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Chapter 1 - An introduction to econometrics. In this chapter, students will be able to understand: Why study econometrics? What is econometrics? The econometric model, how do we obtain data? statistical inference, a research format.
Chapter An Introduction to Econometrics 1.1 Why Study Econometrics? • Econometrics is a set of research tools also employed in the business disciplines of accounting, finance, marketing and management It is also used by social scientists, specifically researchers in history, political science and sociology Econometrics plays an important role in such diverse fields as forestry, and in agricultural economics • A gap exists between what you have learned as an economics student and what economists actually Most economists use economic data to estimate economic relationships, test economic hypotheses, and predict economic outcomes Studying Slide 1.1 Undergraduate Econometrics, 2nd Edition-Chapter econometrics fills a gap between being “a student of economics” and being “a practicing economist.” • If your goal is to earn a master’s or Ph.D degree in economics, finance, accounting, marketing, agricultural economics, sociology, political science, or forestry, you will encounter more econometrics in your future By taking this introduction to econometrics you will gain an overview of what econometrics is about, and develop some “intuition” about how things work, before entering a technically oriented course Slide 1.2 Undergraduate Econometrics, 2nd Edition-Chapter 1.2 What is Econometrics? • In economics we express our ideas about relationships between economic variables using the mathematical concept of a function • For example, to express a relationship between income i and consumption c, we may write c = f(i) • The demand for an individual commodity, say the Honda Accord, might be expressed as q d = f ( p, p s , p c , i ) d which says that the quantity of Honda Accords demanded, q , is a function f ( p, p s , p c , i ) of the price of Honda Accords p, the price of cars that are substitutes ps, the price of items that are complements pc, like gasoline, and the level of income i • The supply of an agricultural commodity such as beef might be written as Slide 1.3 Undergraduate Econometrics, 2nd Edition-Chapter q s = f ( p, p c , p f ) s where q is the quantity supplied, p is the price of beef, pc is the price of competitive products in production (for example, the price of hogs), and pf is the price of factors or inputs (for example, the price of corn) used in the production process • Each of the above equation is a general economic model that describes how we visualize the way in which economic variables are interrelated Economic models of this type guide our economic analysis Econometrics is about how we can use economic, business or social science theory and data, along with tools from statistics, to answer “how much” type questions Slide 1.4 Undergraduate Econometrics, 2nd Edition-Chapter 1.2.1 Some Examples • A question facing Alan Greenspan is “How much should we increase the discount rate to slow inflation, and yet maintain a stable and growing economy?” The answer will depend on the responsiveness of firms and individuals to increases in the interest rates and to the effects of reduced investment on Gross National Product The key elasticities and multipliers are called parameters The values of economic parameters are unknown and must be estimated using a sample of economic data when formulating economic policies • Econometrics is about how to best estimate economic parameters given the data we have “Good” econometrics is important, since errors in the estimates used by policy makers such as the FRB may lead to interest rate corrections that are too large or too small, which has consequences for all of us Other examples include: Slide 1.5 Undergraduate Econometrics, 2nd Edition-Chapter • A city council ponders the question of how much violent crime will be reduced if an additional million dollars is spent putting uniformed police on the street • U.S Presidential candidate Gore questions how many additional California voters will support him if he spends an additional million dollars in advertising in that state • The owner of a local Pizza Hut franchise must decide how much advertising space to purchase in the local newspaper, and thus must estimate the relationship between advertising and sales • Louisiana State University must estimate how much enrollment will fall if tuition is raised by $100 per semester, and thus whether its revenue from tuition will rise or fall • The CEO of Proctor & Gamble must estimate how much demand there will be in ten years for the detergent Tide, as she decides how much to invest in new plant and equipment Slide 1.6 Undergraduate Econometrics, 2nd Edition-Chapter • A real estate developer must predict by how much population and income will increase to the south of Baton