Econometrics for Finance

5. The Multiple Regression Model

Siraj M. September, 2023

 Learning Outcomes

 Understand the extension of simple regression to multiple regression, with

more than one explanatory variable.
 Interpret the effect of each explanatory variable on the dependent variable.
 Understand and explain the meanings of the assumptions for the multiple
regression model.
 Find interval estimates for single coefficients and linear combinations of
coefficients, and interpret the interval estimates.

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 Introduction

 The model in Lectures 1 - 4 is called a simple regression model because the

dependent variable y is related to only one explanatory variable x.
 Although this model is useful for a range of situations, in most practical cases
there are two or more explanatory variables that influence the dependent
variable y.
 When we turn a model with more than one explanatory variable into its
corresponding econometric model, we refer to it as a multiple regression model.

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 Introduction: Notation

 The regression relationship now becomes:

𝑌𝑖 = 𝛽1 + 𝛽2 𝑋2𝑖 + 𝛽3 𝑋3𝑖 + 𝜇𝑖
 Y is the dependent variable, 𝑋2 and 𝑋3 the explanatory variables, 𝜇 the
stochastic disturbance term, and i the ith observation.
 𝛽1 is the intercept term.
 The coefficients 𝛽2 and 𝛽3 are called the partial regression coefficients, and their
meaning will be explained shortly.

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 Illustration

 We will set up a model for a Juice Company that we call 3S juice.

 To assess the effect of different price structures and different
levels of advertising expenditure, 3S juice sets different prices,
and spends varying amounts on advertising, in different regions.
 Of particular interest to management is how sales revenue
changes as the level of advertising expenditure changes.

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 Illustration

Essential questions:
 Does an increase in advertising expenditure lead to an increase
in sales?
 If so, is the increase in sales sufficient to justify the increased
advertising expenditure?
 Will reducing prices lead to an increase or decrease in sales
revenue?
 This economic information is essential for effective
management.
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 Illustration
 The econometric model is:

𝑆𝐴𝐿𝐸𝑆 = 𝐸 𝑆𝐴𝐿𝐸𝑆 + 𝜇𝑖 = 𝛽1 + 𝛽2 𝑃𝑅𝐼𝐶𝐸 + 𝛽3 𝐴𝐷𝑉𝐸𝑅𝑇 + 𝜇𝑖

 SALES represents monthly sales revenue

 PRICE represents price
 ADVERT is monthly advertising expenditure, and
 𝜇 is stochastic disturbance term
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 Illustration
Interpretation of parameters:
 Mathematically, the intercept parameter 𝛽1 is the value of the
dependent variable when each of the independent variables takes
the value zero.
 The other parameters in the model measure the change in the
value of the dependent variable given a unit change in an
explanatory variable, all other variables held constant.
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 Illustration
Interpretation of parameters:

𝛽2 = the change in monthly SALES when price PRICE is increased by

one unit (ETB1) and advertising expenditure ADVERT is held constant.

∆𝑆𝐴𝐿𝐸𝑆 𝜕𝑆𝐴𝐿𝐸𝑆
=
∆𝑃𝑅𝐼𝐶𝐸(𝐴𝐷𝑉𝐸𝑅𝑇 ℎ𝑒𝑙𝑑 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡) 𝜕𝑃𝑅𝐼𝐶𝐸

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 Illustration
Interpretation of parameters:

𝛽3 = the change in monthly SALES when advertising expenditure

ADVERT is increased by one unit (ETB1) and price PRICE is held
constant.

∆𝑆𝐴𝐿𝐸𝑆 𝜕𝑆𝐴𝐿𝐸𝑆
=
∆𝐴𝐷𝑉𝐸𝑅𝑇 𝑃𝑅𝐼𝐶𝐸 ℎ𝑒𝑙𝑑 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡 𝜕𝐴𝐷𝑉𝐸𝑅𝑇

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 Illustration: OLS Estimators

 To find the OLS estimators, let us first write the sample

regression function (SRF) as follow:

𝑌𝑖 = 𝛽1 + 𝛽2 𝑋2𝑖 + 𝛽3 𝑋3𝑖 + 𝜇𝑖

 𝜇𝑖 is the residual term, the sample counterpart of the stochastic

disturbance term ui.
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 Illustration: OLS Estimators

 To find the OLS As noted in previous lectures, the OLS

procedure consists of choosing the values of the unknown
parameters so that the residual sum of squares (RSS) 𝜇2 𝑖 is as
small as possible. Symbolically,

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𝑚𝑖𝑛 𝜇2 𝑖 = 𝑌𝑖 − 𝛽1 − 𝛽2 𝑋2𝑖 − 𝛽3 𝑋3𝑖

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 Illustration: OLS Estimators

 Finally after certain derivation, one can find the following formulas.

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 Illustration: Estimating the parameters

 This table contains the least squares results for the sales equation for
the 3S Juice Company.

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 Illustration: Interpretation

 What can we say about the coefficient estimates in the above table?
Coefficient on PRICE
 The negative coefficient on PRICE suggests that demand is price
elastic; we estimate that, with advertising held constant, an increase in
price of ETB1 will lead to a fall in monthly revenue of ETB7,908.
 Or, expressed differently, a reduction in price of ETB1 will lead to an
increase in revenue of ETB7,908.
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 Illustration: Interpretation

Coefficient on ADVERT
 The coefficient on advertising is positive; we estimate that with price
held constant, an increase in advertising expenditure of ETB1,000 will
lead to an increase in sales revenue of ETB1,863.
 We can use this information, along with the costs of producing the
additional juice, to determine whether an increase in advertising
expenditures will increase profit.
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 Illustration: Interpretation

Coefficient on intercept
 The estimated intercept implies that if both price and advertising
expenditure were zero the sales revenue would be ETB118,914.
 Clearly, this outcome is not possible; a zero price implies zero
sales revenue.

