Econometrics for Management (MGMT-3071)

Instructor: Urgessa.F
 Chapter 1: Introduction
1.1.Definition of Econometrics
➢The term econometrics is derived from two Greek words-Oikovomia
which means economy and Metopov which means measure

➢So econometrics means economic measurements

➢Econometrics deals with measurement of economic relationships

between economic variables (dependent & independent variables).

➢Econometrics is what econometricians do.

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Cont.
• Econometrics is defined as the quantitative analysis of actual economic
phenomena.
 Econometrics is the systematic study of economic phenomena using
observed data.
• Econometrics is the combination of economic theory, mathematical statistics
and Economic statistics, but it is completely different from these three branches
Why a Separate Discipline?

• As its definitions suggest econometrics is an amalgam of economic theory,

economic statistics, mathematical economics and mathematical statistics

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❑Economic theory makes statements or hypotheses that are mostly qualitative in
nature, while econometrics gives empirical contents to the most economic theory

➢For example, microeconomic theory states that, other things remaining the same, a
reduction in the price of a commodity is expected to increase the quantity
demanded of that commodity.

• Thus, economic theory postulates a negative or inverse relationship between the

price and quantity demanded of a commodity
• But the theory itself does not provide any numerical measure of the relationship
between the two
➢It does not tell by how much the quantity will go up or down as a result of a certain
change in the price of the commodity. Urgessa F 4
• It is the job of the econometrician to provide such numerical estimates.
❑Mathematical economics-is to express economic theory in mathematical
form without empirical verification of the theory, while econometrics is mainly
interested in the later.
• Both mathematical economics and economic theory express economic
relationships in an exact or deterministic form
• Econometrics differs from mathematical economics in that, it contains the
random term which is not reflected in mathematical economics & economic
theory
• Neither mathematical economics nor economic theory allows for random
elements which might affect the relationship and make it stochastic.
Furthermore, they do not provide numerical values for the coefficients of
economic relationships.
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 Cont.…
❑Economic statistics- is mainly concerned with collecting, processing and
presenting economic data. It does not being concerned with using the collected
data to test economic theories

• It does not provide explanations of the development of the various variables

and it does not provide measurements for the coefficients that shows the
economic relationships.

❑Mathematical statistics provides many of tools that uses for estimating

and testing for economic studies.
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 Cont’d
• Econometrics contains random element, however, such random element is
not considered by economic theory and mathematical economics which
postulate relationship between the various economic magnitudes
• Econometrics is the science of testing economic theories.
• Econometrics is the process of fitting mathematical economic models to real
world data.
• Econometrics is the science and art of using historical data to make
numerical or quantitative analysis for policy recommendations in
government and business

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So we can generalize as follow

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1.2. Goal of Econometrics
Basically, there are three main goals of Econometrics. those are:
i) Analysis i.e. testing economic theory
ii) Policy making i.e. obtaining numerical estimates of the coefficients of
economic relationships for policy simulations.
iii) Forecasting i.e. using the numerical estimates of the coefficients in order to
forecast the future values of economic magnitudes

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 1.3. Methodology of Econometrics
• Econometrics adopts the following methodological lines:
1. Statement of theory or hypothesis
2. Specification of the mathematical or economic model of the theory
3. Specification of the statistical or econometric model
4. Obtaining the required data
5. Estimation of the parameters of the econometric model
6. Hypothesis testing
7. Forecasting or prediction and interpret the result
8. Using the model for control or policy purposes

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 1. Statement of theory or hypothesis:
Keynes stated consumption increases as income increases, but not
as much as the increase in income. It means that “the marginal
propensity to consume (MPC) for a unit change in income is grater
than zero but less than unit”
2. Specification of mathematical model:Y = ß1+ ß2X ; 0 < ß2< 1
Where: Y= consumption expenditure, X= income
ß1 and ß2 are parameters; ß1 is intercept, and ß2 is slope coefficients

