Lecture 5 & 6

Defining Econometrics, Economic Models, and Econometric Models

Introduction to Econometrics
BSc Eco 2023, Spring 2025
Instructor: Sunaina Dhingra
Email-id: [email protected]
Lecture Date: 17th February ( 2 lectures combined)
Introduction to Sample
Regression Function
 Key Takeaways from PRF

• The population regression function is given

below:
𝑦𝑖 = 𝛽0 + 𝛽1 𝑥𝑖 + 𝜇𝑖 −−− −(1)
• The deterministic component expressed as
the locus of the expected value of y
conditional on fixed values of x
E [𝑦|𝑥] = 𝛽0 + 𝛽1 𝑥 −−−−− −(2)
Source: Wooldridge, Chapter 2, Table 2.1
• The ith observation can be rewritten as
𝑦𝑖 = E[y|x] + μi −−−− −(3)
 Key Takeaways from PRF

• The average influence of these disturbances on the dependent variable is

negligible
E[μ]= μത = 0 -----(4)
• The deviation from the mean for any variable z is
d = z - zത −−−− − 5
• The mean value of d is not computed as it always equals zero
• Applying the property of mean, i.e., sum of deviation from mean is always equal
to zero to disturbances
σ 𝜇𝑖 = 0, 𝜇ҧ =0
 Key Takeaways from PRF

• The equation assumes a linear functional form

𝑦𝑖 = 𝛽0 + 𝛽1 𝑥𝑖 + 𝜇𝑖 −−− −(1)
• Rewriting the above equation in the change form
∆𝑦 = ∆𝛽0 + 𝛽1 ∆𝑥 + ∆𝜇 −−−− − 6
• A constant is a constant, ∆𝛽0 = 0
• x has a linear effect on y if we assume ∆μ = 0
Slope parameter
∆y = 𝛽1 ∆x -------(7)
 Sample Regression Function

• In reality, as we do not have data for the entire population, sample data is used
to discover relationships in the population
• The slope and intercept parameters for the population are estimated using
sample information
• An estimator is denoted with a hat sign “ ̂”
• 𝛽෢1 and 𝛽
෢0 are estimators; they are random variables that take as many values
as the number of samples
• Sample regression function is defined below:
෢0 + 𝛽
𝑦ෝ𝑖 = 𝛽 ෢1 𝑥𝑖 ------(8)
 Sample Regression Function and
Residuals
• The difference between the actual 𝑦𝑖
and predicted 𝑦𝑖 , termed “residuals” is
shown below:
𝜇ෝ𝑖 = 𝑦𝑖 − 𝑦ෝ𝑖 -----(9)
• 𝜇ෝ𝑖 is an estimator for the error
disturbances μ𝑖
𝑦𝑖 = 𝑦ෝ𝑖 + 𝜇ෝ𝑖 -------(10)
• 𝜇ෝ𝑖 can be positive or negative
Figure 1: SRF and the residuals
Source: Wooldridge, Chapter 2, Figure 2.4
 Sample Regression Function and
Residuals
• The figure shows SRF, which is an estimator of PRF, and residuals, which is an
estimator of the error or disturbances

Source: Author’s estimation using Wage1 dataset in STATA, refer Do file for command
Estimation and Interpretation
of OLS Estimators
 Estimation of OLS parameters

• The Wage1 dataset is used to estimate wage

PRF: 𝑤𝑎𝑔𝑒𝑖 = 𝛽0 + 𝛽1 𝑒𝑑𝑢𝑐𝑎𝑡𝑖𝑜𝑛𝑖 + μ𝑖 −−−−−−−(1)
• The model is estimated using a sample from the population
෢0 + 𝛽
SRF: 𝑤𝑎𝑔𝑒𝑖 = 𝛽 ෢1 𝑒𝑑𝑢cation𝑖 + μෝ𝑖 -------(2)

𝑤𝑎𝑔𝑒𝑖 = 𝑤𝑎𝑔𝑒
ෟ𝑖+ෞ μ𝑖
ෟ 𝑖 is the estimated conditional mean value of 𝑤𝑎𝑔𝑒𝑖
• 𝑤𝑎𝑔𝑒
• The parameters of this regression model are estimated using ordinary least
squares (OLS) method
 Estimation of OLS Parameters

