and economic theory. Both state the
same relationships, but while economic theory uses verbal exposition, mathematical economics
uses symbol expression. Both express economic relationships in an exact or deterministic form.
Neither mathematical economics nor economic theory allows for random elements which might

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affect the relationship and make it stochastic. Furthermore, they do not provide numerical values
for the coefficients of economic relationships.
Econometrics differs from mathematical economics in that, although econometrics presupposes,
the economic relationships to be expressed in mathematical forms, it does not assume exact or
deterministic relationship. Econometrics assumes random relationships among economic
variables. Furthermore, econometric methods provide numerical values of the coefficients of
economic relationships.
Econometrics vs. Statistics
Econometrics differs from both mathematical statistics and economic statistics. Economic
statistics is concerned with collecting, processing and presenting economic data (descriptive
statistics). An economic statistician gathers empirical data, records them, tabulates them or charts
them, and attempts to describe the pattern in their development over time and perhaps detect
some relationship between various economic magnitudes. Economic statistics is mainly a
descriptive aspect of economics. It does not provide explanations of the development of the
various variables and it does not provide measurements to the coefficients of economic
relationships.
Mathematical (or inferential) statistics deals with the method of measurement which is developed
on the basis of controlled experiments. But statistical methods of measurement are not
appropriate for a number of economic relationships because for most economic relationships
controlled or carefully planned experiments cannot be designed due to the fact that the nature of
relationships among economic variables are stochastic or random.
Economic Models vs. Econometric Models
i) Economic Models
Any economic theory is an observation from the real world. For one reason, the immense
complexity of the real world economy makes it impossible for us to understand all
interrelationships at once. Another reason is that all the interrelationships are not equally
important as such for the understanding of the economic phenomenon under study. The sensible
procedure is therefore, to pick up the important factors and relationships relevant to our problem
and to focus our attention on these alone. Such a deliberately simplified analytical framework is
called an economic model. It is an organized set of relationships that describes the functioning of

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an economic entity under a set of simplifying assumptions. All economic reasoning is ultimately
based on models. Economic models consist of the following three basic structural elements.
1. A set of variables
2. A list of fundamental relationships and
3. A number of strategic coefficients
ii) Econometric Models
The most important characteristic of econometric relationships is that they contain a random
element which is ignored by mathematical economic models which postulate exact relationships
between economic variables.
Example: Economic theory postulates that the demand for a commodity depends on its price, on
the prices of other related commodities, on consumers‟ income and on tastes. This is an exact
relationship which can be written mathematically as:
Ԛ= 0 + 1P + 2P0 + 3Y + 4t

The above demand equation is exact. However, many more factors may affect demand. In
econometrics the influence of these other factors are taken into account by the introduction into
the economic relationships of random variable. In our example, the demand function studied
with the tools of econometrics would be of the stochastic form:

Ԛ= 0 + 1P + 2P0 + 3Y + 4t +𝗎

Where u stands for the random factors which affect the quantity demanded.
1.2. Goals of Econometrics
 Basically there are three main goals of Econometrics. They are:
i) Analysis i.e. testing economic theory
ii) Policy making i.e. obtaining numerical estimates of the coefficients of economic
relationships for policy simulations.
iii) Forecasting i.e. using the numerical estimates of the coefficients in order to forecast the
future values of economic magnitudes.
1.3. Methodology of Econometrics
Econometric research is concerned with the measurement of the parameters of economic
relationships and with the predication of the values of economic variables.
Econometric analyses usually follow the following steps:

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1. Statement of theory or hypothesis
What does economic theory tell you about the relationship between two or more variables? For
example, Keynes stated: “Consumption increases as income increases, but not by as much as the
increase in income”. It means that “The marginal propensity to consume (MPC) for a unit change
in income is greater than zero but less than a unit”.
2. Specification of the mathematical model of the theory
What functional relationship exists between the two variables? Is it linear or non-linear?
According to Keynes, consumption expenditure and income are linearly related. That is,
Y   0  1 X ; 0  1  1 where, Y = consumption expenditure, X = income and β0 and β1 are

parameters; β0 is intercept, and β1 is slope coefficients.

3. Specification of the econometric model of the theory
There are other factors apart from income that affects consumption. Hence,
Y   0  1 X   ; 0  1  1 ; where Y = consumption expenditure; X = income; β0 and β1 are

parameters; β0 is intercept and β1 is slope coefficients; u is disturbance term or error term. It is a

random or stochastic variable that affects consumption.
4. Obtaining data
Hypothesis testing requires collecting data from a sample. Suppose we obtained the following
data on personal consumption expenditure and income from 3 individuals.
Table 1.1. Personal consumption and income of 3 individuals
Individual Xi Yi
1 3000 1000
2 5000 2000
3 6000 3000
Yi = Personal consumption expenditure
Xi = Income in Ethiopian Birr
5. Estimating the econometric model
Suppose we run OLS and obtained Yˆ  + 0.64X. Then MPC was about 0.64 and it means
that for the sample individuals an increase in income by Birr 1, led (on average) to increases in
consumption expenditure by about 64 cents.
6. Hypothesis testing

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Are the estimates accords with the expectations of the theory that is being tested? Is MPC < 1
statistically? If so, it may support Keynes‟ theory. Confirmation or refutation of economic
theories based on sample evidence is object of statistical analysis.
7. Forecasting or prediction
If we have time series data, with given future value(s) of X, we can estimate the future value(s)
of Y. For example, if the above data is the yearly consumption expenditure of an individual
from1982 to 1984. If income = Birr 7000 in 1985 what is the forecast consumption expenditure?

The predicted value of Y is Yˆ = - 986.69+0.64(7000) = 3493.31.

8. Using model for control or policy purposes
Y = 4000= -986.69+0.64 X implies that X = 7791.7
The MPC = 0.64, an income of Birr 7791.7 will produce an expenditure of Birr 4000. By fiscal
and monetary policy, government can manipulate the control variable X to get the desired level
of target variable Y.
1.4. Elements of Econometrics
There are four basic elements of econometrics include:
1. Data
Collecting and coding the sample data, the raw material of econometrics. Most economic data is
observational or non-experimental data (as distinct from experimental data generated under
controlled experimental conditions).
Economic data can be categorized into three:
i. Cross-sectional data
A cross-sectional data set consists of a sample of individuals, households, firms, cities, states,
countries or a variety of other units, taken at a given point in time. Examples include the Census
of population or manufactures, or a poll or survey.
ii. Time series data
A time series data set consists of observations on a variable or several variables over time. For
example, GNP, employment rates, money supply collected over a period of time, daily, weekly,
monthly or every year are examples of time series data.
iii. Panel data
A panel data set consists of a time series for each cross-sectional member in the data set.

