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Specification and Estimation

Walter R. Paczkowski

Rutgers University

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 1

Chapter Contents

2.2 An Econometric Model

2.3 Estimating the Regression Parameters

2.4 Assessing the Least Squares Estimators

2.5 The Gauss-Markov Theorem

2.6 The Probability Distributions of the Least

Squares Estimators

2.7 Estimating the Variance of the Error Term

2.8 Estimating Nonlinear Relationships

2.9 Regression with Indicator Variables

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 2

2.1

An Economic Model

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 3

2.1

An Economic

Model

studying relationships between variables

– Economic theory tells us that expenditure on

economic goods depends on income

– Consequently we call y the ‘‘dependent

variable’’ and x the independent’’ or

‘‘explanatory’’ variable

– In econometrics, we recognize that real-world

expenditures are random variables. All the

information about the dependent variables y is

contained the in probability density of y.

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 4

2.1

An Economic

Model

density function since it is ‘‘conditional’’ upon an

x

– The conditional mean, or expected value, of y is

E(y|x)

• The expected value of a random variable is

called its ‘‘mean’’ value, which is really a

contraction of population mean, the center of

the probability distribution of the random

variable.

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 5

2.1

An Economic Figure 2.1a Probability distribution of food expenditure y given

Model income x = $1000

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 6

2.1

An Economic

Model

measures the dispersion of y about its mean μy|x

– We assume this to be constant and independent

of the level of income x.

– The conditional mean E(y|x) varies with x but

the conditional variance σ2 is assumed constant.

– Thus E(y|x) is focus of our attention.

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 7

2.1

An Economic Figure 2.1b Probability distributions of food expenditures y

Model given incomes x = $1000 and x = $2000

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 8

2.1

An Economic

Model

expenditure and income we must build an

economic model and then a corresponding

econometric model that forms the basis for a

quantitative or empirical economic analysis

– This econometric model is also called a

regression model

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 9

2.1

An Economic

Model

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 10

2.1

An Economic

Model

It is called E y 1not

( y | x)regression

simple because

2x it is easy,

but because there is only one explanatory variable

on the right-hand side of the equation

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 11

2.1

An Economic Figure 2.2 The economic model: a linear relationship between

Model average per person food expenditure and income

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 12

2.1

An Economic

Model

E ( y | x) dE ( y | x)

Eq. 2.2 β2

x dx

E ( y | x) dE ( y | x)

where “Δ” denotes

2 “change

x

in” and “dE(y|x)/dx”

dx

Eq. 2.2

given an x value

“Δ” denotes “change in” and “dE(y|x)/dx” denotes the derivative of

the expected value of y given an x value

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 13

2.2

An Econometric Model

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 14

2.2

An Econometric

Model

Figure 2.3 The probability density function for y at two levels of income

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 15

2.2

An Econometric

Model

straight line function

deviate from this average level and is given by

y E( y / x) e 1 2 x e

Here e is random error. Why e?

There are several key assumptions underlying the

error term of simple linear regression.

These are required so that statistical inference is

validated

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 16

2.2

An Econometric

Model

ASSUMPTIONS OF THE SIMPLE LINEAR REGRESSION MODEL - II

2.2.1

Introducing the

Error Term

Assumption SR1:

The value of y, for each value of x, is:

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 17

2.2

An Econometric

Model

ASSUMPTIONS OF THE SIMPLE LINEAR REGRESSION MODEL - II

2.2.1

Introducing the

Error Term

Assumption SR2:

The expected value of the random error e is:

E (e) 0

E ( y) β1 β2 x

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 18

2.2

An Econometric

Model

ASSUMPTIONS OF THE SIMPLE LINEAR REGRESSION MODEL - II

2.2.1

Introducing the

Error Term

Assumption SR3:

The variance of the random error e is:

var(e) σ 2 var( y)

same variance because they differ only by

a constant.

