Econometrics for Management

B Y: K A H S AY H A G O S
 1.1. What is Econometrics? What its
methodology?
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 By its literal meaning econometrics means “Economic

Measurement”
 Econometrics can be defined as the social science in which
the economic phenomenon is measured and analysed
through the application of economic theory, mathematics and
statistical methods.
 Although measurement is an important part of econometrics,
the scope of econometrics is much broader, as can be
explained as follow:
 It helps to estimate economic relationship and to test
economic theories based on the development of statistical
methods.
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 It helps to predict the future economic trends by examining

the economic data
 It helps to evaluate and implement government and
business policies
 As its most common application, econometric used to
forecast important macro economic variables such as
interest rate, inflation and GDP.
 It can also be used in economic areas that have nothing to
do with macro-economic forecasting, for example,
analysing the effect of political campaign expenditures on
voting out comes.
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 In general, 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 or refuting them.
 More specifically, it is concerned with the use of statistical
methods to attach numerical values to the parameters of
economic models and also with the use of these models for
prediction.
 The techniques of econometrics consist of a blend of
economic theory, mathematical modelling and statistical
analysis.
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 Econometrics is an interdisciplinary field.

 It uses insights from economics and business in selecting the
relevant variables and models, it uses computer science methods to
collect the data and to solve econometric models, and it uses
statistics and mathematics to develop econometric methods that
are appropriate for the data and the problem at hand.
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 The first task an econometrician faces is that of formulating an

econometric model.
 What is a model?
 A model is a simplified representation of a real-world process.
 For instance, „the demand for oranges depends on the price of
oranges‟ is a simplified representation since there are a host of other
variables that one can think of that determine the demand for
oranges. These include:
 Income of consumers
 The preference of consumers
 Increase or decrease in the price of substitutes (e.g. that of apple)
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Economic Vs Econometric model

 An economic model is a set of assumptions that approximately
describes the behaviour of an economy (or a sector of an
economy).
 An econometric model consists of the following:
a) A set of behavioural equations derived from the economic
model. These equations involve some observed variables and
some „disturbances‟.
b) b) A statement of whether there are errors of observation in
the observed variables.
c) c) A specification of the probability distribution of the
„disturbances „.
 Econometric modelling
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Economic or Business
problem of interest

Economic Statistical
Data Software
Model Method

Econometric No
Revise
model

Ok?
Yes
Use for forecasting
and decision making
 Econometric Methodology
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 The methodology for the analysis of a given economic

problem is the main concern of econometrics.
 Here we deal about the traditional or classical
methodology which still dominates empirical research
in economics and other social and behavioural
sciences.
 This methodology will be discussed under the
following step wise procedures:
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1. Economic theory
2. Specification of mathematical model
3. Specification of econometric model
4. Obtaining the data
5. Estimation of econometric model
6. Hypothesis testing
7. Forecasting or prediction
8. Using the model for control or play purpose
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1. Economic Theory: It is a statement of theory of

hypothesis that is developed in a certain economic
phenomenon.
E.g: Keynesian theory of consumption, that is, individuals
consumption increases as their income increases, but not as
much as the increase in their income.
 In other words, the marginal propensity to consume (MPC)
the rate of change in consumption for a unit change in
income lies between zero & one.
 It shows us the positive relationship between consumption
and the level of income.
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2. Specification of mathematical Model

 Converting the economic theory into mathematical expression as follows:

 The slope β2 measures MPC.

 The above mathematical equation, which states the consumption function
is linearly related to income, is termed as a consumption function in
economics.
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3. Specification of Econometrics Model

 Unlike the mathematical model, the econometric model assumes that the
relationship between consumption and income is not exact or
deterministic because in addition to income other variables such as family
size, age of family members and family religion affect consumption.
 To allow for the inexact relationship between the two variables the
mathematical model is modified and thus turned to econometric model by
introducing the disturbance or error term, U.
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4. Obtaining Data
 In order to estimate the parameters of the econometric model,
that is, the numerical values of β1 & β 2, we need to have data
on consumption and income.
5. Estimation of the Econometric Model
 Once we have the data, we are in a position to estimate the
parameters of the econometric model.
 That is, finding out the numerical values of β1 & β2 and hence
the estimated econometric model or empirical content of the
consumption function.
 Using the statistical technique of regression analysis and the
data the parameters will be estimated.
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 Say the estimates are obtained as: β1=-184.08 and β 2=0.7064, then the
estimated econometric model particularly the estimated consumption
function, Ŷ, is:

