You are on page 1of 13

Basic Econometrics

Chapter 3:
TWO-VARIABLE
REGRESSION MODEL:
The problem of Estimation

1
Prof. Himayatullah May 2004
3-1. The method of ordinary
least square (OLS)
 Least-square criterion:
 Minimizing U^2i = (Yi – Y^i) 2
= (Yi- ^1 - ^2X)2 (3.1.2)
 Normal Equation and solving it
for ^1 and ^2 = Least-square
estimators [See (3.1.6)(3.1.7)]
 Numerical and statistical
properties of OLS are as follows:
2
Prof. Himayatullah May 2004
3-1. The method of ordinary least
square (OLS)
 OLS estimators are expressed solely in terms of
observable quantities. They are point estimators
 The sample regression line passes through
sample means of X and Y
 The mean value of the estimated Y^ is equal to
the mean value of the actual Y: E(Y) = E(Y^)
 The mean value of the residuals U^i is zero:
E(u^i )=0
 u^i are uncorrelated with the predicted Y^i and
with Xi : That are u^iY^i = 0; u^iXi = 0
3
Prof. Himayatullah May 2004
3-2. The assumptions underlying
the method of least squares

 Ass 1: Linear regression model

(in parameters)
 Ass 2: X values are fixed in repeated
sampling
 Ass 3: Zero mean value of ui : E(uiXi)=0
 Ass 4: Homoscedasticity or equal
variance of ui : Var (uiXi) = 2
[VS. Heteroscedasticity]
 Ass 5: No autocorrelation between the
disturbances: Cov(ui,ujXi,Xj ) = 0
with i # j [VS. Correlation, + or - ]
4
Prof. Himayatullah May 2004
3-2. The assumptions underlying
the method of least squares
 Ass 6: Zero covariance between ui and Xi
Cov(ui, Xi) = E(ui, Xi) = 0
 Ass 7: The number of observations n must be
greater than the number of parameters
to be estimated
 Ass 8: Variability in X values. They must
not all be the same
 Ass 9: The regression model is correctly
specified
 Ass 10: There is no perfect multicollinearity
between Xs
5
Prof. Himayatullah May 2004
3-3. Precision or standard errors of
least-squares estimates
 In statistics the precision of an
estimate is measured by its standard
error (SE)
 var( ^2) = 2 / x2i (3.3.1)
 se(^2) =  Var(^2) (3.3.2)
 var( ^1) = 2 X2i / n x2i (3.3.3)
 se(^1) =  Var(^1) (3.3.4)
 ^ 2 = u^2i / (n - 2) (3.3.5)
 ^ =  ^ 2 is standard error of the
estimate 6
Prof. Himayatullah May 2004
3-3. Precision or standard errors of
least-squares estimates

 Features of the variance:

+ var( ^2) is proportional to 2 and
inversely proportional to x2i
+ var( ^1) is proportional to 2 and
X2i but inversely proportional to x2i
and the sample size n.
+ cov ( ^1 , ^2) = -X var( ^2) shows
the independence between ^1 and ^2
7
Prof. Himayatullah May 2004
3-4. Properties of least-squares
estimators: The Gauss-Markov Theorem
 An OLS estimator is said to be BLUE if :
+ It is linear, that is, a linear function of a
random variable, such as the dependent
variable Y in the regression model
+ It is unbiased , that is, its average or expected
value, E(^2), is equal to the true value 2
+ It has minimum variance in the class of all
such linear unbiased estimators
An unbiased estimator with the least variance is
known as an efficient estimator
8
Prof. Himayatullah May 2004
3-4. Properties of least-squares
estimators: The Gauss-Markov
Theorem

 Gauss- Markov Theorem:

Given the assumptions of the
classical linear regression model,
the least-squares estimators, in
class of unbiased linear estimators,
have minimum variance, that is,
they are BLUE

9
Prof. Himayatullah May 2004
β̂ 2

3-5. The coefficient of determination

r2: A measure of “Goodness of fit”
 Yi = Ŷ i + Û i or
 Yi - Y = Ŷ i - Ŷi + Ûi or
 yi = ŷ i + Û i (Note: Y= Ŷ )
Squaring on both side and summing =>
  yi2 = β̂22 x2i +  Û 2i ; or
 TSS = ESS + RSS

10
Prof. Himayatullah May 2004
3-5. The coefficient of determination r2:
A measure of “Goodness of fit”

 TSS =  yi2 = Total Sum of Squares

 ESS =  Y^ i2 = ^22 x2i =
Explained Sum of Squares
 RSS =  u^2I = Residual Sum of
Squares
1= -------- + -------- ; or
TSS TSS
1= r2 + ------- ; or r2 = 1 - -------
TSS TSS 11
Prof. Himayatullah May 2004
3-5. The coefficient of determination r2:
A measure of “Goodness of fit”
 r2 = ESS/TSS
is coefficient of determination, it measures
the proportion or percentage of the total
variation in Y explained by the regression
Model
 0  r2  1;
 r =  r2 is sample correlation coefficient
 Some properties of r

12
Prof. Himayatullah May 2004
3-5. The coefficient of determination r2:
A measure of “Goodness of fit”

3-6. A numerical Example (pages 80-83)

3-7. Illustrative Examples (pages 83-85)
3-8. Coffee demand Function
3-9. Monte Carlo Experiments (page 85)
3-10. Summary and conclusions (pages
86-87)

13
Prof. Himayatullah May 2004