Econometrics – An Introduction

By

Dr. P.G. Vhankade

Head, Dept. of Economics,
PAH Solapur University, Solapur
 What is Econometrics?

• Simply, Econometrics, means “economic

measurement”.

• Some formal definitions:

Econometrics is concerned with the empirical
determination/quantification of theoretical
postulations – economics, management, political
science etc.
Econometrics is “defined as the social science in
which the tools of economic theory, mathematics,
and statistical inference are applied to the
analysis of economic phenomena (Goldberger,
1964).”

Econometrics “….. consists of the application of

mathematical statistics to economic data to lend
empirical support to the models constructed by
mathematical economics and to obtain numerical
results (Gerhard Tintner, 1968).”
Econometrics renders “a positive help in trying
to dispel the poor public image of economics ……
as a subject in which empty boxes are opened by
assuming the existence of can-openers to reveal
contents which any ten economists will interpret
in 11 ways.”
 Examples
• Consumption expenditure = F (Income, Wealth
etc)

• Hourly earnings = F (Education, Labour

productivity etc)

• Quantity Demanded = F (Price, Income of

consumer, Prices of relative commodities etc)

• Election Outcome = F (Economic performance,

Populism etc)
• Debt/Equity = F (Corporate tax rate, Capital
gains tax rate, Inflation rate etc)

• Sales = F (Price, Advertising expenses etc)

• Crop yield = F (Temperature, Rainfall, Fertilizer

use etc.)
 Why Study Econometrics?
(1)To provide empirical support to theories:

• Theories make statements or hypotheses that are

mostly qualitative in nature.

• They do not provide numerical measure of the

proposed ideas.

• Example: Law of Demand in Economics

• In a given situation how to quantify this law?

Econometrics comes to the rescue.
(2)To provide empirical support to
mathematical models:

• Many theories are expressed in mathematical

form/models (Common in Economics, Finance)

• These theoretical models are developed without

regard to their measurability

• Econometrics helps to put these models into

empirical testing (e.g. Tax competition models).
(3) For academicians:

• Research in economics, finance, management,

marketing etc is becoming increasingly
quantitative [Show examples].

• Hence, knowledge about econometrics is very

important to conduct empirical research.
(4) For students:

• For students a command over econometrics will

be of great use in their employment.

• Example: forecasting of sales, consumer

behaviour (KPOs) – corporate research.
 Steps in Econometric Analysis
1. Identify research issue

2. Select Variables

3. Check Data Availability

4. Specify Econometric Model

5. Data Collection
6. Model Estimation

7. Hypothesis Testing

8.Using Estimated Model for

Forecasting/Prediction
Step 1: Identify research issue

• You should have a research problem to probe

(How to identify a problem?)

• Example from Labour Economics: Effect of

economic conditions on people’s willingness to
work (or LFPR).

• Two hypothesises/arguments are postulated.

• Argument 1 (Discouraged worker hypothesis):
As economic conditions worsen, unemployed
may drop out of labour force (falling LFPR) as
they loose hope of finding a job.

• Argument 2 (Added worker hypothesis): As

economic conditions worsen, unemployed may
join labour force (rising LFPR) if the main bread
winner in the family loses job.
• In this context, our research objective could be
to test relative strength/validity of these two
contrasting claims.
Step 2: Select Variables

• For running a regression, we have to select a

DEPENDENT variable and an INDEPENDENT
variable(s).

• A model with one dependent variable and one

independent variable is called simple or two
variable regression model (TWRM).

• A model with one dependent variable and more

than one independent variable is called multiple
regression model (MRM).
• Example:
LFPR = f (Unemployment Rate) - TWRM
LFPR = f (Unemployment Rate; Hourly
Earnings; Family Wealth) – MRM

• Generally, MRM is preferred because it

enhances credibility of research findings.
• How many independent variables do we include?

• Strictly, guiding principle should be underlying

theory or prior literature or nature of problem.

• Even then, it may not always possible to include

every possible variable

• Why?
 Non-availability of data

 Inherent randomness in human behaviour, which cannot

be captured easily (Ex: Being unemployed due to
attitude problem).

 Inability to properly quantify certain variables (Ex.

Interest groups)

 Due to ignorance we may miss relevant variables

 Anyway, ultimate purpose of econometrics is not to

capture complete reality
• How to rectify this problem?

 Add a term – called error term – which could take

care of influence of all omitted variables.

 In other words, error term captures all those

forces that affect the dependent variable but are
not explicitly included in the model.

 Error term will also be useful when we use proxy

independent variables (e.g. interest groups)
 If the error term is small it implies that the
combined influence of omitted variables is
small/negligible.
Step 3: Check Data Availability

• Before proceeding further, check data

availability for relevant variables.

• Three types of data are generally available for

empirical analysis – Cross-sectional, Time-
series, Pooled Data/Panel Data.

