Chapter 1 An Introduction to Econometrics

1.1 Why Study Econometrics? Econometrics is a set of research tools also employed in the business disciplines of accounting, finance, marketing and management. It is also used by social scientists, specifically researchers in history, political science and sociology. Econometrics plays an important role in such diverse fields as forestry, and in agricultural economics. Studying econometrics fills a gap between being a student of economics and being a practicing economist. By taking this introduction to econometrics you will gain an overview of what econometrics is about, and develop some intuition about how things work.

Slide 1.1 Undergraduate Econometrics, 2nd Edition-Chapter 1

1.2 What is Econometrics? In economics we express our ideas about relationships between economic variables using the mathematical concept of a function.

For example, to express a relationship between income i and consumption c, we may write c = f (i )

The demand for an individual commodity, say the Honda Accord, might be expressed as q d = f ( p, p s , p c , i )

s c The quantity of Honda Accords demanded, qd, is a function f ( p, p , p , i ) of the

price of Honda Accords p, the price of cars that are substitutes ps, the price of items that are complements pc, like gasoline, and the level of income i. The supply of an agricultural commodity such as beef might be written as
Slide 1.2 Undergraduate Econometrics, 2nd Edition-Chapter 1

 q s = f ( p, p c , p f ) qs is the quantity supplied, p is the price of beef, pc is the price of competitive products in production (for example, the price of hogs), and pf is the price of factors or inputs (for example, the price of corn) used in the production process. Econometrics is about how we can use economic, business or social science theory and data, along with tools from statistics, to answer how much type questions.

Slide 1.3 Undergraduate Econometrics, 2nd Edition-Chapter 1

1.2.1

Some Examples

A question facing Alan Greenspan is How much should we increase the discount rate to slow inflation, and yet maintain a stable and growing economy? The answer will depend on the responsiveness of firms and individuals to increases in the interest rates and to the effects of reduced investment on Gross National Product. The key elasticities and multipliers are called parameters. The values of economic parameters are unknown and must be estimated using a sample of economic data when formulating economic policies.

Econometrics is about how to best estimate economic parameters given the data we have. Good econometrics is important, since errors in the estimates used by policy makers such as the FRB may lead to interest rate corrections that are too large or too small, which has consequences for all of us. Other examples include: A city council ponders the question of how much violent crime will be reduced if an additional million dollars is spent putting uniformed police on the street.
Slide 1.4 Undergraduate Econometrics, 2nd Edition-Chapter 1

 U.S. Presidential candidate Gore questions how many additional California voters will support him if he spends an additional million dollars in advertising in that state. The owner of a local Pizza Hut franchise must decide how much advertising space to purchase in the local newspaper, and thus must estimate the relationship between advertising and sales. Louisiana State University must estimate how much enrollment will fall if tuition is raised by $100 per semester, and thus whether its revenue from tuition will rise or fall. The CEO of Proctor & Gamble must estimate how much demand there will be in ten years for the detergent Tide, as she decides how much to invest in new plant and equipment. A real estate developer must predict by how much population and income will increase to the south of Baton Rouge, Louisiana, over the next few years, and if it will be profitable to begin construction of a new strip-mall.

Slide 1.5 Undergraduate Econometrics, 2nd Edition-Chapter 1

 You must decide how much of your savings will go into a stock fund and how much into the money market. This requires you to make predictions of the level of economic activity, the rate of inflation and interest rates over your planning horizon.

Slide 1.6 Undergraduate Econometrics, 2nd Edition-Chapter 1

1.3 The Econometric Model

When studying Honda car sales we recognize that the actual number of Hondas sold is the sum of this systematic part and a random and unpredictable component, e, that we will call a random error.

An econometric model representing the sales of Honda Accords is q d = f ( p, p s , p c , i ) + e The random error e accounts for the many factors that affect sales that we have omitted from this simple model, and it also reflects the intrinsic uncertainty in economic activity.

To complete the specification of the econometric model, we must also say something about the form of the algebraic relationship among our economic variables. For
Slide 1.7 Undergraduate Econometrics, 2nd Edition-Chapter 1

example, in your first economics courses quantity demanded was depicted as a linear function of price. We assume that the systematic part of the demand relation is linear f ( p, p s , p c , i ) = 1 + 2 p + 3 ps + 4 pc + 5 i The corresponding econometric model is q d = 1 + 2 p + 3 p s + 4 pc + 5 i + e

Slide 1.8 Undergraduate Econometrics, 2nd Edition-Chapter 1

1.4 How Do We Obtain Data? 1.4.1

Experimental Data

In an ideal world, from a researchers point of view, an economic model would describe how we might design an experiment that could be used to obtain economic observations or sample information, that then could be used to provide insights about the unknown economic parameters. Repeating the experiment T times would create a sample of T sample observations

