Econ 3044: Introduction to Econometrics

Chapter-1: Introduction

Lemi Taye

Addis Ababa University

lemi.taye@aau.edu.et

October 7, 2019

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Overview

1 Definition and Scope of Econometrics

2 Models and their types

3 Methodology of Econometrics

4 Types of Data for Econometric Analysis

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Definition and Scope of Econometrics

Economic theories suggest many relationships among economic

variables.
These, however, have to be checked against data obtained from the
real world.
We use econometrics, to provide a better understanding of economic
relationships and a better guidance for economic policy making.

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Definition and Scope of Econometrics

Econometrics has been defined in many ways:

1 Econometrics simply means “economic measurement”. The “metric”

part of the word indicates measurement and hence it is a branch of
economics concerned with measuring the empirical estimation of
economic relationships among economic variables. (Gujarati, 2003)
2 Econometrics is the application of statistical and mathematical
methods to the analysis of economic data, with a purpose of giving
empirical content to economic theories and verifying them or refuting
them. (Maddala, 1992)

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Definition and Scope of Econometrics

3 Econometrics is the interaction of economic theory, observed data and

statistical methods. These interactions make econometrics interesting,
challenging and difficult. But “econometrics is much easier without
data”. (Verbeek, 2008)
4 Econometrics is based upon the development of statistical methods for
estimating economic relationships, testing economic theories, and
evaluating and implementing government and business policy.
(Woodridge, 2004)

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Why a separate discipline?

Economic Theory makes statements that are mostly qualitative in

nature, while econometrics gives empirical content to most economic
theory.
Mathematical economics is to express economic theory in
mathematical form without empirical verification of the theory, while
econometrics is mainly interested in the later.
Economic statistics is mainly concerned with collecting, processing,
and presenting economic data in the form of charts and tables. It does
not go any further. The one who does that is the econometrician.
Mathematical statistics provides many of tools for economic studies,
but econometrics supplies the later with many special methods of
quantitative analysis based on economic data.

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Why a separate discipline?

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Models and their types

A model is a simplified representation of an actual/real phenomena.

Modeling is an integral part of most scientific inquiry.
A model is a compromise between reality and manageability. Types of
models
1 Verbal/Logical models: use verbal analogies
2 Physical models: scaling down or up of the item investigated.
3 Geometric models: Geometric models are used to represent
relationships geometrically.
4 Algebraic models: verbal and geometric models have to be expressed
algebraically before they can be transformed into an econometric
model.
5 Econometric models: stochastic model that includes one or more
random variables.
An econometric model will either be linear or non-linear in parameters
and variables.
Econometric models can be either static or dynamic.

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Economic vs. Econometric Models

An economic model is a set of assumptions that approximately

describes the behavior of an economy (or a sector of an economy).
Economic models consist of the following three basic structural
elements:
1 A set of variables
2 A list of fundamental relationships and
3 A number of strategic coefficients
An econometric model consists of a set of behavioral equations
derived from the economic model.
These equations involve some observed variables and some
“disturbances” (which are a catchall for all the variables considered
irrelevant for the purpose of this model).

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Economic vs. Econometric Models

Example
Taking the simplest example of a demand model:

Q = b0 + b1 P + b2 P0 + b3 Y + b4 t

An econometric model would be of the stochastic form:

Q = b0 + b1 P + b2 P0 + b3 Y + b4 t + u

where u stands for the random factors which affect the quantity demanded.

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Economic vs. Econometric Models

Example (Job Training and Worker productivity)

Basic economic understanding is sufficient for realizing that factors such as
education, experience, and training affect worker productivity. This simple
reasoning leads to a model such as

wage = f (educ, exper, training),

A complete econometric model might be

wage = β0 + β1 educ + β2 exper + β3 training + u,

where the term u contains factors such as “innate ability,” quality of

education, family background, and the myriad other factors that can
influence a person’s wage.

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Methodology of Econometrics

Broadly speaking, traditional econometric methodology proceeds along

the following lines:

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.

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Methodology of Econometrics

To illustrate the preceding steps, let us consider the well-known

Keynesian theory of consumption.

1. Statement of theory or hypothesis

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.

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Methodology of Econometrics

2. Specification of the Mathematical Model of Consumption

For simplicity, a mathematical economist might suggest the following
form of the Keynesian consumption function:

Y = β1 + β2 X 0 < β2 < 1

where Y = consumption expenditure and X = income, and where β1

and β2 , known as the parameters of the model, are, respectively, the
intercept and slope coefficients.

