Econometrie

Introduction
to Econometrics,
Third Edition
Update
Chapters 1, 2 and 3
The statistical analysis of

economic (and related)
data
© Pearson Education Limited 2015

Brief Overview of the Course
• Economics suggests important relationships, often

with policy implications, but virtually never
suggests quantitative magnitudes of causal
effects.
– What is the quantitative effect of reducing class size on
student achievement?
– How does another year of education change earnings?
– What is the price elasticity of cigarettes?
– What is the effect on output growth of a 1 percentage
point increase in interest rates by the Fed?
– What is the effect on housing prices of environmental
improvements?

1-2
This course is about using data to
measure causal effects.
• Ideally, we would like an experiment

– What would be an experiment to estimate the effect of class
size on standardized test scores?
• But almost always we only have observational
(nonexperimental) data.
– returns to education
– cigarette prices
– monetary policy
• Most of the course deals with difficulties arising from using
observational to estimate causal effects
– confounding effects (omitted factors)
– simultaneous causality
– “correlation does not imply causation”

1-3
In this course you will:
• Learn methods for estimating causal effects using

observational data
• Learn some tools that can be used for other purposes; for
example, forecasting using time series data;
• Focus on applications – theory is used only as needed to
understand the whys of the methods;
• Learn to evaluate the regression analysis of others – this
means you will be able to read/understand empirical
economics papers in other econ courses;
• Get some hands-on experience with regression analysis in
your problem sets.

1-4
Review of Probability and Statistics
(SW Chapters 2, 3)
• Empirical problem: Class size and educational

output
– Policy question: What is the effect on test scores (or
some other outcome measure) of reducing class size by
one student per class? by 8 students/class?
– We must use data to find out (is there any way to answer
this without data?)

1-5
The California Test Score Data Set
All K-6 and K-8 California school districts (n = 420)
Variables:
• 5PthP grade test scores (Stanford-9 achievement test,
combined math and reading), district average
• Student-teacher ratio (STR) = no. of students in the
district divided by no. full-time equivalent teachers

1-6
Initial look at the data:
(You should already know how to interpret this table)
This table doesn’t tell us anything about the relationship

between test scores and the STR.

1-7
Do districts with smaller classes have
higher test scores?
Scatterplot of test score v. student-teacher ratio
What does this figure show?

1-8
We need to get some numerical evidence on whether
districts with low STRs have higher test scores – but how?
1. Compare average test scores in districts with low STRs to

those with high STRs (“estimation”)
2. Test the “null” hypothesis that the mean test scores in the
two types of districts are the same, against the “alternativ
e” hypothesis that they differ (“hypothesis testing”)
3. Estimate an interval for the difference in the mean test
scores, high v. low STR districts (“confidence interval”)

1-9
Initial data analysis: Compare districts with “small” (STR <
20) and “large” (STR ≥ 20) class sizes:
Class Size Average score Standard deviation n

( ) (sBYB)
Small 657.4 19.4 238

Large 650.0 17.9 182
1. Estimation of Δ = difference between group means

2. Test the hypothesis that Δ = 0
3. Construct a confidence interval for Δ

1-10
1. Estimation
= –
= 657.4 – 650.0
= 7.4
Is this a large difference in a real-world sense?
– Standard deviation across districts = 19.1
– Difference between 60PthP and 75PthP percentiles of test
score distribution is 667.6 – 659.4 = 8.2
– This is a big enough difference to be important for school
reform discussions, for parents, or for a school
committee?

1-11
2. Hypothesis testing
Difference-in-means test: compute the t-statistic,

(remember this?)
• where SE( – ) is the “standard error” of – ,

the subscripts s and l refer to “small” and “large”
STR districts, and (etc.)

1-12
Compute the difference-of-means t-statistic:
Size sBYB n
small 657.4 19.4 238
large 650.0 17.9 182
= 4.05
|t| > 1.96, so reject (at the 5% significance level)

the null hypothesis that the two means are the
same.