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It has the dimensions of both time series and cross-sections. An example is a household survey
(census) conducted every 10 years in Ethiopia.
2. Specification
This is about the specification of the econometric model that we think generated the sample data.
3. Estimation
This consists of using the assembled sample data on the observable variables in the model to
compute estimates of the numerical values of all the unknown parameters in the model.
4. Inference
This consists of using the parameter estimates computed from sample data to test hypotheses
about the numerical values of the unknown population parameters that describe the behavior of
the population from which the sample was selected.
 Measurement Scales of Variables
The variables that we will generally encounter fall into four broad categories.
1. Ratio scale
For a variable X, taking two values, X1 and X2, the ratio X1/X2 and the distance (X2 − X1) are
meaningful quantities. Also, there is a natural ordering (ascending or descending) of the values
along the scale. Therefore, comparisons such as X2 ≤ X1 or X2 ≥ X1 are meaningful.
2. Interval scale
An interval scale is a scale on which equal intervals between objects, represent equal differences.
The interval differences are meaningful. But, we can‟t defend ratio relationships. The distance
between two time periods, say (2000–1995) is meaningful, but not the ratio of two time periods
(2000/1995).
3. Ordinal scale
A variable belongs to this category only if it satisfies the third property of the ratio scale (i.e.,
natural ordering). Examples are grading systems (A, B, C grades) or income class (upper,
middle, lower). For these variables the ordering exists but the distances between the categories
cannot be quantified.
4. Nominal scale
Variables in this category have none of the features of the ratio scale variables. Variables such as
gender (male, female) and Marital status (married, unmarried, divorced, separated).

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 Chapter Two: Correlation Theory
2.1. Basic Concepts of Correlation
 Economic variables have a great tendency of moving together and very often data are given
in pairs of observations in which there is a possibility that the change in one variable is on
average accompanied by the change of the other variable. This situation is known as
correlation.
 Correlation is a statistical measure that indicates the extent to which two or more variables
fluctuate together.
 Correlation may be defined as the degree of relationship existing between two or more
variables. The degree of relationship between the variables under consideration is measure
through the correlation analysis. Correlation analysis deals with the association between two
or more variables. The measure of correlation called the correlation coefficient. The degree
of relationship is expressed by coefficient which range from correlation (
) The direction of change is indicated by a sign.
2.2. Types of Correlation
1. Type I
Positive Correlation: The correlation is said to be positive correlation if the values of two
variables changing with same direction. For example, the correlation between price of a
commodity and its quantity supplied is positive since as price rises, quantity supplied will be
increased and vice versa.
Negative Correlation: The correlation is said to be negative correlation when the values of
variables change with opposite direction. For example, the correlation between price of a
commodity and its quantity demanded is negative since as price rises, quantity demanded
will be decreased and vice versa.
Zero Correlation: Means no relationship between the two variables X and Y; i.e. the
change in one variable (X) is not associated with the change in the other variable (Y). For
example, body weight and intelligence, shoe size and monthly salary; etc.
2. Type II
Simple correlation: Under simple correlation there are only two variables are studied.
Multiple Correlations: Under Multiple Correlations three or more than three variables are
studied.

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 Partial correlation: analysis recognizes more than two variables but considers only two
variables keeping the other constant.
3. Type III
Linear Correlation: Correlation is said to be linear when the amount of change in one
variable tends to bear a constant ratio to the amount of change in the other. The graph of the
variables having a linear relationship will form a straight line.
Non Linear Correlation: The correlation would be non-linear if the amount of change in
one variable does not bear a constant ratio to the amount of change in the other variable.

2.3. Methods of Measuring Correlation

 There are three methods of measuring correlation. These are:
1. The Scattered Diagram or Graphic Method
2. The Simple Linear Correlation coefficient
3. The coefficient of Rank Correlation
1. The Scattered Diagram or Graphic Method
The scatter diagram is a rectangular diagram which can help us in visualizing the relationship
between two phenomena. It puts the data into X-Y plane by moving from the lowest data set to
the highest data set. It is a non-mathematical method of measuring the degree of co-variation
between two variables. Scatter plots usually consist of a large body of data. The closer the data
points come together and make a straight line, the higher the correlation between the two
variables, or the stronger the relationship.
If the data points make a straight line going from the origin out to high x- and y-values, then the
variables are said to have a positive correlation. If the line goes from a high-value on the y-axis
down to a high-value on the x-axis, the variables have a negative correlation.

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 Figure 1: Perfect linear correlations
A perfect positive correlation is given the value of 1. A perfect negative correlation is
given the value of -1. If there is absolutely no correlation present the value given is 0. The
closer the number is to 1 or -1, the stronger the correlation, or the stronger the relationship
between the variables. The closer the number is to 0, the weaker the correlation.
Two variables may have a positive correlation, negative correlation, or they may be
uncorrelated. This holds true both for linear and nonlinear correlation. Two variables are said
to be positively correlated if they tend to change together in the same direction, that is, if they
tend to increase or decrease together. Such positive correlation is postulated by economic
theory for the quantity of a commodity supplied and its price. When the price increases the
quantity supplied increases. Conversely, when price falls the quantity supplied decreases.
Two variables are said to be negatively correlated if they tend to change in the opposite
direction: when X increases Y decreases, and vice versa. Such negative correlation is
postulated by economic theory for the quantity demand for a commodity and its price. When
price increases, demand for the commodity decreases and when price falls demand increases.
2. Simple Linear Correlation coefficient
For a precise quantitative measurement of the degree of correlation between Y and X we use a
parameter which is called the correlation coefficient and is usually designated by the Greek
letter . Having as subscripts the variables whose correlation it measures,  refers to the
correlation of all the values of the population of X and Y. Its estimate from any particular

9
sample (the sample statistic for correlation) is denoted by r with the relevant subscripts. For
example if we measure the correlation between X and Y the population correlation coefficient
is represented by xy and its sample estimate by rxy. The simple correlation coefficient is used
to measure relationships which are simple and linear only. It cannot help us in measuring non-
linear as well as multiple correlations. Sample correlation coefficient is defined by the
formula:

n X i Yi   X i Y i
x y i i

r Or rxy 
n X i  ( X i ) 2 n Yi  ( Yi ) 2 x y
2 2
2 2
i i

Where, xi  X i  X and y i  Yi - Y

We will use a simple example from the theory of supply. Economic theory suggests that the
quantity of a commodity supplied in the market depends on its price, ceteris paribus. When
price increases the quantity supplied increases, and vice versa. When the market price falls
producers offer smaller quantities of their commodity for sale. In other words, economic
theory postulates that price (X) and quantity supplied (Y) are positively correlated.
Example 2.1: The following table shows the quantity supplied for a commodity with the
corresponding price values. Determine the type of correlation that exists between these two
variables.

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Mekdela Amba University
Table 1: Data for computation of correlation coefficient
Time period(in days) Quantity supplied Yi (in tons) Price Xi (in shillings)
1 10 2
2 20 4
3 50 6
4 40 8
5 50 10
6 60 12
7 80 14
8 90 16
9 90 18
10 120 20

To estimate the correlation coefficient we, compute the following results.

