Correlation Analysis

Introduction: If two quantities vary in such a way that the movement in one are
accompanied by the movement in other then, then these quantities are said to be
corelated. For example there exists some correlation between family income and
expenditure on luxury items, price and demand and demand and supply.
Hence correlation analysis is defined as a statistical tool with the help of which the
relationship between the variables is studied and is used to measure the closeness of
relationship between the variables.
Significance of studying correlation:
It is of great use in studying the practical life cases.
1. In most of the cases variables show some kind of relationship, such as price and
supply, income expenditure etc. Hence with the help of correlation analysis we can
measure in one figure degree of relationship existing between the variables.
2. Once we know that two variables are closely related, we can estimate the value of
one variable given the value of the other.
3. Correlation analysis contributes to the economic behaviour and aids in locating the
critically important variable on which others depend.
4. Correlation measures the strength of the linear relationship & does not necessarily
imply a relationship.

Correlation Analysis Cause and effect.

Correlation analysis helps in determining the degree of relationship between two or
more variables – it does not tell us about the cause -effect relationship. Even in high
degree of correlation does not necessarily mean that a relation ship of cause and effect
exists between the variable by itself, it only establishes covariation.
1. The correlation may be due to pure chance, especially in a small sample. We may get
high degree of correlation between two variables in small sample, but in the
Universe, there may not be any relation.
2. Both the variables may be mutually influencing other, so that neither can be
designated as cause and other effect. There may be high degree of correlation
between the variables but it may be difficult to pin point to which is cause and which
is effect.
3. Both the variables may be influenced by one or more other variables.

Types of Correlation
1. Positive and Negative
2. Simple, Partial & multiple
3. Linear and Nonlinear
Assumptions
1. There is a linear relationship between variables, i.e when the variables are plotted on
scatter diagram a straight line will be formed by the points so plotted.
2. The two variables under study are affected by a large number of independent causes
so as to form a normal distribution.
3. There is cause & effect relationship between variables. If variables are independent,
there can not be a correlation. (No relationship between income and height).

Interpreting Co-efficient of correlation

1. When r=+1 Perfect positive correlation
2. When r=- 1 Perfect negative correlation
3. When r = 0 No relationship.
4. Closure r to +1 & -1 Closure the relationship
5. Closure r to 0 Less closure the relationship

Scatter diagram
The first step in determining whether there is a relationship between two variables is to
examine the graph of observed data. The graph is called scatter diagram.
A scatter diagram can give us two types of information
1. That the variables are related
2. The kind of relationship i.e what kind of line or relationship estimating equation
describes this relationship