Econometrics for Management

By: Milkessa D.Robi

1
Objective
• The principal objective of the course, “Introduction to Econometrics”,
is to provide an elementary but comprehensive introduction to the art
and science of econometrics.
• It enables students to see how economic theory, statistical and
mathematical methods are combined in the analysis of economic data,
with a purpose of giving empirical content to economic theories and
verify or refute them.
Course contents
1. Introduction
2. Correlation Theory
3. The Classical Regression Analysis: The Simple Linear
regression Models
4. The Classical Regression Analysis: The Multiple Linear
Regression Models
5. Violations of the assumptions of Classical Linear
Regression models
6. Regression on Dummy Variables
3
1.1. Definition and scope of econometrics
• The economic theories we learn in various economics 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.
• In macroeconomics, we study ‘investment function’ to explain the amount of aggregate
investment in the economy as the rate of interest changes; and ‘consumption function’ that
relates aggregate consumption to the level of aggregate disposable income.
• Each of such specifications involves a relationship among economic variables.
• As economists, we 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?
• The purpose of studying the relationships among economic variables and attempting to
answer questions of the type raised here, is to help us understood the real economic world
we live in.
 Cont.…….
• However, economic theories that postulate 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 distill the fundamental features/concepts of all the definitions, we may
obtain the following definition.
• Econometrics may be defined as the quantitative analysis of actual economic
phenomena based on the concurrent development of theory and observation,
related by appropriate methods of inference.
• Econometrics may be defined as the social science in which the tools of economic
theory, mathematics, and statistical inference are applied to the analysis of
economic phenomena.
 Cont.…….
• Econometrics is the science which integrates economic theory, economic statistics,
and mathematical economics to investigate the empirical support of the general
schematic law established by economic theory.
• It is a special type of economic analysis and research in which the general
economic theories, formulated in mathematical terms, is combined with empirical
measurements of economic phenomena.
• Starting from the relationships of economic theory, we express them in
mathematical terms so that they can be measured.
• We then use specific methods, called econometric methods in order to obtain
numerical estimates of the coefficients of the economic relationships.
• 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.
Why a Separate Discipline?
• As the preceding definitions suggest, econometrics is an amalgam of economic theory,
mathematical economics, economic statistics, and mathematical statistics.
• Yet the subject deserves to be studied in its own right for the following reasons.
• Economic theory makes statements or hypotheses that are mostly qualitative in nature.
• For example, microeconomic theory states that, other things remaining the same, a
reduction in the price of a commodity is expected to increase the quantity demanded of
that commodity. Thus, economic theory postulates a negative or inverse relationship
between the price and quantity demanded of a commodity.
• However, the theory itself does not provide any numerical measure of the relationship
between the two; that is, it does not tell by how much the quantity will go up or down
because of a certain change in the price of the commodity.
• It is the job of the econometrician to provide such numerical estimates.
• Stated differently, econometrics gives empirical content to most economic theory.
Cont.………………………….…..
• The main concern of mathematical economics is to express economic theory in
mathematical form (equations) without regard to measurability or empirical
verification of the theory.
• Econometrics, as noted previously, is mainly interested in the empirical verification of
economic theory.
• As we shall see, the econometrician often uses the mathematical equations proposed
by the mathematical economist but puts these equations in such a form that they lend
themselves to empirical testing.
• In addition, this conversion of mathematical into econometric equations requires a
great deal of creativity and practical skill.
Cont.………………………….…..
• Economic statistics is mainly concerned with collecting, processing, and presenting
economic data in the form of charts and tables.
• These are the jobs of the economic statistician.
• He or she is primarily responsible for collecting data on gross national product
(GNP), employment, unemployment, prices, etc.
• The data thus collected constitute the raw data for econometric work.
• However, the economic statistician does not go any further, not being concerned
with using the collected data to test economic theories.
• Of course, one who does that becomes an econometrician.
• Although mathematical statistics provides many tools used in the trade, the
econometrician often needs special methods in view of the unique nature of most
economic data.
Cont.………………………….…..
• Those are that the data are not generated as the result of a controlled
experiment. The econometrician, like the meteorologist, generally
depends on data that cannot be controlled directly.
1.2. 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 use verbal
exposition, mathematical economics use symbols.
• Both express economic relationships in an exact or deterministic form.
• Neither mathematical economics nor economic theory allows for random
elements which might affect the relationship and make it stochastic.
• Both do not provide numerical values for the coefficients of economic
relationships.
Cont.………………………….…..
• 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.
• Econometric methods are designed to take into account random
disturbances which relate deviations from exact behavioral patterns
suggested by economic theory and mathematical economics.
• Further more, econometric methods provide numerical values of the
coefficients of economic relationships.
 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, 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 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.
Cont.………………………….…..
• Yet the fundamental ideas of inferential statistics are applicable in
econometrics, but they must be adapted to the problem economic life.
• 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. Economic models vs. Econometric models
i. Economic models:
• Any economic theory is an observation from the real world.
• 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 on economic model.
• It is an organized set of relationships that describes the functioning of an economic
entity under a set of simplifying assumptions.
Cont.………………………….…..
•
Cont.………………………….…..
•
1.5. Methodology of econometrics
• How do econometricians proceed in their analysis of an economic problem? That is,
what is their methodology?
• Although there are several schools of thought on econometric methodology, we
present here the traditional or classical methodology, which still dominates
empirical research in economics and other social and behavioral sciences.
• Broadly speaking, traditional econometric methodology proceeds along the
following lines/steps:
1. Statement of theory or hypothesis
2. Specification of the mathematical model of the theory
3. Specification of the statistical, or econometric model
4. Obtaining the data
5. Estimation of the parameters of the econometric model
6. Hypothesis testing
7. Forecasting or prediction
8. Using the model for control or policy purposes
Cont.………………………….…..
• To illustrate the preceding steps, let us consider the well-known
Keynesian theory of consumption.
1. Statement of Theory or Hypothesis
• Keynes stated; the fundamental psychological law is that men [women]
are disposed, as a rule and on average, to increase their consumption as
their income increases, but not as much as the increase in their income.
• In short, Keynes postulated that the marginal propensity to consume
(MPC), the rate of change of consumption for a unit (say, a dollar)
change in income, is greater than zero but less than 1.
Cont.………………………….…..
•
Cont.………………………….…..