Table 2: Computations of inputs for correlation coefficients
Y X xi  X i  X yi  Yi  Y x2 y2 xiyi XY X2 Y2
10 2 -9 -51 81 2601 459 20 4 100
20 4 -7 -41 49 1681 287 80 16 400
50 6 -5 -11 25 121 55 300 36 2500
40 8 -3 -21 9 441 63 320 64 1600
50 10 -1 -11 1 121 11 500 100 2500
60 12 1 -1 1 1 -1 720 144 3600
80 14 3 19 9 361 57 1120 196 6400
90 16 5 29 25 841 145 1440 256 8100
90 18 7 29 49 841 203 1620 324 8100
120 20 9 59 81 3481 531 2400 400 14400
Sum=610 110 0 0 330 10490 1810 8520 1540 47700
Mean=61 11

n XY   X  Y
10(8520)  (110)(610)
r   0.975
10(1540)  (110)(110) 10(47700)  (610)(610)
n X  ( X )
2 2
n Y  ( Y )
2 2

Or using the deviation form, the correlation coefficient can be computed as:

1810
r  0.975
330 10490
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 This result shows that there is a strong positive correlation between the quantity supplied and
the price of the commodity under consideration.
 Properties of Simple Correlation Coefficient
The simple correlation coefficient has the following important properties:
1. The value of correlation coefficient always ranges between -1 and +1.
2. The correlation coefficient is symmetric. That means rxy  ryx , where, rxy is the correlation

coefficient of X on Y and ryx is the correlation coefficient of Y on X.

3. The correlation coefficient is independent of change of origin and change of scale. By change
of origin we mean subtracting or adding a constant from or to every values of a variable and
change of scale we mean multiplying or dividing every value of a variable by a constant.
4. If X and Y variables are independent, the correlation coefficient is zero. But the converse is
not true.
5. The correlation coefficient has the same sign with that of regression coefficients.
6. The correlation coefficient is the geometric mean of two regression coefficients.
r  b yx * bxy

Though, correlation coefficient is most popular in applied statistics and econometrics, it has its
own limitations. The major limitations of the method are:
1. The coefficient requires the quantitative measurement of both variables. If one of the two variables
is not quantitatively measured, the coefficient cannot be computed.
2. Great care must be exercised in interpreting the value of this coefficient as very often the
coefficient is misinterpreted. For example, high correlation between lung cancer and smoking
does not show us smoking causes lung cancer.
3. The value of the coefficient is unduly affected by the extreme values.

3. Rank Correlation Coefficient

The formulae of the linear correlation coefficient developed in the previous section are based on
the assumption that the variables involved are quantitative and that we have accurate data for
their measurement. However, in many cases the variables may be qualitative (or binary
variables) and hence cannot be measured numerically. For example, profession, education,
preferences for particular brands, are such categorical variables. Furthermore, in many cases
precise values of the variables may not be available, so that it is impossible to calculate the value
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of the correlation coefficient with the formulae developed in the preceding section. For such
cases it is possible to use another statistic, the rank correlation coefficient (or spearman‟s
correlation coefficient). We rank the observations in a specific sequence for example in order of
size, importance, etc., using the numbers 1, 2, 3… n. Hence, the name of the statistic is given as
rank correlation coefficient. If two variables X and Y are ranked in such way that the values are
ranked in ascending or descending order, the rank correlation coefficient may be computed by
the formula. Sometimes we do not have rank but actual values of variables are available. If we are
interested in rank correlation coefficient, we find ranks from the given values.

6 D 2
r'  1  2.3
n(n 2  1)

Where,
D = difference between ranks of corresponding pairs of X and Y
n = number of observations.
The values that r may assume range from + 1 to – 1.
Two points are of interest when applying the rank correlation coefficient. Firstly, it does not
matter whether we rank the observations in ascending or descending order. However, we must
use the same rule of ranking for both variables. Second if two (or more) observations have the
same value we assign to them the mean rank/common ranks to the repeated items. When there is
( )
a repetition of ranks, a correction factor is added to ∑ in the Spearman‟s rank

correlation coefficient formula, where m is the number of times a rank is repeated. It is very
important to know that this correction factor is added for every repetition of rank in both characters.
Thus, in case of tied or repeated rank Spearman‟s rank correlation coefficient formula is

Example 2.2: A market researcher asks experts to express their preference for twelve different
brands of soap. Their replies are shown in the following table.

Table 3: Example for rank correlation coefficient

Brands of soap A B C D E F G H I J K L
Person I 9 10 4 1 8 11 3 2 5 7 12 6

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 Person II 7 8 3 1 10 12 2 6 5 4 11 9

The figures in this table are ranks but not quantities. We have to use the rank correlation
coefficient to determine the type of association between the preferences of the two persons. This
can be done as follows.

Table 4: Computation for rank correlation coefficient

Brands of soap A B C D E F G H I J K L Total
Person I 9 10 4 1 8 11 3 2 5 7 12 6
Person II 7 8 3 1 10 12 2 6 5 4 11 9
Di 2 2 1 0 -2 -1 1 -4 0 3 1 -3
Di2 4 4 1 0 4 1 1 16 0 9 1 9 50

The rank correlation coefficient

6 D 2
6(50)
r'  1   1  0.827
n(n 2  1) 12(12 2  1)

 This figure, 0.827, shows a marked similarity of preferences of the two persons for the
various brands of soap.

Example 2.3: (Table 5) Calculate rank correlation coefficient from the following data:

Table 6 (Solution): Let us denote the expenditure on advertisement by x and profit by y

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 There is a negative association between expenditure on advertisement and profit.
4. Coefficient of concurrent deviation (Kendall’s Tau correlation)
Coefficient of concurrent deviation or Kendall‟s tau is a correlation coefficient that
measures the relationship between two variables. In contrast to Pearson‟s correlation, it is
non-parametric test procedure. Thus, for Kendall‟s tau the data need not normally distributed
and the two variables need only have ordinal scale levels. Kendall‟s tau is very similar to
Spearman‟s rank correlation coefficient but Kendall‟s tau should be preferred to Spearman‟s
correlation for very few data with many rank ties are available. Kendall‟s tau correlation
coefficient given by the formula

( )

Where; C is the number of concurred pairs and D is number of disconcurred pairs.

Example, suppose two doctors rate the illness severity of six patients as follows.

Doctor A Doctor B
1 3

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2 1 -
3 4 + +
4 2 - + -
5 6 + + + +
6 5 + + + + -

Then the Kendall‟s tau coefficient can be computed as follows.