1-13
3. Confidence interval
A 95% confidence interval for the difference between

the means is,
( – ) ± 1.96×SE( – )
= 7.4 ± 1.96×1.83 = (3.8, 11.0)
Two equivalent statements:
1. The 95% confidence interval for Δ doesn’t include 0;
2. The hypothesis that Δ = 0 is rejected at the 5% level.

1-14
What comes next…
• The mechanics of estimation, hypothesis testing,

and confidence intervals should be familiar
• These concepts extend directly to regression and
its variants
• Before turning to regression, however, we will
review some of the underlying theory of
estimation, hypothesis testing, and confidence
intervals:
– Why do these procedures work, and why use these rather
than others?
– We will review the intellectual foundations of statistics
and econometrics

1-15
Review of Statistical Theory
1. The probability framework for statistical inference

2. Estimation
3. Testing
4. Confidence Intervals
The probability framework for statistical inference

a) Population, random variable, and distribution
b) Moments of a distribution (mean, variance, standard
deviation, covariance, correlation)
c) Conditional distributions and conditional means
d) Distribution of a sample of data drawn randomly from a
population: YB1B, …, YBnB

1-16
(a) Population, random variable, and
distribution
Population
• The group or collection of all possible entities of interest
(school districts)
• We will think of populations as infinitely large (∞ is an
approximation to “very big”)
Random variable Y
• Numerical summary of a random outcome (district average
test score, district STR)

1-17
Population distribution of Y
• The probabilities of different values of Y that occur

in the population, for ex. Pr[Y = 650] (when Y is
discrete)
• or: The probabilities of sets of these values, for ex.
Pr[640 ≤ Y ≤ 660] (when Y is continuous).

1-18
(b) Moments of a population distribution: mean,
variance, standard deviation, covariance,
correlation
mean = expected value (expectation) of Y
= E(Y)
= μBYB
= long-run average value of Y over repeated
realizations of Y
variance = E(Y – μBYB)P2P
=
= measure of the squared spread of the
distribution
standard deviation = = σBYB

1-19
Moments, ctd.
skewness =
= measure of asymmetry of a distribution
• skewness = 0: distribution is symmetric
• skewness > (<) 0: distribution has long right (left) tail
kurtosis =
= measure of mass in tails
= measure of probability of large values
• kurtosis = 3: normal distribution
• skewness > 3: heavy tails (“leptokurtotic”)

1-20
1-21
2 random variables: joint distributions
and covariance
• Random variables X and Z have a joint distribution

• The covariance between X and Z is
– cov(X,Z) = E[(X – μBXB)(Z – μBZB)] = σBXZB
• The covariance is a measure of the linear association
between X and Z; its units are units of X×units of Z
• cov(X,Z) > 0 means a positive relation between X and Z
• If X and Z are independently distributed, then cov(X,Z) = 0
(but not vice versa!!)
• The covariance of a r.v. with itself is its variance:
cov(X,X) = E[(X – μBXB)(X – μBXB)] = E[(X – μBXB)P2P] =

1-22
The covariance between Test Score and STR is negative:
So is the correlation…

1-23
The correlation coefficient is defined in terms of
the covariance:
corr(X,Z) = = rBXZB
• –1 ≤ corr(X,Z) ≤ 1
• corr(X,Z) = 1 mean perfect positive linear association
• corr(X,Z) = –1 means perfect negative linear association
• corr(X,Z) = 0 means no linear association

1-24
The correlation coefficient measures linear
association

1-25
(c) Conditional distributions and
conditional means
Conditional distributions
• The distribution of Y, given value(s) of some other random
variable, X
• Ex: the distribution of test scores, given that STR < 20
Conditional expectations and conditional moments
• conditional mean = mean of conditional distribution
– = E(Y|X = x) (important concept and notation)
• conditional variance = variance of conditional distribution
• Example: E(Test scores|STR < 20) = the mean of test
scores among districts with small class sizes
The difference in means is the difference between the
means of two conditional distributions:

1-26
Conditional mean, ctd.
Δ = E(Test scores|STR < 20) – E(Test scores|STR ≥ 20)
Other examples of conditional means:

