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Introduction To Econometrics

By Kaoru Yamaguchi

What is Econometrics

An Application of Statistics to Economics


The social science in which the tools of economic
theory, mathematics, and statistical inference are
applied to the analysis of economic phenomena (Arthur
S. Goldberger)
The result of a certain outlook on the role of
economics, 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 (P.A.Samuelson)

Why study econometrics


How do we apply Econometrics to
Energy Economics

Essentials For a Practitioner


Essentials of Methodology
Review of Basic Statistical Concepts
Essentials of Linear Regression Model

Essentials of Methodology
Statement of theory or hypothesis
Specification of the mathematical model
Specification of the statistical or econometric
model
Collection of data
Estimation of the parameters of the chosen
econometric model
Tests of the hypothesis derived from the model
Forecasting

Economic Theory

Econometric Model

Estimation

Specification testing
and diagnostic
checking

NO

Is the model
adequate?
YES
Hypotheses tests

Forecast and policy simulation

1. Economic Data
2. Energy Demand Data
3. Energy Supply Data

Quantity

Statement of theory or hypothesis

90
80
70
60
50
40
30
20
10
0
10
Demand
Supply

Examples:

20

30
Price

40

Demand decreases
as price increases
Supply increases as
price increases
Energy demand
increases as GDP
increases

Specification of the mathematical


model
1. Linear Model:
Q=b0 + b1 * P
2. Non-Linear (Log-Linear) Model:
Q=b0 * P^b1
Log(Q)=Log(b0) + b1*Log(P)

Specification of Statistical or
Econometric Model
1. Linear Model:
Q=b0 + b1 * P + u
2. Non-Linear (Log-Linear) Model:
Q=b0 * P^b1 * u
Log(Q)=Log(b0) + b1*Log(P) + u

Collection of Data
Time Series

Data collected over a period of time

Cross-Sectional

Data collected at one point of time

Pooled Data

Combination of time series and cross-sectional


data
Panel data: Same samples surveyed over time

Estimation of Parameters
1. Linear Model:
Q=B0 + B1 * P
2. Non-Linear (Log-Linear) Model:
Q=B0 * P^B1
Log(Q)=Log(B0) + B1*Log(P)

Tests of the Theory or Hypothesis


Coefficient of the Price:
B1 < 0 ?

Q u an tity

Forecasting
90
80
70
60
50
40
30
20
10
0

Estimated Demand Curve

10
Demand
Supply

20

30
Price

40

Basic Statistical Concepts


Probability distribution function
Normal distribution and t-distribution
Estimator and the property of BLUE

PDF: Probability Distribution


Function
Example: Binominal Probability Distribution: p(y)=n!/(y!(n-y)!)*0.5^n
0.5

n=2

0.25
0.2
Probability

Probability

0.4

n=10

0.3
0.2
0.1

0.15
0.1
0.05

0
0

1
Event

Event

10

Normal Distribution
X
Normal distribution is a model for a
continuous random variable whose value
depends on a number of factors.
Mean value Xi/n=
Sample Variance Xi)2/(n-1)=

Standard Normal Distribution


X

The t-Distribution

t-distribution is used to test the


significance of coefficients
(b1-B1)/se(b1) tn-2
Normal Distribution

Standard Error (Deviation)


= Variance
Degree of Freedom d.f.:
The number of independent observations
available to compute a quantity

t20
t5

Desirable Property of
Estimator
The sample mean is the most frequently
used measure of the population mean
because of the following property.
Linearity
Unbiasedness
Efficiency
Best linear unbiased estimater (BLUE)

Linearity
An estimator is a linear estimator if it
is a linear function of the sample
observation.
EX. Sample mean=
(X1+X2+.+Xn)/n

Unbiasedness

UnBiased:E(X)=

Biased: E(X)<>

Efficiency
Efficient:E(X)=

Inefficient: E(X)=

Best Linear Unbiased Estimator


(BLUE)
If the estimator is linear, is unbiased,
and has a minimum variance (most
efficient)

The Linear Regression Model


The meaning of regression

Regression analysis is concerned with the study


of the relationship between one variable called
explained, or dependent variable and one or
more other variable called independent, or
explanatory variable.

Yi = B0 + B1 * Xi + ui
Regression Coefficients
Dependent variable

Random Error (Residual)


Independent variable

Objective of Regression Analysis


To estimate the mean value of the dependent
variable, given the values of independent variabls.
To test hypotheses.
To predict or forecast the mean value of the
dependent variable, given the values of
independent variables.
Notes: Estimated relationship does not imply
causation.

OBJECTIVE: Estimate PRF based on SRF


Whole Population
(Yi, Xi)

Sample Population

PRF: Population
Yi = B0 + B1* Xi + ui
Regression Function
SRF: Sample
Yi = b0 + b1* Xi + ei
Regression Function

Meaning of Linear Regression


Linearity in the variable
Y=B1+B2X2
Y=B1+B2/X

Linearity in the parameters


Y=B1+B22X

Estimation of Parameters
The Method of Ordinary Least
Square (OLS)

Ordinary Least Square

Yi = b0 + b1* Xi + ei

80
Quantity

Estimate parameters to
minimize Residual
Sum of Square (RSS =
ei2)

e4
e3

60

e2

40

e1

20
0
10

20

30

Price

40

Classical Linear Regression


Model
Regression model based on the
assumptions;

The independent, or explanatory variables are


not correlated
The variance of each ui is constant
var(ui)=

There is no correlation between two error


terms.

Regression in Practice
Violation of Assumptions
Multicollinearity

If explanatory variables are correlated

Heteroscedasticity

If the error variance is non-constant

Autocorrelation (Serial correlation)

If error terms are correlated