CHAPTER ONE

Introduction to the nature of

Econometrics
Outline
⁜ Definition of econometrics
⁜ Goals of Econometrics
⁜ Methodology of Econometrics
⁜ Sample, population and random variable
⁜ Types of Data
⁜ Qualitative & Quantitative Variables
⁜ Scales of Measurement and data
⁜ Measures of centralization, dispersion and position

By: Kirsneh A. (MSc.)

 What is Econometrics?
Definition
 Econometrics refers to the quantitative analysis of actual
economic phenomena based on the concurrent
development of theory and observation, related by
appropriate methods of inference
 Econometrics = econo+ metrics (Variable + measurement)
 Econo-metrics: “measurement in economics”.
 Economic theory suggests relationships between economic variables.
Econometrics
a) Test whether this relationship exists, and
b) Provide a magnitude for the effect?
 Generally, econometrics is a combination of economic theory,
mathematical economics and statistics, but it is completely distinct
from each one of these three branches of science.
The relationships and differences among these sciences.
 Economic theory makes statements or hypotheses that are
mostly qualitative in nature but the theory itself does not
provide any numerical measure of the relationship between the
two. It is the job of econometrician to provide such
numerical statements.
 Econometrics presupposes the expression of economic
relationships in mathematical form, like mathematical
economics it does not assume that economic relationships are
exact (deterministic).
 Economic Statistics is mainly concerned with collecting,
processing, and presenting economic data in the form of charts
and tables. It is mainly a descriptive aspect of economics but
econometrics is beyond that.
 Economics vs. Econometrics
• Economics: focus on “how” and “why”
• Econometrics: focus on “how much” and “by how much”
Example:
• Economist: “If the government increases alcohol excise
tax, consumers will cut down on their alcohol
consumption.”
• Econometrician: “If the government increases alcohol
excise tax by 20%, consumers will reduce their alcohol
consumption by 1%.”
Examples of questions we would like to study in
econometrics:
1. What is the effect of an increase in the marginal income
tax rate on the supply of labour?
2. What is the effect of a retraining programme on the
duration of unemployment?
3. What is the effect of an additional year of education on
earnings?
4. How is stock price volatility related to macroeconomic
factors?
 Goals of Econometrics
Three main goals of econometrics
1. Testing Economic Theory: Economic theories developed in
an abstract level that were not tested against economic
reality. Econometrics aims primarily at the verification of
economic theories.
2. Policy-Making: The knowledge of the numerical value of
the coefficients in econometrics is very important for the
decisions of firms as well as for the formulation of the
economic policy of the government.
3. Forecasting: In formulating policy decisions it is essential to
be able to forecast the value of the economic magnitudes.
 Methodology of Econometrics
• How do econometricians proceed in their analysis of an
economic problem? That is, what is their methodology?
• Econometric methodology proceeds along the following
lines or steps:
1. Statement of theory or hypothesis.
2. Specification of the mathematical model of the theory.
3. Specification of the 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 policy purposes.
 Step 1. Statement of Theory or Hypothesis
•
• 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.
• The variable appearing on the left side of the equality sign is
called the dependent variable and the variable(s) on the right
side is called the independent, or explanatory variable(s).
• Consumption (expenditure) is the dependent variable and income
is the explanatory variable.
• The econometrician should be able to make a list of the variables
that might influence the dependent variable by checking:
 General economics theories,
 Previous studies in any particular field and
 The actual behavior of the economic agents may indicate the
general factors that affect the dependent variable.
 Step 3. Specification of the Econometric Model
of Consumption
•
• Is an example of an econometric model. More technically, it is
an example of a linear regression model, which is the major
concern of this course.
Step 4. Obtaining Data
• To estimate the econometric model and to obtain the numerical
values of β1 and β2, we need data. We need data on
consumption expenditure and income.
Step 5. Estimation of the Econometric Model
• Once we have the data, our next task is to estimate the
parameters of the consumption function. At this step we
consider the following.
 Examination of the degree of correlation between the
explanatory variables.
 Choice of the appropriate econometric technique for the
estimation of the function
 6. Hypothesis Testing
• Based on our finding, is MPC statistically less than 1? If it is,
it may support Keynes’s theory.
• Such confirmation of economic theories on the basis of sample
evidence is based on a branch of statistical theory known as
statistical inference (hypothesis testing).
7. Forecasting or Prediction
• If the chosen model does not refute the hypothesis or theory
under consideration, we may use it to predict the future
value(s) of the dependent, or forecast, variable Y on the basis
of the known or expected future value(s) of the explanatory, or
predictor, variable X.
8. Use of the Model for Policy Purposes
• Using estimated model may be used for control, or policy,
purposes. By appropriate policy mix, the government can
manipulate the control variable X to produce the desired level
of the target variable Y.
Summarizes econometric methodology
 Population, Sample, random variable
• The statistician tries to make inferences from samples to
populations.
• It is important to distinguish between a sample and a population.
• A population consists of all subjects (human or otherwise) that
are being studied.
• Most of the time, due to the expense, time, size of population,
medical concerns, etc., it is not possible to use the entire
population for a statistical study; therefore, researchers use
samples.
• A sample is a group of subjects selected from a population.
• If the subjects of a sample are properly selected, most of the time
they should possess the same or similar characteristics as the
subjects in the population.
 Random variables
• A variable was defined as a characteristic or attribute that
can assume different values.
• Various letters of the alphabet, such as X, Y, or Z, are used
to represent variables. Since the variables are associated
with probability, they are called random variables.
• A random variable is a variable whose values are
determined by chance.
• Random variable uses the probability experiment of tossing
three coins. Recall that when three coins are tossed, the
sample space is represented as TTT, TTH, THT, HTT, HHT,
HTH, THH, HHH; and if X is the random variable for the
number of heads, then X assumes the value 0, 1, 2, or 3.
 Types of Data
© Cross-sectional data.
© Time series.
© Pooled cross sections and panel data.
 1. Cross-sectional data

