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After selecting the dependent variable, the specification of a model involves choosing the following components:
1. the independent variables and how they should be measured, 2. the functional (mathematical) form of the variables, and
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Step 2: Specify the Model: Independent Variables and Functional Form (cont.)
A mistake in any of the three elements results in a specification error For example, only theoretically relevant explanatory variables should be included Even so, researchers frequently have to make choices also denoted imposing their priors Example: when estimating a demand equation, theory informs us that prices of complements and substitutes of the good in question are important explanatory variables But which complementsand which substitutes?
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The signs above the variables indicate the hypothesized sign of the respective regression coefficient in a linear model
2011 Pearson Addison-Wesley. All rights reserved.
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Step 4: Collect the Data & Inspect and Clean the Data
A general rule regarding sample size is the more observations the better
as long as the observations are from the same general population!
The reason for this goes back to notion of degrees of freedom (mentioned first in Section 2.4) When there are more degrees of freedom:
Every positive error is likely to be balanced by a negative error (see Figure 3.2) The estimated regression coefficients are estimated with a greater deal of precision
2011 Pearson Addison-Wesley. All rights reserved.
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Step 4: Collect the Data & Inspect and Clean the Data (cont.)
Estimate model using the data in Table 2.2 to get:
Inspecting the dataobtain a printout or plot (graph) of the data Reason: to look for outliers
An outlier is an observation that lies outside the range of the rest of the observations
Examples:
Does a student have a 7.0 GPA on a 4.0 scale? Is consumption negative?
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The evaluation part is more tricky, however, involving answering the following questions:
How well did the equation fit the data? Were the signs and magnitudes of the estimated coefficients as expected?
Afterwards may add sensitivity analysis (see Section 6.4 for details)
2011 Pearson Addison-Wesley. All rights reserved.
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Background:
You have been hired to determine the best location for the next Woodys restaurant (a moderately priced, 24-hour, family restaurant chain)
Objective:
How to decide location using the six basic steps of applied regression analysis, discussed earlier?
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More discussions with in-house experts reveal three major determinants of sales:
Number of people living near the location
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Step 2: Specify the Model: Independent Variables and Functional Form (cont.)
Based on this, the exact definitions of the independent variables you decide to include are:
N = Competition: the number of direct competitors within a twomile radius of the Woodys location P = Population: the number of people living within a three-mile radius of the location I = Income: the average household income of the population measured in variable P
With no reason to suspect anything other than linear functional form and a typical stochastic error term, thats what you decide to use
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After talking some more with the in-house experts and thinking some more, you come up with the following:
(3.4)
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Step 4: Collect the Data & Inspect and Clean the Data
You manage to obtain data on the dependent and independent variables for all 33 Woodys restaurants
Next, you inspect the data The data quality is judged as excellent because:
Each manager measures each variable identically All restaurants are included in the sample All information is from the same year
The resulting data is as given in Tables 3.1 and 3.3 in the book (using Eviews and Stata, respectively)
2011 Pearson Addison-Wesley. All rights reserved.
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(3.5)
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Table 3.1a Data for the Woodys Restaurants Example (Using the Eviews Program)
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Table 3.1b Data for the Woodys Restaurants Example (Using the Eviews Program)
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Table 3.1c Data for the Woodys Restaurants Example (Using the Eviews Program)
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Table 3.3 Data for the Woodys Restaurants Example (Using the Stata Program)
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Table 3.3b Data for the Woodys Restaurants Example (Using the Stata Program)
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