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 Illustration: Interpretation

Prediction
 Suppose 3S is interested in predicting sales revenue for a price of ETB5.50
and an advertising expenditure of ETB1,200. This prediction is:

 The predicted value of sales revenue for PRICE = 5.5 and ADVERT =
1.2 is ETB77,656.
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 Illustration: Interpretation

Estimation of the error variance 𝝈𝟐

 There is one remaining parameter to estimate—the variance of the error term.
𝑁 2
𝑖=1 𝑒𝑖
𝜎2 =
𝑁−𝐾

𝑁 2
𝑖=1 𝑒
1718.943
𝑖
𝜎2 = = = 23.874
𝑁−𝐾 75 − 3

𝜎= 𝜎 2 = 23.874 = 4.8861

 Sometimes 𝜎 is referred to as the standard error of the regression. Sometimes it is

called the root mse (short for mean squared error). 19
 Illustration: Interval Estimation

Interval estimation for a single coefficient

 Suppose we are interested in finding a 95% interval estimate for 𝛽2 , the
response of sales revenue to a change in price at 3S Juice Company.
 Following the procedures described in lecture 4, and noting that we
have N-K = 75-3=72 degrees of freedom, the first step is to find a
value from the t(72)-distribution, call it tc, and use the formula:
𝛽2 − 𝑡𝑐 ∗ 𝑠𝑒 𝛽2 , 𝛽2 + 𝑡𝑐 ∗ 𝑠𝑒 𝛽2
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 Illustration: Interval Estimation

Interval estimation for a single coefficient

 A 95% interval estimate for 𝛽2 based on our particular sample is obtained by
replacing 𝛽2 , se(𝛽2 ) and 𝑡𝑐 by their values 𝛽2 = -7.908, se(𝛽2 ) = 1.096, and
𝑡𝑐 =1.9335. Thus, our 95% interval estimate for 𝛽2 is given by:

−7.908 − 1.9335 ∗ 1.096,7.908 + 1.9335 ∗ 1.096 = (10.093, −5.723)

 This interval estimate suggests that decreasing price by ETB1 will lead to an
increase in revenue somewhere between ETB5,723 and ETB10,093.
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 Illustration: Hypothesis Testing

Testing for Elastic Demand

 With respect to demand elasticity, we wish to know whether:
 𝛽2 ≥ 0: a decrease in price leads to a change in sales revenue
that is zero or negative (demand is price-inelastic).
 𝛽2 < 0 : a decrease in price leads to an increase in sales revenue
(demand is price elastic).

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 Illustration: Hypothesis Testing

Testing for Elastic Demand

 Using t test, since -7.215 < -1.666, we reject 𝐻0 : 𝛽2 ≥ 0 and
conclude that 𝐻1 : 𝛽2 < 0 (demand is elastic) is more compatible
with the data.
 The sample evidence supports the proposition that a reduction in price
will bring about an increase in sales revenue.
 Since 0.000 < 0.05, the same conclusion is reached using the p-value.
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 Illustration: Hypothesis Testing

Testing Advertising Effectiveness

 The other hypothesis of interest is whether an increase in
advertising expenditure will bring an increase in sales revenue
that is sufficient to cover the increased cost of advertising.
 Since such an increase will be achieved if 𝛽3 > 1 , we set up the
hypotheses:

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 Illustration: Hypothesis Testing

Testing Advertising Effectiveness

 𝐻0 : 𝛽2 ≤ 1 and 𝐻1 : 𝛽2 > 1
 Using t test, since 1.263 < 1.666, we do not reject 𝐻0 .
 There is insufficient evidence in our sample to conclude that
advertising will be cost effective.
 Using the p-value to perform the test, we again conclude that 𝐻0
cannot be rejected, because 0.105 > 0.05.
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 Interaction Variables

 What if we wanted the marginal effect of one variable to depend on

the level of another variable?
 How do we model this effect?
 To illustrate this idea we will consider a life-cycle model for pizza
consumption.
 Suppose that we are economists for 3S Pizza, and that we wish to study
the effect of income and age on an individual’s expenditure on pizza.

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 Interaction Variables

 For that purpose we take a random sample of 40 individuals, age

18 and older, and record their annual expenditure on pizza
(PIZZA), their income in thousands of dollars (INCOME) and
age (AGE).
 To account for interaction between AGE and INCOME e, we
model:
𝑃𝐼𝑍𝑍𝐴 = 𝛽1 + 𝛽2 𝐴𝐺𝐸 + 𝛽3 𝐼𝑁𝐶𝑂𝑀𝐸 + 𝛽4 (𝐴𝐺𝐸 + 𝐼𝑁𝐶𝑂𝑀𝐸) + 𝑒
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 Interaction Variables

 In this model, the effects of INCOME and AGE are:

𝜕𝐸 𝑃𝐼𝑍𝑍𝐴
 = 𝛽2 + 𝛽4 𝐼𝑁𝐶𝑂𝑀𝐸: The effect of AGE now depends
𝜕𝐴𝐺𝐸

on income.
𝜕𝐸 𝑃𝐼𝑍𝑍𝐴
 = 𝛽3 + 𝛽4 𝐴𝐺𝐸:The effect of a change in income on
𝜕𝐼𝑁𝐶𝑂𝑀𝐸

expected pizza expenditure, which is the marginal propensity to

spend on pizza, now depends on AGE.
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@@@@@@@@@@@@@@@@@@@@@ end of lecture 5 @@@@@@@@@@@@@@@@@@@@

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