෢0 + 𝛽
𝑤𝑎𝑔𝑒𝑖 = 𝛽 ෢1 𝑒𝑑𝑢cation𝑖 + μෝ𝑖 -------(2)
μෝ𝑖 = 𝑤𝑎𝑔𝑒𝑖 − 𝛽෢0 − 𝛽෢1 𝑒𝑑𝑢𝑐𝑎𝑡𝑖𝑜𝑛𝑖 −−−−−−−(3)
• As the sum of disturbances equals zero, the mean also equals zero
𝐸 𝜇 = 𝜇ҧ = 0−−−−−−−(4)
• As the average value of residual equals zero, we square the residuals, sum them, and
then try to minimize that sum
𝑛 𝑛
2 2
෢0 − 𝛽
𝑚𝑖𝑛 ෍ 𝜇ෝ𝑖 = 𝑚𝑖𝑛 ෍ 𝑤𝑎𝑔𝑒𝑖 − 𝛽 ෢1 𝑒𝑑𝑢𝑐𝑎𝑡𝑖𝑜𝑛𝑖 −−−−−−−(5)
𝑖=1 𝑖=1
෢0 and 𝛽
• The estimators 𝛽 ෢1 are obtained by minimizing the sum of squared residuals.
 Estimation of OLS Parameters
𝑛 𝑛
2 2
෢0 − 𝛽
𝑚𝑖𝑛 ෍ 𝜇ෝ𝑖 = 𝑚𝑖𝑛 ෍ 𝑤𝑎𝑔𝑒𝑖 − 𝛽 ෢1 𝑒𝑑𝑢𝑐𝑎𝑡𝑖𝑜𝑛𝑖 −−−−−−−(5)
𝑖=1 𝑖=1
෢0 , and equate them to 0
• Take the FOC of equation 5 with respect to 𝛽
෢0 − 𝛽
−2 σ𝑛𝑖=1 𝑤𝑎𝑔𝑒𝑖 − 𝛽 ෢1 𝑒𝑑𝑢𝑐𝑎𝑡𝑖𝑜𝑛𝑖 = 0 −−−−−−−(6)
෢1 , and equate them to 0
• Take the FOC of equation 5 with respect to 𝛽
෢0 − 𝛽
−2 σ𝑛𝑖=1 𝑒𝑑𝑢𝑐𝑎𝑡𝑖𝑜𝑛𝑖 𝑤𝑎𝑔𝑒𝑖 − 𝛽 ෢1 𝑒𝑑𝑢𝑐𝑎𝑡𝑖𝑜𝑛𝑖 = 0 −−−−−−−(7)
 Estimation of OLS Parameters

෢0 and β
• Solving 6 and 7 simultaneously, we get the OLS estimators β ෢1

෢0 − 𝛽
−2 σ𝑛𝑖=1 𝑤𝑎𝑔𝑒𝑖 − 𝛽 ෢1 𝑒𝑑𝑢𝑐𝑎𝑡𝑖𝑜𝑛𝑖 = 0 −−−−−−−(6)

෢0 − 𝛽
−2 σ𝑛𝑖=1 𝑒𝑑𝑢𝑐𝑎𝑡𝑖𝑜𝑛𝑖 𝑤𝑎𝑔𝑒𝑖 − 𝛽 ෢1 𝑒𝑑𝑢𝑐𝑎𝑡𝑖𝑜𝑛𝑖 = 0 −−−−−−−(7)

෢0 = 𝑤𝑎𝑔𝑒 − 𝛽
𝛽 ෢1 𝑒𝑑𝑢𝑐𝑎𝑡𝑖𝑜𝑛------(8)

σ𝑛𝑖=1 𝑒𝑑𝑢𝑐𝑎𝑡𝑖𝑜𝑛𝑖 − 𝑒𝑑𝑢𝑐𝑎𝑡𝑖𝑜𝑛 (𝑤𝑎𝑔𝑒𝑖 − 𝑤𝑎𝑔𝑒)

෢1 =
𝛽 −−−−−−(9)
2
σ𝑛𝑖=1 𝑒𝑑𝑢𝑐𝑎𝑡𝑖𝑜𝑛𝑖 − 𝑒𝑑𝑢𝑐𝑎𝑡𝑖𝑜𝑛

• These estimators are also referred to as least-squares estimators

 Fitted Values and Residuals

• Thus, we can write the OLS estimator for any y and x as

෢0 = 𝑦ത − 𝛽
𝛽 ෢1 𝑥ҧ −−−− − 10
σ𝑛
𝑖=1 𝑥𝑖 −𝑥ҧ (𝑦𝑖 −𝑦)
ത
෢1 =
𝛽 2 −−−− − 11
σ𝑛
𝑖=1 𝑥−𝑥ҧ

• Equation 11 can be rewritten as

෢1 = 𝐶𝑜𝑣(𝑥𝑦)
𝛽 −−−− − 12
𝜎𝑥 2

• Covariance and slope have the same sign. Thus, the sign of covariance
determines the expected direction in which x affects y.
 Fitted Values and Residuals

෢0 and 𝛽
• Predicted y: for any given value of 𝑥𝑖 , using the estimated 𝛽 ෢1 values we get

𝑦ෝ𝑖 = ෢ ෢1 𝑥𝑖 -----(13)
𝛽0 +𝛽
𝑦𝑖 = 𝑦ෝ𝑖 + 𝑢ෝ𝑖 −−−−−(14)
• The fitted regression line is called the line of best fit
• The OLS residual associated with each observation i , 𝑢ෝ𝑖 is
𝑢ෝ𝑖 = 𝑦𝑖 − 𝑦ෝ𝑖 −−−−−(15)
• If 𝑢ෝ𝑖 is positive, the line under predicts 𝑦𝑖 and if 𝑢ෝ𝑖 is negative, the line over predicts 𝑦𝑖
 STATA Results

• The Wage1 dataset is used to estimate wage-education model

𝑤𝑎𝑔𝑒
ෟ 𝑖 = −0.91 + 0.54 𝑒𝑑𝑢𝑐𝑎𝑡𝑖𝑜𝑛

. reg wage education

Source SS df MS Number of obs = 526

F(1, 524) = 103.36
Model 1179.73204 1 1179.73204 Prob > F = 0.0000
Residual 5980.68225 524 11.4135158 R-squared = 0.1648
Adj R-squared = 0.1632
Total 7160.41429 525 13.6388844 Root MSE = 3.3784

wage Coefficient Std. err. t P>|t| [95% conf. interval]

education .5413593 .053248 10.17 0.000 .4367534 .6459651

_cons -.9048516 .6849678 -1.32 0.187 -2.250472 .4407687

STATA Result 1: Estimation of OLS Regression Line Figure 1: Line of best fit
Source: Author’s estimation using Wage1 dataset in STATA, refer Do file for command