• Wages of all female workers (Y = wages, X = gender)
• Mortality rate of those given an experimental treatment (Y =
live/die; X = treated/not treated)
• If E(X|Z) = const, then corr(X,Z) = 0 (not necessarily vice
versa however)
The conditional mean is a (possibly new) term for the
familiar idea of the group mean

1-27
(d) Distribution of a sample of data drawn
randomly from a population: YB1B,…, YBnB
We will assume simple random sampling

• Choose and individual (district, entity) at random from the
population
Randomness and data
• Prior to sample selection, the value of Y is random because
the individual selected is random
• Once the individual is selected and the value of Y is
observed, then Y is just a number – not random
• The data set is (YB1B, YB2B,…, YBnB), where YBiB = value of Y
for the iPthP individual (district, entity) sampled

1-28
Distribution of YB1B,…, YBnB under simple
random sampling
• Because individuals #1 and #2 are selected at

random, the value of YB1B has no information
content for YB2B. Thus:
– YB1B and YB2B are independently distributed
– YB1B and YB2B come from the same distribution, that is,
YB1B, YB2B are identically distributed
– That is, under simple random sampling, YB1B and YB2B are
independently and identically distributed (i.i.d.).
– More generally, under simple random sampling, {YBiB}, i
= 1,…, n, are i.i.d.

1-29
This framework allows rigorous statistical inferences
about moments of population distributions using a sample
of data from that population …

2. Estimation
3. Testing
4. Confidence Intervals
Estimation
is the natural estimator of the mean. But:
a) What are the properties of ?
b) Why should we use rather than some other estimator?
• YB1B (the first observation)
• maybe unequal weights – not simple average
• median(YB1B,…, YBnB)
The starting point is the sampling distribution of …

1-30
(a) The sampling distribution of
is a random variable, and its properties are

determined by the sampling distribution of
– The individuals in the sample are drawn at random.
– Thus the values of (YB1B, …, YBnB) are random
– Thus functions of (YB1B, …, YBnB), such as , are random:
had a different sample been drawn, they would have taken
on a different value
– The distribution of over different possible samples of
size n is called the sampling distribution of .
– The mean and variance of are the mean and variance of
its sampling distribution, E( ) and var( ).
– The concept of the sampling distribution underpins all of
econometrics.

1-31
The sampling distribution of , ctd.
Example: Suppose Y takes on 0 or 1 (a Bernoulli random

variable) with the probability distribution,
Pr[Y = 0] = .22, Pr(Y =1) = .78
Then
E(Y) = p×1 + (1 – p) ×0 = p = .78
= E[Y – E(Y)]2 = p(1 – p) [remember this?]
= .78× (1–.78) = 0.1716
The sampling distribution of depends on n.
Consider n = 2. The sampling distribution of is,
– Pr( = 0) = .222 = .0484
– Pr( = ½) = 2×.22×.78 = .3432
– Pr( = 1) = .782 = .6084

1-32
The sampling distribution of when Y is Bernoulli (p =
.78):

1-33
Things we want to know about the
sampling distribution:
• What is the mean of ?

– If E( ) = true μ = .78, then is an unbiased
estimator of μ
• What is the variance of ?
– How does var( ) depend on n (famous 1/n formula)
• Does become close to μ when n is large?
– Law of large numbers: is a consistent estimator of μ
• – μ appears bell shaped for n large…is this
generally true?
– In fact, – μ is approximately normally distributed for n
large (Central Limit Theorem)

1-34
The mean and variance of the sampling
distribution of
• General case – that is, for Yi i.i.d. from any distribution, not
just Bernoulli:
• mean: E( ) = E( )= = = μY
• Variance: var( ) = E[ – E( )]2
= E[ – μY]2
=E
=E

1-35
so var( )=E
=
1-36
Mean and variance of sampling
distribution of , ctd.
E( ) = μY
var( )=
Implications:
1. is an unbiased estimator of μY (that is, E( ) = μY)
2. var( ) is inversely proportional to n
1. the spread of the sampling distribution is
proportional to 1/
2. Thus the sampling uncertainty associated with
is proportional to 1/ (larger samples, less
uncertainty, but square-root law)
© Pearson Education Limited 2015 1-37

