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Chapter 1: The Nature of Econometrics and Economic Data

Chapter 2: The Simple Regression Model
PA R T

Chapter 3: Multiple Regression Analysis: Estimation

Chapter 4: Multiple Regression Analysis: Inference

Chapter 5: Multiple Regression Analysis: OLS Asymptotics

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Chapter 6: Multiple Regression Analysis: Further Issues

P A R T

Chapter 7: Multiple Regression Analysis with Qualitative

Information: Binary (or Dummy) Variables
Chapter 8: Heteroskedasticity

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 Chapter 1

The Nature of Econometrics and

Economic Data

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 Outline
1. What Is Econometrics?
2. Steps in Empirical Economic Analysis
3. The Structure of Economic Data
4. Causality and the Notion of Ceteris Paribus in
Econometric Analysis

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 1. What Is
Econometrics?

1. What Is Econometrics?

• What is econometrics?
– Econometrics => use of statistical methods to analyze economic data
– Econometricians typically analyze nonexperimental data

• Typical goals of econometric analysis

– Estimating relationships between economic variables
– Testing economic theories and hypotheses
– Forecasting economic variables
– Evaluating and implementing government and business policy

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 1. What Is
Econometrics?

Types of data
• Experimental data: often collected in laboratory
environments in the natural sciences, but they are
much more difficult to obtain in the social sciences
• Nonexperimental (observational or retrospective)
data: main type of data used in the social sciences

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 2. Steps in Empirical Economic
Analysis

2. Steps in Empirical Economic Analysis

Steps in econometric analysis:

1) Economic model (this step is often skipped)
2) Econometric model

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 2. Steps in Empirical Economic
Analysis

1. Economic models

– Maybe micro- or macromodels

– Often use optimizing behaviour, equilibrium modeling, …
– Establish relationships between economic variables
– Examples: demand equations, pricing equations, …

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 2. Steps in Empirical Economic
Analysis

1. Economic models

• Economic model of crime (Becker (1968))

– Derives equation for criminal activity based on
utility maximization

Hours spent in
criminal
activities
Age
“Wage” of cri-
minal activities Probability of Expected
Wage for legal
employment Other
Probability of conviction if sentence
income
getting caught caught
– Functional form of relationship not specified
– Equation could have been postulated without
economic modeling

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 2. Steps in Empirical Economic
Analysis

1. Economic models
• Model of job training and worker productivity
– What is effect of additional training on worker
productivity?
– Formal economic theory not really needed to
derive equation:

Hourly wage

Years of formal
education Weeks spent
Years of work- in job training
force experience

– Other factors may be relevant, but these are the

most important (?)

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 2. Steps in Empirical Economic
Analysis

2. Econometric models

• Econometric model of criminal activity

– The functional form has to be specified
– Variables may have to be approximated by other
quantities

Measure of Wage for legal Other Frequency of

cri- minal employment income prior arrests
activity Unobserved deter-
minants of
criminal activity

e.g. moral character,

wage in criminal
Frequency of Average sentence Age activity, family
conviction length after conviction background …

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 2. Steps in Empirical Economic
Analysis

2. Econometric models

• Econometric model of job training and worker

productivity
Unobserved deter-
minants of the
wage
e.g. innate ability,
Hourly wage Years of formal Years of work- Weeks spent quality of education,
education force experience in job training family background
…
• Most of econometrics deals with the specification of
the error u
• Econometric models may be used for hypothesis
testing
– For example, the parameter represents “effect of
training on wage”
– How large is this effect? Is it different from zero?

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 3. The Structure of Economic
Data

3. The Structure of Economic Data

• Econometric analysis requires data

• Different kinds of economic data sets
– Cross-sectional data
– Time series data
– Pooled cross sections
– Panel/Longitudinal data

• Econometric methods depend on the nature

of the data used
– Use of inappropriate methods may lead to
misleading results

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 3. The Structure of Economic
Data

• Cross-sectional data sets

– Sample of individuals, households, firms, cities, states,
countries, or other units of interest at a given point of
time/in a given period
– Cross-sectional observations are more or less
independent.
For example, pure random sampling from a
population
– Sometimes pure random sampling is violated, e.g. units
refuse to respond in surveys, or if sampling is characterized
by clustering
– Cross-sectional data typically encountered in applied
microeconomics

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 3. The Structure of Economic
Data

Cross-sectional data set on wages

and other characteristics

Indicator variables
(1 = yes, 0 = no)

Observation number Hourly wage Years of Years of

education experience

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 3. The Structure of Economic
Data

Cross-sectional data on growth rates and

country characteristics

Average growth rate of real Government consumption Adult secondary

per capita GDP as a percentage of GDP education
rates

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 3. The Structure of Economic
Data

