Introduction to

Econometrics
for Management
 Chapter One
Introduction
Prepared by: Aleboy Mesfin
Outline
• Definition and scope of econometrics
• Econometrics vs. mathematical economics and
statistical economics
• Methodology of econometrics
• Goals of Econometrics
1.1 Definition and scope of
econometrics
• The economic theories you learn in microeconomics and
macroeconomics courses suggest many relationships among
economic variables.
• For instance, in microeconomics we learn demand and supply models
in which the quantities demanded and supplied of a good depend on
its price.
• Each of such specifications involves a relationship among economic
variables. As business analyst, you may be interested in questions
such as: If one variable changes in a certain magnitude, by how much
will another variable change?
• Also, given that we know the value of one variable; can we forecast or
predict the corresponding value of another?
• Economic theories that describe the relationships between economic
variables have to be checked against data obtained from the real
world.
• If empirical data verify the relationship proposed by economic theory,
we accept the theory as valid.
• If the theory is incompatible with the observed behavior, we either
reject the theory or in the light of the empirical evidence of the data,
modify the theory.
• To provide a better understanding of economic relationships and a
better guidance for economic policy making we also need to know the
quantitative relationships between the different economic variables.
• We obtain these quantitative measurements taken from the real
world. The field of knowledge which helps us to carryout such an
evaluation of economic theories in empirical terms is econometrics.
WHAT IS ECONOMETRICS?
• Literally interpreted, econometrics means “economic measurement”,
but the scope of econometrics is much broader as described by
leading econometricians.
• Various econometricians used different ways of wordings to define
econometrics. But if we concentrate the fundamental
features/concepts of all the definitions, we may obtain the following
definition.
• “Econometrics is the science which integrates economic theory,
economic statistics, and mathematical economics to investigate the
empirical support of the general law established by economic theory”.
• In short, econometrics may be considered as the integration of
economics, mathematics, and statistics for the purpose of providing
numerical values for the parameters of economic relationships and
verifying economic theories.
1.2 Econometrics vs. mathematical
economics
• Mathematical economics is primarily concerned with using
mathematical tools and techniques to model and analyze
economic phenomena. It aims to develop mathematical
models that describe economic relationships and behaviors.
• Mathematical economics states economic theory in terms
of mathematical symbols. There is no essential difference
between mathematical economics and economic theory.
• Mathematical economics uses mathematical tools such as
calculus, linear algebra, differential equations, and
optimization techniques to formalize economic theories and
analyze economic problems.
• Both state the same relationships , but while economic
theory uses verbal exposition, mathematical economics
employs mathematical symbolism. Both express the
various economic relationships in an exact form.
• Neither economic theory nor mathematical economics
allows for random elements which might affect the
relationship and make it stochastic . Furthermore, they
do not provide numerical values for the coefficients of
the relationships.
• Although econometrics presupposes the expression of
economic relationships in mathematical form, like
mathematical economics it does not assume that
economic relationships are exact.
• On the contrary, econometrics assumes that
relationships are not exact. Econometric methods are
designed to take into account random disturbances
which create deviations from the exact behavioral
patterns suggested by economic theory and
mathematical economics.
• It involves the use of regression analysis, time series
analysis, panel data methods, and other statistical tools.
• For example, economic theory suggests that the
demand for a product which covers a basic human need
is inelastic. This information is of little assistance to
policy-makers, because the coefficient of elasticity may
assume any value between 0 and 1.
• Econometrics can supply precise estimates of
elasticities and other parameters of economic theory.
• Simply put:
• Economic Theory: The higher the price of a product is
the less of it will be demanded, all else equal.
• Mathematical Economics: Q = a - bP
• Econometrics: Q = a - bP + Error(U)
• In summary, mathematical economics focuses on
developing theoretical models using mathematical
tools, while econometrics focuses on testing and
estimating economic relationships using statistical
methods and empirical data. Both fields play important
roles in economic research and analysis, with
mathematical economics providing the theoretical
foundation and econometrics providing the empirical
validation.
1.3 Econometrics vs. statistics
• Econometrics differs from both mathematical statistics and economic
statistics. An economic statistician gathers empirical data, records
them, tabulates them or charts them.
• 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 the coefficients of
economic relationships.
• Mathematical (or inferential) statistics deals with the method of
measurement which are 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.
• Econometric methods are adjusted so that they may become appropriate for
the measurement of economic relationships which are stochastic. The
adjustment consists primarily in specifying the stochastic (random) elements
that are supposed to operate in the real world and enter into the
determination of the observed data.
1.4 Methodology of econometrics
• The relationships of economic theory which can be measured with
econometric techniques are relationships in which some variables are
postulated as causes of the variation of other variables. Starting with
the postulated theoretical relationships among economic variables,
econometric research or inquiry generally proceeds along the
following lines/stages.
• 1. Specification the model
• 2. Obtaining the data
• 3. Estimation of the model
• 4. Evaluation of the estimates
• 5. Evaluation of he forecasting power of the estimated model
1. Specification of the model
• In this step the econometrician has to express the relationships
between economic variables in mathematical form. This step involves
the determination of three important tasks:
• i) the dependent and independent (explanatory) variables which will
be included in the model.
• ii) the a priori theoretical expectations about the sign of the
parameters of the function.
• iii) the mathematical form of the model (number of equations,
specific form of the equations, etc.)
• Note: The specification of the econometric model will be based on
economic theory and on any available information related to the
phenomena under investigation.
• Specification of the model is the most important and the most
difficult stage of any econometric research.
• It is often the weakest point of most econometric applications. In this
stage there exists enormous degree of likelihood of committing errors
or incorrectly specifying the model.
• The most common errors of specification are:
a. Omissions of some important variables from the function.
b. The omissions of some equations (for example, in simultaneous
equations model).
c. The mistaken mathematical form of the functions.
2. Obtaining the data
• Estimations are possible only if data are gathered. Data can be
collected either by census method or sample method.
• Four types of data are available for empirical analysis, cross sectional,
time series, pooled and panel data.
• Cross Section Data gives information on variables concerning
individual agents (consumers or producers) at a given point of time.
• When we gather information on multiple entities at a point of time, it
is called cross section data.
• For example, if we are gathering details of income, savings, education,
occupation etc of Mekelle city at a point of time(2024), it is the best
example of cross section data. In other words, survey data are broadly
cross section data.
• Time Series Data give information about the numerical values of
variables from period to period. The data can be collected at regular
time intervals (daily, weekly, monthly, annual etc).For a data set to be
time series, there are two conditions. Data collection interval should
be equal and gather information on a single entity.
• Pooled data in a simple way is the integration or mixing of time series
and cross section data. For example GDP and investment data of 5
regions of Ethiopia for the period 2010 to 2016.
• Panel Data (Longitudinal Data) are data where multiple cases(e.g.
firms) are observed over multiple time periods. Panel data provide
information on individual behavior, both across individuals and over
time. For example, profitability of (500 sample) small business firms
in Mekelle city for 2010 to 2016.
3. Estimation of the model
• This is purely a technical stage which requires knowledge of the
various econometric methods, their assumptions and the economic
implications for the estimates of the parameters.
• This stage includes the following activities.
a. Examination of the identification conditions of the function
(especially for simultaneous equations models).
b. Examination of the aggregations problems involved in the variables
of the function.
• c. Examination of the degree of correlation between the explanatory
variables (i.e. examination of the problem of multicollinearity). e.
Choice of appropriate economic techniques for estimation, i.e. to
decide a specific econometric method to be applied in estimation;
such as, OLS, MLM, Logit, and Probit.
4. Evaluation of the estimates
• This stage consists of deciding whether the estimates of the
parameters are theoretically meaningful and statistically satisfactory.
This stage enables the econometrician to evaluate the results of
calculations and determine the reliability of the results. For this
purpose we use various criteria which may be classified into three
groups:
• i. Economic a priori criteria: These criteria are determined by
economic theory and refer to the size and sign of the parameters of
economic relationships.
• ii. Statistical criteria (first-order tests): These are determined by
statistical theory and aim at the evaluation of the statistical reliability
of the estimates of the parameters of the model. Correlation
coefficient test, standard error test, t-test, F-test, and R2 -test are
some of the most commonly used statistical tests.
. regress earnings age female wexp siblings