• Figure 1: Keynesian consumption function.

Cont.………………………….…..
• The variable appearing on the left side of the equality sign is
called the dependent variable and the variable(s) on the
right side are called the independent, or explanatory,
variable(s).
• Thus, in the Keynesian consumption function, consumption
(expenditure) is the dependent variable and income is the
explanatory variable
 Cont.………………………….…..
•
Cont.………………………….…..
• The disturbance term u may well represent all those factors, which
affect consumption; but are not taken into account explicitly.
• The econometric model of the consumption function can be depicted
as shown in Figure 2.
Cont.………………………….…..

• Figure 2: Econometric model of the Keynesian consumption function.

Cont.………………………….…..
• The above equation is an example of an econometric model.
• More technically, it is an example of a linear regression
model, which is the major concern of this book.
• The econometric consumption function hypothesizes that the
dependent variable Y (consumption) is linearly related to the
explanatory variable X (income) but that the relationship
between the two is not exact; it is subject to individual
variation.
Cont.………………………….…………………...
4. Obtaining Data
• To estimate the econometric model given in above equation, that is, to obtain the
numerical values of β1 and β2, we need data.
• let us look at the data given in Table 1.1, which relate to the U.S. economy for
the period 1982–1996.
• The Y variable in this table is the aggregate (for the economy as a whole)
personal consumption expenditure (PCE) and the X variable is gross domestic
product (GDP), a measure of aggregate income, both measured in billions of
1992 dollars.
• Therefore, the data are in “real” terms; that is, they are measured in constant
(1992) prices. The data are plotted in Figure 3.
Cont.………………………….…..
• Table 1.1 Data on Y (Personal Consumption Expenditure) and X (Gross
Domestic Product, 1982–1996), Both in 1992 Billions of Dollars
Year Y X
1982 3081.5 4620.3
1983 3240.6 4803.7
1984 3407.6 5140.1
1985 3566.5 5323.5
1986 3708.7 5487
1987 3822.3 5649.7
1988 3972.7 5865.2
1989 4064.6 6062
1990 1432.2 6136
1991 4105.8 6079.4
1992 4243.6 6244.4
1993 4486.0 6389.6
1994 4595.3 6610..7
1995 4714.1 6742.1
1996 5619.4 6928.4
Cont.………………………….…..

