Business Statistics:

A Decision-Making Approach
6th Edition

Chapter 14
Multiple Regression
and Model Building

Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-

Hall, Inc. Chap 14-1
 Chapter Goals
After completing this chapter, you should be
able to:
 understand model building using multiple
regression analysis
 apply multiple regression analysis to business
decision-making situations
 analyze and interpret the computer output for a
multiple regression model
 test the significance of the independent variables
in a multiple regression model
Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-
Hall, Inc. Chap 14-2
 Chapter Goals
(continued)

After completing this chapter, you should be

able to:
 use variable transformations to model nonlinear
relationships
 recognize potential problems in multiple
regression analysis and take the steps to correct
the problems.
 incorporate qualitative variables into the
regression model by using dummy variables.

Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-

Hall, Inc. Chap 14-3
 The Multiple Regression
Model
Idea: Examine the linear relationship between
1 dependent (y) & 2 or more independent variables (xi)
Population model:
Y-intercept Population slopes Random Error

y β0  β1x1  β 2 x 2    βk x k  ε
Estimated multiple regression model:
Estimated Estimated
(or predicted) Estimated slope coefficients
intercept
value of y

ŷ b0  b1x1  b 2 x 2    bk x k
Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-
Hall, Inc. Chap 14-4
 Multiple Regression Model
Two variable model
y
ŷ b0  b1x1  b 2 x 2

x1
e
abl
ri
r va
fo
l ope x2
S
f or v ariable x 2
Slope

x 1 Statistics: A Decision-Making Approach, 6e © 2005 Prentice-

Business
Hall, Inc. Chap 14-5
 Multiple Regression Model
Two variable model
y Sample

<yi
observation ŷ b0  b1x1  b 2 x 2

yi

<
e = (y – y)

x2i
x2

<
x1i The best fit equation, y ,
is found by minimizing the
x 1 Statistics: A Decision-Making Approach, 6e © 2005 Prentice-
sum of squared errors, e2
Business
Hall, Inc. Chap 14-6
 Multiple Regression
Assumptions

Errors (residuals) from the regression model:

<
e = (y – y)

 The errors are normally distributed

 The mean of the errors is zero
 Errors have a constant variance
 The model errors are independent

Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-

Hall, Inc. Chap 14-7
 Model Specification

 Decide what you want to do and select the

dependent variable
 Determine the potential independent variables for
your model
 Gather sample data (observations) for all
variables

Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-

Hall, Inc. Chap 14-8
 The Correlation Matrix

 Correlation between the dependent variable and

selected independent variables can be found
using Excel:
 Tools / Data Analysis… / Correlation

 Can check for statistical significance of

correlation with a t test

Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-

Hall, Inc. Chap 14-9
 Example
 A distributor of frozen desert pies wants to
evaluate factors thought to influence demand
 Dependent variable: Pie sales (units per week)

Independent variables: Price (in $)
Advertising
($100’s)
 Data are collected for 15 weeks

Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-

Hall, Inc. Chap 14-10
 Pie Sales Model
Pie Price Advertising
Week Sales ($) ($100s)
Multiple regression model:
1 350 5.50 3.3
2 460 7.50 3.3
3 350 8.00 3.0 Sales = b0 + b1 (Price)
4 430 8.00 4.5
5 350 6.80 3.0 + b2 (Advertising)
6 380 7.50 4.0
7 430 4.50 3.0
8 470 6.40 3.7 Correlation matrix:
9 450 7.00 3.5
Pie Sales Price Advertising
10 490 5.00 4.0
Pie Sales 1
11 340 7.20 3.5
Price -0.44327 1
12 300 7.90 3.2
Advertising 0.55632 0.03044 1
13 440 5.90 4.0
14 450 5.00 3.5
15 300 7.00 2.7
Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-
Hall, Inc. Chap 14-11
 Interpretation of Estimated
Coefficients
 Slope (bi)
 Estimates that the average value of y changes by bi units
for each 1 unit increase in Xi holding all other variables
constant
 Example: if b1 = -20, then sales (y) is expected to
decrease by an estimated 20 pies per week for each $1
increase in selling price (x1), net of the effects of changes
due to advertising (x2)
 y-intercept (b0)
 The estimated average value of y when all xi = 0
(assuming all xi = 0 is within the range of observed
values)
Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-
Hall, Inc. Chap 14-12
 Pie Sales Correlation Matrix

