Chapter 1

An Introduction to Econometrics

Principles of
Econometrics
Fifth Edition
R. Carter Hill William E. Griffiths Guay C. Lim
Chapter Outline
 1.1 Why Study Econometrics

 1.2 What is Econometrics About

 1.3 The Econometric Model

 1.4 How Are Data Generated

 1.5 Economic Data Types

 1.6 The Research Process

 1.7 Writing An Empirical Research Paper

 1.8 Sources of Economic Data

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 1.1 Why Study Econometrics?
 Econometrics fills a gap between being a “student of economics” and
being a “practicing economist.”
 It lets you tell your employer:
 “I can predict the sales of your product.”

 “I can estimate the effect on your sales if your competition lowers its price by $1
per unit.”
 “I can test whether your new ad campaign is actually increasing your sales.”

 Helps you develop “intuition” about how things work and is invaluable if
you go to graduate school.

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1.2 What Is Econometrics All About?

Econometrics is about how we can use theory and data from

economics, business, and the social sciences, along with tools
from statistics, to answer ‘‘how much’’ questions. to predict
outcomes, answer “how much” type questions, and test
hypotheses.

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Functions
 In economics we express our ideas about relationships between
economic variables using the mathematical concept of a
function.
Consumption f Income
d

Q f P, P , P , INC s C

Qs f P, P C
, Pf 

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 1.2.1 Some Examples (1 of 2)
Every day, decision-makers face ‘‘how much:’’
 A city council ponders the question of how much violent crime will be reduced if an
additional million dollars is spent putting uniformed police on the street.
 The owner of a local Pizza Hut must decide how much advertising space to purchase in
the local newspaper, and thus must estimate the relationship between advertising and
sales.
 Louisiana State University must estimate how much enrollment will fall if tuition is
raised by $300 per semester, and thus whether its revenue from tuition will rise or fall.
 The CEO of Proctor & Gamble must estimate how much demand there will be in ten
years for the detergent Tide, and how much to invest in new plant and equipment.

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 1.2.1 Some Examples (2 of 2)
 To answer these questions of “how much,” decision-makers rely on
information provided by empirical economic research.
 In such research, an economist uses economic theory and
reasoning to construct relationships between the variables in
question.
 The CEO of Proctor & Gamble may hire econometric consultants to
provide the firm with projections of sales.

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 1.3 The Econometric Model (1 of 3)
 Economic theory describes the average or systematic behavior of many individuals or
firms.
 When studying car sales we recognize that the actual number of Hondas sold is the sum
of this systematic part and a random and unpredictable component e that we will call a
random error.

Q d = f P, P s , P c , INC + e 
 The random error e accounts for the many factors that affect sales that we have omitted
from this simple model.
d s c
Q 1   2 P  3P   4 P  5 INC  e

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1.3 The Econometric Model (2 of 3)
 The coefficients β1, β2, …, β5 are unknown parameters of the

model that we estimate using economic data and an econometric

technique.
 The functional form represents a hypothesis about the
relationship between the variables.
 In any particular problem, one challenge is to determine a
functional form that is compatible with economic theory and
the data.
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1.3 The Econometric Model (3 of 3)
 We use the econometric model as a basis for statistical inference.

 The ways in which statistical inference are carried out include:

 Estimating economic parameters, such as elasticities, using

econometric methods.
 Predicting economic outcomes, such as the enrollment in two-year
colleges in the United States for the next ten years.
 Testing economic hypotheses, such as the question of whether
newspaper advertising is better than store displays for increasing sales.

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 1.3.1 Causality and Prediction
 Consider an equation where a student’s grade in Econometrics (GRADE) is related to
the proportion of class lectures that are skipped (SKIP).
 GRADE is related to the proportion of class lectures that are skipped (SKIP).
GRADE 1   2 SKIP  e

 We would expect to be negative: The greater the proportion of lectures that are
skipped, the lower the grade.
 Skipping lectures may be due to being busy with a job or due to lack of commitment
or motivation.
 SKIP can be used to help predict GRADE. However, we cannot call it a causal
relationship.

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1.4 How Are Data Generated?
 We must have data.

 Where do data come from?

 What type of real processes generate data?

 Economists and other social scientists work in a complex world in

which data on variables are ‘‘observed’’ and rarely obtained from a
controlled experiment.

 This makes the task of learning about economic parameters all

the more difficult.
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1.4.1 Experimental Data
 One way to acquire information about the unknown parameters of economic

relationships is to conduct or observe the outcome of an experiment

 Such controlled experiments are rare in business and the social sciences

due to the difficulties in organizing and funding them.

 A notable example of a planned experiment is Tennessee’s Project

Star.

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1.4.2 Quasi-Experimental Data
 It is useful to distinguish between “pure” experimental data and “quasi”-
experimental data.
 A pure experiment is characterized by random assignment.

 With quasi-experimental data, allocation to the control and treatment

groups is not random but based on another criterion.
 An example is a study done on the effect of an increase in New
Jersey’s minimum wage in 1992 on the number of people employed
in fast-food restaurants.