The sampling distribution of when n is
large
For small sample sizes, the distribution of is

complicated, but if n is large, the sampling
distribution is simple!
1. As n increases, the distribution of becomes more
tightly centered around μY (the Law of Large Numbers)
2. Moreover, the distribution of – μY becomes normal
(the Central Limit Theorem)

1-38
The Law of Large Numbers:
An estimator is consistent if the probability that its falls within

an interval of the true population value tends to one as the
sample size increases.
If (Y1,…,Yn) are i.i.d. and < ∞, then is a consistent
estimator of μY, that is,
Pr[| – μY| < μ]  1 as n  ∞
which can be written, μY

(“ μY” means “ converges in probability to μY”).
(the math: as n  ∞, var( )=  0, which implies that
Pr[| – μY| < ε]  1.)

1-39
The Central Limit Theorem (CLT):
If (Y1,…,Yn) are i.i.d. and 0 < < ∞ , then when n is

large the distribution of is well approximated by
a normal distribution.
– is approximately distributed N(μY, ) (“normal
distribution with mean μY and variance /n”)

– ( – μY)/σY is Y approximately distributed N(0,1)
(standard normal)
– That is, “standardized” = = is
approximately distributed as N(0,1)

– The larger is n, the better is the approximation.

1-40
Sampling distribution of when Y is Bernoulli,
p = 0.78:

1-41
Same example: sampling distribution of :

1-42
Summary: The Sampling Distribution of
For Y1,…,Yn i.i.d. with 0 < < ∞,

• The exact (finite sample) sampling distribution of has mean
μY (“ is an unbiased estimator of μY”) and variance /n
• Other than its mean and variance, the exact distribution of
is complicated and depends on the distribution of Y (the
population distribution)
• When n is large, the sampling distribution simplifies:
– μY (Law of large numbers)
– is approximately N(0,1) (CLT)

1-43
(b) Why Use To Estimate μY?
• is unbiased: E( ) = μY
• is consistent: μY
• is the “least squares” estimator of μY; solves,
so, minimizes the sum of squared “residuals”

optional derivation (also see App. 3.2)
= =
Set derivative to zero and denote optimal value of m
by m̂ :
n
=  mˆ = nmˆ or m̂ =
i 1
=
1-44
Why Use To Estimate μY, ctd.
• has a smaller variance than all other linear unbiased

1 n
ˆ Y   aiYi
estimators: consider the estimator, n i 1 , where
ˆ Y ˆ Y
{ai} are such that is unbiased; then var( ) ≤ var( )
(proof: SW, Ch. 17)

• isn’t the only estimator of μY – can you think of a time you
might want to use the median instead?
1.The probability framework for statistical inference
2.Estimation
3.Hypothesis Testing
4.Confidence intervals

1-45
Hypothesis Testing
The hypothesis testing problem (for the

mean): make a provisional decision based
on the evidence at hand whether a null
hypothesis is true, or instead that some
alternative hypothesis is true. That is, test
– H0: E(Y) = μY,0 vs. H1: E(Y) > μY,0 (1-sided, >)
– H0: E(Y) = μY,0 vs. H1: E(Y) < μY,0 (1-sided, <)
– H0: E(Y) = μY,0 vs. H1: E(Y) ≠ μY,0 (2-sided)

1-46
Some terminology for testing statistical
hypotheses:
p-value = probability of drawing a statistic (e.g. ) at least

as adverse to the null as the value actually computed with your
data, assuming that the null hypothesis is true.
The significance level of a test is a pre-specified probability
of incorrectly rejecting the null, when the null is true.
Calculating the p-value based on :
p-value =
Where is the value of actually observed (nonrandom)

1-47
Calculating the p-value, ctd.
• To compute the p-value, you need the to know the sampling

distribution of , which is complicated if n is small.
• If n is large, you can use the normal approximation (CLT):
p-value = ,
=
~ probability under left+right N(0,1) tails
=
where = std. dev. of the distribution of = σY/ .