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Methodology of Econometrics

3. Specification of the Econometric Model of Consumption

The relationships between economic variables are generally inexact. In

addition to income, other variables affect consumption expenditure.
For example, size of family, ages of the members in the family, family
religion, etc., are likely to exert some influence on consumption.
To allow for the inexact relationships between economic variables, the
mathematical equation is modified as follows:

Y = β1 + β2 X + u 0 < β2 < 1

where u is disturbance term or error term. It is a random or stochastic

variable.

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4. Obtaining Data

An econometric model requires data on all the variables in the model.

Figure: Data on Y (Personal Consumption Expenditure) and X (Gross

Domestic Product), both in Billions of Dollars

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Methodology of Econometrics

5. Estimation of the Econometric Model

The actual mechanics of estimating the parameters will be discussed in

Chapter 2. For now, note that the statistical technique of regression
analysis is the main tool used to obtain the estimates.
Using this technique and the data given in Table 1, we obtain the
following estimates of β1 and β2 , namely, 299.5913 and 0.7218. Thus,
the estimated consumption function is:

Ŷt = −299.5913 + 0.7218Xt

The hat on the Y indicates that it is an estimate.

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Methodology of Econometrics

6. Hypothesis Testing
Are the estimates in accord with the expectations of the theory that is
being tested? Is M P C < 1 statistically?

7. Forecasting or Prediction

With given future value(s) of X, what is the future value(s) of Y ?

Example: if GDP=$6000Bill in 1994, what is the forecast consumption
expenditure?

Ŷ = −299.5913 + 0.7218(6000) ≈ 4031.21

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Methodology of Econometrics

8. Use of the Model for Control or Policy Purposes

Suppose that the government believes that consumer expenditure of

about 8750 (billions of 2000 dollars) will keep the unemployment rate
at its current level of about 4.2 percent (early 2006). What level of
income will guarantee the target amount of consumption expenditure?
If the regression results seem reasonable, simple arithmetic will show
that
8750 = −299.5913 + 0.7218(GDP2006 )
which gives X = 12537, approximately.
That is, an income level of about 12537 (billion) dollars, given an
M P C of about 0.72, will produce an expenditure of about 8750 billion
dollars.
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 .

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Types of Data for Econometric Analysis

Data based on sources is classified in to primary and secondary.

Data types can also be classified as:
Non-experimental vs. experimental data
Non-experimental data are obtained from observations of a system that
is not subject to experimental control, while experimental data are
obtained from controlled experiments in laboratory.
Qualitative versus quantitative data
Data, as a matter of definition, is quantitative. Thus facts, which are
already expressed as numbers.
There are also variables, which are qualitative by nature and variables
which show qualitative shifts over time or space.
Such qualitative information is usually quantified by what are known as
dummy variables .

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The Structure of Economic Data

Economic data sets come in a variety of types.

Whereas some econometric methods can be applied with little or no
modification to many different kinds of data sets, the special features
of some data sets must be accounted for or should be exploited.
The most important data structures encountered in applied work
include the following:
1 Cross-Sectional Data
2 Time Series Data
3 Pooled Cross Sections
4 Panel or Longitudinal Data

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Cross-Sectional Data

1. Cross-Sectional Data
Sample of individuals, households, firms, cities, states, countries, or
other units of interest at a given point of time/in a given period.
Cross-sectional observations are more or less independent.
For example, pure random sampling from a population.
Sometimes pure random sampling is violated, e.g. units refuse to
respond in surveys, or if sampling is characterized by clustering
Cross-sectional data typically encountered in applied microeconomics

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Cross-Sectional Data (Continued)

Example

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Time Series Data

Observations of a variable or several variables over time.

For example, stock prices, money supply, consumer price index, gross
domestic product, annual homicide rates, automobile sales, etc.
Time series observations are typically serially correlated.
Ordering of observations conveys important information.
Data frequency: daily, weekly, monthly, quarterly, annually, etc.
Typical features of time series: trends and seasonality.
Typical applications: applied macroeconomics and finance.

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Time Series Data (Continued)

Example

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Pooled Cross Sections

Two or more cross sections are combined in one data set

Cross sections are drawn independently of each other
Pooled cross sections often used to evaluate policy changes
Example:
Evaluate effect of change in property taxes on house prices.
Random sample of house prices for the year 1993
A new random sample of house prices for the year 1995.
Compare before/after (1993: before reform, 1995: after reform).