Figure 3: Personal consumption expenditure (Y) in relation to GDP (X), 1982–1996,

both in billions of 1992 dollars.
 Cont.………………………….…..
•
 Cont.………………………….…..
• The hat on the Y indicates that it is an estimate.
• The estimated consumption function (i.e., regression line) is shown in Figure 3.
• As Figure 3 shows, the regression line fits the data quite well in that the data points are
very close to the regression line.
• From this figure, we see that for the period 1982–1996 the slope coefficient (i.e., the
MPC) was about 0.70, suggesting that for the sample period an increase in real income
of 1 dollar led, on average, to an increase of about 70 cents in real consumption
expenditure.
• We say on average because the relationship between consumption and income is inexact;
as is clear from Figure 3; not all the data points lie exactly on the regression line.
• In simple terms, we can say that, according to our data, the average, or mean,
consumption expenditure went up by about 70 cents for a dollar’s increase in real
income.
 Cont.………………………….…..
6. Hypothesis Testing
• As noted earlier, Keynes expected the MPC to be positive but less than 1.
• In our example, we found the MPC to be about 0.70.
• However, before we accept this finding as confirmation of Keynesian consumption
theory, we must enquire whether this estimate is sufficiently below unity to convince
us that this is not a chance occurrence or peculiarity of the particular data we have
used.
• In other words, is 0.70 statistically less than 1? If it is, it may support Keynes’ theory.
• Such confirmation or refutation of economic theories based on sample evidence is
based on a branch of statistical theory known as statistical inference (hypothesis
testing).
 Cont.………………………….…..
•
Cont.………………………….…..
• The actual value of the consumption expenditure reported in 1997 was 4913.5
billion dollars.
• The estimated model, thus over predicted the actual consumption expenditure by
about 37.82 billion dollars.
• We could say the forecast error is about 37.82 billion dollars, which is about 0.76
percent of the actual GDP value for 1997.
• When we fully discuss the linear regression model in subsequent chapters, we will
try to find out if such an error is “small” or “large.”
• However, what is important for now is to note that such forecast errors are
inevitable given the statistical nature of our analysis.
Cont.………………………….…..
•
Cont.………………………….…..
• If we use the MPC of 0.70 obtained earlier, this multiplier
becomes about M = 3.33.
• That is, an increase (decrease) of a dollar in investment will
eventually lead to more than a threefold increase (decrease)
in income.
Cont.………………………….…..
•
Cont.………………………….…..
• As these calculations suggest, an estimated model may be used for
control, or policy purposes.
• By appropriate fiscal and monetary policy mix, the government can
manipulate the control variable X to produce the desired level of the
target variable Y.
summarizes the anatomy of classical
econometric modeling.
Economic theory

Mathematical model of the theory

Econometric model of the theory

Collecting data

Evaluation of Estimates (Hypothesis testing)

Application (forecasting)