Pie Sales Price Advertising

Pie Sales 1
Price -0.44327 1
Advertising 0.55632 0.03044 1

 Price vs. Sales : r = -0.44327

 There is a negative association between
price and sales
 Advertising vs. Sales : r = 0.55632
 There is a positive association between
advertising and sales
Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-
Hall, Inc. Chap 14-13
 Scatter Diagrams

Sales vs. Price

Sales
600
500
400
300
200
Sales vs. Advertising
100 Sales
600
0
0 2 4 6 8 10 500
Price 400
300
200
100
0
0 1 2 3 4 5
Advertising
Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-
Hall, Inc. Chap 14-14
 Estimating a Multiple Linear
Regression Equation
 Computer software is generally used to
generate the coefficients and measures of
goodness of fit for multiple regression

 Excel:
 Tools / Data Analysis... / Regression
 PHStat:
 PHStat / Regression / Multiple Regression…

Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-

Hall, Inc. Chap 14-15
 Multiple Regression Output
Regression Statistics
Multiple R 0.72213
R Square 0.52148
Adjusted R Square 0.44172
Standard Error 47.46341 Sales 306.526 - 24.975(Price)  74.131(Adv ertising)
Observations 15

ANOVA df SS MS F Significance F
Regression 2 29460.027 14730.013 6.53861 0.01201
Residual 12 27033.306 2252.776
Total 14 56493.333

Coefficients Standard Error t Stat P-value Lower 95% Upper 95%

Intercept 306.52619 114.25389 2.68285 0.01993 57.58835 555.46404
Price -24.97509 10.83213 -2.30565 0.03979 -48.57626 -1.37392
Advertising 74.13096 25.96732 2.85478 0.01449 17.55303 130.70888
Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-
Hall, Inc. Chap 14-16
 The Multiple Regression
Equation

Sales 306.526 - 24.975(Price)  74.131(Adv ertising)

where
Sales is in number of pies per week
Price is in $
Advertising is in $100’s.
b1 = -24.975: sales b2 = 74.131: sales will
will decrease, on increase, on average,
average, by 24.975 by 74.131 pies per
pies per week for week for each $100
each $1 increase in increase in
selling price, net of advertising, net of the
the effects of effects of changes
changes due to due to price
advertising
Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-
Hall, Inc. Chap 14-17
 Using The Model to Make
Predictions
Predict sales for a week in which the selling
price is $5.50 and advertising is $350:

Sales  306.526 - 24.975(Price)  74.131(Advertising)

 306.526 - 24.975 (5.50)  74.131 (3.5)
 428.62

Note that Advertising is

Predicted sales in $100’s, so $350
means that x2 = 3.5
is 428.62 pies
Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-
Hall, Inc. Chap 14-18
 Predictions in PHStat
 PHStat | regression | multiple regression …

Check the
“confidence and
prediction interval
estimates” box

Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-

Hall, Inc. Chap 14-19
 Predictions in PHStat
(continued)

Input values

<
Predicted y value
Confidence interval for the

<
mean y value, given
these x’s

Prediction interval for an

<
individual y value, given
Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice- these x’s
Hall, Inc. Chap 14-20
 Multiple Coefficient of
Determination
 Reports the proportion of total variation in y
explained by all x variables taken together

SSR Sum of squares regression

2
R  
SST Total sum of squares

Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-

Hall, Inc. Chap 14-21
 Multiple Coefficient of
Determination
(continued)
Regression Statistics
2SSR 29460.0
Multiple R 0.72213
R   .52148
R Square 0.52148 SST 56493.3
Adjusted R Square 0.44172
Standard Error 47.46341
52.1% of the variation in pie sales
Observations 15 is explained by the variation in
price and advertising
ANOVA df SS MS F Significance F
Regression 2 29460.027 14730.013 6.53861 0.01201
Residual 12 27033.306 2252.776
Total 14 56493.333

