Sodsod, Bryan Dave S.

BSBA BE 3-1
Special Topics on Business Economics Assignment #1

The Nature of Econometrics and its Methodology

1. Econometrics Defined
Econometrics is the quantitative application of statistical and mathematical models using data to
develop theories or test existing hypotheses in economics and to forecast future trends from
historical data. It subjects real-world data to statistical trials and then compares and contrasts
the results against the theory or theories being tested.
2. Economic Theory
Economic Theory provides an outlet for research in all areas of economics based on rigorous
theoretical reasoning and on topics in mathematics that are supported by the analysis of
economic problems. Published articles contribute to the understanding and solution of
substantive economic problems.
3. Mathematical Economics
Mathematical economics is a method of economics that utilizes math principles and tools to
create economic theories and to investigate economic quandaries. Mathematics permits
economists to construct precisely defined models from which exact conclusions can be derived
with mathematical logic, which can then be tested using statistical data and used to make
quantifiable predictions about future economic activity.

Mathematical economics is a form of economics that relies on quantitative methods to describe

economic phenomena.

4. Economic Statistics
Economic statistics is a topic in applied statistics that concerns the collection, processing,
compilation, dissemination, and analysis of economic data.
5. Methodology of Econometrics
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.

6. Regression Analysis
Regression analysis is a set of statistical methods used for the estimation of relationships
 between a dependent variable and one or more independent variables. It can be utilized to
assess the strength of the relationship between variables and for modeling the future
relationship between them.
Types of regression:
Simple Linear Regression Y = a + bX + ϵ
Multiple Linear Regression Y = a + bX1 + cX2 + dX3 + ϵ

7. Regression, Causation, Correlation

Regression deals with dependence amongst variables within a model. But it cannot always imply
causation. For example, we stated above that rainfall affects crop yield and there is data that
support this. However, this is a one-way relationship: crop yield cannot affect rainfall. It means
there is no cause-and-effect reaction on regression if there is no causation.

Correlation is a statistic that measures the degree to which two variables move in relation to
each other. Correlations form a branch of analysis called correlation analysis, in which the
degree of linear association is measured between two variables. There is a distinction in how we
regard the relationship between rainfall and crop yield. In statistics, both variables are assumed
to be variables with random error in them. Both are treated on an equal footing and there is no
distinction between them.

Causation indicates that one event is the result of the occurrence of the other event. The
econometric approach to causality develops explicit models of outcomes where the causes of
effects are investigated and the mechanisms governing the choice of treatment are analyzed.
The relationship between treatment outcomes and treatment choice mechanisms is studied.

8. Population Regression Function (PRF) and Sample Regression Function (SRF)

PRF also known as conditional expectation function (CEF) tells how the mean or average of response
of Y varies with X. Sample Function Regression is used to estimate the PRF based on the information
provided for by the SRF.

9. Significance of the Error Term

Vagueness of Theory: The theory, if any, determining the behavior of Y may be, and often is,
incomplete. Used as a substitute for all the excluded or omitted variables from the model.

Unavailability of Data: Even if we know what some of the excluded variables are and
therefore consider a multiple regression rather than a simple regression, we may not have
quantitative information about variables.

Core Variable versus Peripheral Variables: It is quite possible that the joint influence of all
or some of these variables may be so small and at best nonsystematic or random that as a
practical matter and for cost considerations it does not pay to introduce them into the model
explicitly. One hopes that their combined effect can be treated as a random variable ui.

Intrinsic Randomness in Human Behavior: There is bound to be some “intrinsic”

randomness in individual Y’s that cannot be explained no matter how hard we try even if we
 succeed in introducing all the relevant variables into the model, the disturbances, the u’s, may
very well reflect this intrinsic randomness.

Poor proxy variables: Although the classical regression model assumes that the variables Y
and X are measured accurately, the data may be plagued by errors of measurement. The
disturbance term u may in this case then also represent the errors of measurement.

Principle of parsimony: Relevant and important variables should not be excluded just to keep
the regression model simple.

Wrong functional form: Very often we do not know the form of the functional relationship
between the regress and the regressors even if we have theoretically correct variables
explaining a phenomenon and even if we can obtain data on these variables.

10. Developing an Econometric Model

10.1 Single-equations and Simultaneous Equations Model
A Simultaneous Equation Model (SEM) is a model in the form of a set of linear simultaneous
equations.

Single-equation models are used to study the pattern of changes in aggregate productivity over
time in conjunction with the time pattern of other aggregate variables that might be expected to
relate to, or explain, productivity.

10.2 Static and Dynamic Model

Static model deals with an existing particular point and relationship between dependent and
one or more variable.

The dynamic model includes both the lag and time element on it.

10.3 Qualitative and Quantitative Variables

Qualitative variables are variables that are not numerical and describes data that fits in
respective categories.

Quantitative variable are variables that can be measure resulted from counting or measuring the
values of data

10.4 Aliases of X and Y Variables

X variables means it is under your control and it is also called as independent variable.

Y variables means its value is dependent to the independent variable.

11. 10 Assumptions of the Classical Linear Regression Model

Assumption 1 - The regression model is linear in parameters

- Requires the specified model to be linear in
parameters, but it doesn’t require the model to be
 linear in variables.
Assumption 2 -The mean of residuals is zero
-The error term itself cannot be observed
Assumption 3 -Homoscedasticity of residuals or equal variance
- The variance of the error, or disturbance, term is
the same regardless of the value of X.
Assumption 4 - No autocorrelation of residuals
- The observations are sampled independently.
Assumption 5 -The X variables and residuals are uncorrelated

Assumption 6 -The number of observations must be greater than

number of Xs
-Alternatively, the number of observations must be
greater than the number of explanatory variables.
Assumption 7 -The variability in X values is positive
-X values must not all be the same. Var (X) must be
a positive value
in order to work.
Assumption 8 -The regression model is correctly specified
Assumption 9 -No perfect multicollinearity
Assumption 10 -Normality of residuals

12. Properties of the Least Squares Estimators and the Gauss- Marcov Theorem
The least squares method provides the overall rationale for the placement of the line of best fit
among the data points being studied.

This method of regression analysis begins with a set of data points to be plotted on an x- and y-
axis graph. An analyst using the least squares method will generate a line of best fit that explains
the potential relationship between independent and dependent variables.

The Gauss Markov theorem tells us that if a certain set of assumptions are met, the ordinary
least squares estimate for regression coefficients gives you the best linear unbiased estimate
(BLUE) possible.

There are five Gauss Markov assumptions (conditions):

1. Linearity: the parameters we are estimating using the OLS method must be
themselves linear.
2. Random: our data must have been randomly sampled from the population.
3. Non-Collinearity: the regressors being calculated aren’t perfectly correlated with
each other.
4. Exogeneity: the regressors aren’t correlated with the error term.
5. Homoscedasticity: no matter what the values of our regressors might be, the
error of the variance is constant.
 References:

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