• Each observation is a new individual, household, firm,

etc.. With information at a point in time.
• 1 observation= information about 1 cross-sectional
unit
• cross-sectional units: individuals, households, firms,
cities or states that data taken at a given point in time
• Examples: Data on expenditures, income, hours of
work, household composition, assets, investments,
employment, etc..
• Cross sectional data is usually a random sample of the
underlying population.
Table 1: Cross sectional data set example on wage

Observation wage education experience Age female

1 105.25 12 6 45 0

2 130.40 18 7 36 1

…… …… …… ……… …….. ……

200 200.50 20 10 42 1
 2. Time series data
• A time series is a set of observations on the values that a
variable takes at different times.
• Time series data consists of observations on a set of variables
over time.
• Such data may be collected at regular time intervals, such as:
daily, weekly, monthly , quarterly and annually.
• Separate observation for each time period.
• Ordering of observations does matter.
• Example: Typically Macroeconomic measures: GDP, Inflation,
Prices, Exchange Rates, Interest Rates, etc..
Table 2: Time series data set example for Ethiopia GDP, inflation
and population growth
Year Inflation (%) Population growth(%) GDP in Billion US $
2000 6.1 2.88 8.24
2001 8.3 2.88 8.23
2002 1.5 2.87 7.85
2003 2.2 2.85 8.62
2004 13.6 2.83 10.13
2005 11.8 2.80 12.40
2006 10.8 2.77 15.28
2007 11.5 2.75 19.71
2008 10.8 2.74 27.07
2009 8.8 2.76 32.44
2010 12.6 2.78 29.93
2011 11.2 2.81 31.95
2012 8.6 2.83 43.31
2013 10.6 2.83 47.65
2014 10.3 2.80 55.61
2015 10.4 2.76 64.59
 Pooled Cross Sections
• Both cross-sectional and time-series features
• A number of similar cross sections over time.
• Data collected in multiple (typically, two) points in time.
 E.g. survey of households in two years.
 Identical questions in each survey but a different set of
households sampled.
• Pooling is often used to increase sample size.
• Ordering is not crucial, year is recorded as an additional
variable.
• Typical application: evaluation of the effect of a policy change
(before and after).
Table 3: Pooled cross-sections: two years of household income
Observation year HHs income HHs size education
1 2019 80000 4 18
2 2019 65000 5 16
3 2019 90000 2 14
… …. …. …. ….
… …. …. …. ….
250 2019 120000 6 10
251 2020 75000 4 18
252 2020 68000 3 15
… …. …. …. ….
… …. …. …. ….
540 2020 135000 3 17
 Panel (longitudinal) Data
• This is a special type of pooled data in which the same cross-
sectional unit (say, a family or a firm) is surveyed over time.
• Similar to pooled cross sections with one important difference.
 Responses are related to the same cross sectional unit
(individual, firm, country) over time.
Table 4: Panel (longitudinal) Data set example