Source SS df MS Number of obs = 540

F(4, 535) = 10.81
Model 9012.66906 4 2253.16727 Prob > F = 0.0000
Residual 111505.758 535 208.421978 R-squared = 0.0748
Adj R-squared = 0.0679
Total 120518.427 539 223.59634 Root MSE = 14.437

earnings Coef. Std. Err. t P>|t| [95% Conf. Interval]

age -.0545205 .2862845 -0.19 0.849 -.6169001 .507859

female -6.860996 1.277986 -5.37 0.000 -9.371482 -4.350511
wexp .1775912 .1426546 1.24 0.214 -.1026407 .457823
siblings -.6765435 .2984417 -2.27 0.024 -1.262805 -.0902823
_cons 24.74396 11.14863 2.22 0.027 2.843505 46.64441
• iii. Econometric criteria (second-order tests): These are set by the
theory of econometrics and aim at the investigation of whether the
assumptions of the econometric method employed are satisfied or
not in any particular case.
• They help us establish whether the estimates have the desirable
properties of unbiasedness, consistency etc.
• Econometric criteria aim at the detection of the violation or validity of
the assumptions of the various econometric techniques.
5) Evaluation of the forecasting
power of the model:
• Forecasting is one of the aims of econometric research. However, before
using an estimated model for forecasting by some way or another the
predictive power of the model.
• It is possible that the model may be economically meaningful and statistically
and econometrically correct for the sample period for which the model has
been estimated; yet it may not be suitable for forecasting due to various
factors (reasons).
• Therefore, this stage involves the investigation of the stability of the
estimates and their sensitivity to changes in the size of the sample.
Consequently, we must establish whether the estimated function performs
adequately outside the sample of data. i.e. we must test an extra sample
performance the model.
1.5 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 according
to the following desirable properties.
1. Theoretical plausibility:
• The model should be compatible with the postulates of economic
theory. It must describe adequately 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.
3. Accuracy of the estimates of the parameters:
• 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
he 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 is considered, ceteris
paribus (that is to say provided that the other desirable properties are
not affected by the simplifications of the model)
1.6 Goals of Econometrics
• Three main goals of Econometrics are identified:
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.
End of Chapter one.