Partial Correlation Coefficients

A partial correlation coefficient measures the relationship between any two variables, when all
other variables connected with those two are kept constant. For example, let us assume that we
want to measure the correlation between the number of hot drinks (X1) consumed in a summer
resort and the number of tourists (X2) coming to that resort. It is obvious that both these variables
are strongly influenced by weather conditions, which we may designate by X3. On a priori
grounds we expect X1 and X2 to be positively correlated: when a large number of tourists arrive
in the summer resort, one should expect a high consumption of hot drinks and vice versa. The
computation of the simple correlation coefficient between X1 and X2 may not reveal the true
relationship connecting these two variables, however, because of the influence of the third
variable, weather conditions (X3).
In other words, the above positive relationship between number of tourists and number of hot
drinks consumed is expected to hold if weather conditions can be assumed constant. If weather
condition changes, the relationship between X1 and X2 may change to such an extent as to appear
even negative. Thus, if the weather is hot, the number of tourists will be large, but because of the
heat they will prefer to consume more cold drinks and ice-cream rather than hot drinks. If we
overlook the weather and look only at X1 and X2 we will observe a negative correlation between
these two variables which is explained by the fact that hot drinks as well as number of visitors
are affected by heat. In order to measure the true correlation between X1 and X2, we must find
some way of accounting for changes in X3. This is achieved with the partial correlation
coefficient between X1 and X2, when X3 is kept constant. The partial correlation coefficient is

16
determined in terms of the simple correlation coefficients among the various variables involved
in a multiple relationship. In our example there are three simple correlation coefficients.
r12 = correlation coefficient between X1 and X2
r13 = correlation coefficient between X1 and X3
r23 = correlation coefficient between X2 and X3
The partial correlation coefficient between X1 and X2, keeping the effect of X3 constant is given
by:
r12  r13 r23
r12..3 
(1  r13 )(1  r23 )
2 2

Similarly, the partial correlation between X1 and X3, keeping the effect of X2 constant is given
by:

r13  r12 * r23 r23  r12 * r13

r13.2  and r23.1 
(1  r12 )(1  r23 )
2 2
(1  r122 )(1  r132 )

Example 2.4: The following table gives data on the yield of corn per acre(Y), the amount of
fertilizer used(X1) and the amount of insecticide used (X2). Compute the partial correlation
coefficient between the yield of corn and the fertilizer used keeping the effect of insecticide
constant.
Table 6: Data on yield of corn, fertilizer and insecticides used
Year 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980
Y 40 44 46 48 52 58 60 68 74 80
X1 6 10 12 14 16 18 22 24 26 32
X2 4 4 5 7 9 12 14 20 21 24
The computations are done as follows:
Table 7: Computation for partial correlation coefficients
Year Y X1 X2 Y x1 x2 x1y x2y x1x2 x12 x22 y2
1971 40 6 4 -17 -12 -8 204 136 96 144 64 289
1972 44 10 4 -13 -8 -8 104 104 64 64 64 169
1973 46 12 5 -11 -6 -7 66 77 42 36 49 121
1974 48 14 7 -9 -4 -5 36 45 20 16 25 81
1975 52 16 9 -5 -2 -3 10 15 6 4 9 25
1976 58 18 12 1 0 0 0 0 0 0 0 1
1977 60 22 14 3 4 2 12 6 8 16 4 9
1978 68 24 20 11 6 8 66 88 48 36 64 121

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 1979 74 26 21 17 8 9 136 153 72 64 81 289
1980 80 32 24 23 14 12 322 276 168 196 144 529
Sum 570 180 120 0 0 0 956 900 524 576 504 1634
Mean 57 18 12

ryx1=0.9854,
ryx2=0.9917
rx1x2=0.9725
Then,

ryx1  ryx2 rx1x2 0.9854  (0.9917)(0.9725)

ryx1 . x2    0.7023
(1  ryx2 )(1  rx1x2 )
2 2
(1  0.9917 )(1  0.9725 )
2 2

Chapter Three: Simple Linear Regression Models

3.1. Basic Concepts and Assumptions
3.1.1. Concepts of simple linear regression
Define the term simple, linear and regression in econometrics perspectives?
Regression Analysis is a very powerful tool in the field of statistical analysis in predicting the
value of one variable, given the value of another variable, when those variables are related to
each other.
Regression analysis is a statistical tool used in prediction of value of unknown variable from
known variable.
Linear regression or linear regression modes are extremely powerful, and have the power to
empirically simplify out very complicated relationships between variables. In general, the
technique is useful, among other applications, in helping explain observations of a dependent
variable, usually denoted Y, with observed values of one or more independent variables, usually
denoted by X1, X2, ... Xk. A key feature of all regression models is the inclusion of the error term,
which capture sources of error that are not captured by other variables.
Why we should add an error term (u)?
What are the sources of the error term in the PRF equation?
There are three main sources:
1. Unpredicted element of randomness in human response
For example if Y is consumption expenditure and X is disposable income of household, there is
unpredictable elements of randomness in each household‟s consumption. The household does not
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behave like a machine. In one month, the people in the household are on a spending spree. In
another month they are tightfisted.
2. Effect of large number of omitted variable
In our example disposable income is not the only variable affecting the level of consumption.
Family size, tastes of family, spending habit etc. can also influencing consumption. The error
term is a catchall for effect of all these variables, some of which may quantifiable and some
which may not even be identifiable.
3. Measurement error
There may be a measurement error of both the dependent variable and independent
variable/s. In our case this refers to the measurement error in the house hold consumption.
We cannot measure it accurately.
Simple regression includes estimating a simple linear function between two variables (one
dependent variable and one independent variable).
Regression model: an ideal formula to approximate the regression.
Consider the following hypothetical data of two variables, which is an example of simple
regression.

Table3.1 Conditional distribution of expenditure for various levels of income

X
Y 80 100 120 140 160 180 200 220 240 260

Weakly 55 65 79 80 102 110 120 135 137 150

family 60 70 84 93 107 115 136 137 145 152
consumpt 65 74 90 95 110 120 140 140 155 175
ion 70 80 94 103 116 130 144 152 165 178
expenditu 75 85 98 108 118 135 145 157 175 180
re - 88 - 113 125 140 160 189 185
- - - 115 - - - 162 - 191
Total 325 462 445 707 678 750 685 1043 966 1211
Condition 65
al mean
77 89 101 613 125 137 149 161 173
of Y,
( )

19
Conditional expected values, ( ) which is read as the expected value of Y given the value
of X.
Unconditional expected value of weekly consumption expenditure, ( )

“What is the expected value of weekly consumption expenditure of a family?” The answer:
$121.20 (the unconditional mean).
“What is the expected value of weekly consumption expenditure of a family whose monthly
income is $160?” The answer: $113.00 (the conditional mean). Each conditional mean E(Y | Xi )
is a function of Xi , where Xi is a given value of X. Symbolically, ( ) ( ) where f
(X is some function of Xi ). This is called conditional expectation function (CEF) or population
regression function (PRF) ( ) The Concept of Population Regression
Function states merely that the expected value of the distribution of Y given Xi is functionally
related to Xi.
In the simple regression model, the
population regression model or,
simply, the population model is the
following:

Deterministic Stochastic

Where β0 and β1 are unknown

parameters, and the are independent random variables with zero mean and constant variance
for all.
The parameters β0 and β1 are called regression parameters. They are the intercept and the slope,
respectively. Whereas, the line Y   0  1 X is called the regression line.
Regression line is the line which gives the best estimate of one variable from the value of any
other given variable. We are going to consider that there are three types of variables in the
model: y, x and u. In this model there is only one factor x to explain y. All the other factors that
affect y are jointly captured by u. The variable represents factors other than x that affect y. It is
random disturbance. The disturbance term is an unobservable variable.