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 19

2.2

An Econometric

Model

ASSUMPTIONS OF THE SIMPLE LINEAR REGRESSION MODEL - II

2.2.1

Introducing the

Error Term

Assumption SR4:

The covariance between any pair of random

errors, ei and ej is:

cov( ei , e j ) cov( yi , y j ) 0

the random errors e are statistically independent,

in which case the values of the dependent

variable y are also statistically independent

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 20

2.2

An Econometric

Model

ASSUMPTIONS OF THE SIMPLE LINEAR REGRESSION MODEL - II

2.2.1

Introducing the

Error Term

Assumption SR5:

The variable x is not random, and must take at

least two different values

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 21

2.2

An Econometric

Model

ASSUMPTIONS OF THE SIMPLE LINEAR REGRESSION MODEL - II

2.2.1

Introducing the

Error Term

Assumption SR6:

(optional) The values of e are normally

distributed about their mean if the values of y

are normally distributed, and vice versa

e ~N (0, σ ) 2

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 22

2.3

Estimating the Regression Parameters

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 23

The parameters of the population regression

y β1 β2 x e

are unknown.

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 24

2.3

Estimating the

Regression Table 2.1 Food Expenditure and Income Data

Parameters

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 25

2.3

Estimating the

Regression Figure 2.6 Data for food expenditure example

Parameters

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 26

2.3

Estimating the

Regression

Parameters

2.3.1

The Least Squares

Principle

Eq. 2.5 yˆi b1 b2 xi

The least squares residual is:

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 27

2.3

Estimating the

Regression Figure 2.7 The relationship among y, ê and the fitted regression line

Parameters

2.3.1

The Least Squares

Principle

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 28

2.3

Estimating the

Regression

Parameters

2.3.1

The Least Squares

Principle

yˆ i* b1* b2* xi

squared residuals:

N N

if SSE ei and SSE ei then SSE SSE

ˆ 2 *

ˆ *2 *

i 1 i 1

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 29

Least Square Principle

30

2.3

Estimating the

Regression

Parameters

2.3.1

The Least Squares

Principle

parameters β1 and β2 are obtained by minimizing

the error sum of squares function:

N

S (β1 ,β 2 ) ( yi β1 β 2 xi ) 2

i 1

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 31

2.3

Estimating the

Regression THE LEAST SQUARES ESTIMATORS

Parameters

2.3.1

The Least Squares

Principle

Derivation

b2

( x x )( y y )

i i

(x x)

Eq. 2.7

2

i

Eq. 2.8 b1 y b2 x

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 32

2.3

Estimating the

Regression

Parameters

2.3.2

Estimates for the

Food Expenditure

Function

( x x )( y y ) 18671.2684

b2 i

i

10.2096

(x x) i

2

1828.7876

and b2 is to write out the estimated or fitted

regression line:

yˆ i 83.42 10.21xi

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 33

2.3

Estimating the

Regression Figure 2.8 The fitted regression line

Parameters

2.3.2

Estimates for the

Food Expenditure

Function

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 34

2.3

Estimating the

Regression

Parameters

2.3.3

Interpreting the

Estimates

household increases when household weekly

income increases by $100. Thus, we estimate that

if income goes up by $100, expected weekly

expenditure on food will increase by

approximately $10.21

– Strictly speaking, the intercept estimate b1 =

83.42 is an estimate of the weekly food

expenditure on food for a household with zero

income

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 35

2.3

Estimating the

Regression

Parameters

2.3.3a

Elasticities Income elasticity is a useful way to characterize

the responsiveness of consumer expenditure to

changes in income. The elasticity of a variable y

with respect to another variable x is:

percentage change in y y x

percentage change in x x y

have shown that

E ( y )

β2

x

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 36

2.3

Estimating the

Regression

Parameters

2.3.3a

Elasticities The elasticity of mean expenditure with respect to

income is:

E ( y ) E ( y ) E ( y ) x x

β2

x x x E ( y ) E ( y)

Eq. 2.9

A frequently used alternative is to calculate the elasticity

at the “point of the means” because it is a

representative point on the regression line.

x 19.60

ˆ b2 10.21 0.71

y 283.57

Interpretation: If income of a household increases by

1% expenditure on food increases by 0.71% on

average. This is true for an average household, why?

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 37

Was food a normal good or inferior good?

Classification: ε > 0 normal, otherwise inferior

Was food a luxury or necessity for the average

household in the sample?

Classification: ε > 1 luxury, otherwise necessity

What goods are luxury and what are necessity?