• Time series data

– Observations of a variable or several variables over time
– For example, stock prices, money supply, consumer price
index, gross domestic product, annual homicide
rates, automobile sales, …
– Time series observations are typically serially
correlated
– Ordering of observations conveys important
information
– Data frequency: daily, weekly, monthly, quarterly,
annually, …
– Typical features of time series: trends and
seasonality
– Typical applications: applied macroeconomics
and
finance 16
 3. The Structure of Economic
Data

Time series data on minimum wages and related

variables

Average minimum Average Unemployment Gross national

wage for the given year coverage rate rate product

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 3. The Structure of Economic
Data

• Pooled cross sections

– Two or more cross sections are combined in one data set
– Cross sections are drawn independently of each other
– Pooled cross sections often used to evaluate policy
changes
– Example:
• Evaluate effect of change in property taxes on house
prices
• Random sample of house prices for the year 1993
• A new random sample of house prices for the year
1995
• Compare before/after (1993: before reform, 1995: after
reform)

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 3. The Structure of Economic
Data

Pooled cross sections on housing

prices
Property tax
Size of house
in square
feet
Number of bedrooms
Number of bathrooms

Before reform

After reform

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 3. The Structure of Economic
Data

• Panel or longitudinal data

– The same cross-sectional units are followed over time
– Panel data have a cross-sectional and a time series
dimension
– Panel data can be used to account for time-invariant
unobservables
– Panel data can be used to model lagged responses
– Example:
• City crime statistics; each city is observed in two
years
• Time-invariant unobserved city characteristics may be
modeled
• Effect of police on crime rates may exhibit time lag

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 3. The Structure of Economic
Data

Two-year panel data on city crime statistics

Each city has two time

series observations

Number of
police in 1986

Number of
police in 1990

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 4. Causality and the Notion of Ceteris Paribus in Econometric
Analysis

4. Causality and the Notion of Ceteris Paribus in

Econometric Analysis
• Causality and the notion of ceteris paribus
Definition of causal effect of on :

“How does variable change if variable is

changed but all other relevant factors are held
constant”

• Most economic questions are ceteris paribus

questions
• It is important to define which causal effect one is
interested in
• It is useful to describe how an experiment would have to
be designed to infer the causal effect in question
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 4. Causality and the Notion of Ceteris Paribus in Econometric
Analysis

• Example: Causal effect of fertilizer on crop yield

– “By how much will the production of soybeans increase if
one increases the amount of fertilizer applied to the ground”
– Implicit assumption: all other factors that influence crop
yield such as quality of land, rainfall, presence of
parasites etc. are held fixed

• Experiment:
– Choose several one-acre plots of land; randomly assign
different amounts of fertilizer to the different plots; compare
yields
– Experiment works because amount of fertilizer applied is
unrelated to other factors influencing crop yields

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 4. Causality and the Notion of Ceteris Paribus in Econometric
Analysis

• Example: Measuring the return to education

– “If a person is chosen from the population and given
another year of education, by how much will his
or her wage increase?”
– Implicit assumption: all other factors that influence wages
such as experience, family background, intelligence etc. are
held fixed

• Experiment:
– Choose a group of people; randomly assign different
amounts of education to them (infeasible!); compare wage
outcomes
– Problem without random assignment: amount of education
is related to other factors that influence wages (e.g.
intelligence)
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 4. Causality and the Notion of Ceteris Paribus in Econometric
Analysis

• Example: Effect of law enforcement on city crime

level
– “If a city is randomly chosen and given ten additional police
officers, by how much would its crime rate fall?”
– Alternatively: “If two cities are the same in all respects,
except that city A has ten more police officers than city B, by
how much would the two cities‘ crime rates differ?”

• Experiment:
– Randomly assign number of police officers to a large
number of cities
– In reality, number of police officers will be determined by
crime rate (simultaneous determination of crime and
number of police)

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 4. Causality and the Notion of Ceteris Paribus in Econometric
Analysis

• Example: effect of the minimum wage on

unemployment
– “By how much (if at all) will unemployment increase if the
minimum wage is increased by a certain amount (holding
other things fixed)?”

• Experiment:
– Government randomly chooses minimum wage each year
and observes unemployment outcomes
– Experiment will work because level of minimum wage is
unrelated to other factors determining
unemployment
– In reality, the level of the minimum wage will depend on
political and economic factors that also influence
unemployment
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 Summar
y

Summary
– Econometrics is used in all applied economics fields to test
economic theories.
– Sometimes, an econometric model is derived from a formal
economic model, but in other cases, econometric models are
based on informal economic reasoning and intuition.
– The goals of any econometric analysis are to estimate the
parameters in the model and to test hypotheses about
these parameters.
– Cross-sectional, time series, pooled cross-sectional, and
panel data are the most common types of data structures.
– In most cases, hypotheses in the social sciences are ceteris
paribus in nature.
– Because of the nonexperimental nature of most data collected
in the social sciences, uncovering causal relationships is very
challenging.

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