20
On the right hand of we can distinguish two parts: the systematic component and the random
disturbance .
The dependent and independent variables can be indicated in different terminologies shown in
the following Table.
Table 3.2
Dependent variable Independent variable
Explained variable Explanatory variable
Predictand Predictor
Regressand Regressor
Response Stimulus
Endogenous Exogenous
Outcome Covariate
Controlled variable Control variable

3.1.2. Assumptions of the Classical Simple Linear Regression Model

The classical made important assumption in their analysis of regression. The most important of
these assumptions is discussed below.
1. The model is linear in parameters.
The simple linear regression requires linearity in parameters; but not necessarily linearity in
variables. This is because if the parameters are non-linear it is difficult to estimate them.
Example 1: Yi = is linear in both parameters and variables, so it satisfies the
assumption.
+ + is linear only in parameters. Since the classical worry on variables,
the model satisfies the assumptions.
Table 3.3
Model Linear in Parameters? Model Linear in Variables?
Yes No
Yes LRM LRM
No NLRM NLRM
Note: LRM = linear regression model
NLRM = nonlinear regression model

21
2. The mean value of error term ‘Ui’ is zero. This implies the sum of the individual
disturbance terms is zero. The deviations of the values of some of the disturbance terms are
negative; some are zero and some are positive and the sum or the average is zero.
Mathematically, E ( ) .
3. The random terms of different observations ( ) are independent. (The assumption
of no autocorrelation). This means that there is no systematic variation or relation among the
value of the error terms ( ) Algebraically, ( ) ( ( )][

( )]
4. The variance of the random variable (Ui) is constant.
( ) ( )] ( )
This constant variance is called homoscedasticity assumption and the constant variance itself is
called homoscedastic variance.
5. The random variable (U) is independent of the explanatory variables. This means there is
no correlation between the random variable and the explanatory variables. If two variables are
unrelated their covariance is zero.
Cov ( ) – E ( )] [ ( )]
=E[ ( – E ( ))] given E ( ) = 0
= E( ) – E( ) E( )
=E( ) or ( ), since E( ) = 0
= 0, by assumption 2
6. Normality assumption-The disturbance term Ui is assumed to have a normal distribution with
zero mean and a constant variance. This assumption is given as follows:
Ui ~ 
N 0,  u
2
.
This assumption is a combination of zero mean of error term assumption and homoscedasticity
assumption. This assumption or combination of assumptions is used in testing hypotheses about
significance of parameters.
7. The number of observations n must be greater than the number of parameters to be
estimated. Alternatively, the number of observations n must be greater than the number of
explanatory variables.

3.2. Least Squares Criteria

There are three common methods of estimation.

22
  Method of least squares,
 Method of moments, and
 Maximum likelihood estimation.
The most common method for fitting a regression line is the method of least-squares.
Estimating a linear regression function using the Ordinary Least Square (OLS) criteria is simply
about calculating the parameters of the regression function for which the sum of square of the
error terms is minimized using a mathematical function or formula. A square is determined by
squaring the distance between a data point and the regression line or mean value of the data set.
Linear regression calculates a line that best fits the observations. In the following image, the line
that best fits the regression is clearly the blue line or line A.

The model chooses the estimated or fitted parameters (β0 and β1) that minimize the sum of the
squared vertical differences between the observations and the regression line (Sum of squared
errors (SSE). The procedure is given as follows. Suppose we want to estimate the following
equation

̂ ̂ ̂

Q. What is the difference between the error term ( ) and the residual( ̂ )?
An error term is generally unobservable and a residual is observable and calculable, making it
much easier to quantify and visualize. In effect, while an error term represents the way observed
data differs from the actual population, a residual represents the way observed data differs from
sample population data.

23
Since most of the time we predict the sample (or it is difficult to get population data) the
corresponding sample regression prediction is given as follows.

Yˆi  ˆ0  ˆ1 X i

From this identity, we solve for the residual term ' ei ' , square both sides and then take sum of
both sides. These three steps are given (respectively as follows).

ei  Yi  Yˆi  Yi  ˆ0  ˆ1 X i


 ei   Yi  ˆ0  ˆ1 X i
2

2

Where,  ei  RSS= Residual Sum of Squares.

2

To minimize the residual sum of squares we take the first order partial derivatives of and equate
them to zero.

That is, the partial derivative with respect to ˆ 0 :

  ei
 
2
 2  Yi  ˆ0  ˆX i (1)  0
ˆ 0

 Y
i 
 ˆ0  ˆ1 X i  0

  Yi  nˆ0  ˆ1  X i =0

24
  Y i  nˆ0  ˆ1  X i

But, ∑ ̅ and ∑ = ̅

Where n is the sample size.

So, we can rewrite ̅ - ̂ ̂ ̅=0

Solving for, ̂
̂ =̅- ̂ ̅

Partial derivative With respect to ˆ1

  ei
 
2
 2  Yi  ˆ0  ˆ1 X i ( X i )  0
ˆ
 1

we have ∑ ( - ̂ -̂ )=0
̂ =̅- ̂ ̅

Substitute ̅ - ̂ ̅ into ̂

∑ ( -̅ ̂ ̅- ̂ )=0

∑ - ̅∑ + ̂ ̅∑ -̂ ∑ =0

∑ - n̅ ̅ + ̂ n ̅ - ̂ ∑ =0

Solving for ̂ ,
̂ (n ̅ - ∑ ) = n̅ ̅ - ∑

So overall we have
̅̅ ∑ ∑ ̅̅
̂ =
̅ ∑ ∑ ̅

This method or criteria of finding the optimum is known as ordinary least squares (OLS).
Now we have the formula to estimate the simple linear regression function. Let us illustrate with
example.
Example 2.1: Given the following sample data of three pairs of „Y‟ (dependent variable) and „X‟
(independent variable), find a simple linear regression function; Y = f(X).

25
Table 3.4

Yi Xi
10 30
20 50
30 60
a) find a simple linear regression function; Y = f(X)
b) Interpret your result.
c) Predict the value of Y when X is 45.
Solution: a. To fit the regression equation, we do the following computations.

