Econometrics

TWO-VARIABLE REGRESSION ANALYSIS: SOME BASIC IDEAS

Domodar N. Gujarati

HamidUllah
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A HYPOTHETICAL EXAMPLE
Regression analysis is largely concerned with estimating and/or predicting the (population) mean value of the dependent variable on the basis of the known or fixed values of the explanatory variable(s).

Look at table 2.1 which refers to a total population of 60 families and their weekly income (X) and weekly consumption expenditure (Y). The 60 families are divided into 10 income groups.

Weekly family income and consumption

 There is considerable variation in weekly consumption expenditure in each income group. But the general picture that one gets is that, despite the variability of weekly consumption expenditure within each income bracket, on the average, weekly consumption expenditure increases as income increases.

The dark circled points in Figure 2.1 show the conditional mean values of Y against the various X values. If we join these conditional mean values, we obtain what is known as the population regression line (PRL), or more generally, the population regression curve. More simply, it is the regression of Y on X. The adjective population comes from the fact that we are dealing in this example with the entire population of 60 families. Of course, in reality a population may have many families.
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THE CONCEPT OF POPULATION REGRESSION FUNCTION (PRF)

From the preceding discussion and Figures. 2.1 and 2.2, it is clear
that each conditional mean E(Y | Xi) is a function of Xi. Symbolically, E(Y | Xi) = f (Xi) (2.2.1)

Equation (2.2.1) is known as the conditional expectation function (CEF)

or population regression function (PRF) or population regression (PR) for short. The functional form of the PRF is an empirical question. For example, we may assume that the PRF E(Y | Xi) is a linear function of Xi, say, of the type E(Y | Xi) = 1 + 2Xi (2.2.2)
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THE MEANING OF THE TERM LINEAR

Linearity in the Variables
The first meaning of linearity is that the conditional expectation of Y is a linear function of Xi, the regression curve in this case is a straight line. But E(Y | Xi) = 1 + 2X2i is not a linear function

Linearity in the Parameters

The second interpretation of linearity is that the conditional expectation of Y, E(Y | Xi), is a linear function of the parameters, the s; it may or may not be linear in the variable X. E(Y | Xi) = 1 + 2X2i is a linear (in the parameter) regression model. All the models shown in Figure 2.3 are thus linear regression models, that is, models linear in the parameters.
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 Now consider the model:

E(Y | Xi) = 1 + 22 Xi . The preceding model is an example of a nonlinear (in the parameter) regression model. From now on the term linear regression will always mean a regression that is linear in the parameters; the s (that is, the parameters are raised to the first power only).

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STOCHASTIC SPECIFICATION OF PRF

We can express the deviation of an individual Yi around its expected value as follows: ui = Yi E(Y | Xi) or Yi = E(Y | Xi) + ui (2.4.1) Technically, ui is known as the stochastic disturbance or stochastic error term. How do we interpret (2.4.1) The expenditure of an individual family, given its income level, can be expressed as the sum of two components:
(1) E(Y | Xi), the mean consumption of all families with the same level of income. This component is known as the systematic, or deterministic, component, (2) ui, which is the random, or nonsystematic, component.

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THE SIGNIFICANCE OF THE STOCHASTIC DISTURBANCE TERM

The disturbance term ui is a surrogate for all those variables that are omitted from the model but that collectively affect Y. Why dont we introduce them into the model explicitly? The reasons are many: 1. Vagueness of theory: The theory, if any, determining the behavior of Y may be, and often is, incomplete. We might be ignorant or unsure about the other variables affecting Y. 2. Unavailability of data: Lack of quantitative information about these variables, e.g., information on family wealth generally is not available.

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 3. Core variables versus peripheral variables:

Assume that besides income X1, the number of children per family X2, sex X3, religion X4, education X5, and geographical region X6 also affect consumption expenditure. But the joint influence of all or some of these variables may be so small and it does not pay to introduce them into the model explicitly. One hopes that their combined effect can be treated as a random variable ui. 4. Intrinsic randomness in human behavior: Even if we succeed in introducing all the relevant variables into the model, there is bound to be some intrinsic randomness in individual Ys that cannot be explained no matter how hard we try. The disturbances, the us, may very well reflect this intrinsic randomness.

