Lecture 2

Defining Econometrics, Economic Models, and Econometric Models

Introduction to Econometrics
BSc Eco 2023, Spring 2025
Instructor: Sunaina Dhingra
Email-id: [email protected]
Lecture Date: 6th February
 Introduction - Econometrics

• The term econometrics is attributed to Frisch; 1969 Nobel prize co-winner

• “[E]conometrics is by no means the same as economic statistics. Nor is it
identical with what we call general economic theory, although a considerable
portion of this theory has a definitely quantitative character. Nor should
econometrics be taken as synonymous with the application of mathematics to
economics. Experience has shown that each of these three view-points, that
of statistics, economic theory, and mathematics, is a necessary, but not by
itself a sufficient, condition for a real understanding of the quantitative
relations in modern economic life. It is the unification of all three that is
powerful. And it is this unification that constitutes econometrics.” Frisch,
Econometrica, 1933, volume 1, pgs. 1-2.

• Haavelmo (1944) states “The method of econometric research aims, essentially, at

a conjunction of economic theory and actual measurements, using the theory and
technique of statistical inference as a bridge pier.”
 Econometric Methods and It’s
Applications
• Econometrics: based on the development of statistical methods for estimating economic relationships, testing
economic theories, and evaluating and implementing government and business policy

• Useful in estimating economic relationships between variables: Analyzing micro and macro variables:
• Theory usually suggests the direction of change in one variable when another variable changes
• Simplification of reality
• Estimating relationships between different variables
• not exact and one must incorporate stochastic elements into the model
• Incorporating stochastic elements transforms the theory from one of an exact statement to a probabilistic description
about expected outcomes
• Probability or stochastic approach to econometrics dates to Haavelmo (1944); 1989 Nobel Prize winner

Forecasting macroeconomic variables

• Cobb-Douglas model of production; Asset pricing model; Effects of fertilizer use on crop yields ;Impact of school
spending on student performance
 Economic Model
• Economic model consists of mathematical equations that describe various
relationships
• Consider an example of utility maximization model
𝑚𝑎𝑥𝑦1……,𝑦𝑛 u(𝑦1,……., 𝑦𝑛 ) subject to σ𝑁
𝑖=0 𝑦𝑖 ≤ 𝑚

𝑦𝑖 ≥0 for all i
• Max U() subject to budget constraints
Economic Model (contd.)

y=f (𝑥1 , 𝑥2 , 𝑥3 , 𝑥4 , 𝑥5 )

where ,
y = quantity of pizza
𝑥1 = price of pizza
𝑥2 = price of substitute good
𝑥3 = price of complimentary good
𝑥4 = income
𝑥5 = characteristics that affect taste
Economic Model (contd.)

Let’s consider another example of an equation that we can derive using informal
reasoning
wage = f(educ, exper, training)
Or y = f(𝑥1 , 𝑥2 , 𝑥3 )

where,
y = hourly wage
𝑥1 = years of formal education
𝑥2 = years of workforce experience
𝑥3 = did the employee receive any job training (yes-1; no-0)
 Econometric Model

Let’s consider a complete econometric model for example

wage = β0 + β1 educ + β2 exper + β3 training + μ

where,
β0 , β1 , β2 , and β3 = parameters of econometric model
μ = error term that contains unobserved factors
 Goals of Econometric Model

we proceed to obtain relevant data on education, experience, training,

wages. Two main goals after obtaining data:

• Estimating parameters in the econometric model

• Testing hypotheses of interest.
Types of Datasets
 Types of Economic Data
• The success of any analysis depends on the availability of appropriate
data.
• Data used in econometric methods can be experimental or non-experimental data
• Experimental data is collected in a lab or field
• Non-experimental is observational data. Researcher is a passive collector
• The three common types of economic data
• Cross-sectional data
• Time series data
• Pooled cross-sectional data
• Panel/longitudinal data
Cross-Sectional Data
• Cross-sectional data consists of data on multiple agents or a sample of individuals, households, cities,
states, countries, firms or a variety of other units at a single point in time t = t0.