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 3. Specification of the econometric model:
Y = ß1+ ß2X + u ; 0 < ß2< 1;
• Y = consumption expenditure;
• X = income; ß1 and ß2 are parameters; ß1is intercept and ß2 is slope
coefficients; u is disturbance term or error term/ random or stochastic variable
• The error/stochastic/disturbance term. It captures several factors:
• o m i t t e d variables,
•
m e a s u r e m e n t error in the dependentvariable and/or wrong functional
form.
• r a n d o m n e s s of human behavior

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4.Obtaining Data
Year X Y
1980 2447.1 3776.3
1981 2476.9 3843.1
1982 2503.7 3760.3
1983 2619.4 3906.6
1984 2746.1 4148.5
1985 2865.8 4279.8
1986 2969.1 4404.5
1987 3052.2 4539.9
1988 3162.4 4718.6
1989 3223.3 4838.0
1990 3260.4 4877.5
1991 3240.8 4821.0
5. Estimating the Econometric Model
Y = 231.8 + 0.7194 X
MPC was about 0.72 and it means that for the sample period when real
income increases 1 USD, led (on average) real consumption expenditure
increases of about 72 cents
6.Hypothesis testing: Are the estimates accord with the expectations of the
theory that is being tested? Is MPC < 1 statistically? If so, it may support
Keynes’ theory. Confirmation or refutation of economic theories based on
sample evidence is object of Statistical Inference (hypothesis testing)
➢ Is 0.72 statistically significantly > 0? < 1?
7. Forecasting or Prediction
With given future value(s) of X, what is the future value(s) of Y?
✓ GDP=$6000Bill in 1994, what is the forecast consumption expenditure? Y^= -
231.8+0.7196(6000) = 4084.6
8) Interpret the results & use the model for policy or forecasting:
1 $  in X ➔ an 0.72 cent  in average Y. If X =
0, then on average consumer can consume (Y) =
231.8
Pick a value of control variable
(X) to get a desired value of target
variable (Y)
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1.4. Models, Economic models and econometric models.
➢ Model is Simplified representations of the real world phenomena.
➢ Economic models:- is models that shows the relationships among or between
economic variables in simpler method.
• Economic model is an organized set of relationships that describes the
functioning of an economic entity under a set of simplifying assumptions.
• Economic models consist of the following three basic structural elements.
1. A set of variables
2. A list of fundamental relationships and
3. A number of strategic coefficients

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Econometric models:-combined with assumptions about the random nature of
the data
• The most important characteristic of econometrics models is that they contain a
random element which is ignored by mathematical economic models (postulate
exact relationships between economic variables)
• Example: Economic theory postulates that the demand for a commodity
depends on its price, on the prices of other related commodities, on consumers’
income and on tastes.
• This is an exact relationship which can be written mathematically as:

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Cont.……………………………………………

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 Cont.………………………………………..
• Starting with the postulated theoretical relationships among
economic variables, econometric research or inquiry generally
proceeds along the following lines/stages.
1. Specification the model
2. Estimation of the model
3. Evaluation of the estimates
4. Forecasting the estimated model

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1. Specification of the model
• In this step, the econometrician has to express the relationships
between economic variables in mathematical form.
• This step involves the determination of three important tasks:
• the dependent and independent (explanatory) variables which will
be included in the model.
• the a priori theoretical expectations about the size and sign of the
parameters of the function.
• the mathematical form of the model (number of equations,
specific form of the equations, etc.)

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 Cont.……………………………………………
Note:
• The specification of the econometric model will be based on economic theory
and on any available information related to the phenomena under investigation.
• Thus, specification of the econometric model presupposes knowledge of
economic theory and familiarity with the particular phenomenon being studied.
• Specification of the model is the most important and the most difficult
stage of any econometric research.
• It is often the weakest point of most econometric applications.
• In this stage there exists enormous degree of likelihood of committing errors or
incorrectly specifying the model.