What is a necessity and what is a luxury depends

on the level of income. For people with a low

income, food and clothing can be luxuries. So the

level of income has a big effect on income

elasticity of demand

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 38

Income elasticity of demand for some products in the US

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 39

Figure: income elasticity of demand for food in 20 countries. Source

: Theil et al. (1989). Advances in Econometrics, edited book

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 40

2.3

Estimating the

Regression

Parameters

2.3.3b

Prediction

expenditure for a household with a weekly income

of $2000. This prediction is carried out by

substituting x = 20 into our estimated equation to

obtain:

yˆ 83.42 10.21xi 83.42 10.21(20) 287.61

of $2000 will spend $287.61 per week on food

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 41

2.3

Estimating the

Regression Figure 2.9 EViews Regression Output

Parameters

2.3.3c

Computer Output

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 42

2.3

Estimating the

Regression

Parameters

2.3.4

Other Economic

Models

estimate the parameters of many relationships in

economics, business, and the social sciences

– The applications of regression analysis are

fascinating and useful

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 43

Is a CEO compensated for good company

performance?

Salary ($1000) 967 5.58ROE (%)

education?

Wage ($ / h) 8.49 1.18EDU ( years )

Input-Output relation:

Output (# units) 36 0.75Labor (hours )

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 44

2.4

Assessing the Least Squares Fit

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 45

2.4

1 Assessing the

and

2Least Squares Fit

yˆ i 83.42 10.21xi b1 b2 x

are to the true parameters

We call b1 and b2 the least squares estimators.

– We can investigate the properties of the estimators b1

and b2 , which are called their sampling properties, and

deal with the following important questions:

1. If the least squares estimators are random

variables, then what are their expected values,

variances, covariances, and probability

distributions?

2. How do the least squares estimators compare with

other procedures that might be used, and how can

we compare alternative estimators?

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 46

2.5

The Gauss-Markov

Theorem

GAUSS-MARKOV THEOREM

regression model, the estimators b1 and b2 have the

smallest variance of all linear and unbiased

estimators of b1 and b2. They are the Best Linear

Unbiased Estimators (BLUE) of b1 and b2

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 47

2.5

The Gauss-Markov

Theorem MAJOR POINTS ABOUT THE GAUSS-MARKOV THEOREM

estimators, those which are linear and unbiased. The Theorem does

not say that b1 and b2 are the best of all possible estimators.

2. The estimators b1 and b2 are best within their class because they

have the minimum variance. When comparing two linear and

unbiased estimators, we always want to use the one with the

smaller variance, since that estimation rule gives us the higher

probability of obtaining an estimate that is close to the true

parameter value.

SR5 must be true. If any of these assumptions are not true, then b1

and b2 are not the best linear unbiased estimators of β1 and β2.

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 48

2.5

The Gauss-Markov

Theorem MAJOR POINTS ABOUT THE GAUSS-MARKOV THEOREM

of normality (assumption SR6).

and unbiased estimator, then we have to do no more searching.

The estimators b1 and b2 are the ones to use. This explains why

we are studying these estimators and why they are so widely used

in research, not only in economics but in all social and physical

sciences as well.

estimators. It does not apply to the least squares estimates from a

single sample.

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 49

2.4

Assessing the

Least Squares Fit

2.4.1

The Estimator b2 The estimator b2 can be rewritten as:

N

Eq. 2.10 b2 wi yi

i 1

where

xi x

wi

i

Eq. 2.11

( x x ) 2

Eq. 2.12 b2 β2 wi ei

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 50

2.4

Assessing the

Least Squares Fit

2.4.2

The Expected

Values of b1 and b2

We will show that if our model assumptions hold,

then E(b2) = β2, which means that the estimator is

unbiased. We can find the expected value of b2

using the fact that the expected value of a sum is

the sum of the expected values:

E (b2 ) E (b2 wi ei ) E (β 2 w1e1 w2e2 ... wN eN )

E (β 2 ) E ( w1e1 ) E ( w2e2 ) ... E ( wN eN )

Eq. 2.13 E (β 2 ) E ( wi ei )

β 2 wi E (ei )

β2

using E (ei ) 0 and E (wi ei ) wi E (ei )

