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Dougherty

Introduction to Econometrics,
5th edition
Chapter heading
Review: Random Variables,
Sampling, Estimation, and
Inference

© Christopher Dougherty, 2016. All rights reserved.

 CONFIDENCE INTERVALS

null hypothesis
probability density function of X
conditional on m = m0 being true
H0: m = m0

2.5% 2.5%

m0–1.96sd m0–sd m0 m0+sd m0+1.96sd X

In the sequence on hypothesis testing, we started with a given hypothesis, for example H0:
m = m0, and considered whether an estimate X derived from a sample would or would not
lead to its rejection.
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 CONFIDENCE INTERVALS

null hypothesis
probability density function of X
conditional on m = m0 being true
H0: m = m0

2.5% 2.5%

m0–1.96sd m0–sd m0 m0+sd m0+1.96sd X

Using a 5% significance test, this estimate would not lead to the rejection of H0.

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 CONFIDENCE INTERVALS

null hypothesis
probability density function of X
conditional on m = m0 being true
H0: m = m0

2.5% 2.5%

m0–1.96sd m0–sd m0 m0+sd m0+1.96sd X

This estimate would cause H0 to be rejected.

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 CONFIDENCE INTERVALS

null hypothesis
probability density function of X
conditional on m = m0 being true
H0: m = m0

2.5% 2.5%

m0–1.96sd m0–sd m0 m0+sd m0+1.96sd X

So would this one.

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 CONFIDENCE INTERVALS

null hypothesis
probability density function of X
conditional on m = m0 being true
H0: m = m0

acceptance region for X

2.5% 2.5%

m0–1.96sd m0–sd m0 m0+sd m0+1.96sd X

We ended by deriving the range of estimates that are compatible with H0 and called it the
acceptance region.

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 CONFIDENCE INTERVALS

Now we will do exactly the opposite. Given a sample estimate, we will find the set of
hypotheses that would not be contradicted by it, using a two-tailed 5% significance test.

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 CONFIDENCE INTERVALS

null hypothesis
H0: m = m0

m0 X

Suppose that someone came up with the hypothesis H0: m = m0.

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 CONFIDENCE INTERVALS

null hypothesis
probability density function of X
conditional on m = m0 being true
H0: m = m0

m0–1.96sd m0–sd m0 X m0+1.96sd

To see if it is compatible with our sample estimate X, we need to draw the probability
distribution of X conditional on H0: m = m0 being true.

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 CONFIDENCE INTERVALS

null hypothesis
probability density function of X
conditional on m = m0 being true
H0: m = m0

m0–1.96sd m0–sd m0 X m0+1.96sd

To do this, we need to know the standard deviation of the distribution. For the time being
we will assume that we do know it, although in practice we have to estimate it.

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 CONFIDENCE INTERVALS

null hypothesis
probability density function of X
conditional on m = m0 being true
H0: m = m0

m0–1.96sd m0–sd m0 X m0+1.96sd

Having drawn the distribution, it is clear this null hypothesis is not contradicted by our
sample estimate.

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 CONFIDENCE INTERVALS

null hypothesis
H0: m = m1

X m1

Here is another null hypothesis to consider.

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 CONFIDENCE INTERVALS

null hypothesis
probability density function of X
conditional on m = m1 being true
H0: m = m1

m1–1.96sd X m1 m1+sd m1+1.96sd

Having drawn the distribution of X conditional on this hypothesis being true, we can see
that this hypothesis is also compatible with our estimate.

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 CONFIDENCE INTERVALS

null hypothesis
H0: m = m2

m2 X

Here is another null hypothesis.

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 CONFIDENCE INTERVALS

null hypothesis
probability density function of X
conditional on m = m2 being true
H0: m = m2

m2–1.96sd m2–sd m2 m2+sd X

It is incompatible with our estimate because the estimate would lead to its rejection.

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 CONFIDENCE INTERVALS

null hypothesis
probability density function of X
conditional on m = m max being true
H0: m = m max

X mmax–sd mmax mmax+sd mmax+1.96sd

The highest hypothetical value of m not contradicted by our sample estimate is shown in the
diagram.

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 CONFIDENCE INTERVALS

null hypothesis
probability density function of X
conditional on m = m max being true
H0: m = m max

X mmax–sd mmax mmax+sd mmax+1.96sd

When the probability distribution of X conditional on it is drawn, it implies X lies on the

edge of the left 2.5% tail. We will call this maximum value mmax.

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 CONFIDENCE INTERVALS

null hypothesis
probability density function of X
conditional on m = m max being true
H0: m = m max

X mmax–sd mmax mmax+sd mmax+1.96sd

If the hypothetical value of m were any higher, it would be rejected because X would lie
inside the left tail of the probability distribution.

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 CONFIDENCE INTERVALS

null hypothesis
probability density function of X
conditional on m = m max being true
H0: m = m max

reject any m > mmax

X = mmax – 1.96 sd

X mmax–sd mmax mmax+sd mmax+1.96sd

Since X lies on the edge of the left 2.5% tail, it must be 1.96 standard deviations less than
mmax.

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 CONFIDENCE INTERVALS

null hypothesis
probability density function of X
conditional on m = m max being true
H0: m = m max

reject any m > mmax

X = mmax – 1.96 sd
mmax = X + 1.96 sd
reject any m > X + 1.96 sd

X mmax–sd mmax mmax+sd mmax+1.96sd

Hence, knowing X and the standard deviation, we can calculate mmax.