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 Cont.………………………………………….
• Some of the common reasons for incorrect specification of the econometric
models are:
1. the imperfections, looseness of statements in economic theories.
2. the limitation of our knowledge of the factors which are operative in any
particular case.
3. the formidable obstacles presented by data requirements in the estimation
of large models.
• The most common errors of specification are:
a. Omissions of some important variables from the function.
b. The omissions of some equations (for example, in simultaneous equations
model).
c. The mistaken mathematical form of the functions.
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2. Estimation of the model
• This is purely a technical stage which requires knowledge of the various
econometric methods, their assumptions and the economic implications for the
estimates of the parameters.
• This stage includes the following activities.
1. Gathering of the data on the variables included in the model.
2. Examination of the identification conditions of the function (especially for
simultaneous equations models).
3. Examination of the aggregation’s problems involved in the variables of the
function.
4. Examination of the degree of correlation between the explanatory variables
(i.e., examination of the problem of multicollinearity).
5. Choice of appropriate economic techniques for estimation, i.e. to decide a
specific econometric method to be applied in estimation; such as, OLS,
MLM, Logit, and Probit. Urgessa F 24
 Cont.………………………………………….
3. Evaluation of the estimates
• This stage consists of deciding whether the estimates of the parameters are
theoretically meaningful and statistically satisfactory.
• This stage enables the econometrician to evaluate the results of calculations and
determine the reliability of the results.
• For this purpose, we use various criteria which may be classified into three
groups:
i. Economic criteria- a priori criteria: These criteria are determined by
economic theory and refer to the size and sign of the parameters of
economic relationships.

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 Cont.………………………………….………..
ii. Statistical criteria (first-order tests):
• These are determined by statistical theory and aim at the
evaluation of the statistical reliability of the estimates of the
parameters of the model.
• Correlation coefficient test, standard error test, t-test, F-test, and
R2-test are some of the most commonly used statistical tests.
iii. Econometric criteria (second-order tests):
• These are set by the theory of econometrics and aim at the
investigation of whether the assumptions of the econometric
method employed are satisfied or not in any particular case.

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 Cont.……
➢The econometric criteria serve as a second order test (as test of
the statistical tests) i.e. they determine the reliability of the
statistical criteria; they help us establish whether the estimates
have the desirable properties of unbiasedness, consistency etc
➢Econometric criteria aim at the detection of the violation or
validity of the assumptions of the various econometric techniques.

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iv. Forecasting the estimated model
• Forecasting is one of the aims of econometric research.
• It is possible that the model may be economically meaningful and statistically
and econometrically correct for the sample period for which the model has
been estimated; yet it may not be suitable for forecasting due to various factors
(reasons).
• Therefore, this stage involves the investigation of the stability of the estimates
and their sensitivity to changes in the size of the sample.
• Consequently, we must establish whether the estimated function performs
adequately outside the sample of data. i.e. we must test an extra sample
performance the model.

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 Desirable properties of an econometric model
• An econometric model is a model whose parameters have been estimated with
some appropriate econometric technique.
• The ‘goodness’ of an econometric model is judged customarily according to
the following desirable properties:
Theoretical plausibility.
• The model should be compatible with the postulates of economic theory.
• It must describe adequately the economic phenomena to which it relates.
Explanatory ability.
• The model should be able to explain the observations of the actual world.
• It must be consistent with the observed behavior of the economic variables
whose relationship it determines.

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 Cont.…………………………………………
Accuracy of the estimates of the parameters.
• The estimates of the coefficients should be accurate in the sense that they
should approximate as best as possible the true parameters of the structural
model. The estimates should, if possible, possess the desirable properties of
unbiasedness, consistency and efficiency.
Forecasting ability: The model should produce satisfactory predictions of future
values of the dependent (endogenous) variables.
Simplicity: The model should represent the economic relationships with
maximum simplicity.
• The fewer the equations and the simpler their mathematical form, the better
the model is considered, ceteris paribus (that is to say provided that the other
desirable properties are not affected by the simplifications of the model).