Rouge, Louisiana, over the next few years, and if it will be profitable to begin construction of a new strip-mall • You must decide how much of your savings will go into a stock fund and how much into the money market This requires you to make predictions of the level of economic activity, the rate of inflation and interest rates over your planning horizon • To answer these questions of “how much,” decision makers rely on information provided by empirical economic research In such research, an economist uses economic theory and reasoning to construct relationships between the variables in question Data on these variables are collected and econometric methods are used to estimate the key underlying parameters and to make predictions Slide 1.7 Undergraduate Econometrics, 2nd Edition-Chapter 1.3 The Econometric Model • Economic theory does not claim to be able to predict the specific behavior of any individual or firm, but rather it describes the average and systematic behavior of many individuals or firms When studying Honda car sales we recognize that the actual number of Hondas sold is the sum of this systematic part and a random and unpredictable component, e, that we will call a random error • An econometric model representing the sales of Honda Accords is q d = f ( p, p s , p c , i ) + e • The random error e accounts for the many factors that affect sales that we have omitted from this simple model, and it also reflects the intrinsic uncertainty in economic activity • To complete the specification of the econometric model, we must also say something about the form of the algebraic relationship among our economic variables For Slide 1.8 Undergraduate Econometrics, 2nd Edition-Chapter example, in your first economics courses quantity demanded was depicted as a linear function of price We assume that the systematic part of the demand relation is linear f ( p, p s , p c , i ) = β1 + β2 p + β3 p s + β4 p c + β5i • The corresponding econometric model is q d = β1 + β2 p + β3 p s + β4 p c + β5i + e • The function form represents a hypothesis about the relationship between the variables In a particular problem our interest centers on trying to determine a form that is compatible with economic theory and the data • In every econometric model, there is a systematic portion and an unobservable random component The systematic portion is the part we obtain from economic theory, and Slide 1.9 Undergraduate Econometrics, 2nd Edition-Chapter an assumption about the functional form The random component represents a “noise” component, which obscures our understanding of the relationship among variables, and which we represent using the random variable e Slide 1.10 Undergraduate Econometrics, 2nd Edition-Chapter 1.4 How Do We Obtain Data? 1.4.1 Experimental Data • In an ideal world, from a researcher’s point of view, an economic model would describe how we might design an experiment that could be used to obtain economic observations or sample information, which then could be used to provide insights about the unknown economic parameters Repeating the experiment T times would create a sample of T sample observations • In an ideal world for research, controlled experiments could be conducted to investigate the relationship between these “explanatory” variables and the “dependent” variable qd For example, we might set p = price of Accords = $25,000 Slide 1.11 Undergraduate Econometrics, 2nd Edition-Chapter ps = price of Maximas = $25,000 pc = price of gasoline per gallon = $1.35 i = income of individuals in sample = $42,000 • At the end of a month we observe the number of Honda Accords sold at one dealership to be qd = 37 • By repeating this process a number of times, a sample of economic data is created • In every experiment there is an unobservable random error, or noise, that enters the observable outcome We sets the values of the primary explanatory variables that are indicated by economic reasoning, but it is clear that there are “other” substitute and complement goods whose prices are not controlled There are unobservable factors dictating the level of consumer confidence and willingness to spend These are “random” factors that are not controlled, but which affect the outcome we observe by blurring the picture or adding “noise” to the problem Slide 1.12 Undergraduate Econometrics, 2nd Edition-Chapter • The experimental outcome we observe is the sum of a systematic component that depends on the controlled explanatory variables and this random noise Consequently, the experimental outcome is random too • We never know what we will observe in any trial of the experiment, and thus the quantity of Accords sold, qd, is random • Every sample of size T we collect will be different, and the differences are due to “sampling variability,” which is evidence of the presence of the random error e • If we repeat the experiment a few times, we obtain observations such as those in Table 1.1 Slide 1.13 