Module 1 – Lecture Notes

In this module, we shall discuss the following: Econometrics: Definition and scope, why a separate
discipline? Economic models versus econometric models, types of econometrics, methodology of
econometrics, properties of econometrics, goals of econometrics, and Data.

Objectives:

At the end of the lecture, students should be able to:

(i) explain the term econometrics using various examples;

(ii) mention and explain the types of econometrics;
(iii) explain the uses of econometrics;
(iv) explain econometric models, explain its purpose and how they are formulated; and
(v) discuss the process of econometrics methodology

1. Definition and scope of econometrics

What is Econometrics?
Simply stated 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 (Arthur Goldberger).
In the words of Maddala econometrics 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.”
Econometrics utilizes economic theory, as embodied in an econometric Model; facts, as
summarized by relevant data, and statistical theory, as refined into econometric techniques to
measure and to test empirically certain relationships among economic variables.
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.

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Why a Separate Discipline?
As the definition suggests econometrics is an amalgam of economic theory, mathematical statistics
and economic statistics. But: a distinction has to be made between Econometrics, and economic
theory, statistics and mathematics.
1. 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.
2. Economic statistics is concerned with collecting, processing and presenting economic data
(descriptive statistics).
Example: collecting and refining data on national accounts, index numbers, employment, prices,
etc.
3. Mathematical statistics and mathematical economics do provide much of the tools used in
Econometrics. But Econometrics needs special methods to deal with economic data which are
never experimental data.
Examples: Errors of measurement, problem of multicollinearity, problem of serial correlation are
only econometric problems and are not the concerns of mathematical statistics.
Econometrics utilizes these data to estimate quantitative economic relationships and to test
hypothesis about them. The Econometrician is called upon to develop special methods of analysis
and deal with such kinds of Econometric problems.

Economic models vs. Econometric models

A model is any representation of an actual phenomenon such as an actual system or process. The
real world system is represented by the model in order to explain it, to predict it, and to control it.
Any model represents a compromise between reality and manageability. A given representation of
real world system can be a model if it fulfills the following requirements.

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 (1) It must be a “reasonable” representation of the real world system and in that sense it should
be realistic.
(2) On the other hand it must be “manageable” in that it yields certain insights or conclusions.
A good model is both realistic and manageable. A highly realistic but too complicated model is a
“bad” model in the sense it is not manageable. A model that is highly manageable but so idealized
that it is unrealistic not accounting for important components of the real world system, is a “bad”
model too. In general to find the proper balance between realism and manageability is the essence
of good Modeling. Thus a good model should, on the one hand, specify the interrelationship among
the parts of a system in a way that is sufficiently detailed and explicit and, on the other hand, it
should be sufficiently simplified and manageable to ensure that the model can be readily analyzed
and conclusions can be reached concerning the real world.

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
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 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

Econometric models
The most important characteristic of economic relationships is that they contain a random element
which is ignored by mathematical economic models which postulate exact relationships between
economic variables.

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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:

Q  b0  b1 P  b2 P0  b3Y  b4 t

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

Q  b0  b1 P  b2 P0  b3Y  b4 t  u , where u stands for the random factors which affect the
quantity demanded. The random term (also called error term or disturbance term) is a surrogate
variable for important variables excluded from the model, errors committed and measurement
errors.

Types of Econometrics
a. Theoretical Econometrics: This is concerned with the development of basic estimation
approaches, properties of estimators, etc. More closely related to mathematical statistics
(e.g. proofs, axioms).
b. Applied Econometrics: This is built on the theoretical foundation. It applies estimation
techniques to various areas of economic enquiry, e.g. where to open a new restaurant? How
many hours do we need to study to pass excellently? etc.
Desirable Properties of an Econometric Model
An econometric model is a model whose parameters have been estimated with some appropriate
econometric technique. The ‘goodness’ of an econometric model is judged customarily based on
the following desirable properties.
1. Theoretical plausibility: The model should be compatible with the postulates of economic
theory and adequately describe the economic phenomena to which it relates.
2. Explanatory ability: The model should be able to explain the observations of the actual
world. It must be consistent with the observed behaviour of the economic variables whose
relationship it determines.

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 3. Accuracy of the estimates of the parameter: The estimates of the coefficients should be
accurate in the sense that they should approximate as best as possible the true parameters
of the structural model. The estimates should if possible possess the desirable properties
of unbiasedness, consistency and efficiency.
4. Forecasting ability: The model should produce satisfactory predictions of future values
of the dependent (endogenous) variables.
5. Simplicity: The model should represent the economic relationships with maximum
simplicity. The fewer the equations and the simpler their mathematical form, the better the
model provided that the other desirable properties are not affected by the simplifications
of the model.

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.

Data

To estimate the parameters in the model, we need necessary data.

Classification of data according to index subscript

Data source could involve time series, cross sectional or panel data.

Time series data are collected over time for the same country or other single aggregate economic
unit. Usually in microeconomics, we use subscript t.
Cross sectional data: These are collected for a sample over individuals, households, firms or other
disaggregate economic activity at a point in time, e.g. C and Yd could be obtained for sample of
2000 Nigerian families during year 2000. In this case, we normally use “i” subscript

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Panel Data: These contain elements of both time series and cross-sectional data e.g C and Yd could
be obtained for 18 West African Countries during the period 1970 to 2006. Since we have variation
across countries at any single point in time as well as variation across time we would write both i
and t subscripts

Classification of data according to their genesis

1. Experimental data: These are rare outside experimental economics

2. Sample data: Example 1000 out of 1000000 are randomly selected
3. Observational data: example, GDP in 2015 only exists once in CBN statistical Bulletin
The use of observational data has three implications: firstly, the econometrician often uses data
without knowledge of how the data were sampled; secondly, since the econometrician has no
knowledge of how the data were generated, i.e. how people and companies behaved, there is
uncertainty as to which economic or statistical model best represents these data; and thirdly, in
order to obtain a suitable model that can be used for inference, econometrics is concerned with
avoiding misspecification, or else the results of the model may be wrongly interpreted