EBE 2174/EBQ2074 Econometrics

Tutorial 2 (ANSWERS)
Evan Lau

Question 1
Explain how a classical linear regression model can be classified as the best linear unbiased estimator (BLUE).
The BLUE properties of the OLS estimator are often referred to as the Gauss-Markov Theorem. The
theorem states that given the assumptions of the classical linear regression model, the least squares
estimators, in the class of unbiased linear estimators, have minimum variance, that is, they are best
linear unbiased estimators (BLUE). An estimator is BLUE if:
i. It is linear.
ii. It is unbiased. The average or expected value of the estimator is equal to the true value.
iii. It is efficient. It has a minimum variance in the class of all such linear unbiased estimators.
iv. It is consistent. As the sample size gets larger, the variance gets smaller, and the estimate
converges to the true value.
v. It is normally distributed with mean b and variance s b2 .
The BLUE properties justify that the OLS estimator is unbiased and provide lowest variance, making
the OLS estimator superior and widely applied in linear regression estimates.

Question 2
What is meant by the best unbiased or efficient estimator? Why is this important?
The best unbiased or efficient estimator refers to the one with the smallest variance among unbiased
estimators. It is the unbiased estimator with the most compact or least spread-out distribution. This
is important because the researcher would be more certain that the estimator is closer to the true
population parameter being estimated/ Efficient estimator has the smallest confidence interval and
is more likely to be statistically significant than any other estimator.

Question 3

A random sample of 8 drivers insured with a company and having similar into insurance policies was selected. The
following table lists their driving experience (in years) and monthly auto insurance premiums.

Driving Experience (years) Monthly Auto Insurance Premium ($)

5 64
2 87
12 50
9 71
15 44
6 56
25 42
16 60

(a) Does the insurance premium depend on the driving experience or does the driving experience depend on the
insurance premium? Do you expect a positive or a negative relationship between these two variables?
Based on theory and intuition, we expect the insurance premium to depend on driving experience.
Consequently, the insurance premium is a dependent variable and driving experience is an
independent variable in the regression model. A new driver is considered a high risk by the insurance
companies, and he or she has to pay a higher premium for auto insurance. On average, the insurance
premium is expected to decrease with an increase in the years of driving experience. Therefore, we
expect a negative relationship between these two variables.
(b) Compute 𝛽" and 𝛽# and write out the estimation regression.
x y ( 𝑥 − 𝑥̅ ) (𝑦 − 𝑦*) (𝑥 − 𝑥̅ )(𝑦 − 𝑦*) ( 𝑥 − 𝑥̅ )#
5 64 -6.25 4.75 -29.6875 39.0625
2 87 -9.25 27.75 -256.688 85.5625
12 50 0.75 -9.25 -6.9375 0.5625
9 71 -2.25 11.75 -26.4375 5.0625
15 44 3.75 -15.25 -57.1875 14.0625
6 56 -5.25 -3.25 17.0625 27.5625
25 42 13.75 -17.25 -237.188 189.0625
16 60 4.75 0.75 3.5625 22.5625
Total 90 474 -593.5 383.5
Mean 11.25 59.25

−593.5
𝛽# = = −1.5476
383.5

𝛽" = 59.25 − [11.25 ∗ (−1.5476)] = 76.6604

Thus, the estimated regression: 𝒚

< = 𝟕𝟔. 𝟔𝟔𝟎𝟒 − 𝟏. 𝟓𝟒𝟕𝟔𝒙

(c) Interpret 𝛽" and 𝛽# .

The value of 𝜷𝟏 = 76.6605 gives the value of ŷ for x = 0; that is, it gives the monthly auto insurance
premium for a driver with no driving experience.

The value of 𝜷𝟐 gives the change in ŷ due to a change of one unit in x. Thus, 𝜷𝟐 = −1.5476 indicates
that, on average, for every extra year of driving experience, the monthly auto insurance premium
decreases by $1.55.

Question 4
(a) Lists out the assumptions of the simple linear regression model in terms of the random error, e.
The assumptions are:
1. The value of y, for each value of x, is: y = β1 + β2 x + e
2. The expected value of the random error e is: E (e) = 0 and this is equivalent to assuming
that E ( y ) = β1 + β 2 x
3. The variance of the random error e is: var(e) = σ = var( y ). The random variables y and e
2

have the same variance because they differ only by a constant.

4. The covariance between any pair of random errors, ei and ej is: cov(ei , e j ) = cov( yi , y j ) = 0
The stronger version of this assumption is that the random errors e are statistically
independent, in which case the values of the dependent variable y are also statistically
independent.
5. The variable x is not random, and must take at least two different values
6. The values of e are normally distributed about their mean if the values of y are normally
distributed, and vice versa: 2
e ~N (0, σ )
 (b) Write out the formula for 𝛽" and 𝛽# and how does the slope of the regression line can be calculated?

The formula:
b2 =
å ( x - x )( y - y )
i i

å (x - x)
i
2

𝛽" = 𝑦* − 𝛽# 𝑥̅

The slope of the regression line can be written as:

DE ( y | x) dE ( y | x)
β2 = =
Dx dx