Introduction to Econometrics

Overview
• Economics suggests important relationships, often with policy
implications, but virtually never suggests quantitative magnitudes of
causal effects.
• What is the quantitative effect of reducing class size on student
achievement?
• How does another year of education change earnings?
• What is the price elasticity of cigarettes?
• What is the effect on output growth of a 1 percentage point increase
in interest rates by the Fed?
• What is the effect on housing prices of environmental improvements?
What is Econometrics?
• Broadly defined: the study of economics using
statistical methods

• Founding members of the econometric society

described it:
“..as the quantitative analysis of actual economic phenomena based on the
concurrent development of theory and observation, related by appropriate
methods of inference.” --Samuelson, P., Koopmans, T. & Stone, R. Report of
the Evaluative Committee for Econometrica, Econometrica, 1954, p. 142

Lecture 1 4
Why Econometrics?
• When we read the newspaper or see announcements of
economic statistics or predictions, how are the statistics and
predictions derived?

• Some uses:
• Returns from investing in 1 more year of school
• 2000 Florida election
• Macroeconomic indicators (Phillips Curve)
• Production function estimates

Lecture 1 5
 This course is about using data to measure
causal effects…
• Ideally, we would like an experiment
• what would be an experiment to estimate the effect of class size on standardized test
scores?
• But almost always we only have observational (nonexperimental) data.
• returns to education
• cigarette prices
• monetary policy
• Most of the course deals with difficulties arising from using observational to
estimate causal effects
• confounding effects (omitted factors)
• simultaneous causality
• “correlation does not imply causation”
Takeaways
• Econometrics is a doing subject!
• It is an art that must be learned through practice - working out
problems algebraically, using economic data, building models using
computer software
• No one exact way to present a statistical argument
• Course objective: providing you with knowledge of econometrics in
theory and application
• Vocational uses
• consultancy
• business planning
• politics or public policy
• lawyers, circuit court judge, Supreme Court judge 7
What is Econometrics?
• Theoretical foundations
• Microeconometrics and Macroeconometrics
• Behavioral Modeling: Optimization, labor supply, demand
equations, etc.
• Statistical foundations
• Mathematical Elements
• ‘Model’ building – the econometric model
• Mathematical elements
• The underlying truth – is there one?
• An econometric model consists of:
• Set of equations describing the behavior (observed variables and
disturbances)
• Statement about the errors in the observed values of variables
• Specification of the probability distribution of disturbances
Aims of econometrics
• Formulation and specification of econometric models
• Estimation and testing of models
• Use of models
Econometrics and statistics
• In economic statistics, the empirical data is collected recorded,
tabulated and used in describing the pattern in their development
over time.
• Statistical methods describe the methods of measurement which are
developed on the basis of controlled experiments. Such methods may
not be suitable for economic phenomenon as they don’t fit in the
framework of controlled experiments.
• Econometrics uses statistical methods after adapting them to the
problems of economic life. These adopted statistical methods are
usually termed as econometric methods. Such methods are adjusted
so that they become appropriate for the measurement of stochastic
relationships.
Why Use This Framework?

• Understanding covariation
• Understanding the relationship:
• Estimation of quantities of interest such as elasticities,
partial effects, treatment effects
• Prediction of the outcome of interest
• The search for “causal” effects
• Controlling future outcomes using knowledge of
relationships
In this course you will:
What is Statistics? Types of Statistics
1. Collecting raw data 1. Descriptive
2. Manipulating raw data 2. Inferential
3. Summarizing data
Descriptive Statistics
• Numbers that summarizes or describes
• Plots

• E.g
• Philippines inflation rate is 4.9% in 2016
• Economic graduates 12 students per faculty members.
Inferential statistics
• Estimation
• Hypothesis testing
• Draw conclusions, given randomness

• E.g
• Higher tariffs have statistically significant effect on trade
• At 99% confidence, living inn an area with a significant cancer risk
lowers housing prices between 11 and 20 %

• Note: it always deals with hypothesis.

Example: Wages
• Effect of education on wages outcome

• Q: How can we claim a causal impact of education on wages when IQ

also matters?
Key terms:
• Population- “universe”
• Sample
• Parameter- summary value of population
• Statistic- summary measure of sample
Summary measures
Sample Popn
Mean 𝜇Ƹ 𝑥 𝜇𝑥
2 2
Variance 𝜎ො 𝜎
SD 𝜎ො𝑥 𝜎𝑥
Size 𝑛 𝑁
You and your friends have just measured the heights of your
dogs (in millimeters):
Find out the Mean, the Variance, and the Standard Deviation.

