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Correlation Analysis

Definition: Correlation analysis attempts to determine the degree of
relationship between variables.
Thus correlation is a statistical device which helps us in analyzing the
covariation of two or more variables.
The problem of analyzing the relation between different series should be
broken into three steps:
1. Determining whether a relation exists and, if it does; measuring it.
2. Testing whether it is significant.
3. Establishing the cause and effect relation, if any.
Significance of the study of correlation:
1. Reduces uncertainty: The study of correlation reduces uncertainty and
helps in decision making. In business, forecasting is an important factor
and correlation helps to make relatively better forecasting.
2. Measure relationship: Most of the variables show some kind of
relationship. i.e. b/w price and supply, income & expenditure, etc. With
the help of correlation analysis we can measure in one figure the degree
of relationship existing between the variables.
3. Helpful in understanding the behavior of economy: Correlation is very
helpful in understanding the behavior of economy. It helps in studying
factors by which economic events are affected. i.e. find out the factors
responsible for price rise or low productivity.
4. Helps to estimate the likely changes: Correlation study helps us to
estimate the likely change in a variable with a particular amount of
change in related variable. i.e. it could help finding out the change in
demand with a certain of change in price.
Properties of Correlation Coefficient:
1. Correlation coefficient is a pure number .i.e it has no unit.
2. The correlation coefficient ranges from -1 to 1.
3. The correlation between two variables is known as simple correlation or
correlation of zero order.

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Correlation Analysis

4. It is not affected by coding of variables or variate values.

5. The relation between the correlation coefficient and regression
coefficients

and

is

.
6. The sign of will be the same as that of

and

.
7. If the two variables are independent, the correlation coefficient between
them is zero but the converse is not true.
8. If , it shows that the relationship between the variables X and Y is
not linear.
9. The relationship between the correlation coefficient with a regression
coefficients is

and

.
Types of Correlation: There are four types of correlation:
1. Positive and Negative Correlation: When the values of two variables
move in same direction i.e. when increase or decrease in the value of
one variable is associated with increase or decrease in the value of the
other variable, correlation is said to be positive. e.g. The correlation
between price and supply is of positive nature.
If, on the other hand, the value of two variables move in opposite
directions, so that with the increase in the value of one variable, the
value of the other variable decreases, or vice-versa, correlation is said to
be negative. e.g. The correlation between price and demand is of
negative nature.
2. Simple and Multiple Correlation: Under simple correlation, the
relationship is confined to two variables, say, yield of wheat and the use
of chemical fertilizers, or between money supply and the general price
level, cost and sales etc.
In case, of multiple correlation, the relationship between more than two
variables is considered . i.e., the relationship between of yield of wheat
may be examined with reference to chemical fertilizers and pesticides.
However, the coefficient of correlation will be expressed in the usual
manner.


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Correlation Analysis

3. Partial and Total Correlation: In case of partial correlation, relationship
of two or more variables is examined and other variables are excluded.
i.e. , if correlation between production of wheat and chemical fertilizers
is calculated and effects of pesticides are excluded, it is called partials
correlation.
The total correlation is based on all the relevant variables.
4. Linear and Non-Linear Correlation: the correlation between two
variables is said to be linear if a unit change in the value of one variable.
There is a constant change in the value of the other variable. Generally,
correlation refers to the linear relationship. The graph of variables
having such a relationship will form a straight line.
In non-linear or curvilinear correlation, the amount of change of one
variable does not bear a constant ratio to the amount of change in the
other related variable
Methods of Studying Correlation:
1. Scatter Diagram Method: The simplest device for ascertaining whether
two variables are related is to prepare a dot chart called scatter diagram.
When this method is used the given data are plotted on a graph paper or
simply scatter plot in the form of dots. For each pair of X and Y values we
put a dot and thus obtain as many points as the number of observations.
By looking to the scatter of the various points we can form an idea as to
whether the variables are related or not. The greater the scatter of the
plotted points on the chart, the lesser is the relationship between the
two variables. The more closely the points come to a straight line falling
from the lower left-hand corner to the upper right-hand corner,
correlation is said to be perfectly positive. On the other hand, if all the
points are lying on a straight line rising from the upper left-hand corner
to the lower right-hand corner of the diagram, correlation is said to be
perfectly negative



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Correlation Analysis























Positive Correlation
Negative Correlation
Perfect Positive Correlation Perfect Negative Correlation
Curvi-Linear Correlation NO Correlation
X
Y
Y
Y