Use of the Model for Control or Policy Purposes

1.6. What is data
• Data are facts/values that variables will assume.
• Data are a raw fact/figures that will be used to draw a conclusion or
make a decision.
• It is a raw numerical description of a variable ready to be analyzed
which is obtained by measuring or counting.
Types of Data
• Data are classified as:
1. quantitative or qualitative data
2. Primary or secondary data
3. Time series, cross sectional data or pooled (i.e., combination of time
series and cross section data.
Cont.………………………….…..
1. quantitative or qualitative data
I. quantitative
are data that is expressed numerically or they are numerical observations of
variables.
Example: age, Grade Point Average (GPA), Sales, income, etc.
Valid computations such as mean, variance, etc are possible in the case of
quantitative data.
II. Qualitative data:
is non-numeric.
Example: marital status (married, single, widowed, divorce), race (Asian, African, etc),
gender (male/female), blood type (A, B, O, AB).
Valid Computation: Proportions in each category are possible,
 Example. What percent of students in this class is female?
 Cont.………………………….…..
2. Primary or Secondary data
I. Primary Data
 Data originally collected by the researcher for the purpose/problem at hand.
Data generated from primary source of data.
Data that are collected by the investigator himself for the first time for the purpose of a
specific inquiry or study.
II. Secondary data
• When an investigator uses data, which have already been collected by others, such data
are called “secondary data.”
• Data generated from a secondary source of data.
• Data generated by someone else for some other purpose.
• The secondary data can be obtained from journals, reports, government publications,
publications of professionals and research organizations, internet, videos, library,
etc.
Cont.………………………….…..
3. Time series, cross sectional data or pooled (i.e., combination of time
series and cross section data.
a. Time Series Data: A time series is a set of observations on the values
that a variable takes at different times.
• Data collected overtime on one or more variables.
• Time series data is a collection of observations obtained through
repeated measurements over time.
• These data points typically consist of successive measurements made
from the same source over a time interval and are used to track change
over time.
 Cont.………………………….…..
• Such data may be collected at regular time intervals,
such as daily (e.g., stock prices, weather reports), weekly (e.g., money supply
figures),
monthly [e.g., the unemployment rate, the Consumer Price Index (CPI)],
quarterly (e.g., GDP),
annually (e.g., government budgets),
quin-quennially, that is, every 5 years (e.g., the census of manufactures), or
decennially (e.g., the census of population).
• Sometime data are available both quarterly as well as annually, as in the
case of the data on GDP and consumer expenditure.
Cont.………………………….…..
• Example:
Cont.………………………….…..
b. Cross-Section Data: Cross-section data are data on one or more variables
collected at the same point in time.
• With cross-sectional data, we are not interested in the change of data over time, but in
the current.
• Example: The data collected on household of Harar town in 2001 can be presented as
a cross sectional data as follows.
 Cont.………………………….…..
c. Pooled Data: In pooled, or combined, data are elements of both time series and
cross-section data.
• Pooled data is a mixture of time series data and cross-section data. One example is
GNP per capita of all European countries over ten years.
• Example: the following table show egg production and prices in four towns of
Oromia region in 2012, 2013 and 2014.
2012 2013 2014
Town Egg (Y) in Price (X) Town Egg Price Town Egg (Y) Price (X)
million In million (Y) (X) In In
million million
Ambo 10 0.5 Ambo 7 0.5 Ambo 9 1
Nekemte 15 0.25 Nekemte 16 0.4 Nekemte 25 3
Dambi Dollo 20 1 Dambi Dollo 14 0.3 Dambi Dollo 30 5
Adama 3 0.1 Adama 6 0.25 Adama 13 1.5
1.6. 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
he actual world.
It must be consistent with the observed behavior of the economic variables
whose relationship it determines.
 Cont.………………………….…..
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 estimates should if possible possess the desirable properties of
best ,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).
1.7. Goals of Econometrics
• The major objectives and uses of a regression function are:
1. To estimate mean or average value of the dependent variable,
given the value of independent variable(s);
2. To test hypothesis about sign and magnitude of relationship
between the dependent variable and one or more independent
variable(s) or (Analysis i.e. testing economic theory);
3. To predict or forecast future value(s) of the dependent variable
which is in turn used in policy formulation;
4. Policy making i.e. obtaining numerical estimates of the
coefficients of economic relationships for policy simulations and
5. Combination of any two or more of the above objectives.