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Pooled Cross Sections (Continued)

Example

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Panel or Longitudinal Data

The same cross-sectional units are followed over time.

Panel data have a cross-sectional and a time series dimension.
Panel data can be used to account for time-invariant unobservables.
Panel data can be used to model lagged responses.
Example:
City crime statistics; each city is observed in two years.
Time-invariant unobserved city characteristics may be modeled.
Effect of police on crime rates may exhibit time lag.

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Panel or Longitudinal Data (Continued)

Example

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Causality and the Notion of Ceteris Paribus

In most tests of economic theory the economist’s goal is to infer that

one variable (such as education) has a causal effect on another
variable (such as worker productivity).
The notion of ceteris paribus—which means “other (relevant) factors
being equal”—plays an important role in causal analysis.
Although this may seem pretty simple, except in very special cases, it
will not be possible to literally hold all else equal.
The key question in most empirical studies is: Have enough other
factors been held fixed to make a case for causality? Rarely is an
econometric study evaluated without raising this issue.

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Causality and the Notion of Ceteris Paribus

The problem of inferring causality disappears if an appropriate

experiment can be carried out.
Thus, it is useful to describe how such an experiment might be
structured, and to observe that, in most cases, obtaining experimental
data is impractical.

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Causality and the Notion of Ceteris Paribus

Example (Effects of Fertilizer on Crop Yield)

Some early econometric studies considered the effects of new fertilizers on
crop yields. Suppose the crop under consideration is soybeans. Since
fertilizer amount is only one factor affecting yields—some others include
rainfall, quality of land, and presence of parasites—this issue must be posed
as a ceteris paribus question. One way to determine the causal effect of
fertilizer amount on soybean yield is to conduct an experiment, which
might include the following steps.
1 Choose several one-acre plots of land.
2 Apply different amounts of fertilizer to each plot and subsequently
measure the yields; this gives us a cross-sectional data set.
3 Then, use statistical methods (to be introduced in Chapter 2) to
measure the association between yields and fertilizer amounts.

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Causality and the Notion of Ceteris Paribus

Example (Effects of Fertilizer on Crop Yield (continued))

This may not seem like a very good experiment because we have said
nothing about choosing plots of land that are identical in all respects
except for the amount of fertilizer.
In fact, choosing plots of land with this feature is not feasible: some of
the factors, such as land quality, cannot even be fully observed. How
do we know the results of this experiment can be used to measure the
ceteris paribus effect of fertilizer?
The answer depends on the specifics of how fertilizer amounts are
chosen. If the levels of fertilizer are assigned to plots independently of
other plot features that affect yield—that is, other characteristics of
plots are completely ignored when deciding on fertilizer amounts—then
we are in business. We will justify this statement in Chapter 2.

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Causality and the Notion of Ceteris Paribus

Example (Measuring the Return to Education)

If a person is chosen from the population and given another year of
education, by how much will his or her wage increase?
As with the previous examples, this is a ceteris paribus question, which
implies that all other factors are held fixed while another year of
education is given to the person.
We can imagine a social planner designing an experiment to get at
this issue.
The planner would choose a group of people and randomly assign each
person an amount of education; some people are given an
eighth-grade education, some are given a high school education, some
are given two years of college, and so on.
Subsequently, the planner measures wages for this group of people
(where we assume that each person then works in a job).

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Causality and the Notion of Ceteris Paribus
Example (Measuring the Return to Education (continued))
Unlike the fertilizer-yield example, this experiment is unfeasible. The
ethical issues, not to mention the economic costs, associated with
randomly determining education levels for a group of individuals are
obvious.
Even though experimental data cannot be obtained for measuring the
return to education, we can certainly collect nonexperimental data on
education levels and wages for a large group by sampling randomly
from the population of working people.
Such data are available from a variety of surveys used in labor
economics, but these data sets have a feature that makes it difficult to
estimate the ceteris paribus return to education.
People choose their own levels of education; therefore, education
levels are probably not determined independently of all other factors
affecting wage.
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Causality and the Notion of Ceteris Paribus

Example (Measuring the Return to Education (continued))

For instance, it is believed that people with more innate ability often
choose higher levels of education. Since higher ability leads to higher
wages, we have a correlation between education and a critical factor
that affects wage.
If levels of education are assigned independently of other
characteristics that affect productivity (such as experience and innate
ability), then an analysis that ignores these other factors will yield
useful results. More on this in Chapter 2.

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 ************* End of Chapter One *************

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