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 CONFIDENCE INTERVALS

null hypothesis
probability density function of X
conditional on m = m min being true
H0: m = m min

mmin–1.96sd mmin–sd mmin mmin +sd X

In the same way, we can identify the lowest hypothetical value of m that is not contradicted
by our estimate.

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 CONFIDENCE INTERVALS

null hypothesis
probability density function of X
conditional on m = m min being true
H0: m = m min

mmin–1.96sd mmin–sd mmin mmin +sd X

It implies that X lies on the edge of the right 2.5% tail of the associated conditional
probability distribution. We will call it mmin.

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 CONFIDENCE INTERVALS

null hypothesis
probability density function of X
conditional on m = m min being true
H0: m = m min

mmin–1.96sd mmin–sd mmin mmin +sd X

Any lower hypothetical value would be incompatible with our estimate.

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 CONFIDENCE INTERVALS

null hypothesis
probability density function of X
conditional on m = m min being true
H0: m = m min

reject any m < m min

X = m min + 1.96 sd
m min = X – 1.96 sd
reject any m < X – 1.96 sd

mmin–1.96sd mmin–sd mmin mmin +sd X

Since X lies on the edge of the right 2.5% tail, X is equal to mmin plus 1.96 standard
deviations. Hence mmin is equal to X minus 1.96 standard deviations.

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 CONFIDENCE INTERVALS

probability density function of X

(1) conditional on m = m max being true
(2) conditional on m = m min being true

(2) (1)

mmin–1.96sd mmin–sd mmin mmin +sd X mmax–sd mmax mmax+sd mmax+1.96sd

The diagram shows the limiting values of the hypothetical values of m, together with their
associated probability distributions for X.

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 CONFIDENCE INTERVALS

reject any m > m max = X + 1.96 sd

reject any m < m min = X – 1.96 sd
95% confidence interval:
X – 1.96 sd ≤ m ≤ X + 1.96 sd

(2) (1)

mmin–1.96sd mmin–sd mmin mmin +sd X mmax–sd mmax mmax+sd mmax+1.96sd

Any hypothesis lying in the interval from m min to m max would be compatible with the sample
estimate (not be rejected by it). We call this interval the 95% confidence interval.

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 CONFIDENCE INTERVALS

reject any m > m max = X + 1.96 sd

reject any m < m min = X – 1.96 sd
95% confidence interval:
X – 1.96 sd ≤ m ≤ X + 1.96 sd

(2) (1)

mmin–1.96sd mmin–sd mmin mmin +sd X mmax–sd mmax mmax+sd mmax+1.96sd

The name arises from a different application of the interval. It can be shown that it will
include the true value of the coefficient with 95% probability, provided that the model is
correctly specified.
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 CONFIDENCE INTERVALS

Standard deviation known

95% confidence interval

X – 1.96 sd ≤ m ≤ X + 1.96 sd
99% confidence interval
X – 2.58 sd ≤ m ≤ X + 2.58 sd

In exactly the same way, using a 1% significance test to identify hypotheses compatible
with our sample estimate, we can construct a 99% confidence interval.

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 CONFIDENCE INTERVALS

Standard deviation known

95% confidence interval

X – 1.96 sd ≤ m ≤ X + 1.96 sd
99% confidence interval
X – 2.58 sd ≤ m ≤ X + 2.58 sd

m min and m max will now be 2.58 standard deviations to the left and to the right of X,
respectively.

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 CONFIDENCE INTERVALS

Standard deviation known

95% confidence interval

X – 1.96 sd ≤ m ≤ X + 1.96 sd
99% confidence interval
X – 2.58 sd ≤ m ≤ X + 2.58 sd

Standard deviation estimated by standard error

95% confidence interval

X – tcrit (5%) se ≤ m ≤ X + tcrit (5%) se
99% confidence interval
X – tcrit (1%) se ≤ m ≤ X + tcrit (1%) se

Until now we have assumed that we know the standard deviation of the distribution. In
practice we have to estimate it.

29
 CONFIDENCE INTERVALS

Standard deviation known

95% confidence interval

X – 1.96 sd ≤ m ≤ X + 1.96 sd
99% confidence interval
X – 2.58 sd ≤ m ≤ X + 2.58 sd

Standard deviation estimated by standard error

95% confidence interval

X – tcrit (5%) se ≤ m ≤ X + tcrit (5%) se
99% confidence interval
X – tcrit (1%) se ≤ m ≤ X + tcrit (1%) se

As a consequence, the t distribution has to be used instead of the normal distribution when
locating m min and m max.

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 CONFIDENCE INTERVALS

Standard deviation known

95% confidence interval

X – 1.96 sd ≤ m ≤ X + 1.96 sd
99% confidence interval
X – 2.58 sd ≤ m ≤ X + 2.58 sd

Standard deviation estimated by standard error

95% confidence interval

X – tcrit (5%) se ≤ m ≤ X + tcrit (5%) se
99% confidence interval
X – tcrit (1%) se ≤ m ≤ X + tcrit (1%) se

This implies that the standard error should be multiplied by the critical value of t, given the
significance level and number of degrees of freedom, when determining the limits of the
interval.
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Copyright Christopher Dougherty 2016.

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Introduction to Econometrics, fifth edition 2016, Oxford University Press.
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2015.12.17