Econometrics for Management

Chapter 1: introduction to econometrics

Definition of Econometrics: - Econometrics deals with measurement of economic relationships
between economic variables (dependent & independent variables). The term econometrics is
derived from two Greek words. I.e. economy & measure. Different economists give different
definition for Econometrics, but all of them are arriving at the same conclusions and we can boils
down the whole definition in to the following.
“Econometrics is the positive interaction between data & ideas about the way the economy
works. “The central role of Econometrics was often regarded as one of estimating the parameters
of the model as efficient way as possible, given a particular set of data with which to apply
statistical & mathematical techniques. To test the validity of Economic theory Econometrics
provides us numerical values for the parameters of economic relationships & using these
numerical values, we can verify the economic theories. To arrive at these numerical values of
economic relationships we use economic theory, mathematics & statistics. Though econometrics
uses all these it is different from each one of them due to its distinctive nature. One of the most
distinctive natures of Econometrics is that it contains the random term which is not reflected in
mathematical economics & economic theory
Methodology of econometrics
Econometric research is concerned with the measurement of the parameters of economic
relationships and with the predication of the values of economic variables. The relationships of
economic theory which can be measured with econometric techniques are relationships in which
some variables are postulated as causes of the variation of other variables. Starting with the
postulated theoretical relationships among economic variables, econometric research or inquiry
generally proceeds along the following lines/stages.
1. Specification the model
2. Estimation of the model
3. Evaluation of the estimates
4. Evaluation of he forecasting power of the estimated model
1. Specification of the model
In this step the econometrician has to express the relationships between economic variables in
mathematical form. This step involves the determination of three important tasks:

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 i) The dependent and independent (explanatory) variables, which will be
included in the model.
ii) The a priori theoretical expectations about the size and sign of the parameters
of the function.
iii) The mathematical form of the model (number of equations, specific form of
the equations, etc.)
Note: The specification of the econometric model will be based on economic theory and on any
available information related to the phenomena under investigation. Thus, specification of the
econometric model presupposes knowledge of economic theory and familiarity with the
particular phenomenon being studied.
Specification of the model is the most important and the most difficult stage of any econometric
research. It is often the weakest point of most econometric applications. In this stage, there
exists enormous degree of likelihood of committing errors or incorrectly specifying the model.
Some of the common reasons for incorrect specification of the econometric models are:
1. The imperfections, looseness of statements in economic theories.
2. The limitation of our knowledge of the factors, which are operative in any particular
case.
3. The formidable obstacles presented by data requirements in the estimation of large
models.
The most common errors of specification are:
a. Omissions of some important variables from the function.
b. The omissions of some equations (for example, in simultaneous equations model).
c. The mistaken mathematical form of the functions.
2. Estimation of the model
This is purely a technical stage, which requires knowledge of the various econometric methods,
their assumptions and the economic implications for the estimates of the parameters. This stage
includes the following activities.
a. Gathering of the data on the variables included in the model.
b. Examination of the identification conditions of the function (especially
for simultaneous equations models).

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 c. Examination of the aggregations problems involved in the variables of
the function.
d. Examination of the degree of correlation between the explanatory
variables (i.e. examination of the problem of multicollinearity).
e. Choice of appropriate economic techniques for estimation, i.e. to
decide a specific econometric method to be applied in estimation; such
as, OLS, MLM, Logit, and Probit.
3. Evaluation of the estimates
This stage consists of deciding whether the estimates of the parameters are theoretically
meaningful and statistically satisfactory. This stage enables the econometrician to evaluate the
results of calculations and determine the reliability of the results. For this purpose, we use
various criteria, which may be classified into three groups:
i. Economic a priori criteria: These criteria are determined by economic theory and
refer to the size and sign of the parameters of economic relationships.
ii. Statistical criteria (first-order tests): These are determined by statistical theory and
aim at the evaluation of the statistical reliability of the estimates of the parameters of
the model. Correlation coefficient test, standard error test, t-test, F-test, and R2-test
are some of the most commonly used statistical tests.
iii. Econometric criteria (second-order tests): These are set by the theory of
econometrics and aim at the investigation of whether the assumptions of the
econometric method employed are satisfied or not in any particular case. The
econometric criteria serve as a second order test (as test of the statistical tests) i.e.
they determine the reliability of the statistical criteria; they help us establish whether
the estimates have the desirable properties of unbiasedness, consistency etc.
Econometric criteria aim at the detection of the violation or validity of the
assumptions of the various econometric techniques.

4) Evaluation of the forecasting power of the model:

Forecasting is one of the aims of econometric research. However, before using an estimated
model for forecasting by some way or another the predictive power of the model. It is possible
that the model may be economically meaningful and statistically and econometrically correct for

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the sample period for which the model has been estimated; yet it may not be suitable for
forecasting due to various factors (reasons). Therefore, this stage involves the investigation of
the stability of the estimates and their sensitivity to changes in the size of the sample.
Consequently, we must establish whether the estimated function performs adequately outside the
sample of data. i.e. we must test an extra sample performance the model.
Types of Variables:
Quantitative and Qualitative
Quantitative variables: are variables (outcomes) that may be expressed as numbers or some
transformation of them. Example: prices or income such as real prices or per capita income,
wage, interest rate, etc.
Qualitative variables: are variables (outcomes) that are of an ''either-or'' situation. For example,
a consumer either did or did not make a purchase of a particular good, or a person either is or is
not married, a customer is satisfied or not satisfied with the service,
Population, Sample and Random variable
Population:-Collection of all the sampling units in a given region at a particular point of time or
a particular period is called the population.
Sample is one or more sampling units selected from the population according to some specified
procedure
Sampling: The process or method of sample selection from the population.
Parameter: Characteristic or measure obtained from a population.
Estimator: Characteristic or measure obtained from a sample.
 Random variables: is a numerical summary of random outcome.  For example, the number
of times that the power interrupted while you are reading in the library is random and takes on a
numerical value, so it is a random variable.  In the experiment of tossing a coin 3 times, we
could define X as a random variable "the total number of heads."
 There are two kinds of random variables (RV):
I. Discrete RV- is a variable which takes on only a finite (or countably infinite) number of
values, like 0,1,2,3,....
II. Continuous RV- is a variable, which can take any value in the real line within a bounded
or unbounded interval.

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Time Series Data: A time series is a set of observations on the values that a variable takes at
different times. Such data may be collected at regular time intervals, such as daily (e.g., stock
prices, weather reports), weekly (e.g., money supply figures), monthly [e.g., the unemployment
rate, the Consumer Price Index (CPI)], quarterly (e.g., GDP), annually (e.g., government
budgets).
Cross-Section Data: Cross-section data are data on one or more variables collected at the same
point in time, such as the census of population conducted by the Census Bureau at specific year.
Pooled Data: In pooled, or combined, data are elements of both time series and cross-section
data.
Panel data: a special type of pooled data in which the same cross-section unit is surveyed
overtime.
Measures of Central Tendency & Dispersion
Measures that indicate the approximate center of a distribution are called measures of central
tendency. Measures that describe the spread of the data are measures of dispersion. These
measures include the mean, median, mode,
The measures of central dispersion includes range, upper and lower quartiles, variance, and
standard deviation.
Types of Data
Three types of data may be available for empirical analysis: time series, cross-section, and
pooled (i.e., combination of time series and cross-section) data.