Yi Xi Yi Xi Xi2
10 30 300 900
20 50 1000 2500
30 60 1800 3600
Sum 60 140 3100 7000
Mean Y = 20 140
X =
3

n XY  ( X )( Y )
3(3100)  (140)(60)
ˆ1    0.64
3(7000)  (140) 2
n X 2  ( X ) 2

ˆ0  Y  ˆ1 X  20  0.64(140 / 3)  10

Thus the fitted regression function is given by: Yˆi   10  0.64 X i

b) Interpretation, the value of the intercept term,-10, implies that the value of the dependent
variable „Y‟ is – 10 when the value of the explanatory variable is zero. The value of the
slope coefficient ( ˆ  0.64 ) is a measure of the marginal change in the dependent
variable „Y‟ when the value of the explanatory variable increases by one. For instance, in
this model, the value of „Y‟ increases on average by 0.64 units when „X‟ increases by
one.

c) Yˆi   10  0.64 X i ( )( )

That means when X assumes a value of 45, the value of Y on average is expected to be 18.8.
The regression coefficients can also be obtained by simple formulae by taking the deviations
between the original values and their means. Now, if

26
 xi  X i  X , and yi  Yi  Y

x y
i i

Then, the coefficients can be represented by alternative formula given below ˆ1  ,
x i
2

and ˆ0  Y  ˆ1 X

Example 2.2: Find the regression equation for the data under Example 2.1, using the shortcut
formula. Table 3.5: To solve this problem, we proceed as follows.

Yi Xi y X xy x2 y2
10 30 -10 -16.67 166.67 277.78 100
20 50 0 3.33 0.00 11.11 0
30 60 10 13.33 133.33 177.78 100
Sum 60 140 0 0 300.00 466.67 200
Mean 20 46.66667
Then

x i yi
300 , and ˆ0  Y  ˆ1 X =20-(0.64) (46.67) = -10 with results
ˆ1    0.64
466.67
x i
2

similar to previous case.

Properties of OLS Estimators

According to this theorem, under the basic assumptions of the classical linear regression model,
the least squares estimators are linear, unbiased and have minimum variance (i.e. are best of all
linear unbiased estimators). Sometimes the theorem referred as the BLUE theorem i.e. Best,
Linear, Unbiased Estimator. An estimator is called BLUE if:
a. Linear: a linear function of the random variable, such as, the dependent variable Y.
b. Unbiased: its average or expected value is equal to the true population parameter.
c. Minimum variance: It has a minimum variance in the class of linear and unbiased
estimators. An unbiased estimator with the least variance is known as an efficient
estimator.
According to the Gauss-Markov theorem, the OLS estimators possess all the BLUE properties.

27
Mean and Variance of Parameter Estimates
Formula for mean and variance of the respective parameter estimates and the error term are
given below.
 
1. The mean of 1  E (1 )  1
     U2
2. The variance of 1  Var ( 1 )  E ((1  E ( ))  2

 xi2
  
3. The mean of  0  E (  0 )   0
    U2  X i2
4. The variance of  0  E (( 0  E ( 0 )) 2 
n  xi2

 ei2
5. The estimated value of the variance of the error term  U 
2

n2
3.3. Normal Equations of OLS
In linear regression analysis, the normal equations are a system of equations whose solution is
the Ordinary Least Squares (OLS) estimator of the regression coefficients. The normal equations
are derived from the first-order condition of the Least Squares minimization problem.
Let us start from the simple linear regression model specified as

However, as we noted in 3.1 and 3.2, the PRF is not directly observable. We estimate it from the
SRF given as ̂ ̂ ̂ where, ̂ ̂ ̂ ̂

Where ̂ is the estimated (conditional mean) value of .

The OLS method calculates the best-fitting line for a dataset by minimizing the sum of the
squares of the vertical deviations from each data point to the line (the Residual Sum of Squares,
RSS).

Minimize RSS = ∑ ̂

We could think of minimizing RSS by successively choosing pairs of values for ̂ ̂

until RSS is made as small as possible. Why the sum of the squared residuals? Why not just
minimize the sum of the residuals? To prevent negative residuals from cancelling positive ones,
sum of the squared residual is used.

28
If we use ∑ ̂ , all the error terms ̂ would receive equal importance no matter how
closely/widely scattered the individual observations are from SRF.
If so, the algebraic sum of ̂ ‟s may be small (even zero) though the ̂ s are widely scattered
about SRF.

Now let‟s set ∑ ̂ ∑( ̂)

But ̂ ̂ ̂

∑ ̂ ∑( ̂ ̂ )

OLS: minimize ̂ ̂ ∑ ̂ ∑( ̂ ̂ )

FOC 1: ∑ ̂ ∑ ̂ *∑( ̂ ̂ ) +
̂ ̂

*∑( ̂ ̂ ) +( )

∑( ̂ ̂ )

∑ ∑ ̂ ̂ ∑

∑ ̂ ̂ ∑

∑ ̂ ∑ ̂

Divided both sides by

∑ ̂ ∑ ̂

̂ ̅ ̂ ̅ ( )

∑ ̂ ∑ ̂ *∑( ̂ ̂ ) +
̂ ̂

*∑( ̂ ̂ ) +( )

∑( ̂ ̂ ) ( )

∑ ̂ ∑ ̂ ∑

∑ ̅ ̂ ̅(∑ ) ̂ ∑

∑ ̅∑ ̂ ̅(∑ ) ̂ ∑

29
 ∑ ̅∑ ̂ ∑ ̂ ̅(∑ )

∑ ̅∑ ̂ (∑ ̅(∑ ))

∑ ̅̅ ̂ (∑ ̅)
∑ ̅̅
̂
∑ ̅

∑( ̅ )( ̅)
̂ or
∑( ̅)

∑
̂ ̅ ̅
∑

( )
̂ or
( )

∑ ∑ ∑
̂
∑ (∑ )

Thus, in the case of a simple linear regression, the normal equations are a system of two
equations ( ) and ( ) in two unknowns ( ̂ and ̂ ).If the system has a unique
solutions, then the two values of ( ̂ and ̂ ) that solve the system are the OLS estimators of
the intercept ( ̂ and the slope ̂ ) respectively.
3.4. Coefficient of Correlation and Determination
The coefficient of determination r 2 (two-variable case) or R2 (multiple regression) is a summary
measure that tells how well the sample regression line fits the data. Before we show how r 2 is
computed, let us consider an explanation of r2 in terms of a graphical device, known as the Venn
diagram.

30
In this figure the circle Y represents variation in the dependent variable Y and the circle X
represents variation in the explanatory variable X. The overlap of the two circles (the shaded
area) indicates the extent to which the variation in Y is explained by the variation in X (say, via
an OLS regression). The greater the extent of the overlap, the greater the variation in Y is
explained by X. The is simply a numerical measure of this overlap. In the figure, as we move
from left to right, the area of the overlap increases, that is, successively a greater proportion of
the variation in Y is explained by X. In short, increases. When there is no overlap, is
obviously zero, but when the overlap is complete, is 1, since 100 percent of the variation in Y
is explained by X. As we shall show shortly lies between 0 and 1.

To compute this , we proceed as follows: Recall that

_
Total var iationin Yi  (Yi  Y ) 2
 _
Total exp lained var iation  (Yi  Y ) 2
Total un exp lained var iation   ei2

̂ ̂ On the deviation form ̂ ̂

∑ ∑̂ ̂ ∑ ̂ ̂ Since ∑ ̂ ̂ .∑ ∑̂ ̂ . Therefore,

that means

31
Mathematically; the explained variation as a percentage of the total variation is explained
∑̂
as:
∑

∑( ̂ ̅ ) ∑̂
∑( ̅) ∑( ̅)

∑( ̂ ̅ )
We can define r2 as ∑( ̅)

∑̂
Alternatively, ∑( ̅)

(∑ )
Or ,
∑ ∑

Give the definition of r2, we can express ESS and RSS as follows.