Coefficients Standard Error t Stat P-value Lower 95% Upper 95%

Intercept 306.52619 114.25389 2.68285 0.01993 57.58835 555.46404
Price -24.97509 10.83213 -2.30565 0.03979 -48.57626 -1.37392
Advertising 74.13096 25.96732 2.85478 0.01449 17.55303 130.70888
Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-
Hall, Inc. Chap 14-22
 Adjusted R2
 R2 never decreases when a new x variable is
added to the model
 This can be a disadvantage when comparing

models
 What is the net effect of adding a new variable?
 We lose a degree of freedom when a new x

variable is added
 Did the new x variable add enough

explanatory power to offset the loss of one

degree of freedom?
Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-
Hall, Inc. Chap 14-23
 Adjusted R2
(continued)
 Shows the proportion of variation in y explained by
all x variables adjusted for the number of x
variables used

2  n 1  2
R 1  (1  R )
A 
 n  k  1
(where n = sample size, k = number of independent variables)

 Penalize excessive use of unimportant independent

variables
 Smaller than R2
 Useful in comparing among models
Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-
Hall, Inc. Chap 14-24
 Multiple Coefficient of
Determination
(continued)
Regression Statistics
Multiple R 0.72213 R 2A .44172
R Square 0.52148
Adjusted R Square 0.44172
44.2% of the variation in pie sales is
Standard Error 47.46341
explained by the variation in price and
Observations 15 advertising, taking into account the sample
size and number of independent variables
ANOVA df SS MS F Significance F
Regression 2 29460.027 14730.013 6.53861 0.01201
Residual 12 27033.306 2252.776
Total 14 56493.333

Coefficients Standard Error t Stat P-value Lower 95% Upper 95%

Intercept 306.52619 114.25389 2.68285 0.01993 57.58835 555.46404
Price -24.97509 10.83213 -2.30565 0.03979 -48.57626 -1.37392
Advertising 74.13096 25.96732 2.85478 0.01449 17.55303 130.70888
Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-
Hall, Inc. Chap 14-25
 Is the Model Significant?
 F-Test for Overall Significance of the Model
 Shows if there is a linear relationship between all
of the x variables considered together and y
 Use F test statistic
 Hypotheses:
 H0: β1 = β2 = … = βk = 0 (no linear relationship)
 HA: at least one βi ≠ 0 (at least one independent
variable affects y)

Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-

Hall, Inc. Chap 14-26
 F-Test for Overall
Significance
(continued)
 Test statistic:
SSR
k MSR
F 
SSE MSE
n k  1
where F has (numerator) D1 = k and
(denominator) D2 = (n – k - 1)
degrees of freedom
Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-
Hall, Inc. Chap 14-27
 F-Test for Overall
Significance
(continued)
Regression Statistics
Multiple R 0.72213
R Square 0.52148 MSR 14730.0
F  6.5386
Adjusted R Square 0.44172
MSE 2252.8
Standard Error 47.46341
With 2 and 12 degrees P-value for
Observations 15
of freedom the F-Test

ANOVA df SS MS F Significance F
Regression 2 29460.027 14730.013 6.53861 0.01201
Residual 12 27033.306 2252.776
Total 14 56493.333

Coefficients Standard Error t Stat P-value Lower 95% Upper 95%

Intercept 306.52619 114.25389 2.68285 0.01993 57.58835 555.46404
Price -24.97509 10.83213 -2.30565 0.03979 -48.57626 -1.37392
Advertising 74.13096 25.96732 2.85478 0.01449 17.55303 130.70888
Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-
Hall, Inc. Chap 14-28
 F-Test for Overall
Significance
(continued)

H0: β1 = β2 = 0 Test Statistic:

HA: β1 and β2 not both zero MSR
F 6.5386
 = .05 MSE
df1= 2 df2 = 12
Decision:
Critical Reject H0 at  = 0.05
Value:
F = 3.885
Conclusion:
The regression model does explain
 = .05 a significant portion of the
variation in pie sales
0 Do not Reject H0
F (There is evidence that at least one
reject H0
F.05 = 3.885
Business Statistics: A Decision-Making
independent variable affects y)
Approach, 6e © 2005 Prentice-
Hall, Inc. Chap 14-29
 Are Individual Variables
Significant?
 Use t-tests of individual variable slopes
 Shows if there is a linear relationship between the
variable xi and y
 Hypotheses:
 H0: βi = 0 (no linear relationship)
 HA: βi ≠ 0 (linear relationship does exist
between xi and y)

Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-

Hall, Inc. Chap 14-30
 Are Individual Variables
Significant?
(continued)

H0: βi = 0 (no linear relationship)

HA: βi ≠ 0 (linear relationship does exist
between xi and y)

Test Statistic:

bi  0
t (df = n – k – 1)
sbi
Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-
Hall, Inc. Chap 14-31
 Are Individual Variables
Significant?
(continued)
Regression Statistics
t-value for Price is t = -2.306, with
Multiple R 0.72213
R Square 0.52148
p-value .0398
Adjusted R Square 0.44172
Standard Error 47.46341 t-value for Advertising is t = 2.855,
Observations 15 with p-value .0145

ANOVA df SS MS F Significance F
Regression 2 29460.027 14730.013 6.53861 0.01201
Residual 12 27033.306 2252.776
Total 14 56493.333

Coefficients Standard Error t Stat P-value Lower 95% Upper 95%

Intercept 306.52619 114.25389 2.68285 0.01993 57.58835 555.46404
Price -24.97509 10.83213 -2.30565 0.03979 -48.57626 -1.37392
Advertising 74.13096 25.96732 2.85478 0.01449 17.55303 130.70888
Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-
Hall, Inc. Chap 14-32
 Inferences about the Slope:
t Test Example
From Excel output:
H0: βi = 0
Coefficients Standard Error t Stat P-value
HA: βi  0 Price -24.97509 10.83213 -2.30565 0.03979
Advertising 74.13096 25.96732 2.85478 0.01449
d.f. = 15-2-1 = 12
 = .05 The test statistic for each variable falls
t/2 = 2.1788 in the rejection region (p-values < .05)
Decision:
/2=.025 /2=.025
Reject H0 for each variable
Conclusion:
Reject H0 Do not reject H0 Reject H0
There is evidence that both
-tα/2 0
tα/2 Price and Advertising affect
-2.1788 2.1788 pie sales at  = .05
Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-
Hall, Inc. Chap 14-33
 Confidence Interval Estimate
for the Slope
Confidence interval for the population slope β1
(the effect of changes in price on pie sales):

bi t  / 2sbi where t has

(n – k – 1) d.f.

Coefficients Standard Error … Lower 95% Upper 95%

Intercept 306.52619 114.25389 … 57.58835 555.46404
Price -24.97509 10.83213 … -48.57626 -1.37392
Advertising 74.13096 25.96732 … 17.55303 130.70888

Example: Weekly sales are estimated to be reduced

by between 1.37 to 48.58 pies for each increase of $1
in the selling price
Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-
Hall, Inc. Chap 14-34
 Standard Deviation of the
Regression Model

 The estimate of the standard deviation of the

regression model is:

SSE
s   MSE
n k  1
 Is this value large or small? Must compare to the
mean size of y for comparison

Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-

Hall, Inc. Chap 14-35
 Standard Deviation of the
Regression Model
(continued)
Regression Statistics
Multiple R 0.72213
R Square 0.52148
The standard deviation of the
Adjusted R Square 0.44172
regression model is 47.46
Standard Error 47.46341
Observations 15

ANOVA df SS MS F Significance F
Regression 2 29460.027 14730.013 6.53861 0.01201
Residual 12 27033.306 2252.776
Total 14 56493.333