Undergraduate Econometrics, 2nd Edition-Chapter Table 1.1 Monthly Sales of Honda Accords month qd p ps pc i 37 25 25 1.35 42 28 23 25 1.35 32 30 23 25 1.35 32 35 20 25 1.35 35 40 25 27 1.35 42 46 25 30 1.35 52 52 25 32 1.35 55 55 25 25 1.40 60 60 25 25 1.45 70 10 65 25 25 1.55 100 Slide 1.14 Undergraduate Econometrics, 2nd Edition-Chapter • We, the econometricians, wish to determine the relationship between each of the explanatory variables (p, pc, ps, i) and the dependent variable qd using a sample of T observations on values of the explanatory variables and the observed quantities sold • When the experiments are uncontrolled, economists take the role of observers, and economic theory indicates the relevant variables to consider By observing T values of each economic variable, a sample with T observations is created 1.4.2 Nonexperimental Data • Most economic data are collected for administrative rather than research purposes, often by government agencies The data may be collected in a: • time series form—data collected over discrete intervals of time • cross section form—data collected over sample units in a particular time period • panel data form—data that follow individual micro-units over time Slide 1.15 Undergraduate Econometrics, 2nd Edition-Chapter • These data may be collected at various levels of aggregation: • micro—data collected on individual economic decision making units such as individuals, households or firms • macro—data resulting from a pooling or aggregating over individuals, households or firms at the local, state or national levels • The data collected may also represent a flow or a stock: • flow—outcome measures over a period of time, such as the consumption of gasoline during the last quarter of 1999 • stock—outcome measured at a particular point in time, such as the quantity of crude oil held by Chevron in its US storage tanks April 1, 1999 Slide 1.16 Undergraduate Econometrics, 2nd Edition-Chapter • The data collected may be quantitative or qualitative: • quantitative—outcomes such as prices or income that may be expressed as numbers or some transformation of them, such as real prices or per capita income • qualitative—outcomes that are of an “either-or” situation For example, a consumer either did or did not make a purchase of a particular good, or a person either is or is not married Slide 1.17 Undergraduate Econometrics, 2nd Edition-Chapter 1.5 Statistical Inference The phrase statistical inference will appear often in this book By this we mean we want to “infer” or learn something about the real world by analyzing a sample of data The ways in which statistical inference are out carried include: • Estimating economic parameters, such as elasticities, using econometric methods • Predicting economic outcomes, such as the enrollment in 2-year colleges in the U.S for the next 10 years • Testing economic hypotheses, such as the question of whether newspaper advertising is better than store displays for increasing sales Slide 1.18 Undergraduate Econometrics, 2nd Edition-Chapter 1.6 A Research Format It all starts with a problem or question Economic theory gives us a way of thinking about the problem: What economic variables are involved and what is the possible direction of the relationship(s)? The working economic model leads to an econometric model We must choose a functional form and make some assumptions about the nature of the error term Sample data are obtained, and a desirable method of statistical analysis chosen, based on our initial assumptions, and our understanding of how the data were collected Estimates of the unknown parameters are obtained with the help of a statistical software package, predictions are made and hypothesis tests are performed Model diagnostics are performed to check the validity of assumptions we’ve made For example, were all of the right-hand-side explanatory variables relevant? Was the correct functional form used? Slide 1.19 Undergraduate Econometrics, 2nd Edition-Chapter The economic consequences and the implications of the empirical results are analyzed and evaluated What economic resource allocation and distribution results are implied, and what are their policy-choice implications? What remaining questions might be answered with further study or new and better data? Slide 1.20 Undergraduate Econometrics, 2nd Edition-Chapter ... much to invest in new plant and equipment Slide 1.6 Undergraduate Econometrics, 2nd Edition -Chapter • A real estate developer must predict by how much population and income will increase to the... parameters and to make predictions Slide 1.7 Undergraduate Econometrics, 2nd Edition -Chapter 1.3 The Econometric Model • Economic theory does not claim to be able to predict the specific behavior of any... 100 Slide 1.14 Undergraduate Econometrics, 2nd Edition -Chapter • We, the econometricians, wish to determine the relationship between each of the explanatory variables (p, pc, ps, i) and the dependent