• The heights (at the shoulders) are: 600mm, 470mm, 170mm, 430mm
and 300mm.
Answers:
• Mean = (600 + 470 + 170 + 430 + 300)/5 = 1970/5 = 394
• Now we calculate each dog's difference from the Mean:

• And we can calculate the Variance

• To calculate the Variance, take each difference, square it, and then
average the result:

• Solve for the Standard Deviation

• So, using the Standard Deviation we have a "standard" way of
knowing what is normal, and what is extra large or extra small.

• Rottweilers are tall dogs. And Dachshunds are a bit short ... but
don't tell them!
Types of Data – Cross Sectional
• Cross-sectional data is a random sample

• Each observation is a new individual, firm, etc. with information at a

point in time

• If the data is not a random sample, we have a sample-selection

problem

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Types of Data – Time Series
• Time series data has a separate observation for each time period – e.g.
stock prices

• Since not a random sample, different problems to consider

• Trends and seasonality will be important

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Types of Data – Panel
• Can pool random cross sections and treat similar to a normal cross
section. Will just need to account for time differences.

• Can follow the same random individual observations over time –

known as panel data or longitudinal data

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The Question of Causality
• Simply establishing a relationship between variables is rarely
sufficient
• Want the effect to be considered causal
• If we’ve truly controlled enough other variables, then the estimated
ceteris paribus effect can often be considered to be causal
• Can be difficult to establish causality

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Returns to Education
• Examining relationship between years of education and earnings using
Gary S. Becker’s 1964 theory on human capital

• Comparing the cost and future returns of an additional year of

schooling
• Future earnings are function of schooling given by:
W=f (s) where s = given # years of schooling
• But there’s a simultaneity problem: do you earn more because you have more
schooling or do you pursue more schooling to earn higher wages?

Lecture 1 31
Example: Returns to Education

• A model of human capital investment implies getting more education

should lead to higher earnings
• In the simplest case, this implies an equation like

Earnings   0  1education  u

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Example: (continued)

• The estimate of 1, is the return to education, but can

it be considered causal?
• While the error term, u, includes other factors
affecting earnings, want to control for as much as
possible
• Some things are still unobserved, which can be
problematic

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Wrap up
• An overview of what’s to come
• An introduction to economic data and the idea of empirical
relationships between two measured variables.
• Example: years of education and gross earnings
• Votes cast in Florida and ‘Butterfly Ballot’.
• Problems inherent in using economic data to test empirical
relationships
• Conditional mean function

Lecture 1 34
Review of Probability and Statistics
(SW Chapters 2, 3)
Empirical problem: Class size and educational output

 Policy question: What is the effect on test scores (or some

other outcome measure) of reducing class size by one student
per class?
 We must use data to find out (is there any way to answer this
without data?)

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The California Test Score Data Set
All K-6 and K-8 California school districts (n = 420)

Variables:
 5th grade test scores (Stanford-9 achievement test,
combined math and reading), district average
 Student-teacher ratio (STR) = no. of students in the
district divided by no. full-time equivalent teachers

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Initial look at the data:
(You should already know how to interpret this table)

• This table doesn’t tell us anything about the relationship

between test scores and the STR.

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Do districts with smaller classes have
higher test scores?
Scatterplot of test score v. student-teacher ratio

What does this figure show?

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How do we answer this question with data?
1. Compare average test scores in districts with low STRs to
those with high STRs (“estimation”)

2. Test the “null” hypothesis that the mean test scores in the
two types of districts are the same, against the
“alternative” hypothesis that they differ (“hypothesis
testing”)

3. Estimate an interval for the difference in the mean test

scores, high v. low STR districts (“confidence interval”)
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Compare districts with “small” (STR < 20) and
“large” (STR ≥ 20) class sizes

Class Size Average score Standard n

(Y ) deviation (sY)
Small 657.4 19.4 238
Large 650.0 17.9 182

1. Estimation of  = difference between group means

2. Test the hypothesis that  = 0
3. Construct a confidence interval for 

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