Introduction to Econometrics

Introduction
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Decision making in business and economics is often supported

by the use of quantitative information.

Econometrics is concerned with summarizing relevant data
information by means of a model. Such econometric models help
to understand the relation between economic and business
variables and to analyse the possible effects of decisions.
Econometrics was founded as a scientic discipline around 1930.
In the early years, most applications dealt with macroeconomic
questions to help governments and large rms in making their
long-term decisions.

Introduction
3

Nowadays econometrics forms an indispensable tool to model

empirical reality in almost all economic and business disciplines.

There are three major reasons for this increasing attention for
factual data and econometric models.

Economic theory often does not give the quantitative information that is needed

in practical decision making.

Relevant quantitative data are available in many economic and business
disciplines.
Realistic models can easily be solved by modern econometric techniques
to support everyday decisions of economists and business managers.

Introduction
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In areas such as nance and marketing, quantitative data (on

price movements, sales patterns, and so on) are collected on a

regular basis, weekly, daily, or even every split second. Much
information is also available in microeconomics (for instance, on
the spending behaviour of households).
Econometric techniques have been developed to deal with all
such kinds of information.
Econometrics is an interdisciplinary eld. It uses insights from
economics and business in selecting the relevant variables and
models, it uses computer science methods to collect the data and
to solve econometric models, and it uses statistics and
mathematics to develop econometric methods that are
appropriate for the data and the problem at hand.

Econometrics as an interdisciplinary eld

5

Economics &
Business

Statistics

Econometrics

Computer Science

Mathematics

Purpose of this course

6

To obtains a solid understanding of econometric methods and an

active training in econometrics as it is applied in practice. This

involves the following steps.
1.
Question- Formulate the economic and business
questions of central interest.
2. Information - Collect and analyse relevant statistical data.
3. Model -Formulate and estimate an appropriate
econometric model.
4. Analysis - Analyse the empirical validity of the model.
5. Application - Apply the model to answer the questions
and to support decisions.

Econometric modelling
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Economic or Business
problem of interest

Data

Statistical
Method

Economic
Model

Econometric
model
Ok?
Yes
Use for forecasting
and decision making

No

Software

Revise

Econometrics as separate from statistics

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Econometrics is based upon the development of statistical

methods for estimating economic relationships, testing economic

theories and evaluating and implementing economic and
business policy.
Econ0metrics has evolved as a separate discipline from
mathematical statistics because the former focuses on problems
inherent in collecting and analyzing non experimental economic
data.

Steps in empirical Economic Analysis

9

Econometric methods are relevant in virtually every branch of applied

economics. They come into play either when we have an economic

theory to test or when we have a relationship in mind that has some
importance for business decisions or policy analysis. An empirical
analysis uses data to test a theory or to estimate a relationship.
The first step in any empirical analysis is obviously the careful
formulation of the question of interest. The question might deal with
testing a certain aspect of an economic theory or it might pertain to
testing the effect of a governmental policy
In some cases, especially those that involve testing of economic
theories, a formal economic model is constructed to begin with. But
it is more common to use economic theory less formally, or even
to rely entirely on intuition.
After the economic model (formal or developed less formally or based
on intuition) is specified, it needs to be turned into an econometric
model.

Example of economic models

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A formal economic model: Beckers (1968) economic model

of criminal behaviour: In a seminal article, Noble Prize winner

Gary Becker postulated a utility maximizing framework to
describe an individuals participation in crime. From Beckers
perspective, decision to undertake illegal activity is one of
resource allocation, with the benefits and costs of competing
activities taken into account
Y = f(x1, x2, x3, x4, x5, x6,x7)
Where, y=hours spent in criminal activities; x1 = wage for an
hour spent in criminal activity; x2= hourly wage in legal
employment; x3 = income other than from crime or employment;
x4 = probability of getting caught; x5 = probability of getting
convicted if caught, x6 = expected sentence if convicted and x7 =
age

Example of economic models

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Less formal economic model: A labour economist would

like to examine the effects of workers productivity on wage.

In this case there is little need for formal economic theory.
Basic economic understanding is sufficient for realizing
that factors workers are paid commensurate with their
productivity which in turn depends on factors such as
education, experience and training. Thus, one can think of a
model
Wage = f (education, experience, training)

Economic to Econometric model

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First, in each of the last two models f(.) needs to specified

Second, the variables in each of these models which cannot be

reasonably observed needs to be dealt with

These ambiguities inherent in an economic model are
resolved by specifying a particular econometric model
An econometric model for economic model 1:
Crime =b0+b1wagem+b2othinc+b3freqarr+b4freqconv
+b5avgsen+b6age+e
An econometric model for economic model 2:
Wage = b0+b1edu + b2exper +b3training +e
Where the term e contains factors such as innate ability, quality of
education, family background etc

Data
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Often in empirical analysis we straight away start with the econometric

model and then various hypotheses of interest can be stated in terms of

unknown parameters and go on refining the model
Once the econometric model is specified, the requisite data is collected
The econometric methods are used to estimate the parameters in the
econometric model and to formally test the hypotheses of interest

Structure of Economic Data

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Cross-section data set consists of a sample of individuals, households,

firms, cities etc taken at a given point of time. Sometimes data on all
units may not correspond to precisely the same time period. An
important feature of cross-sectional data is that they can often be
assumed to be obtained from random sampling from an underlying
population. But this assumption may not always be true.
Time series data set- consists of observations on a variable or several

variables over time. A key feature of this data that makes it difficult to
analyze is that economic observations are rarely independent across
time. Second, issue is the frequency of data.

Structure of Economic Data

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Pooled Cross Sections data- some data have both cross-sectional and

time series features. For example, two cross sectional household

surveys are taken in the USA, one in1985 and one in 1990 using the
same survey. To increase our sample size, we can form a pooled cross
section by combining the two years. Here the econometric model
normally has year as a separate variable. This data is most often
analyzed as a standard cross section , except that we often need to
account for the secular differences in variables across time.
Panel Data set consists of a time series for each cross-sectional

member in the data set. Key feature of this data set which distinguishes
it from pooled cross section is the same cross sectional units
(households, firms etc) are followed over a given time period

Causality and Notion of Ceteris Paribus in

Econometric Analysis
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In most tests of economic theory, and certainly for evaluating policies,

the economists goal is to infer that one variable has a causal effect on
another variable. Simply finding an association between two or more
variables might be suggestive, but unless causality can be established, it
is rarely compelling.
Second, the notion of ceteris paribus- which means other (relevant)

factors being equal- plays an important role in causal analysis in

econometric modeling.

Discussion ahead
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Against the backdrop, we start with cross section data set and focus on

explaining causal relationship between the variables under study

Regression analysis

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