Chapter 1

An Introduction to Econometrics

Walter R. Paczkowski
Rutgers University
Principles of Econometrics, 4th Edition Chapter 1: An Introduction to Econometrics Page 1
 Chapter Contents

 1.1 Why Study Econometrics

 1.2 What is Econometrics About
 1.3 The Econometric Model
 1.4 How Are Data Generated
 1.5 Economic Data Types
 1.6 The Research Process
 1.7 Writing An Empirical Research Paper
 1.8 Sources of Economic Data

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 1.1
Why Study Econometrics

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 1.1
Why Study
Econometrics

Econometrics fills a gap between being a “student

of economics” and being a “practicing economist”
– It lets you tell your employer:
• “I can predict the sales of your product”
• “I can estimate the effect on your sales if
your competition lowers its price by $1 per
unit”
• “I can test whether your new ad campaign is
actually increasing your sales”
– Helps you develop “intuition” about how things
work and is invaluable if you go to graduate
school
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 1.2
What is Econometrics About

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 1.2
What is
Econometrics
About

Econometrics is about how we can use

theory and data from economics, business,
and the social sciences, along with tools from
statistics, to answer ‘‘how much’’ questions.

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 1.2
What is
Econometrics
About

In economics we express our ideas about

relationships between economic variables using
the mathematical concept of a function

Consumption  f Income
d

Q  f P, P , P , INC s C

Qs  f P, P C
,Pf 

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 1.2
What is
Econometrics
About

1.2.1
Some Examples

Every day, decision-makers face ‘‘how much’’:

– 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
– The owner of a local Pizza Hut 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 $300 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, and how much to
invest in new plant and equipment

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 1.2
What is
Econometrics
About

1.2.1
Some Examples Every day, decision-makers face ‘‘how much’’ questions
(Continued):

– 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 whether it will be profitable to begin
construction of a gambling casino and golf course
– 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
– A public transportation council in Melbourne, Australia, must
decide how an increase in fares for public transportation (trams,
trains, and buses) will affect the number of travelers who switch to
car or bike, and the effect of this switch on revenue going to public
transportation

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 1.3
The Econometric Model

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 1.3
The Econometric
Model

An econometric model consists of a systematic

part and a random and unpredictable component e
that we will call a random error

Q d  f P, P s , P c , INC  e 
 
f P, P s , P c , INC  β1  β 2 P  β3 P s  β 4 P c  β5 INC
Q d  β1  β 2 P  β3 P s  β 4 P c  β5 INC  e

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 1.3
The Econometric
Model

The coefficients β1, β2, …, β5 are unknown

parameters of the model that we estimate using
economic data and an econometric technique
– The functional form represents a hypothesis
about the relationship between the variables
– In any particular problem, one challenge is to
determine a functional form that is compatible
with economic theory and the data

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 1.3
The Econometric
Model

The systematic portion is the part we obtain from

economic theory, and includes 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

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 1.3
The Econometric
Model

We use the econometric model as a basis for

statistical inference
The ways in which statistical inference are carried
out include:
1. Estimating economic parameters, such as
elasticities, using econometric methods
2. Predicting economic outcomes, such as the
enrollment in two-year colleges in the United
States for the next ten years
3. Testing economic hypotheses, such as the
question of whether newspaper advertising is
better than store displays for increasing sales
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 1.4
How are Data Generated?

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 1.4
How Are Data
Generated?

We must have data

– Where do data come from?
– What type of real processes generate data?
Economists and other social scientists work in a
complex world in which data on variables are
‘‘observed’’ and rarely obtained from a controlled
experiment
– This makes the task of learning about economic
parameters all the more difficult

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 1.4
How Are Data
Generated?

1.4.1
Experimental Data One way to acquire information about the
unknown parameters of economic relationships is
to conduct or observe the outcome of an
experiment
– Such controlled experiments are rare in
business and the social sciences
– There are some examples of planned
experiments in the social sciences
• A notable example of a planned experiment
is Tennessee’s Project Star

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 1.4
How Are Data
Generated?

1.4.2
Non-experimental
Data

An example of nonexperimental data is survey

data
– Data on all variables are collected
simultaneously, and the values are neither fixed
nor repeatable
• These are nonexperimental data

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 1.5
Economic Data Types

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 1.5
Economic Data
Types

Economic data comes in a variety of ‘‘flavors.”