Coefficients Standard Error t Stat P-value Lower 95% Upper 95%

Intercept 306.52619 114.25389 2.68285 0.01993 57.58835 555.46404
Price -24.97509 10.83213 -2.30565 0.03979 -48.57626 -1.37392
Advertising 74.13096 25.96732 2.85478 0.01449 17.55303 130.70888
Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-
Hall, Inc. Chap 14-36
 Standard Deviation of the
Regression Model
(continued)
 The standard deviation of the regression model is
47.46
 A rough prediction range for pie sales in a given
week is 2(47.46) 94.2
 Pie sales in the sample were in the 300 to 500
per week range, so this range is probably too
large to be acceptable. The analyst may want to
look for additional variables that can explain more
of the variation in weekly sales

Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-

Hall, Inc. Chap 14-37
 Multicollinearity

 Multicollinearity: High correlation exists

between two independent variables
 This means the two variables contribute
redundant information to the multiple regression
model

Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-

Hall, Inc. Chap 14-38
 Multicollinearity
(continued)
 Including two highly correlated independent
variables can adversely affect the regression
results
 No new information provided
 Can lead to unstable coefficients (large
standard error and low t-values)
 Coefficient signs may not match prior
expectations
Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-
Hall, Inc. Chap 14-39
 Some Indications of Severe
Multicollinearity
 Incorrect signs on the coefficients
 Large change in the value of a previous
coefficient when a new variable is added to the
model
 A previously significant variable becomes
insignificant when a new independent variable
is added
 The estimate of the standard deviation of the
model increases when a variable is added to
the model
Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-
Hall, Inc. Chap 14-40
 Detect Collinearity
(Variance Inflationary
Factor)
VIFj is used to measure collinearity:

1
VIFj  2
1 Rj
R2j is the coefficient of determination when the jth
independent variable is regressed against the
remaining k – 1 independent variables

If VIFj > 5, xj is highly correlated with

the other explanatory variables
Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-
Hall, Inc. Chap 14-41
 Detect Collinearity in PHStat

PHStat / regression / multiple regression …

Check the “variance inflationary factor (VIF)” box

Regression Analysis Output for the pie sales example:

Price and all other X  Since there are only two
Regression Statistics
explanatory variables, only one VIF
Multiple R 0.030437581
is reported
R Square 0.000926446
Adjusted R

VIF is < 5
Square -0.075925366 
There is no evidence of
Standard Error 1.21527235
collinearity between Price and
Observations 15
VIF 1.000927305
Advertising
Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-
Hall, Inc. Chap 14-42
 Qualitative (Dummy)
Variables

 Categorical explanatory variable (dummy

variable) with two or more levels:
 yes or no, on or off, male or female
 coded as 0 or 1
 Regression intercepts are different if the variable
is significant
 Assumes equal slopes for other variables
 The number of dummy variables needed is
(number of levels - 1)

Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-

Hall, Inc. Chap 14-43
 Dummy-Variable Model
Example (with 2 Levels)

Let:
y = pie sales ŷ b0  b1x1  b 2 x 2
x1 = price
x2 = holiday (X2 = 1 if a holiday occurred during the week)
(X2 = 0 if there was no holiday that week)

Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-

Hall, Inc. Chap 14-44
 Dummy-Variable Model
Example
(with 2 Levels)
(continued)

ŷ b0  b1x1  b 2 (1) (b0  b 2 )  b1x1 Holiday

ŷ b0  b1x1  b 2 (0)  b0  b1 x 1 No Holiday

Different Same
intercept slope
y (sales)
If H0: β2 = 0 is
b0 + b2
Holi rejected, then
day
b0 “Holiday” has a
No H
olida significant effect
y
on pie sales
Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-
Hall, Inc. x1 (Price) Chap 14-45
 Interpretation of the Dummy
Variable Coefficient (with 2
Levels)
Example: Sales 300 - 30(Price)  15(Holiday)
Sales: number of pies sold per week
Price: pie price in $
1 If a holiday occurred during the week
Holiday:
0 If no holiday occurred

b2 = 15: on average, sales were 15 pies greater in

weeks with a holiday than in weeks without a
holiday, given the same price
Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-
Hall, Inc. Chap 14-46
 Dummy-Variable Models
(more than 2 Levels)
 The number of dummy variables is one less than
the number of levels
 Example:
y = house price ; x1 = square feet