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 5. Poor proxy variables: for example, Friedman regards permanent consumption (Yp) as a function of permanent income (Xp). But since data on these variables are not directly observable, in practice we use proxy variables, such as current consumption (Y) and current income (X), there is the problem of errors of measurement, u may in this case then also represent the errors of measurement. 6. Principle of parsimony: we would like to keep our regression model as simple as possible. If we can explain the behavior of Y substantially with two or three explanatory variables and if our theory is not strong enough to suggest what other variables might be included, why introduce more variables? Let ui represent all other variables.
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 7. Wrong functional form: Often we do not know the form of the functional relationship between the regressend (dependent) and the repressors. Is consumption expenditure a linear (in variable) function of income or a nonlinear (invariable) function? If it is the former, Yi = 1 + B2Xi + ui is the proper functional relationship between Y and X, but if it is the latter, Yi = 1 + 2Xi + 3X2i + ui may be the correct functional form. In two-variable models the functional form of the relationship can often be judged from the scattergram. But in a multiple regression model, it is not easy to determine the appropriate functional form, for graphically we cannot visualize scattergrams in multiple dimensions. 15

THE METHOD OF ORDINARY LEAST SQUARES. (OLS)

To understand this method, we first explain the least squares principle. Recall the two-variable PRF: Yi = 1 + 2Xi + ui (2.4.2) The PRF is not directly observable. We estimate it from the SRF: Yi = 1 + 2Xi +ui (2.6.2) = Yi +ui (2.6.3) where Yi is the estimated (conditional mean) value of Yi .

But how is the SRF itself determined? First, express (2.6.3) as ui = Yi Yi = Yi 1 2Xi (3.1.1)
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 Now given n pairs of observations on Y and X, we would like to determine the SRF in such a manner that it is as close as possible to the actual Y. To this end, we may adopt the following criterion: Choose the SRF in such a way that the sum of the residuals ui = (Yi Yi) is as small as possible.

But this is not a very good criterion. If we adopt the criterion of minimizing ui , Figure 3.1 shows that the residuals u2 and u3 as well as the residuals u1 and u4 receive the same weight in the sum (u1 + u2 + u3 + u4). A consequence of this is that it is quite possible that the algebraic sum of the ui is small (even zero) although the ui are widely scattered about the SRF. To see this, let u1, u2, u3, and u4 in Figure 3.1 take the values of 10, 2, +2, and 10, respectively. The algebraic sum of these residuals is zero although u1 and u4 are scattered more widely around the SRF than u2 and u3.
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 We can avoid this problem if we adopt the least-squares criterion, which states that the SRF can be fixed in such a way that u2i = (Yi Yi)2 = (Yi 1 2Xi)2 (3.1.2) is as small as possible, where u2i are the squared residuals.

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 By squaring ui , this method gives more weight to residuals such as u1 and u4 in Figure 3.1 than the residuals u2 and u3. It is obvious from (3.1.2) that: u2i = f (1, 2) (3.1.3) that is, the sum of the squared residuals is some function of the estimators 1 and 2. To see this, consider Table 3.1 and conduct two experiments.

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Example

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 Since the values in the two experiments are different, we get different values for the estimated residuals. Now which sets of values should we choose? Obviously the s of the first experiment are the best values. But we can make endless experiments and then choosing that set of values that gives us the least possible value of u2i But since time, and patience, are generally in short supply, we need to consider some shortcuts to this trial-and-error process. Fortunately, the method of least squares provides us with unique estimates of 1 and 2 that give the smallest possible value of u2i.

u2i = (Yi 1 2Xi)2

(3.1.2)

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 The process of differentiation yields the following equations for estimating 1 and 2: Yi Xi = 1Xi + 2X2i (3.1.4) Yi = n1 + 2Xi (3.1.5) where n is the sample size. These simultaneous equations are known as the normal equations. Solving the normal equations simultaneously, we obtain

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 where X and Y are the sample means of X and Y and where we define xi = (Xi X ) and yi = (Yi Y). Henceforth we adopt the convention of letting the lowercase letters denote deviations from mean values.

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THE COEFFICIENT OF DETERMINATION r 2: A MEASURE OF GOODNESS OF FIT

We now consider the goodness of fit of the fitted regression line to a set of data; that is, we shall find out how well the sample regression line fits the data. The coefficient of determination r2 (two-variable case) or R2 (multiple regression) is a summary measure that tells how well the sample regression line fits the data. Consider a heuristic explanation of r2 in terms of a graphical device, known as the Venn diagram shown in Figure 3.9. In this figure the circle Y represents variation in the dependent variable Y and the circle X represents variation in the explanatory variable X. The overlap of the two circles indicates the extent to which the variation25 in Y is explained by the variation in X.

THE COEFFICIENT OF DETERMINATION r 2: A MEASURE OF GOODNESS OF FIT

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Derivation of R2
TSS= ESS+RSS
(3.5.3)

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 The quantity r2 thus defined is known as the (sample)

coefficient of determination and is the most commonly used measure of the goodness of fit of a regression line.

Verbally, r2 measures the proportion or percentage

of the total variation in Y explained by the regression model. Two properties of r2 may be noted: 1. It is a nonnegative quantity. 2. Its limits are 0 r2 1.

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Coefficient Correlation
In correlation analysis, the primary objective is to measure the strength or degree of linear association between two variables. The coefficient, measures this strength of (linear) association.

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