What is Econometrics?

• Some definitions
Introduction to Econometrics • Why study econometrics?
• The Econometric Process
Economics 4421 • Example: wages and productivity
• Causality
• Example
• Types of data
Slides by F. Bokhari. Adapted from Ken Clark (2003), P. Anderson (2003) and
David A. Macpherson (1999). 1 2

Econometrics Definition(s)
• Econometrics - Apply statistical methods to • Goldberger – “Econometrics may be defined as
economic data the social science in which the tools of economic
theory, mathematics, and statistical inference are
• Econometric approach: applied to the analysis of economic phenomena”
– Develop working model from an economic • Sameulson – “… econometrics may be defined as
theory the quantitative analysis of actual economic
– Estimate model with real world data. phenomena based on the concurrent development
• Real world data is not perfect of theory and observation, related by appropriate
methods of science”
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 Econometric Output Econometric Inputs
• Estimation/Measurement • Ingredients of an econometric exercise:
• Inference/Hypothesis testing – Economic Theory
• Forecasting/Prediction – Mathematics
• Evaluation – Statistical Theory
– Data
– Computing Power
– Interpretation/Economic
Knowledge/Common Sense.
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Why study Econometrics?

Econometrics as a process
• Use econometrics to test and refine theory Mathematics

• Theory may be ambiguous about impact of a policy change

Economic Deterministic
– econometrics can evaluate the program Economic
Theory
• Econometric analysis is useful to decision makers. Model

• Rare in economics to have experimental data Statistical Theory

Conclusions
• Need to use nonexperimental, or observational, data to
make inferences Computing

• Important to be able to apply economic theory to real

Statistical
world data Estimates &
Model
Inferences

Data
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 Keynesian Consumption Keynesian Consumption
Function Function
• Theory: people increase consumption as • C = D + EY
income increases, but not by as much as the – C = Consumption
increase in their income. D = Intercept
– Marginal Propensity to Consume (MPC) is the – Y = Income
change in consumption divided by change in E = slope (how much C changes for a given
income. change in Y)
• Not an econometric model
– Assumes a deterministic relationship

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Econometric Model Expected Results

• C = D + EY + H • D>0
H= error term • 0<E<1
• Error term captures several factors: E represents the MPC
– omitted variables
– measurement error in the dependent variable
– randomness of human behavior

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 Model Estimation Least Squares
• How estimate model? - Fit a line through • Estimate on basis of least squares
the data. – the line of best fit minimizes the sum of the
• Suppose get C = 1000 + .8Y squared deviations of the points on the graph
from the points on the straight line.
D = 1000
• Minimize 6 (CAi - CPi)2
E = .8 – CAi = Actual Consumption for obs i
– CPi = Predicted Consumption for obs i

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Econometric Studies
Interpretation • Price and Quantity
– Demand and elasticities of demand:
• ln Q = D + E lnP + H
• Sample income levels
– Y = 0, Consumption = 1000 • Production Function
– Y = 1000, Consumption = 1800 – Relationship between inputs and outputs.
• Y = f (K,L)
• If Y increases by 1 dollar, then C increases on • Cobb Douglas Y = AKaLb
average by .8 dollars.
• Wage equation
– These estimates are consistent with theory since D >0 – ln W = D0+ D1EDUC + D2EXP + D3GENDER + D4RACE
and 0<E<1
• Suppose E was .9? • Phillips Curve
E < 1, but is it due to the sample? – Relationship between change in money wages and
unemployment 'w = f ('u)
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• Price and Quantity
– Demand and elasticities of demand
• ln Q = D + E lnP + H

• If we were to estimate a equation like above on a data set of price and

quantity (as below), how do we know that we are not measuring the
supply relation?

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Example: wages and productivity Example

use computer to estimate the parameters
• wage=f(educ,exper,training)
what is the ceteris paribus effect of educ on
– deterministic economic model
the wage?
• wage=ǃ0+ ǃ1educ + ǃ2 exper + and to test hypotheses (inference)
ǃ3training + u is ǃ3=0?
– econometric (statistical model) could also forecast wages for workers with given
– u – random error term characteristics.
– ǃ’s parameters.

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 The Question of Causality
• Simply establishing a relationship between
variables is rarely sufficient
• Want to know if the effect is causal
• Can be difficult to establish causality
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Example: (continued)
• The estimate of E1, 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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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 E 0  E1education  u
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General Terminology
• Y: dependent variable
• X: independent or explanatory
• subscript i: refers to ith observation
• t: for time series data at time t
• Cross-sectional data: collected at 1 point in
time
• Time series data: collected over a period of
time
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 Some Terminology
• In the simple linear regression model,
where y = E0 + E1x + u, we typically refer
to y as the
– Dependent Variable, or
– Left-Hand Side Variable, or
– Explained Variable, or
– Regressand
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General Terminology
• Pooled data: mixture of cross-sectional and
time series data
• Panel data: follow a microeconomic unit
over time
• Quantitative data: continuous data
• Qualitative data: categorical data
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Some Terminology, cont.
• In the simple linear regression of y on x,
we typically refer to x as the
– Independent Variable, or
– Right-Hand Side Variable, or
– Explanatory Variable, or
– Regressor, or
– Covariate, or
– Control Variables
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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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