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 1.5.Types of Data for Econometric Analysis
• The success of any econometric analysis ultimately depends on the availability
of the appropriate data.
• It is therefore essential that we spend some time discussing the nature, sources,
and limitations of the data that one may encounter in empirical analysis.
Sources and Types of Data
• In econometrics, data come from two sources: experiments or non-experiment
observations.
• Experimental data come from experiments designed to evaluate a
treatment or policy to investigate a casual effect.
• Non-experimental data are data obtained by observing actual behavior
outside an experimental setting. It is also known as observational data.

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 Cont’d
• Observational data are collected using surveys such as personal interview or
telephone interview or any other methods of collecting primary data.
• Observational data pose major challenges to econometric attempts to estimate
casual effects.
• Whether data are experimental or observational, data sets come in three main
types: Time series, cross-sectional and pooled data.
• Time Series Data: A time series data is a set of observational data
collection for a single subject(entity) at different time intervals
over years (time)
• Such data may be collected at regular time intervals, such as daily (e.g.,
stock prices, weather reports), weekly (e.g., money supply figures),
monthly [e.g., the unemployment rate, the Consumer Price Index (CPI)],
quarterly (e.g., GDP), annually
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Time series data

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Time series data

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 Cont’d
• Cross-Section Data: Cross-section data are data on one or more variables
collected at the same point in time. These are data on different entities
collected for a single time period.

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• Pooled Data: Are combined data that have elements of both time series
and cross-section data. It is cross-sectional observations collected over
time, but the units don’t have to be the same

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• Panel/Longitudinal-This is a special type of pooled data in which the same
cross-sectional unit (say, a family or a firm) is surveyed over time.
• Panel data are very important to make comparisions between different economic
variables over time.These are data for multiple entities in which each entity is
observed at two or more periods

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Also panel data can be like this

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 1.6.Types of study variables
Study variable can be Quantitative or Qualitative or both
1. Quantitative Variables:
A. Discrete Variable
B. Continuous Variable
2. Qualitative Variables:
A. Ordinal Variable
B. Nominal Variable (Categorical vs Binary Variables)

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Quantitative Vs Qualitative Variable
Quantitative Variable Qualitative Variables
Definition variables whose values variable whose value
result from counting or varies by attributes or
measuring something. characteristics.
Example Number of student in a Gender
class
Number of square feet in a Level of Education
house
Population size of a city Martial Status
Age of an individual Eye Colour

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3/15/2024 By : Habtamu Legese
UrgessaFeyisa
F (Asst.Prof) 41
Discrete Variable
• Quantitative discrete variables are variables for
which the values it can take are countable and
have a finite number of possibilities.
• It is a variable whose value is obtained by
counting.
Example
• Number of languages an individual speaks
• Number of children per family
• Number of students in a class
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 Continuous Variable
• Quantitative continuous variables are variables for which
the values are not countable and have an infinite number of
possibilities.
• Continuous variables can take on any numeric value, and it
can be meaningfully divided into smaller increments,
including fractional and decimal values.
Example:
▪Age ; Weight; Height
▪GNP, Money supply etc..

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•Continuous variables assumes any value between
two values.
•For example, take age. You can’t count “age”.
Why not?
•A 22 year old man could actually be: 22 years, 10
months, 2 days, 5 hours, 4 minute, 5 seconds, 3
microsecond, 4 milliseconds, 8 nanoseconds, 99
picoseconds…and so on.

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 Nominal variable
• A nominal variable is a qualitative variable which
do not have a natural order or ranking.
• A nominal variable can have between two levels
(e.g., do you smoke? Yes/No) => Binary variable
• A large number of levels (what is your college
major? Each major is a level in that case).
=> Categorical variable

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Ordinal Variable
•An ordinal variable is a categorical variable for
which the possible values are ordered (the order
matters).
Examples of ordinal variables include:
Socioeconomic status
▪Education level
▪Income level

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