1-48
Calculating the p-value with σY known:
• For large n, p-value = the probability that a N(0,1)

random variable falls outside |( – μY,0)/ |
• In practice, is unknown – it must be estimated
1-49
Estimator of the variance of Y:
= = “sample variance of Y”
Fact:
If (Y1,…,Yn) are i.i.d. and E(Y4) < ∞ , then
Why does the law of large numbers apply?

• Because is a sample average; see Appendix 3.3
• Technical note: we assume E(Y4) < ∞ because here
the average is not of Yi, but of its square; see App. 3.3

1-50
Computing the p-value with estimated:
p-value = ,
~
= (large n)
so
p-value = ( estimated)
~ probability under normal tails

= outside |tact|
where t = (the usual t-statistic)

1-51
What is the link between the p-value and
the significance level?
• The significance level is prespecified. For

example, if the prespecified significance
level is 5%,
• you reject the null hypothesis if |t| ≥ 1.96.
• Equivalently, you reject if p ≤ 0.05.
• The p-value is sometimes called the marginal
significance level.
• Often, it is better to communicate the p-value than
simply whether a test rejects or not – the p-value
contains more information than the “yes/no”
statement about whether the test rejects.

1-52
At this point, you might be wondering,...
What happened to the t-table and the degrees of
freedom?
Digression: the Student t distribution

If Yi, i = 1,…, n is i.i.d. N(μY, ), then the t-statistic
has the Student t-distribution with n – 1 degrees of
freedom.
The critical values of the Student t-distribution is
tabulated in the back of all statistics books.
Remember the recipe?
1. Compute the t-statistic
2. Compute the degrees of freedom, which is n – 1
3. Look up the 5% critical value
4. If the t-statistic exceeds (in absolute value) this critical
value, reject the null hypothesis.

1-53
Comments on this recipe and the Student
t-distribution
1. The theory of the t-distribution was one of the early triumphs

of mathematical statistics. It is astounding, really: if Y is
i.i.d. normal, then you can know the exact, finite-sample
distribution of the t-statistic – it is the Student t. So, you
can construct confidence intervals (using the Student t
critical value) that have exactly the right coverage rate, no
matter what the sample size. This result was really useful in
times when “computer” was a job title, data collection was
expensive, and the number of observations was perhaps a
dozen. It is also a conceptually beautiful result, and the
math is beautiful too – which is probably why stats profs love
to teach the t-distribution. But….

1-54
Comments on Student t distribution, ctd.
2. If the sample size is moderate (several dozen) or large

(hundreds or more), the difference between the t-
distribution and N(0,1) critical values is negligible. Here are
some 5% critical values for 2-sided tests:
degrees of freedom 5% t-distribution

(n – 1) critical value
10 2.23
20 2.09
30 2.04
60 2.00
∞ 1.96

1-55
3. So, the Student-t distribution is only relevant

when the sample size is very small; but in that
case, for it to be correct, you must be sure that
the population distribution of Y is normal. In
economic data, the normality assumption is
rarely credible. Here are the distributions of
some economic data.
– Do you think earnings are normally distributed?
– Suppose you have a sample of n = 10 observations
from one of these distributions – would you feel
comfortable using the Student t distribution?

1-56
1-57
4. You might not know this. Consider the t-statistic testing

the hypothesis that two means (groups s, l) are equal:
Even if the population distribution of Y in the two groups is

normal, this statistic doesn’t have a Student t distribution!
There is a statistic testing this hypothesis that has a
normal distribution, the “pooled variance” t-statistic – see
SW (Section 3.6) – however the pooled variance t-statistic
is only valid if the variances of the normal distributions are
the same in the two groups. Would you expect this to be
true, say, for men’s v. women’s wages?