∑ ∑ ( )

( ) ∑ ∑ ∑ ( )

A quantity closely related to but conceptually very much different from is the coefficient of
correlation, which, as noted in Chapter 2, is a measure of the degree of association between two

variables. It can be computed either from √

Two properties of r2 may be noted:
1. It is a nonnegative quantity.

2. Its limits are 0 ≤ ≤ 1. An of 1 means a perfect fit. On the other hand, an of zero means
that there is no relationship between the regressand and the regressor.
The higher the coefficient of determination is the better the fit. Conversely, the smaller the
coefficient of determination is the poorer the fit. That is why the coefficient of determination is
used to compare two or more models. One minus the coefficient of determination is called the
coefficient of non-determination, and it gives the proportion of the variation in the dependent
variable that remained undetermined or unexplained by the model.

32
Interpretation of

Suppose , this means that the regression line gives a good fit to the observed data since
this line explains 90% of the total variation of the Y value around their mean. The remaining
10% of the total variation in Y is unaccounted for by regression line and is attributed to the
factors included in the disturbance variable .

3.5. Hypothesis Testing

Hypothesis testing is a statistical procedure in which a choice is made between a null hypothesis
and an alternative hypothesis based on information in a sample.
Hypothesis testing is formulated in terms of two hypotheses:
Null hypothesis: which states there is no significance difference between the two parameters.
 It has no direction.
 It is denoted by Ho.
Alternative hypothesis: states about there is significance difference between the two parameters.
 It has direction.
 It is denoted by H1.
There are different tests that are available to test the statistical reliability of the parameter
estimates. The most common methods of hypothesis testing are:

1. Standard error test

2. Students t-test
3. Confidence interval
1. Standard Error Test
This test first establishes the two hypotheses that are going to be tested which are commonly
known as the null and alternative hypotheses. The null hypothesis addresses that the sample is
coming from the population whose parameter is not significantly different from zero while the
alternative hypothesis addresses that the sample is coming from the population whose parameter
is significantly different from zero. The two hypotheses are given as follows:
H0: βi=0
H1: βi≠0
The standard error test is outlined as follows:

33
 1. Compute the standard deviations of the parameter estimates using the above formula for
variances of parameter estimates.
This is because standard deviation is the positive square root of the variance.

  U2
se( 1 ) 
 xi2
  U2  X i2
se(  0 ) 
n  xi2

2. Compare the standard errors of the estimates with the numerical values of the estimates and
make decision.
A. If the standard error of the estimate is less than half of the numerical value of the estimate, we
 1 
can conclude that the estimate is statistically significant. That is, if se(  i )  (  i ) , reject the
2
null hypothesis.
B. If the standard error of the estimate is greater than half of the numerical value of the estimate,
we can conclude that the parameter estimate is not statistically significant. That is, if
 1 
se(  i )  (  i ) , conclude to accept the null hypothesis.
2

Example: Suppose that from a sample of size , we estimate the following supply
function.

( ) ( )
Test the significance of the slope parameter at 5% level of significance using the standard error
test.

(̂ )
̂
̂

This implies that (̂ ) ̂ . The implication is ̂ is statistically significant at 5% level of

significance.

34
2. Student’s t-test
t-test can be used to test the statistical reliability of the parameter estimates.
The test depends on the degrees of freedom that the sample has. The test procedures of t-test are
similar with that of the z-test.
Since we have two parameters in simple linear regression, our degree of freedom is . Like
the standard error test we formally test the hypothesis: against the alternative:
for the slope parameter; and: against the alternative: for
the intercept.
To undertake the above test, we follow the following steps.
Step 1: Compute t*, which is called the computed value of t, by taking the value of
in the null hypothesis. In our case , then t* becomes:
̂ ̂ ̂
(̂ ) (̂ ) (̂ )

Step 2: Choose level of significance. Level of significance is the probability of making „wrong‟
decision, i.e. the probability of rejecting the hypothesis when it is actually true or the probability
of committing a type I error. It is customary in econometric research to choose the 5% or the 1%
level of significance. This means that in making our decision we allow (tolerate) five times out
of a hundred to be „wrong‟ i.e. reject the hypothesis when it is actually true.
Step 3: Check whether there is one tail test or two tail test. If the inequality sign in the
alternative hypothesis is , then it implies a two tail test and divide the chosen level of
significance by two; decide the critical region or critical value of t called . But if the inequality
sign is either or then it indicates one tail test and there is no need to divide the chosen level
of significance by two to obtain the critical value of from the t-table.
Example:
If we have:
against:
Then this is a two tail test. If the level of significance is 5%, divide it by two to obtain critical
value of from the t-table.
Step 4: Obtain critical value of , called at and degree of freedom for two tail test.
Step 5: Compare t* (the computed value of t) and (critical value of ).

35
  If t* , reject and accept . The conclusion is ̂ or ̂ is statistically
significant.
 If t* , accept and reject H1. The conclusion is ̂ or ̂ is statistically
insignificant.
Numerical Example:
Suppose that from a sample size we estimate the following consumption function:

( ) ( )
The values in the brackets are standard errors. We want to test the null hypothesis:
against the alternative: using the t-test at 5% level of significance.
a. The t-value for the test statistic is:
̂ ̂ ̂
(̂ ) (̂ ) (̂ )

b. Since the alternative hypothesis (H1) is stated by inequality sign ( ), it is a two tail test, hence

we divide to obtain the critical value of „ ‟ at and 18 degree of

freedom (df) i.e. ( ). From the t-table „ ‟ at 0.025 level of significance and 18 df
is 2.10.
c. Since t* and .1, t* . It implies that ̂ is statistically significant.
The test rule or decision is given as follows:
Reject H0 if n-k

3. Confidence interval

In order to define how close the estimate to the true parameter; we must construct the confidence
interval for the parameter. In other words we must establish limiting values around the estimate
within which the true parameter is expected to lie within a certain degree of confidence. In this
respect we say that with a given probability the population parameter will be within the defined
confidence interval (confidence limits).
We choose probability in advance and refer to it as confidence level (interval coefficient). It is
customarily in econometrics to choose 95% confidence level. This means that in repeated
sampling, the confidence limits, computed from the sample, would include the true population

36
parameter in 95% of the cases. In the other 5% of the cases the population parameter will fall
outside the confidence interval.
In a two-tail test level of significance, the probability of obtaining the specific t-value either or
is ⁄ at n-2 degree of freedom. The probability of obtaining any value of t which is equal to
̂
at n-2 degree of freedom is 1 – ( ⁄ + ⁄ ) i.e. 1 -
( ̂)

i.e. Pr {- < t* =1– ………………………………….. (X1)

̂
But t* = ………………………………………………….. (X2)
( ̂)

Substituting (X2) into (X1) we obtain the following expression.