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 51

2.4

Assessing the

Least Squares Fit

2.4.2

The Expected

Values of b1 and b2

The property of unbiasedness is about the average

values of b1 and b2 if many samples of the same size

are drawn from the same population

– If we took the averages of estimates from many

samples, these averages would approach the true

parameter values b1 and b2

– Unbiasedness does not say that an estimate from

any one sample is close to the true parameter value,

and thus we cannot say that an estimate is unbiased

– We can say that the least squares estimation

procedure (or the least squares estimator) is

unbiased

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 52

2.4

Assessing the

Least Squares Fit

Table 2.2 Estimates from 10 Samples

2.4.3

Repeated

Sampling

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 53

2.4

Assessing the

Least Squares Fit

Figure 2.10 Two possible probability density functions for b2

2.4.3

Repeated The variance of b2 is defined as var( b2 ) E[b2 E (b2 )]2

Sampling

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 54

2.4

Assessing the

Least Squares Fit

2.4.4

The Variances and

Covariances of b1

If the regression model assumptions SR1-SR5 are

and b2

correct (assumption SR6 is not required), then the

variances and covariance of b1 and b2 are:

Eq. 2.14

var(b1 ) σ 2

x 2

i

N xi x

2

σ2

Eq. 2.15 var(b2 )

xi x

2

x

Eq. 2.16 cov(b1 , b2 ) σ 2

xi x

2

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 55

2.4

Assessing the MAJOR POINTS ABOUT THE VARIANCES AND COVARIANCES

Least Squares Fit OF b1 AND b2

2.4.4

The Variances and 1. The larger the variance term σ2 , the greater the uncertainty

Covariances of b1

and b2

there is in the statistical model, and the larger the variances

and covariance of the least squares estimators.

2

2.

variances of the least squares estimators and the more

precisely we can estimate the unknown parameters.

3. The larger the sample size N, the smaller the variances and

covariance of the least squares estimators.

The larger the term x , the larger the variance of the least

2

4. i

larger in magnitude is the sample mean x , and the

covariance has a sign opposite to that of x.

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 56

series x

series y

x=10*nrnd

y=3+2*x+50*nrnd

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 57

2.4 Figure 2.11 The influence of variation in the explanatory variable x on

Assessing the precision of estimation (a) Low x variation, low precision (b) High x

Least Squares Fit

variation, high precision

2.4.4

The Variances and

Covariances of b1

The variance of b2 is defined as var( b2 ) Eb2 E (b2 )

2

and b2

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 58

2.6

The Probability Distributions of the

Least Squares Estimators

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 59

2.6

The Probability

Distributions of the

Least Squares

Estimators

SR6 about the error term) then the least squares

estimators are normally distributed:

σ 2 xi2

Eq. 2.17 b1 ~ N β1 ,

N x x 2

i

σ2

Eq. 2.18 b2 ~ N β2 ,

x x

2

i

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 60

2.6

The Probability

Distributions of the

Least Squares

A CENTRAL LIMIT THEOREM

Estimators

size N is sufficiently large, then the least squares

estimators have a distribution that approximates the

normal distributions shown in Eq. 2.17 and Eq. 2.18

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 61

2.7

Estimating the Variance of the Error

Term

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 62

2.7

Estimating the

Variance of the

Error Term

consider estimating σ2 as the average of the

squared errors:

σ̂ 2

i

e 2

N

where the error terms are ei yi β1 β 2 xi

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 63

2.7

Estimating the

Variance of the

Error Term

the unknown parameters by their least squares

estimates:

eˆi yi yˆi yi b1 b2 xi

σ2

i

ˆ

e 2

N

There is a simple modification that produces an

unbiased estimator, and that is:

Eq. 2.19 ˆ 2 i

e 2

N 2

so that:

E σ̂ 2 σ 2

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 64

2.7

Estimating the

Variance of the

Error Term

2.7.1

Estimating the

Variance and

Replace the unknown error variance σ2 in Eq. 2.14

Covariance of the

Least Squares – Eq. 2.16 by ˆ 2 to obtain:

Estimators

Eq. 2.20

var(b1 ) σˆ 2

xi

2

N xi x

2

σ̂ 2

Eq. 2.21 var(b2 )

xi x

2

x

Eq. 2.22 cov(b1 , b2 ) σˆ 2

xi x

2

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 65

2.7

Estimating the

Variance of the

Error Term

2.7.1

Estimating the

Variance and

Covariance of the

Least Squares

Estimators

The square roots of the estimated variances are the

“standard errors” of b1 and b2:

Principles of Econometrics, 4th Edition Chapter 2: The Simple Linear Regression Model Page 66

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