1-58
The Student-t distribution – Summary
• The assumption that Y is distributed N(μY, ) is rarely plausible in

practice (Income? Number of children?)
• For n > 30, the t-distribution and N(0,1) are very close (as n
grows large, the tn–1 distribution converges to N(0,1))
• The t-distribution is an artifact from days when sample sizes were
small and “computers” were people
• For historical reasons, statistical software typically uses the t-
distribution to compute p-values – but this is irrelevant when the
sample size is moderate or large.
• For these reasons, in this class we will focus on the large-n
approximation given by the CLT
2. Estimation
3. Testing
4. Confidence intervals

1-59
Confidence Intervals
• A 95% confidence interval for μY is an interval

that contains the true value of μY in 95% of
repeated samples.
• Digression: What is random here? The values of
Y1,...,Yn and thus any functions of them – including
the confidence interval. The confidence interval will
differ from one sample to the next. The population
parameter, μY, is not random; we just don’t know it.

1-60
Confidence intervals, ctd.
A 95% confidence interval can always be constructed as the

set of values of μY not rejected by a hypothesis test with a 5%
significance level.
{μY: ≤ 1.96} = {μY: –1.96 ≤ ≤ 1.96}
= {μY: –1.96 ≤ – μY ≤ 1.96 }
= {μY ε ( – 1.96 , + 1.96 )}
This confidence interval relies on the large-n results that is

approximately normally distributed and .

1-61
Summary:
From the two assumptions of:

1. simple random sampling of a population, that is,
{Yi, i =1,…,n} are i.i.d.
2. 0 < E(Y4) < ∞
we developed, for large samples (large n):
– Theory of estimation (sampling distribution of )
– Theory of hypothesis testing (large-n distribution of t-
statistic and computation of the p-value)
– Theory of confidence intervals (constructed by inverting
the test statistic)
Are assumptions (1) & (2) plausible in practice? Yes

1-62
Let’s go back to the original policy
question:
What is the effect on test scores of reducing STR by one
student/class?
Have we answered this question?

1-63

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Introduction

The statistical analysis of

© Pearson Education Limited 2015

• Economics suggests important relationships, often

© Pearson Education Limited 2015

• Ideally, we would like an experiment

© Pearson Education Limited 2015

• Learn methods for estimating causal effects using

© Pearson Education Limited 2015

• Empirical problem: Class size and educational

© Pearson Education Limited 2015

All K-6 and K-8 California school districts (n = 420)

© Pearson Education Limited 2015

This table doesn’t tell us anything about the relationship

© Pearson Education Limited 2015

Scatterplot of test score v. student-teacher ratio

What does this figure show?

1. Compare average test scores in districts with low STRs to

© Pearson Education Limited 2015

Class Size Average score Standard deviation n

Small 657.4 19.4 238

1. Estimation of Δ = difference between group means

© Pearson Education Limited 2015

© Pearson Education Limited 2015

Difference-in-means test: compute the t-statistic,

• where SE( – ) is the “standard error” of – ,

© Pearson Education Limited 2015

|t| > 1.96, so reject (at the 5% significance level)

© Pearson Education Limited 2015

A 95% confidence interval for the difference between

© Pearson Education Limited 2015

• The mechanics of estimation, hypothesis testing,

© Pearson Education Limited 2015

1. The probability framework for statistical inference

The probability framework for statistical inference

© Pearson Education Limited 2015

© Pearson Education Limited 2015

• The probabilities of different values of Y that occur

© Pearson Education Limited 2015

© Pearson Education Limited 2015

© Pearson Education Limited 2015

• Random variables X and Z have a joint distribution

© Pearson Education Limited 2015

© Pearson Education Limited 2015

© Pearson Education Limited 2015

© Pearson Education Limited 2015

© Pearson Education Limited 2015

Δ = E(Test scores|STR < 20) – E(Test scores|STR ≥ 20)

Other examples of conditional means:

© Pearson Education Limited 2015

We will assume simple random sampling

© Pearson Education Limited 2015

• Because individuals #1 and #2 are selected at

© Pearson Education Limited 2015

1. The probability framework for statistical inference

© Pearson Education Limited 2015

is a random variable, and its properties are

© Pearson Education Limited 2015

Example: Suppose Y takes on 0 or 1 (a Bernoulli random

© Pearson Education Limited 2015