ECONOMETRICS TEST PREP

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2 distinguishing factors of ECONOMETRICS Economic data is non experimental data o Individuals are normally able to self-select themselves in a group Economic models o Key to interpret the statistical results Cons = 0 + 1inc + 1 = cons / inc 0 < 1 <1 1.2 Steps in empirical economic analysis 1) formulation of the question of interest (EMPIRICAL QUESTIONS) 2) collection of data 3) specification of the economic model 4) estimation, validation, hypothesis testing, prediction estimate model o Cons = 0 + 1inc + o 1 = cons / inc o 0 < 1 <1 test if estimate is between 0 and 1 o average propensity to consume assuming error is 0 cons = 0 + 1inc = 0 + 1 inc inc inc 0 + 1 > 1 OR 0 > 0 inc inc Thus 0 > 0 Estimation o Use OLS to find the estimators 0 and 1.

1.3 Learning by doing (LBD) process by which the cost of producing a product goes down with the cumulative output that the firm has produced Different types of Economic data Cross-sectional Data o Sample of n observations on variables of interest o For a given point in time o Usually collected from random sampling

Time series Data o Observations on variables taken over time o Order is important Data are chronologically arranged Cannot change order o Not a random sample o Not independent across time Most economic series are related to their recent history o Seasonality is important to remember o Data frequency Monthly Weekly Daily Annually quarterly Pooled Cross sectional data o Sequence of cross sectionals of the same variables for different years o Useful data to analyze the evolution over time of the crosssectional distributions of variables o DO NOT FOLLOW THE SAME INDIVIDUALS OVER TIME Panel Data o Group of individuals who are observed at several points in time Time series data for each individual in the sample o FOLLOW THE SAME INDIVIDUALS OVER TIME o Can control for time-invariant unobserved characteristics of firms, individuals, countries

o Individuals are mutually independent from one another but for a given individual observations are mutually dependent o Time dimensions ORDER does Matter Causality and the notion of Ceteris Paribus Goal of econometrics is to find if one variable has causal effects on another variable, the essence of Ceteris Paribus

o Simply establishing a relationship between two variables is rarely sufficient o It has to be Ceteris Paribus Ceteris paribus o Keeping all other factors fixed Example: observe almost identical plants: a and b o YA and YB are current output of Plant A and Plant B NA and NB are respective cumulative outputs o Model: LnYA LnYB = N (LnNA LnNB) o N = (LnYA LnYB) / (LnNA LnNB) o we do not know if the unobserved, , are the same or not. o Plants are different in many aspects Age Location o Does not mean it is impossible to find causal effects Just very difficult Have to use econometric analysis o If does not know values of Model: LnYA LnYB = N (LnNA LnNB) + (A - B) N= LnYA LnYB + A - B lnNA lnNB lnNA lnNB do not observe s so cannot estimate N o if observe sample with many pairs of plants with same levels of observable inputs, labor and capital can observe the average of the expression Model: N= E ( LnYA LnYB ) + E ( A - B ) ( lnNA lnNB ) ( lnNA lnNB ) Estimate effect by using sample mean: LnYA LnYB lnNA lnNB

11/3/2012 9:54:00 AM Definition of a simple regression model Explain y in terms of x Study how y varies with changes in x Use equation: y = 0 + 1x + Average value of is 0 o Assumption 1: average value of in the population is 0. E() = 0 o So y = 1x o 1 is the slope parameter o 0 is the intercept parameter Assumption 2: the average value of does not depend on the regressors o E(|x) = E()= 0 zero-conditional mean assumption Thus o E(y|x) = 0 + 1x Linear function of x PRF: population regression function Passes through average values of E(Y|X)

1 = Cov(x,y) . Var(X) 0 = E(y) E(x)1 Deriving the OLS estimates Basic idea of regression is to estimate the population parameters of the sample o In the population, has a zero mean and is uncorrelated with x o E() = 0 o So Cov(x) = E(x) = 0 o From E()=0 we get E(y-0-1x) = 0 o From E(x) = 0 we get E(x(y- 0-1x) = 0 These two can be used to estimate 0 and 1 0 = E(y) 1E(x)

1 = E{x[y- E(Y)]} = Cov(x, y) E{X[x-E(X)]} Var(X) 0 = Ybar 1xBar 1 = Sxy / Sxy2 1 = (Xi Xbar)(Yi Ybar) (Xi Xbar)2 Slope estimate (1) is the sample covariance of x and y divided by the sample variance of x Sxy = (1/n) (xi xBar)(yi yBar) OLS is fitting a line through the sample points such that the sum of the squared residuals, RSS, is as small as possible. The residual, , is an estimate of the error term, , and is the difference between the fitted line and the sample point. i= yi - yi = yi - 0 - 1xi i2 = (Yi - 0 - 1xi)2 Sample Regression function SRF- sample o 1= y / x y = 1x Final OLS equations:

o PRF: Yi = 0 + 1Xi o SRF: Yi = 0 + 1Xi + i. = Yi + i i = Yi - 0 + 1Xi Algebraic Properties of OLS 1) The sum, and therefore the sample average of the OLS residuals is zero i = 0 o The mean OLS estimates 0 and 1 are chosen to make the residuals add up to zero. 2) the Sample covariance between the regressor and OLS residuals is zero Xi i = 0 3) the point (Xbar, YBar) is always on the OLS regression line The fitted values and residuals are uncorrelated in the sample Yi = yi i Mechanics of OLS

SST: Total sum of squares o SST = (Yi Ybar)2 SSE: Explained sum of the squares o SSE = (Yi Ybar)2 SSR: Residual sum of the squares o SSR = i2 . Sample variance of y = SST / (n-1) SST = SSE + SSR i(yi yBar) = 0 Goodness of fit: o 1= SSE/SST + SSR/SST o R2 = SSE/SST = 1- SSR/SST o R2 is the percentage of the sample variation in y that is explained by x. o Perfect goodness of fit: R2 = 1 Summary of Functional Forms Involving Logs o Interpretation of 1 Level-level y = 1 X

Level-log y = (1/100)%X log-levels %Y = (1001)X log-log %Y = 1%X Expected Values and variances of the OLS estimates Unbiasedness of OLS o 1 = (Xi Xbar)yi / Sx2 o Sx2= (Xi Xbar)2

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