 The style of the house is also thought to matter:

Style = ranch, split level, condo

Three levels, so two dummy

variables are needed
Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-
Hall, Inc. Chap 14-47
 Dummy-Variable Models
(more than 2 Levels)
(continued)
Let the default category be “condo”

1 if ranch 1 if split level

x 2  x 3 
0 if not 0 if not

ŷ b0  b1x1  b 2 x 2  b 3 x 3
b2 shows the impact on price if the house is a
ranch style, compared to a condo
b3 shows the impact on price if the house is a
split level style, compared to a condo
Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-
Hall, Inc. Chap 14-48
 Interpreting the Dummy
Variable Coefficients (with 3
Levels)
Suppose the estimated equation is
ŷ 20.43  0.045x1  23.53x 2  18.84x 3

For a condo: x2 = x3 = 0
With the same square feet, a
ŷ 20.43  0.045x 1 ranch will have an estimated
average price of 23.53
For a ranch: x3 = 0 thousand dollars more than a
condo
ŷ 20.43  0.045x1  23.53
With the same square feet, a
For a split level: x2 = 0 split level will have an
estimated average price of
ŷ 20.43  0.045x 1  18.84 18.84 thousand dollars more
Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-
than a condo.
Hall, Inc. Chap 14-49
 Nonlinear Relationships
 The relationship between the dependent
variable and an independent variable may not
be linear
 Useful when scatter diagram indicates non-
linear relationship
 Example: Quadratic model

2
y β0  β1x j  β 2 x  ε j

 The second independent variable is the square of

the first variable

Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-

Hall, Inc. Chap 14-50
 Polynomial Regression
Model
General form:
2 p
y β0  β1x j  β 2 x    βp x  ε j j
 where:
β0 = Population regression constant
βi = Population regression coefficient for variable xj : j = 1, 2, …k
p = Order of the polynomial
i = Model error

If p = 2 the model is a quadratic model:

2
y β0  β1x j  β 2 x  ε j
Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-
Hall, Inc. Chap 14-51
 Linear vs. Nonlinear Fit

y y

x x
residuals

x residuals x

Linear fit does not give Nonlinear fit gives

random residuals
Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-
Hall, Inc.  random residuals
Chap 14-52
 Quadratic Regression Model
2
y β0  β1x j  β 2 x  ε j

Quadratic models may be considered when scatter

diagram takes on the following shapes:
y y y y

x1 x1 x1 x1
β1 < 0 β1 > 0 β1 < 0 β1 > 0
β2 > 0 β2 > 0 β2 < 0 β2 < 0
β1 = the coefficient of the linear term
β = the coefficient of the squared term
2
Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-
Hall, Inc. Chap 14-53
 Testing for Significance:
Quadratic Model
 Test for Overall Relationship
MSR

F test statistic = MSE
 Testing the Quadratic Effect
 Compare quadratic model
y β0  β1x j  β 2 x 2j  ε
with the linear model
y β0  β1x j  ε
 Hypotheses

H0: β2 = 0 (No 2nd order polynomial term)

HA: β2  0 (2nd order polynomial term is needed)
Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-
Hall, Inc. Chap 14-54
 Higher Order Models

If p = 3 the model is a cubic form:

2 3
y β0  β1x j  β 2 x  β3 x  ε j j

Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-

Hall, Inc. Chap 14-55
 Interaction Effects
 Hypothesizes interaction between pairs of x
variables
 Response to one x variable varies at different

levels of another x variable

 Contains two-way cross product terms

y β0  β1x1  β 2 x12  β3 x 3  β 4 x1x 2  β5 x12 x 2

Basic Terms Interactive Terms

Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-

Hall, Inc. Chap 14-56
 Effect of Interaction
 Given:
y β0  β1x1  β 2 x 2  β3 x1x 2  ε

