Lecture 11

Summary of previous Lecture

Gauss-Markov Theorem

Coefficient of determination

Monte Carlo Experiment

How to Interpret the Results

Example
Simple Demand Equation
Qd= 20-0.5P

Coefficient of determination= 0.85

Var (B^1)= 4

Se (B^1)=2

Var (B^2)=0.09

Se (B^2)=0.3

Hypothesis testing
Estimation and hypothesis testing constitute the two major branches of
statistics.
The theory of estimation consists of two parts: point estimation and interval
estimation.
Point estimator gives only one value of the parameter
Across sample parameter value may change.
However the mean value of the estimated parameter is equal to the true
parameter.

Hypothesis Testing
Relying only on the point estimate alone, we may construct an interval
around the point estimator.
The interval may be within two or three standard errors on either side of the
point estimator.
This interval has, say, 95 percent probability of including the true parameter
value.

Confidence Interval

Two
positive numbers and , the latter lying between 0 and 1, such
that the probability that the Random interval( , + ) contains the true is
1 . Symbolically,
Pr ( + ) = 1
Such an interval, if it exists, is known as a confidence interval
1 is known as the confidence coefficient; and (0 < <1) is known
as the level of significance.
The endpoints of the confidence interval are known as the confidence
limits(also known as critical values), - being the lower confidencelimit

and + the upper confidencelimit.

In practice and 1 are often expressed in percentage forms
as100 and 100(1 ) percent.

Lower
Confidence
Limit

Upper

Point Estimate

Confidence
Limit

Width of
confidence interval

Aspects of interval estimation

1 Confidence interval does not say that the probability of lying between
the given limits is 1 .
2- although an unknown, is assumed to be some fixed number, either it
lies in the interval or it does not. What states is that, the probability of
constructing an interval that contains is 1 .
3- The interval is a random interval; that is, it will vary from one sample
to the next because it is based on , which is random.
4- The interval is random till the value of the parameter is unknown. While
it is estimated the probability is either 0 or 1. It means either interval
includes the value or not.

Constructing Confidence interval for parameters

the normality assumption of the error term OLS estimators are also
Under

ND.

If is known the important property of Normally Distributed variable with

mean and is that area under the curve is.

68%, 95% and 99.7% diagram

But is rarely know we find it through the unbiased estimator i.e. ^

Confidence intervals for Regression Coefficients

Constructing confidence interval for

Example
Suppose
Further assume
Table show that

Properties of the t Distribution

1-The t distribution is different for different values of n, the sample size.

2- The area under the curve is 1. Because of the symmetry, the area under the curve
to the right of 0 equals the area under the curve to the left of 0 equals
1 /2
3- As t increases without bound, the graph approaches, but never equals, zero. As t
decreases without bound the graph approaches, but never equals, zero.

Properties of the t Distribution

4-

The area in the tails of the t distribution is a little greater than

the area in the tails of the standard normal distribution. This

result is because we use s as an estimate of , which introduces
more variability to the t statistic.
5- As the sample n increases, the density curve of t gets closer
to the standard normal density curve because values of S gets
closer to the values of by the law of large number

Summary

Point and interval estimation

Area under the normal curve
The t-distribution

Confidence interval for variance

It follows the Chi-square distribution

Example

If
and we chose
Df=11
The critical values for are given as:
(.025)=21.92 and (.975)=3.81
0.4484

Hypothesis testing

What we test: Is a given observation or finding compatible with some stated

hypothesis or not?

The word compatible, means sufficiently close to the hypothesized value so

that we do not reject the stated hypothesis.

The null hypothesis: H0.

The null hypothesis is usually tested against an alternative hypothesis (also

known as maintained hypothesis) denoted by H1.

The alternative hypothesis may be simple or composite

For example, H1: 2 = 1.5 is a simple hypothesis.

H1: 2 is not equal to 1.5 is a composite hypothesis.

Theory of Hypothesis Testing

It is concerned with developing rules or procedures for
deciding whether to reject or not reject the null hypothesis.
Two approaches for devising such rules
Confidence interval and Test of significance.
Both these approaches assume that the variable (statistic or
estimator)
distribution.

under

consideration

has

some

probability

THE CONFIDENCE-INTERVAL APPROACH

Two-Sided or Two-Tail Test:

Alternative hypothesis is composite and bidirectional
It shows that we do not have a strong or theoretical expectation
about the direction in which the alternative hypothesis should
move from the null hypothesis.
If 2 under H0 falls within the 100(1 )% confidence interval,
we do not reject the null hypothesis;
If it lies outside the interval, we may reject it

Rule of Thumb
Decision Rule: Construct a 100(1 )% confidence interval for 2.
If the 2 under H0 falls within this confidence interval, do not reject
H0, but if it falls outside this interval, reject H0.
Make diagram:

Type 1 error: Rejecting of the true Null hypothesis

Type 2 error: Accepting a false Null hypothesis or failure to reject a
false null hypothesis.

Rejection or acceptance of H0

When we reject the null hypothesis, we say that our finding is statistically
significant.

On the other hand, when we do not reject the null hypothesis, we say that
our finding is not statistically significant.

It is better to leave it to the researcher to decide whether a statistical finding

is significant, moderately significant, or highly significant.

One sided or one Tail Test

time we have strong priori or theoretical expectations

Some

that the alternative hypothesis is unidirectional rather than two

sided.
H0: 0.5
H1: 0.5
Diagram one tail

Test-of-significance approach
Testing the Significance of Regression Coefficients: The t Test
Broadly speaking, a test of significance is a procedure by which
sample results are used to verify the truth or falsity of a null
hypothesis.
The decision to accept or reject H0 is made on the basis of the value
of the test statistic obtained from the data at hand.

Confidence interval vs. test of Significance Approach

In the confidence-interval procedure we try to establish a range
or an interval that has a certain probability of including the true
but unknown 2.
In the test-of-significance approach we hypothesize some value
for 2 and try to see whether the computed 2 lies within
reasonable (confidence) limits around the hypothesized value.

Practically Easy

In practice no need to compute the confidence interval just compute the t

value from

t=

See whether it lies between the critical t values or outside them.

Forming Null and Alternative Hypothesis

Given the null and the alternative hypotheses, testing them for statistical signicance is not a
mystery.

But how does one formulate these hypotheses?

There are no hard-and-fast rules.

Very often the phenomenon under study will suggest the nature of the null and alternative
hypotheses.

Thus, theoretical expectations or prior empirical work or both can be relied upon to formulate
hypotheses.

It is extremely important that the researcher establish these hypotheses before carrying out the
empirical investigation.

May be the temptation to form hypotheses that justify ones results.

Such a practice should be avoided at all costs, at least for the sake of scientic objectivity.

The Exact Level of Signicance: The p Value

The major drawback of the classical approach to hypothesis

testing is its arbitrariness in selecting .
However, once a test statistic is obtained why not simply
nd out the actual probability of obtaining a value of the
test statistic as much as or greater than that obtained.
This probability is called the p-value.
Many statistical packages report p-value along with t-values.
Let the researcher decide at which p-value to reject or not
to reject the null hypotheses.
Risk lovers versus risk averse

Summary

Hypothesis testing
How to form null and alter native hypothesis
The p-value
Let the researcher decide at which value to reject or not to
reject the null hypothesis.