Introduction To Econometrics, 5 Edition: Chapter 2: Properties of The Regression Coefficients and Hypothesis Testing

Type author name/s here
Dougherty
Introduction to Econometrics,
5th edition
Chapter heading
Chapter 2: Properties of the
Regression Coefficients and
Hypothesis Testing
© Christopher Dougherty, 2016. All rights reserved.

ONE-SIDED t TESTS OF HYPOTHESES RELATING TO REGRESSION COEFFICIENTS
True model Fitted model

Y  1   2 X  u Ŷ  ˆ1  ˆ2 X
Null hypothesis H 0 :  2   20
Alternative hypothesis H 1 :  2   20
ˆ2   20
t
s.e.  ˆ2 
Test statistic
Reject H0 if t  t crit
In the previous sequence, we were performing what are described as two-sided t tests.
These are appropriate when we have no information about the alternative hypothesis.
1

Y  1   2 X  u Ŷ  ˆ1  ˆ2 X
Alternative hypothesis H 1 :  2   20
ˆ2   20
t
s.e.  ˆ2 
Test statistic
Under the null, the coefficient is hypothesized to be a certain value. Under the alternative
hypothesis, the coefficient could be any value other than that specified by the null. It could
be higher or it could be lower.
2

Y  1   2 X  u Ŷ  ˆ1  ˆ2 X
Alternative hypothesis H 1 :  2   20
ˆ2   20
t
s.e.  ˆ2 
Test statistic
However, sometimes we are in a position to say that, if the null hypothesis is not true, the
coefficient cannot be lower than that specified by it. We re-write the null hypothesis as
shown and perform a one-sided test.
3

Y  1   2 X  u Ŷ  ˆ1  ˆ2 X
Alternative hypothesis H 1 :  2   20
ˆ2   20
t
s.e.  ˆ2 
Test statistic
On other occasions, we might be in a position to assert that, if the null hypothesis is not
true, the coefficient cannot be greater than the value specified by it. The modified null
hypothesis for this case is shown.
4

Y  1   2 X  u Ŷ  ˆ1  ˆ2 X
ˆ2   20
t
s.e.  ˆ2 
Test statistic
The theory behind one-sided tests, in particular, the gain in the trade-off between the size
(significance level) and power of a test, is non-trivial and an understanding requires a
careful study of section R.13 of the Review chapter.
5

Y  1   2 X  u Ŷ  ˆ1  ˆ2 X
ˆ2   20
t
s.e.  ˆ2 
Test statistic
This sequence assumes a good understanding of that material.
6
Example: p = b 1 + b2w + u
Null hypothesis: H0: b2 = 1.0
Alternative hypothesis: H1: b2 ≠ 1.0
pˆ  1.21  0.82 w
(0.05) (0.10)
ˆ2   20 0.82  1.00

t   1.80
s.e.   2 
ˆ 0.10
n  20 degrees of freedom  18 tcrit, 5%  2.101  two - sided test 
Returning to the price inflation/wage inflation model, we saw that we could not reject the
null hypothesis b2 = 1, even at the 5% significance level. That was using a two-sided test.
7
Example: p = b1 + b2w + u
pˆ  1.21  0.82 w
(0.05) (0.10)
ˆ2   20 0.82  1.00

t   1.80
s.e.   2 
ˆ 0.10
However, in practice, improvements in productivity may cause the rate of cost inflation, and
hence that of price inflation, to be lower than that of wage inflation.
8
pˆ  1.21  0.82 w
(0.05) (0.10)
ˆ2   20 0.82  1.00

t   1.80
s.e.   2 
ˆ 0.10
Certainly, improvements in productivity will not cause price inflation to be greater than
wage inflation and so in this case we are justified in ruling out b2 > 1. We are left with H0: b2
= 1 and H1: b2 < 1.
9
pˆ  1.21  0.82 w
(0.05) (0.10)
ˆ2   20 0.82  1.00

