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Econometrics Odar N. Gujarati: Chapter # 2: Two-Variable Regression Analysis: Some Basic Ideas

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16 views

Econometrics Odar N. Gujarati: Chapter # 2: Two-Variable Regression Analysis: Some Basic Ideas

Uploaded by

komalzaheer0310
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ECONOMETRICS

Chapter # 2: TWO-VARIABLE REGRESSION


ANALYSIS: SOME BASIC IDEAS
Domodar N. Gujarati
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.
• 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.
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) = β1 + β2Xi (2.2.2)
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) = β1 + β2X2i 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 β’s; it may or may not
be linear in the variable X.
• E(Y | Xi) = β1 + β2X2i
• 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.
• Now consider the model:
• E(Y | Xi) = β1 + β22 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 β’s (that is, the parameters are raised to the
first power only).
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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