̂
Pr {- < }=1– ……………………………………….. (X3)
( ̂)

Pr {- ( ̂) < ̂– < ( ̂) =1– ……………… by multiplying by ( ̂)

Pr {- ̂ - ( ̂) <– <-̂ + ( ̂) }=1– ……….by subtracting ( ̂ )

Pr {+ ̂ + ( ̂) > >̂ - ( ̂) }=1– …………… by multiplying by -1

Pr { ̂ - ( ̂) < <̂+ ( ̂) }=1– ……………. by interchanging

The limit within which the true lies at (1 – ) degree of confidence is:

[̂- ( ̂) ̂ + ( ̂) ], where is the critical value of t at ⁄ confidence interval and n-

2 degree of freedom. This is the same as:

1  ˆ1  t / 2,n k ( se( ˆ1 )) The test procedure is outlined as follows:

=0

And for the intercept:

 0  ˆ0  t / 2,n k ( se( ˆ 0 ))

Decision rule: If the hypothesized value of in the null hypothesis is within the confidence
interval, accept and reject . The implication is that ̂ is statistically insignificant; while if
the hypothesized value of in the null hypothesis is outside the limit, reject and accept .
This indicates ̂ is statistically significant.

37
Numerical Example:
Suppose we have estimated the following regression line from a sample of 20 observations.

(38.2) (0.85)
The values in the bracket are standard errors.
a. Construct 95% confidence interval for the slope of parameter
b. Test the significance of the slope parameter using constructed confidence interval.

Solution:
a. The limit within which the true lies at 95% confidence interval is:
̂ (̂ )
̂

(̂ )
at 0.025 level of significance and 18 degree of freedom is 2.10.

 ̂ (̂ ) ( )

The confidence interval is (1.09, 4.67).

b. The value of in the null hypothesis is zero which implies it is outside the confidence
interval. Hence is statistically significant.

Example: The following table gives the quantity supplied (Y in tons) and its price (X pound per
ton) for a commodity over a period of twelve years.
Table 3.6: Data on supply and price for given commodity
Y 69 76 52 56 57 77 58 55 67 53 72 64
X 9 12 6 10 9 10 7 8 12 6 11 8

Table 3.7: Data for computation of different parameters

Time Y X XY X2 Y2 X Y Xy x2 y2 Yˆ ei ei2
1 69 9 621 81 4761 0 6 0 0 36 63.00 6.00 36.00
2 76 12 912 144 5776 3 13 39 9 169 72.75 3.25 10.56
3 52 6 312 36 2704 -3 -11 33 9 121 53.25 -1.25 1.56
4 56 10 560 100 3136 1 -7 -7 1 49 66.25 -10.25 105.06
5 57 9 513 81 3249 0 -6 0 0 36 63.00 -6.00 36.00

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 6 77 10 770 100 5929 1 14 14 1 196 66.25 10.75 115.56
7 58 7 406 49 3364 -2 -5 10 4 25 56.50 1.50 2.25
8 55 8 440 64 3025 -1 -8 8 1 64 59.75 -4.75 22.56
9 67 12 804 144 4489 3 4 12 9 16 72.75 -5.75 33.06
10 53 6 318 36 2809 -3 -10 30 9 100 53.25 -0.25 0.06
11 72 11 792 121 5184 2 9 18 4 81 69.50 2.50 6.25
12 64 8 512 64 4096 -1 1 -1 1 1 59.75 4.25 18.06
Sum 756 108 6960 1020 48522 0 0 156 48 894 756.00 0.00 387.00
Use Tables (table 2.6 and table 2.7) to answer the following questions
1. Estimate the Coefficient of determination (r2)
2. Run significance test of regression coefficients using the following test methods
A) The standard error test
B) The students t-test
3. Fit the linear regression equation and determine the 95% confidence interval for the slope.
Solution
1. Estimate the Coefficient of determination (r2)
Use data in table 2.7 to estimate r2 using the formula given below.

e
2
i
387
R2  1  1  1  0.43  0.57
894
y i
2

This result shows that 57% of the variation in the quantity supplied of the commodity under
consideration is explained by the variation in the price of the commodity; and the rest 43%
remain unexplained by the price of the commodity. In other word, there may be other important
explanatory variables left out that could contribute to the variation in the quantity supplied of the
commodity, under consideration.
2. Run significance test of regression coefficients using the following test methods
Fitted regression line for the data given is:

Yi  33.75  3.25 X i , where the numbers in parenthesis are standard errors of the respective
(8.3) (0.9)

coefficients.
A. Standard Error test
In testing the statistical significance of the estimates using standard error test, the following
information needed for decision.
Since there are two parameter estimates in the model, we have to test them separately.

39
 
Testing for 1
  
We have the following information about 1 i.e 1 =3.25 and se( 1 )  0.9
The following are the null and alternative hypotheses to be tested.
H 0 : 1  0
H 1 : 1  0
 
Since the standard error of 1 is less than half of the value of 1 , we have to reject the null

hypothesis and conclude that the parameter estimate 1 is statistically significant.

Testing for  0

Again we have the following information about  0
 
 0  33.75 and se(  0 )  8.3
The hypotheses to be tested are given as follows;
H0 : 0  0
H1 :  0  0
 
Since the standard error of  0 is less than half of the numerical value of  0 , we have to reject the

null hypothesis and conclude that  0 is statistically significant.
B. The students t-test
In the illustrative example, we can apply t-test to see whether price of the commodity is
significant in determining the quantity supplied of the commodity under consideration? Use
=0.05.
The hypothesis to be tested is:
H 0 : 1  0
H 1 : 1  0
The parameters are known.
ˆ  3.25, se(ˆ )  0.8979
1 1

Then we can estimate tcal as follows

ˆi 3.25
t cal    3.62
ˆ
se(  i ) 0.8979

40
 Further tabulated value for t is 2.228. When we compare these two values, the calculated t is
greater than the tabulated value. Hence, we reject the null hypothesis. Rejecting the null
hypothesis means, concluding that the price of the commodity is significant in determining the
quantity supplied for the commodity.
3. Fit the linear regression equation and determine the 95% confidence interval for the slope.


Fitted regression model is indicated Yi  33.75  3.25 X i , where the numbers in parenthesis are
(8.3) (0.9)
standard errors of the respective coefficients. To estimate confidence interval, we need standard
error which is determined as follows

e
2
i
387 387
u2     38.7
nk 12  2 10
1 1
var( ˆ1 )   u  38.7( )  0.80625
2

48
x 2

The standard error of the slope is se( ˆ1 )  var( ˆ1 )  0.80625  0.8979
The tabulated value of t for degrees of freedom 12-2=10 and /2=0.025 is 2.228.
Hence the 95% confidence interval for the slope is given by:
ˆ1  3.25  (2.228)(0.8979)  3.25  2  3.25  2, 3.25  2  1.25, 5.25 . The value of 1 in the
null hypothesis is zero which implies it is outside the confidence interval. Hence ˆ is 1

statistically significant.