• In cross-section data, values of one or more

variables are collected for several sample units,
or entities at the same point in time (e.g. GDP
figure of countries for a given year).
 Cross-Sectional data
States Tax Revenue in 2000-01 (in crores)

Andhra Pradesh 10551.92

Bihar 2934.75

Haryana 4311.48

Karnataka 9042.67

Kerala 5870.26

Maharashtra 19724.28

Orissa 2184.03

Punjab 4895.22

Rajasthan 5299.97
• In time series data we observe the values of one
or more variables over a period of time – daily
stock prices or annual GDP figures

• In panel data, same cross-sectional unit (say a

firm or state or country) is surveyed over time

• Thus, in panel data we have elements of both

time series and cross-sectional data.
 Time Series Data
Year Tax Revenue of Andhra Pradesh
1990-91 2647.25
1991-92 3054.96
1992-93 3388.72
1993-94 3832.93
1994-95 4227.43
1995-96 4120.44
1996-97 4881.83
1997-98 7113.55
1998-99 7961.4
1999-00 9008.6
2000-01 10551.92
 Panel Data: Tax Revenues of States
Year AP KAR KER TN
1990-91 2647.25 2332.12 1340.35 3124.05
1991-92 3054.96 2900.2 1673.93 3734.11
1992-93 3388.72 3097.81 1886.97 4162.06
1993-94 3832.93 3812.34 2344.87 4801.37
1994-95 4227.43 4289.31 2799.1 5833.76
1995-96 4120.44 5273.93 3382.68 7151.2
1996-97 4881.83 5767.84 3898.5 7983.45
1997-98 7113.55 6411.87 4501.05 8682.64
1998-99 7961.4 6943.1 4649.5 9625.3
1999-00 9008.6 7744.37 5193.51 10918.93
2000-01 10551.92 9042.67 5870.26 12282.25
Step 4: Specify Econometric Model

• LFPR = B1 + B2UR +u

LFPR – Labour force participation rate

UR – Unemployment rate (a proxy for economic

condition. Other option could be GDP)

B1 - Intercept term. Gives value of LFPR (dependent

variable) when UR (value of independent variable) is
zero
 B2 - Slope term. Measures the rate of change in LFPR
for a unit change in UR. Together B1 and B2 are known
as the parameters of the regression model
u – Error term [LFPR – (B1 + B2UR)]

• This is a linear regression model - LFPR is linearly

related to UR

• Our objective is to explain the behaviour of dependent

variable in relation to the explanatory variable.
Step 5: Data Collection

• For empirical estimation, we need to collect data

on the variables used in the econometric model.

• Data can be obtained either from primary sources

[HR] or from secondary sources [Finance,
Economics]
Step 6: Model Estimation

• By estimation we mean estimating the parameters

(B1 & B2) of the chosen model.

• Estimation is carried out using the technique of

regression analysis.
• What is regression analysis?

“Regression analysis is concerned with the

study of the dependence of one variable, the
dependent variable, on one or more other
variables, the explanatory variables, with a view
to estimating and/or predicting the (population)
mean or average value of the former in terms of
the known or fixed (in repeated sampling)
values of the latter”
• Assume that after estimation we get the following
result:

LFPR = 50.63 - 0.45UR

 B2 = –0.45. Implies that if UR goes up by 1%

point, ceteris paribus, LFPR is expected to
decrease on the average by about 0.45% points –
Discouraged worker hypothesis finds support.

 B1 = 50.63. Implies that average value of LFRP

will be about 50.63% if the UR were zero (i.e.
full employment).
 Sometimes/often, intercept term has no
particular economic meaning.

 But, in the present example it has meaning

(How?)

 We say “on the average” because the presence

of error term is likely to make the relationship
somewhat imprecise.
Step 7: Hypothesis Testing

• Objective here is to test certain hypotheses

suggested by theory and/or prior empirical
experience on parameters of the model.

• Specifically, we are interested to verify how

close the estimated parameter is to a pre-
supposed value of that parameter
ˆ  0.45)
H 0 : B1 1; B
(e.g. 1
• Hypothesis testing helps to verify whether the
results obtained through regression analysis
conform to the underlying theory
Step 8: Using Estimated Model for
Forecasting/Prediction

• LFPR = 50.6333 - 0.4486UR

• If we want to predict LFPR in some future

periods for a given value of UR (say 5) we can
obtain it (How?)

• Substitute UR value (5) in the above equation

• When data on LFPR (for a given UR) for
future period is out, we can compare the
predicted value with the actual value.

• The discrepancy between the two is called the

prediction error.
 Regression Vs. Correlation
Regression Correlation
Estimate/predict average value of Measure the strength or degree of
one variable on the basis of the linear association between two
fixed values of other variables variables

The dependent variable is treated Both the variables are treated as

as stochastic or random random

The explanatory variables are

assumed to have fixed values
 Our Immediate Task
• Identification of research issue, selection of
variables, checking of data availability,
specification of econometric model and data
collection are not big tasks

• Hence, our focus would be on

 Model Estimation
 Hypothesis Testing
 Criticisms
• By and large, events can be explained without
econometric analysis

• Data mining – Results are created!

• Problem with intercept term