– Data may be collected at various levels of
aggregation: Micro or Macro
– Data may also represent a flow or a stock:
• Flow: measured over a period of time
• Stock: measured at a particular point in time
– Data may be quantitative or qualitative:
• Quantitative: expressed as numbers
• Qualitative: expressed as an ‘‘either-or’’
situation

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 1.5
Economic Data
Types

1.5.1
Time-Series Data

A time-series is data collected over discrete

intervals of time
– The key feature of time-series data is that the
same economic quantity is recorded at a regular
time interval

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 1.5
Economic Data
Types
Table 1.1 Annual GDP of Real 2005 Dollars

1.5.1
Time-Series Data

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 1.5
Economic Data
Types
Figure 1.1 Real U.S. GDP, 1980–2008

1.5.1
Time-Series Data

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 1.5
Economic Data
Types

1.5.2
Cross-Section Data

A cross-section of data is collected across sample

units in a particular time period
– The ‘‘sample units’’ are individual entities and
may be firms, persons, households, states, or
countries

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 1.5
Economic Data
Types
Table 1.2 Cross Section Data: CPS August 2009

1.5.2
Cross-Section Data

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 1.5
Economic Data
Types

1.5.3
Panel or
Longitudinal Data
A ‘‘panel’’ of data, also known as ‘‘longitudinal’’
data, has observations on individual micro-units
who are followed over time
– The key aspect of panel data is that we observe
each micro-unit for a number of time periods
– If we have the same number of time period
observations for each micro-unit, we have a
balanced panel
– Usually the number of time series observations
is small relative to the number of micro-units,
but not always
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 1.5
Economic Data
Types
Table 1.3 Panel Data from Two Rice Farms

1.5.3
Panel or
Longitudinal Data

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 1.6
The Research Process

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 1.6
The Research
Process

Econometrics is ultimately a research tool

– Students of econometrics plan to do research or
they plan to read and evaluate the research of
others, or both
– Research is a process, and like many such
activities, it flows according to an orderly
pattern
• Research is an adventure, and can be fun!

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 1.6
The Research
Process

Steps in the research process:

1. Use economic theory to think about the
problem
2. Develop a working economic model leading
to an econometric model
3. Obtain sample data and choose a desirable
method of statistical analysis based on initial
assumptions and an understanding of how the
data were collected
4. Estimate the unknown parameters with the
help of a statistical software package, make
predictions, and test hypotheses
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 1.6
The Research
Process

Steps in the research process (Continued)

5. Perform model diagnostics to check the
validity of assumptions
6. Analyze and evaluate the economic
consequences and the implications of the
empirical results

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 1.7
Writing an Empirical Research Paper

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 1.7
Writing an
Empirical Research
Paper

The process of writing forces the distillation of

ideas
– In no other way will your depth of
understanding be so clearly revealed

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 1.7
Writing an
Empirical Research
Paper

1.7.1
Writing a Research An abstract should include:
Proposal
1. A concise statement of the problem
2. Comments on the information that is available,
with one or two key references
3. A description of the research design that includes
a) the economic model
b) the econometric estimation and inference
methods
c) data sources
d) estimation, hypothesis testing and prediction
procedures, including econometric software
version
4. The potential contribution of the research

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 1.7
Writing an
Empirical Research
Paper

1.7.2
A Format for
Writing a Research
The following outline for a report is typical:
Report
1. Statement of the problem
2. Review of the literature
3. The economic model
4. The econometric model
5. The data
6. The estimation and inference procedures
7. The empirical results and conclusions
8. Possible extensions and limitations of the study
9. Acknowledgments
10. References
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 1.7
Writing an
Empirical Research
Paper

1.7.2
A Format for
Writing a Research
A style guide is a good investment. Two classics
Report
are:
– The Chicago Manual of Style, 15th edition
• Available online and in other formats
– A Manual for Writers of Research Papers,
Theses, and Dissertations: Chicago Style for
Students and Researchers, 7th edition, by Kate
L. Turabian; revised by Wayne C. Booth,
Gregory G. Colomb, and Joseph M Williams
(2007, University of Chicago Press)

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 1.8
Sources of Economic Data

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 1.8
Sources of
Economic Data

Economic data are much easier to obtain since the

development of the World Wide Web

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 1.8
Sources of
Economic Data

1.8.1
Links to Economic
Data on the
Internet

Resources for Economists (RFE)

National Bureau of Economic Research (NBER)
EconEdLink
Economagic

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 1.8
Sources of
Economic Data

1.8.2
Interpreting
Economic Data

In many cases it is easier to obtain economic data

than it is to understand the meaning of the data
– Useful reference:
• A Guide to Everyday Economic Statistics,
6th edition, by Gary E. Clayton and Martin
Gerhard Giesbrecht, (Boston:
Irwin/McGraw-Hill 2003)

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 1.8
Sources of
Economic Data

1.8.3
Obtaining the Data

Finding a data source is not the same as obtaining

the data. Although there are a great many easy-to-
use websites, ‘‘easy-to-use’’ is a relative term
– Some good sources:
• The Federal Reserve Bank of St. Louis:
FRED (Federal Reserve Economic Data).
• The Current Population Survey
(www.census.gov/cps/): Data Ferrett
• The Penn World Tables

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