t   1.80
s.e.   2 
ˆ 0.10
n  20 degrees of freedom  18 tcrit, 5%  1.734  one - sided test 
Thus we can perform a one-sided test, for which the critical value of t with 18 degrees of
freedom at the 5% significance level is 1.73. Now we can reject the null hypothesis and
conclude that price inflation is significantly lower than wage inflation, at the 5% significance level.
10
Model Y = b1 + b2X + u
Null hypothesis: H0: b2 = 0
Alternative hypothesis: H1: b2 ≠ 0
Now we will consider the special, but very common, case H0: b2 = 0.
11
Model Y = b1 + b2X + u
Alternative hypothesis: H1: b2 ≠ 0
It occurs when you wish to demonstrate that a variable X influences another variable Y.
You set up the null hypothesis that X has no effect (b2 = 0) and try to reject H0.
12

probability density Alternative hypothesis: H1: b2 ≠ 0
function of ˆ2
reject H0 do not reject H0 reject H0
2.5% 2.5%
–1.96 0 1.96 sd ˆ2

sd
The figure shows the distribution of ̂ 2 , conditional on H0: b2 = 0 being true. For simplicity,
we initially assume that we know the standard deviation.
13

probability density Alternative hypothesis: H1: b2 ≠ 0
function of ˆ2
reject H0 do not reject H0 reject H0
2.5% 2.5%
–1.96 0 1.96 sd ˆ2

sd
If you use a two-sided 5% significance test, your estimate must be 1.96 standard deviations
above or below 0 if you are to reject H0.
14

probability density Alternative hypothesis: H1: b2 > 0
function of ˆ2
do not reject H0 reject H0
5%
0 1.65 sd ˆ2
However, if you can justify the use of a one-sided test, for example with H0: b2 > 0, your
estimate has to be only 1.65 standard deviations above 0.
15

function of ˆ2
5%
0 1.65 sd ˆ2
This makes it easier to reject H0 and thereby demonstrate that Y really is influenced by X
(assuming that your model is correctly specified).
16

function of ˆ2
5%
0 1.65 sd b2 ˆ2
Suppose that Y is genuinely determined by X and that the true (unknown) coefficient is b2,
as shown.
17

function of ˆ2
5%
0 1.65 sd b2 ˆ2
Suppose that we have a sample of observations and calculate the estimated slope
coefficient, ˆ2 . If it is as shown in the diagram, what do we conclude when we test H0?
18

function of ˆ2
5%
0 1.65 sd b2 ˆ2
The answer is that ˆ2 lies in the rejection region. It makes no difference whether we
perform a two-sided test or a one-sided test. We come to the correct conclusion.
19

function of ˆ2
5%
0 1.65 sd b2 ˆ2
What do we conclude if ˆ2 is as shown? We fail to reject H0, irrespective of whether we

perform a two-sided test or a two-sided test. We would make a Type II error in either case.
20

function of ˆ2
5%
0 1.65 sd b2 ˆ2
What do we conclude if ˆ2 is as shown here? In the case of a two-sided test, ˆ2 is not in
the rejection region. We are unable to reject H0.
21

function of ˆ2
5%
0 1.65 sd b2 ˆ2
This means that we are unable to demonstrate that X has a significant effect on Y. This is
disappointing, because we were hoping to demonstrate that X is a determinant of Y.
22

function of ˆ2
5%
0 1.65 sd b2 ˆ2
However, if we are in a position to perform a one-sided test, ˆ2 does lie in the rejection
region and so we have demonstrated that X has a significant effect on Y (at the 5%
significance level, of course).
23

function of ˆ2
5%
0 1.65 sd b2 ˆ2
Thus we get a positive finding that we could not get with a two-sided test.
24

function of ˆ2
2.5%
0 1.96 sd b2 ˆ2
To put this reasoning more formally, the power of a one-sided test is greater than that of a
two-sided test. The blue area shows the probability of making a Type II error using a two-
sided test. It is the area under the true curve to the left of the rejection region.
25

function of ˆ2
5%
0 1.65 sd b2 ˆ2
The red area shows the probability of making a Type II error using a one-sided test. It is
smaller. Since the power of a test is (1 – probability of making a Type II error when H0 is
false), the power of a one-sided test is greater than that of a two-sided test.
26