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 1.4.3 Non-Experimental Data
 An example of non-experimental data is survey data.

 Data on all variables are collected simultaneously, and the

values are neither fixed nor repeatable.
 The Current Population Survey (CPS) carried out by the U.S.
Bureau of the Census is an example.

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1.5 Economic Data Types
 Economic data comes in a variety of ‘‘flavors.”

1. Data may be collected at various levels of aggregation: micro or macro.

2. Data may also represent a flow or a stock:

• Flow: measured over a period of time

• Stock: measured at a particular point in time

3. Data may be quantitative or qualitative:

• Quantitative: expressed as numbers

• Qualitative: expressed as an ‘‘either-or’’ situation

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 1.5.1 Time-Series Data
 Time-series data is collected over discrete intervals of time.

 The key feature of time-series data is that the same economic

quantity is recorded at a regular time interval.
 Examples include:

 The annual price of wheat in the United States

 The daily price of General Electric stock shares

 Financial data, such as stock prices

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1.5.2 Cross-Section Data
 A cross-section of data is collected across sample units in a
particular time period.
 The ‘‘sample units’’ are individual entities and may be
firms, persons, households, states, or countries.
 Examples are income by counties in California during
2016 or high school graduation rates by state in 2015.

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1.5.3 Panel or Longitudinal Data
 A ‘‘panel’’ of data, also known as ‘‘longitudinal’’ data, has observations on
individual micro-units that are followed over time.
 The key aspect of panel data is that we observe each micro-unit for a
number of time periods.
 If we have the same number of time period observations for each micro-
unit, we have a balanced panel.
 Usually the number of time-series observations is small relative to the
number of micro-units, but not always.

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 1.6 The Research Process
 Econometrics is ultimately a research tool.

 Students of econometrics plan to do research or they plan to

read and evaluate the research of others, or both.
 Research is a process, and like many such activities, it flows
according to an orderly pattern.
 A research project is an opportunity to investigate a topic that
is important to you.

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Steps in the Research Process (1 of 2)
1. Use economic theory to think about the problem.

2. Develop a working economic model leading to an econometric

model.

3. Obtain sample data and choose a desirable method of statistical

analysis based on initial assumptions and an understanding of

how the data were collected.

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Steps in the Research Process (2 of 2)

4. Estimate the unknown parameters with the help of a statistical

software package, make predictions, and test hypotheses.

5. Perform model diagnostics to check the validity of assumptions.

6. Analyze and evaluate the economic consequences and the

implications of the empirical results.

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1.7 Writing an Empirical Research Paper

 Research rewards you with new knowledge, but it is

incomplete until a research paper or report is written.

 The process of writing forces the distillation of ideas

 In no other way will your depth of understanding be so

clearly revealed.

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1.7.1 Writing a Research Paper
The summary should be short, and should include the following:
1. A concise statement of the problem.
2. Comments on the information that is available, with one or two
key references.
3. A description of the research design that includes:
• a. the economic model
• b. the econometric estimation and inference methods
• c. data sources
• d. estimation, hypothesis testing, and prediction procedures,
including the econometric software and version used
4. The potential contribution of the research.
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1.7.2 A Format for Writing a Research
Report
The following outline for a report is typical.

1. Statement of the problem 7. The empirical results and

2. Review of the literature conclusions
3. The economic model 8. Possible extensions and limitations
4. The econometric model of the study
5. The data 9. Acknowledgments
6. The estimation and inference 10. References
procedures

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Style Guides
 A style guide is a good investment. Two classics are the following:

 The Chicago Manual of Style, 16th edition, is available online

and in other formats
 A Manual for Writers of Research Papers, Theses, and
Dissertations: Chicago Style or Students and Researchers, 8th
edition, by Kate L. Turabian; revised by Wayne C. Booth,
Gregory G. Colomb, and Joseph M Williams (2013, University
of Chicago Press)
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 1.8 Sources of Economic Data
 Economic data are much easier to obtain since the development
of the World Wide Web.
 Links to economic data on the Internet:

 Resources for Economists (RFE) www.rfe.org

 National Bureau of Economic Research (NBER)

 Economagic

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1.8.2 Interpreting Economic Data
 In many cases it is easier to obtain economic data than it is to
understand the meaning of the data.
 It is essential when using macroeconomic or financial data that you
understand the definitions of the variables.
 Useful reference

 A Guide to Everyday Economic Statistics, 7th edition, by Gary E.

Clayton and Martin Gerhard Giesbrecht (Boston: Irwin/McGraw-
Hill, 2009)

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1.8.3 Obtaining the Data
 Finding a data source is not the same as obtaining the data. Although
there are great many easy-to-use websites.
 Some good sources:

 The Federal Reserve Bank of St. Louis: FRED (Federal Reserve

Economic Data)
 The Current Population Survey (www.census.gov/cps/): DataFerrett

 The Penn World Tables

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