Slide 1.9 Undergraduate Econometrics, 2nd Edition-Chapter 1

In an ideal world for research, controlled experiments could be conducted to

investigate the relationship between these explanatory variables and the dependent variable qd. For example, we might set p = price of Accords = $25,000 ps = price of Maximas = $25,000 pc = price of gasoline per gallon = $1.35 i = income of individuals in sample = $42,000

At the end of a month we observe the number of Honda Accords sold at one dealership to be qd = 37. By repeating this process a number of times, a sample of economic data is created. depends on the controlled explanatory variables and this random noise. Consequently, the experimental outcome is random too.
Slide 1.10 Undergraduate Econometrics, 2nd Edition-Chapter 1

The experimental outcome we observe is the sum of a systematic component that

 If we repeat the experiment a few times, we obtain observations such as those in Table 1.1.

Slide 1.11 Undergraduate Econometrics, 2nd Edition-Chapter 1

Table 1.1 Monthly Sales of Honda Accords month qd p ps pc 1 37 25 25 1.35 2 28 23 25 1.35 3 30 23 25 1.35 4 35 20 25 1.35 5 40 25 27 1.35 6 46 25 30 1.35 7 52 25 32 1.35 8 55 25 25 1.40 9 60 25 25 1.45 10 65 25 25 1.55

i 42 32 32 35 42 52 55 60 70 100

Slide 1.12 Undergraduate Econometrics, 2nd Edition-Chapter 1

We, the econometricians, wish to determine the relationship between each of the explanatory variables (p, pc, ps, i) and the dependent variable qd using a sample of T observations on values of the explanatory variables and the observed quantities sold.

1.4.2 Nonexperimental Data Most economic data are collected for administrative rather than research purposes, often by government agencies. The data may be collected in a:

time series formdata collected over discrete intervals of time. cross section formdata collected over sample units in a particular time period panel data formdata that follow individual micro-units over time.

Slide 1.13 Undergraduate Econometrics, 2nd Edition-Chapter 1

These data may be collected at various levels of aggregation:

microdata collected on individual economic decision making units such as macrodata resulting from a pooling or aggregating over individuals,

individuals, households or firms.

households or firms at the local, state or national levels. The data collected may also represent a flow or a stock:

flowoutcome measures over a period of time, such as the consumption of stockoutcome measured at a particular point in time, such as the quantity of

gasoline during the last quarter of 1999.

crude oil held by Chevron in its US storage tanks April 1, 1999

Slide 1.14 Undergraduate Econometrics, 2nd Edition-Chapter 1

The data collected may be quantitative or qualitative:

quantitativeoutcomes such as prices or income that may be expressed as qualitativeoutcomes that are of an either-or situation. For example, a

numbers or some transformation of them, such as real prices or per capita income.

consumer either did or did not make a purchase of a particular good, or a person either is or is not married. 1.5 Statistical Inference The phrase statistical inference will appear often in this book. By this we mean we want to infer or learn something about the real world by analyzing a sample of data. The ways in which statistical inference are out carried include: Estimating economic parameters, such as elasticities, using econometric methods.
Slide 1.15 Undergraduate Econometrics, 2nd Edition-Chapter 1

 Predicting economic outcomes, such as the enrollment in 2-year colleges in the U.S. for the next 10 years. Testing economic hypotheses, such as the question of whether newspaper advertising is better than store displays for increasing sales.

Slide 1.16 Undergraduate Econometrics, 2nd Edition-Chapter 1

1.6 A Research Format 1. It all starts with a problem or question 2. Economic theory gives us a way of thinking about the problem: What economic variables are involved and what is the possible direction of the relationship(s)? 3. The working economic model leads to an econometric model. We must choose a functional form and make some assumptions about the nature of the error term. 4. Sample data are obtained, and a desirable method of statistical analysis chosen, based on our initial assumptions, and our understanding of how the data were collected. 5. Estimates of the unknown parameters are obtained with the help of a statistical software package, predictions are made and hypothesis tests are performed. 6. Model diagnostics are performed to check the validity of assumptions weve made. For example, were all of the right-hand-side explanatory variables relevant? Was the correct functional form used?
Slide 1.17 Undergraduate Econometrics, 2nd Edition-Chapter 1

7. The economic consequences and the implications of the empirical results are analyzed and evaluated. What economic resource allocation and distribution results are implied, and what are their policy-choice implications? What remaining questions might be answered with further study or new and better data?

Slide 1.18 Undergraduate Econometrics, 2nd Edition-Chapter 1