function of ˆ2
5%
0 1.65 sd ˆ2
In all of this, we have assumed that we knew the standard deviation of the distribution ˆ2
of . In practice, of course, the standard deviation has to be estimated as the standard
error, and the t distribution is the relevant distribution. However, the logic is exactly the
same. 27

function of ˆ2
5%
0 1.65 sd ˆ2
At any given significance level, the critical value of t for a one-sided test is lower than that
for a two-sided test.
28

function of ˆ2
5%
0 1.65 sd b2 ˆ2
Hence, if H0 is false, the risk of not rejecting it, thereby making a Type II error, is smaller,
and so the power of a one-sided test is greater than that of a two-sided test.
29
Copyright Christopher Dougherty 2016.
These slideshows may be downloaded by anyone, anywhere for personal use.

Subject to respect for copyright and, where appropriate, attribution, they may be
used as a resource for teaching an econometrics course. There is no need to
refer to the author.
The content of this slideshow comes from Section 2.6 of C. Dougherty,

Introduction to Econometrics, fifth edition 2016, Oxford University Press.
Additional (free) resources for both students and instructors may be
downloaded from the OUP Online Resource Centre
http://www.oxfordtextbooks.co.uk/orc/dougherty5e//.
Individuals studying econometrics on their own who feel that they might benefit
from participation in a formal course should consider the London School of
Economics summer school course
EC212 Introduction to Econometrics
http://www2.lse.ac.uk/study/summerSchools/summerSchool/Home.aspx
or the University of London International Programmes distance learning course
EC2020 Elements of Econometrics
www.londoninternational.ac.uk/lse.
2016.04.19

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© Christopher Dougherty, 2016. All rights reserved.

True model Fitted model

True model Fitted model

True model Fitted model

True model Fitted model

True model Fitted model

True model Fitted model

This sequence assumes a good understanding of that material.

ˆ2   20 0.82  1.00

n  20 degrees of freedom  18 tcrit, 5%  2.101  two - sided test 

ˆ2   20 0.82  1.00

n  20 degrees of freedom  18 tcrit, 5%  2.101  two - sided test 

ˆ2   20 0.82  1.00

n  20 degrees of freedom  18 tcrit, 5%  2.101  two - sided test 

ˆ2   20 0.82  1.00

n  20 degrees of freedom  18 tcrit, 5%  1.734  one - sided test 

Null hypothesis: H0: b2 = 0

reject H0 do not reject H0 reject H0

–1.96 0 1.96 sd ˆ2

Null hypothesis: H0: b2 = 0

reject H0 do not reject H0 reject H0

–1.96 0 1.96 sd ˆ2

Null hypothesis: H0: b2 = 0

do not reject H0 reject H0

Null hypothesis: H0: b2 = 0

do not reject H0 reject H0

Null hypothesis: H0: b2 = 0

do not reject H0 reject H0

Null hypothesis: H0: b2 = 0

do not reject H0 reject H0

Null hypothesis: H0: b2 = 0

do not reject H0 reject H0

Null hypothesis: H0: b2 = 0

do not reject H0 reject H0

What do we conclude if ˆ2 is as shown? We fail to reject H0, irrespective of whether we

Null hypothesis: H0: b2 = 0

do not reject H0 reject H0

Null hypothesis: H0: b2 = 0

do not reject H0 reject H0

Null hypothesis: H0: b2 = 0

do not reject H0 reject H0

Null hypothesis: H0: b2 = 0

do not reject H0 reject H0

Null hypothesis: H0: b2 = 0

do not reject H0 reject H0

Null hypothesis: H0: b2 = 0

do not reject H0 reject H0

Null hypothesis: H0: b2 = 0

do not reject H0 reject H0

Null hypothesis: H0: b2 = 0

do not reject H0 reject H0

Null hypothesis: H0: b2 = 0

do not reject H0 reject H0

These slideshows may be downloaded by anyone, anywhere for personal use.

The content of this slideshow comes from Section 2.6 of C. Dougherty,

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