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Correlation Analysis

Merits and Limitations of the Method:
Merits:
a. It is simple a non-mathematical method of studying correlation
between the variables. As such it can easily be understood and a
rough idea can quickly be formed as to whether or not the variables
are related.
b. It is not influenced by the size of extreme items whereas most of the
mathematical methods of finding correlation are influenced by
extreme items.
c. Making a scatter diagram usually is the first step in investigating the
relationship between two variables.
Limitations: By applying this method we can get an idea about the direction of
correlation and also whether it is high or low. But we cannot establish the
exact degree of correlation between the variables as is possible by applying the
mathematical methods.
2. Graphic Method:
When this method is used the individual values of the two variables are
plotted on the graph paper. We thus obtain two curves, one for X
variables and another for Y variables. By examining the direction and
closeness of the two curves so drawn we can infer whether or not the
variables are related. If both the curves drawn on the graph are moving
in same direction (either upward or downward) correlation is said to be
positive. On the other hand, if the curves are moving in the opposite
directions correlation is said be negative.
Example:
Year Average
income
Average
Expenditure
Year Average
income
Average
Expenditure
1998 3100 3000 2003 4300 4100
1999 3320 3200 2004 4500 4200
2000 3500 3350 2005 4650 4400
2001 3700 3500 2006 4800 4650
2002 4200 4000 2007 5000 4500

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Correlation Analysis


This method is normally used where the given data over a period of time i.e. in
case of time series. However, as with the scatter diagram method, in this
method also we cannot get a numerical value describing the extent to which
the variables are related.
3. KARL PEARSONS COEFFICIENT OF CORRELATION OR PEARSONS PRODUCT
MOMENT:
Karl Pearsons method popularly known as Pearsons coefficient of
correlation. It is denoted by r or

( ) ( )

For Raw Data:
Where,

(

)(

and

;

0
1000
2000
3000
4000
5000
6000
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Average Income
Average Expenditure
Correlation Graph
I
n
c
o
m
e

&

E
x
p
e
n
d
i
t
u
r
e



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Correlation Analysis

=

()

; =

()

OR
Direct Method:

()

()

Short-cut Method:

Where d
x
is deviation from assumed mean for X or step deviation
d
y
is deviation from assumed mean for Y or step deviation
N is number of observation
For Ungrouped & Grouped Data: When the number of
observations is large, the data are often classified into two-way frequency
distribution.

Assumption of the Pearsons Coefficient:
There is linear relationship between the variables.
The two variables under study are affected by a large number of
independent causes so as to form a normal distribution.
There is a cause and effect relationship between the forces affecting the
distribution of the items in the two series


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Correlation Analysis


Merits and Limitations of the Pearsonian Coefficient:
The correlation coefficient always assumes linear relationship regardless
of the fact whether that assumption is correct or not.
Great care must be exercised in interpreting the value of this coefficient
as very often the coefficient is misinterpreted.
The value of the coefficient is unduly affected by the extreme items.
As compared with other methods this method takes more time to
compute the value of correlation coefficient.
Coefficient of Correlation and Probable Error:
The probable error of the coefficient of correlation helps in interpreting its
value and to determine the reliability of the value of the coefficient. It can be
obtained through:

, where r is the coefficient of

correlation and N is the number of pairs of observations.
If the value of r is less than the probable error there is no evidence of
correlation.
If the value of r is more than six times the probable error, the coefficient
of correlation is practically certain.
By adding and subtracting the value of probable error from the
coefficient of correlation we get respectively the upper and lower limits
within which coefficient of correlation in the population can be expected
to lie. Symbolically:
Note: If 0.6745 is omitted from the formula of probable error, we get the
standard error of coefficient of correlation. Therefore, the standard error
of r is:

Coefficient of Determination: It is very useful way to interpret the
value of coefficient of correlation between two variables is to use square of

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Correlation Analysis
coefficient of correlation, which is called
coefficient of determination. The coefficient of determination thus equals r
2
.
Its maximum value is 1.






Rank Correlation Coefficient (Spearmans Correlation
Coefficient): When the distribution is not known, there is need for a
measure of correlation that involves no assumption about the parameter of
the population. There are two cases:
1. Ranks are not repeated:

2. Ranks are repeated:

)}

Concurrent Deviation Method: This method is to find out the
direction of change of X variable and Y variable.