Module 4

Hypothesis Testing of OLS Estimates

This module is structured into three (3) units
Unit 1: The square of correlation coefficient ( r 2 )
Unit 2: The standard error test of the parameter estimates

Unit 3: Extensions of Regression Models

Unit 1:
The square of correlation coefficient ( r 2 )

Introduction
After estimation of the parameters there are important issues to be considered by the researcher.
We have to know that to what extent our estimates are reliable enough and acceptable for further
purpose. That means, we have to evaluate the degree of representativeness of the estimate to the
true population parameter. Simply a model must be tested for its significance before it can be used
for any other purpose. In this module, we will evaluate the reliability of model estimated using the
procedure we explained above.
The available test criteria are divided in to three groups: Theoretical a priori criteria, statistical
criteria and econometric criteria. A-priori criteria set by economic theories are in line with the
consistency of coefficients of econometric model to the economic theory. Statistical criteria, also
known as first order tests, are set by statistical theory and refer to evaluate the statistical reliability
of the model. Econometric criteria refer to whether the assumptions of an econometric model
employed in estimating the parameters are fulfilled or not. There are two most commonly used
tests in econometrics. These are:
1. The square of correlation coefficient ( r 2 ) which is used for judging the explanatory power of
the linear regression of Y on X or on X’s. The square of correlation coefficient in simple regression
is known as the coefficient of determination and is given by R 2 . The coefficient of determination
measures the goodness of fit of the line of regression on the observed sample values of Y and X.
2. The standard error test of the parameter estimates applied for judging the statistical
reliability of the estimates. This test measures the degree of confidence that we may attribute to
the estimates.
i) The Coefficient of determination (R2)
The coefficient of determination is the measure of the amount or proportion of the total variation
of the dependent variable that is determined or explained by the model or the presence of the
explanatory variable in the model. The total variation of the dependent variable is split in two

1
additive components; a part explained by the model and a part represented by the random term.
The total variation of the dependent variable is measured from its arithmetic mean.
_
Total var iation in Yi  (Yi  Y ) 2
 _
Total exp lained var iation  (Yi  Y ) 2
Total un exp lained var iation   ei2
The total variation of the dependent variable is given in the following form; TSS=ESS + RSS,
which means total sum of square of the dependent variable is split into explained sum of square
and residual sum of square.

ei  yi  yi

yi  y i  ei
 2 
y  yi  ei2  2 y i ei
2
i
2 
 y   y i   ei2  2  y i ei
2
i

But  y i ei  0
2
Therefore,  y i2   y i   ei2

The coefficient of determination is given by the formula

 (Yˆ  Y )2  yˆ
2
i i

R2   
Explained Variation in Y 2.16
Total Variation in Y
 (Y Y ) y
2 2
i i

 2 
Since  y i   1  xi y i the coefficient of determination can also be given as

 1  xi y i
R2 
 y i2

Or

 (Y  Yˆi ) 2 e
2
i i
Unexplaine d Variation in Y 2.17
R2  1  1  1
Total Variation inY
 (Y  Y )2 y
2
i i

The higher the coefficient of determination is the better the fit. Conversely, the smaller the
coefficient of determination is the poorer the fit. That is why the coefficient of determination is
used to compare two or more models. One minus the coefficient of determination is called the
coefficient of non-determination, and it gives the proportion of the variation in the dependent
variable that remained undetermined or unexplained by the model.

2
Example 2.6: The following table gives the quantity supplied (Y in tons) and its price (X pound
per ton) for a commodity over a period of twelve years.
Table 1: Data on supply and price for given commodity
Y 69 76 52 56 57 77 58 55 67 53 72 64
X 9 12 6 10 9 10 7 8 12 6 11 8

1. Estimate the Coefficient of determination (R2)

Table 2: Data for computation of different parameters

Time Y X XY X2 Y2 x Y Xy x2 y2 Yˆ ei ei2
1 69 9 621 81 4761 0 6 0 0 36 63.00 6.00 36.00
2 76 12 912 144 5776 3 13 39 9 169 72.75 3.25 10.56
3 52 6 312 36 2704 -3 -11 33 9 121 53.25 -1.25 1.56
4 56 10 560 100 3136 1 -7 -7 1 49 66.25 -10.25 105.06
5 57 9 513 81 3249 0 -6 0 0 36 63.00 -6.00 36.00
6 77 10 770 100 5929 1 14 14 1 196 66.25 10.75 115.56
7 58 7 406 49 3364 -2 -5 10 4 25 56.50 1.50 2.25
8 55 8 440 64 3025 -1 -8 8 1 64 59.75 -4.75 22.56
9 67 12 804 144 4489 3 4 12 9 16 72.75 -5.75 33.06
10 53 6 318 36 2809 -3 -10 30 9 100 53.25 -0.25 0.06
11 72 11 792 121 5184 2 9 18 4 81 69.50 2.50 6.25
12 64 8 512 64 4096 -1 1 -1 1 1 59.75 4.25 18.06
Sum 756 108 6960 1020 48522 0 0 156 48 894 756.00 0.00 387.00

Solution
1. Estimate the Coefficient of determination (R2)
Refer to previous example to determine what percent of the variations in the quantity supplied is
explained by the price of the commodity and what percent remained unexplained.
Use data in the table above to estimate R2 using the formula given below.

e
2
i
387
R2  1  1  1  0.43  0.57
894
y
2
i

This result shows that 57% of the variation in the quantity supplied of the commodity under
consideration is explained by the variation in the price of the commodity; and the rest 37% remain
unexplained by the price of the commodity. In other word, there may be other important
explanatory variables left out that could contribute to the variation in the quantity supplied of the
commodity, under consideration.