Population GDP in Billion

Country Year GDP growth growth US$
Ethiopia 2017 2.91 2.66 81.77
Ethiopia 2018 2.60 2.62 84.27
Ethiopia 2019 1.81 2.58 96.11
Kenya 2017 4.81 2.36 78.97
Kenya 2018 6.32 2.31 87.78
Kenya 2019 5.37 2.27 95.50
Sudan 2017 4.28 2.40 45.38
Sudan 2018 -2.32 2.39 26.08
Sudan 2019 -2.56 2.39 18.90
 Variables: Qualitative & Quantitative
• Variables can be classified as qualitative or quantitative.
• Qualitative variables are variables that can be placed into
distinct categories, according to some characteristic or
attribute. For example, if subjects are classified according to
gender (male or female), then the variable gender is
qualitative.
• Other examples of qualitative variables are religious
preference and geographic locations.
• Quantitative variables are numerical and can be ordered or
ranked.
• For example, the variable age is numerical, and people can be
ranked in order according to the value of their ages.
• Other examples of quantitative variables are heights, weights,
and body temperatures.
 Cont.…
• Quantitative variables can be further classified into two
groups: discrete and continuous.
 Discrete variables can be assigned values such as 0, 1, 2, 3
and are said to be countable.
Examples of discrete variables are the number of children in a
family, class room and etc.
 Continuous variables, by comparison, can assume an infinite
number of values in an interval between any two specific
values.
Examples of Continuous variables are the heights and weights of
someone
The classification of variables can be summarized as
follows:
 Scales of measurement in data

Scales of measurement refer to ways in which

variables/numbers are defined and categorized. There are four
common scales of measurement:
Nominal, Ordinal, Interval and Ratio (Scale)
 Nominal data: is a categorical data where there is no inherent
order to the categories.
 E.g., (1) Religion: Muslim, Orthodox, Catholic and others
 E.g., (2) Ethnicity: Amhara, Oromo, Gurage, and others.
• But we cannot carry out any arithmetic operation (addition,
subtraction, division or multiplication) on the value attached to
each category
 Ordinal data: Categorical data where there is a meaningful
order of categories, but there is no measurable distance
between categories
For example, there is an order to the values high, medium, and
low, but the "distance" between the values cannot be calculated.
• The values assumed or assigned here are meant to explain or
show comparison/Rank.
• And we cannot apply any of the arithmetic operations.
Examples: Language ability (e.g., beginner, intermediate, fluent)
For these variables the ordering exists but the distances between
the categories cannot be quantified.
• Interval Data: You can categorize, rank, and infer a
measurable distance between categories, but there is no true
zero point.
• Example., A zero on a test is arbitrary; it does not mean that
the test-taker has an absolute lack of the trait being measured
• Example., temperature, heartbeat, blood pressure, and grade
ranking.
 Ratio (Scale) Data: Measured on an interval or ratio scale,
where the data values indicate both the order of values and the
distance between values.
• There is a true zero point. In ratio scales, zero does mean an
absolute lack of the variable.
• For example, Height, Age, Weight
 Measures of centralization and dispersion

• Measures that indicate the approximate centre of a distribution

are called measures of central tendency.
Example, include the mean, median and mode
• Measures that describe the spread of the data are measures of
dispersion.
Example, Range, variance, standard deviation.
• Measures of Positions: are used to locate the relative position
of a data value in the data set.
Example, percentiles, deciles, and quartiles