6. Hypothesis Testing
 In this step we need to check whether the estimates obtained are in accord
with the expectation of the theory that is being tested. Although the
estimated obtained (i.e, MPC = 0.70) is confirmed with the Keynes theory
that MPC lies between zero one we need to still check whether this
confirmation is not a chance of occurrence or peculiarity of a particular
data we have used..
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 In other words, is 0.70 statistically less than one? If so, we proved that the
estimated value confirmed with the theory.
 Such confirmation of the estimates with the theory using statistical
method is known as statistical inference or hypothesis testing.
7. Forecasting or prediction
 If the chosen model does not refute the hypothesis or theory under
consideration, we use it to predict the dependent or forecast variable Y on
the basis of expected future value of the explanatory or predictor variable
X.
 For example, if the expected GDP or income value for 2016 is 8000 billion
dollars, the estimated consumption in that year will be:
Ŷ2016 = -184.0779+0.7064(8000) = 5467.1216
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8. Use of the Model for Control or Policy Purposes

 1.2. Data: cross-section, time series, panel data
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 The success of any econometric analysis ultimately depends on the

availability of appropriate data.
 So need to concern much on the type, source, nature and quality of
the data that we are used in a given empirical work.
 Mainly there are three types of data available for empirical analysis
or applied work: cross sectional, time series and panel.
Furthermore, let see the classification of data:
 Based on their type: cross sectional, time series and panel.
 Based on their source: Primary and secondary
 Based on their nature: Qualitative and quantitative
 Based on their measurement scale: Nominal, Ordinal,
Interval and ratio.
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1. Cross sectional data: Cross sectional data are data

collected on one or more variables on a sample of individuals,
households, firms or other units at the same point in time.
 For example, data on the census of population and the
surveys of consumer expenditure are cross sectional data.
 Sometimes the data on all units do not correspond to
precisely the same time period.
 For example, on consumer expenditure several families may
be surveyed during different weeks within a year.
 Thus, in a pure cross sectional analysis we would ignore any
minor timing differences in collecting the data.
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2. Time series data: Time series data are data collected on one or
more variables at different times such data may be collected a regular
time intervals, such as daily (eg. Stock prices, weather reports),
weekly (eg. Money Supply figures) Monthly (eg. Unemployment rate,
consumer price Index-CPI), quarterly (eg. GDP), annually (eg.
Government budgets, infant mortality rates) etc.
3. Pooled data: Pooled data is a data obtained by combining both
cross-sectional and time series data.
 A data collected on house hold surveys from sampled households
for two different years is a pooled data.
 For example, a random sample of households is surveyed for
variables such as income, saving, family size and so on in 2010 in a
country. Similarity, a new random sample of households is taken
for the same variables in 2015 in the same country.
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 Panel, longitudinal or Micro panel Data: is a special

type of pooled data in which the same cross-sectional units
are surveyed over time. For example, the data on investment
and financial matters might collect from the same sampled
firms over a five years time period.
 The key feature of panel data that distinguishes it from the
pooled data is that the same cross-section units (eg.
Individuals, households, firms, countries) are surveyed in
each time period.
 1.3. Variables: quantitative and qualitative
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What are Variables ?

 Variables: are properties or characteristics of some event, object, or
person that can ‘take on’ different values or amounts.
 Variables may be.....
 independent or dependent;

 discrete or continuous; variables

 qualitative or quantitative.

1. Independent and dependent variables

 The dependent variable is a variable that is being predicted or
estimated where as the independent variables are variables used as
predictor and basis for estimation.
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2. Qualitative and quantitative variables
 Qualitative variables: are those that express a qualitative attribute such as
hair colour, eye colour, religion, favourite movie, gender, and so on.
 Quantitative variables: are those variables that are measured in terms of
numbers. Some examples of quantitative variables are height, weight, and
shoe size.
3. Discrete and continuous variables
 Discrete variables can take only certain values.
 For example, a household could have three children or six children, but
not 4.53 children.
 Continuous variables can take any value within the range of the scale.
 For example, ‘time to respond to a question’ are continuous variables
since the scale is continuous and not made up of discrete steps, say, the
response time could be 1.64 seconds.
2. Regression analysis
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