 Without interaction term, effect of x1 on y is

measured by β1
 With interaction term, effect of x1 on y is
measured by β1 + β3 x2
 Effect changes as x2 increases

Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-

Hall, Inc. Chap 14-57
 Interaction Example
where x2 = 0 or 1 (dummy variable)
y = 1 + 2x1 + 3x2 + 4x1x2
y
x2 = 1
12 y = 1 + 2x1 + 3(1) + 4x1(1)
= 4 + 6x1
8
x2 = 0
4 y = 1 + 2x1 + 3(0) + 4x1(0)
= 1 + 2x1
0
x1
0 0.5 1 1.5
Effect (slope) of x1 on y does depend on x2 value
Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-
Hall, Inc. Chap 14-58
 Interaction Regression Model
Worksheet
Case, i yi x1i x2i x1i x2i
1 1 1 3 3
2 4 8 5 40
3 1 3 2 6
4 3 5 6 30
: : : : :

multiply x1 by x2 to get x1x2, then

run regression with y, x1, x2 , x1x2
Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-
Hall, Inc. Chap 14-59
 Evaluating Presence
of Interaction
 Hypothesize interaction between pairs of
independent variables

y β0  β1x1  β 2 x 2  β3 x1x 2  ε

 Hypotheses:
 H : β = 0 (no interaction between x and x )
0 3 1 2

 HA: β3 ≠ 0 (x1 interacts with x2)

Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-

Hall, Inc. Chap 14-60
 Model Building
 Goal is to develop a model with the best set of
independent variables

Easier to interpret if unimportant variables are
removed

Lower probability of collinearity
 Stepwise regression procedure
 Provide evaluation of alternative models as variables
are added
 Best-subset approach
 Try all combinations and select the best using the
highest adjusted R2 and lowest sε
Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-
Hall, Inc. Chap 14-61
 Stepwise Regression

 Idea: develop the least squares regression

equation in steps, either through forward
selection, backward elimination, or through
standard stepwise regression

 The coefficient of partial determination is the

measure of the marginal contribution of each
independent variable, given that other
independent variables are in the model

Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-

Hall, Inc. Chap 14-62
 Best Subsets Regression

 Idea: estimate all possible regression equations

using all possible combinations of independent
variables

 Choose the best fit by looking for the highest

adjusted R2 and lowest standard error sε

Stepwise regression and best subsets

regression can be performed using PHStat,
Minitab, or other statistical software packages
Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-
Hall, Inc. Chap 14-63
 Aptness of the Model

 Diagnostic checks on the model include

verifying the assumptions of multiple
regression:
 Each x is linearly related to y
i
 Errors have constant variance
 Errors are independent
 Error are normally distributed

Errors (or Residuals) are given by ei ( y  ŷ )

Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-
Hall, Inc. Chap 14-64
 Residual Analysis
residuals

residuals
x x

Non-constant variance Constant variance

residuals

x residuals x

Not Independent
Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-
Hall, Inc.
 Independent
Chap 14-65
 The Normality Assumption

 Errors are assumed to be normally distributed

 Standardized residuals can be calculated by
computer
 Examine a histogram or a normal probability plot
of the standardized residuals to check for
normality

Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-

Hall, Inc. Chap 14-66
 Chapter Summary

 Developed the multiple regression model

 Tested the significance of the multiple
regression model
 Developed adjusted R2
 Tested individual regression coefficients
 Used dummy variables
 Examined interaction in a multiple regression
model

Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-

Hall, Inc. Chap 14-67
 Chapter Summary
(continued)

 Described nonlinear regression models

 Described multicollinearity
 Discussed model building
 Stepwise regression
 Best subsets regression
 Examined residual plots to check model
assumptions

Business Statistics: A Decision-Making Approach, 6e © 2005 Prentice-

Hall, Inc. Chap 14-68