• In pure cross-section, ignore any minor differences in timing of survey (e.g. households interviewed on
different days or weeks)
• Assume that data have been obtained by a random sampling from the underlying population
• e.g. information on wages, education, experience etc have been obtained from a random draw of 500
people of all working population
• M
 Cross-Sectional Data
• For example, the table gives data of 526 working individuals for the year 1976.
The variables included in the table are:
• Observation number obsno wage educ exper female married
1 3.10 11 2 1 0
• Wage 2 3.24 12 22 1 1

• Number of years of education 3 3.00 11 2 0 0

4 6.00 8 44 0 1
• Experience earned 5 5.30 12 7 0 1
. . . . . .
• Indicator for gender . . . . . .
. . . . . .
• Marital status 525 11.56 16 5 0 1
526 3.50 14 5 1 0
Time Series Data
• Time series data is data on a single agent at multiple points in time

• Example: stock prices, GDP, inflation, unemployment, homicide rates, etc

• Here, past events can influence future events
• Thus, time series data is rarely ever assumed to be independent across time
• Special attention given to data frequency here
• GDP recorded quarterly
• Inflation recorded monthly
• Stock prices recorded daily
• Unemployment recorded monthly
• Monthly, daily, quarterly, etc show strong seasonal patterns that are important considerations in time series
data
 Time Series Data
• For example, the table gives data of Puerto Rico for 38 years. The variables
included in the table are:
• Observation number obsno year avgmin avgcov prunemp prgnp

• Year 1 1950 0.20 20.1 15.4 878.7

2 1951 0.21 20.7 16.0 925.0

• Minimum wage
3 1952 0.23 22.6 14.8 1015.9
• Coverage rate
. . . . . .
• Unemployment rate . . . . . .

• Gross national product 37 1986 3.35 58.1 18.9 4281.6

38 1987 3.35 58.2 16.8 4496.7

Panel/Longitudinal Data
• Panel data is data on multiple agents at multiple points in time

• A panel consists of a time series for each cross-sectional member in the data set.
• For example
• wage, educ, exper for a same set of individuals over a period of 10 years
• investment or financial data for a same set of firms over a period of 5 years
• Note: panel follows the same cross-sectional units over time
• i.e. follows the same set of households over time
The table below shows a two year panel on crime and related statistics for 150 cities in the US
Pooled Cross-Section Data
• The difference between pooled cross-section and panel data is that the agents in each cross
sections can differ
• Also referred to as repeated cross-sections
• e.g. 2 cross-sectional data of household surveys in India (NSS)
• not the same households
• Let us look at data on effect of property taxes on house prices
• a random sample of house prices in 1993
• a new random sample of house prices in 1995
 Pooled Cross-Section Data

• For example, the table gives data of 520 houses. The variables included in the
table are:
• Observation number obsno year hprice proptax sqrft bdrms bthrms
1 1993 85,500 42 1600 3 2.0
• Year 2 1993 673,00 36 1440 3 2.5
3 1993 1,34,000 38 2000 4 2.5
• House price . . . . . . .
. . . . . . .
• Property tax . . . . . . .
250 1993 2,43,600 41 2600 4 3.0
• Square feet 251 1995 65,000 16 1250 2 1.0
252 1995 1,82,400 20 2200 4 2.0
• Bedrooms 253
.
1995
.
97,500
.
15
.
1540
.
3
.
2.0
.
. . . . . . .
• Bathrooms . . . . . . .
520 1995 57,200 16 1100 2 1.5
Pooled cross-section versus panel data

• Panel data requires replication of the same units/agents/individuals/households overtime

whereas pooled/repeated cross-sections do not require the same agents
• Thus, panel especially on households, individuals, firms, etc are more difficult to obtain
• e.g. IHDS for India
• Observing the same units over time leads to advantages over cross-sectional or pooled cross-
sectional data
• multiple observations on the same units allows us to control for unobserved characteristics
of individuals, firms or households etc
• aids in causal inferences
• allows us to study the importance of lags in behaviour (many economic policies have an
impact only after some time has passed)
 Panel/Longitudinal Data

• Special type of pooled cross-section data

• Same cross-sectional units are surveyed over time
• Example: Census data
• Advantages of panel data
• Useful in establishing causality
• Ability to analyze behavioral lags or the outcome of decisions