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Introductory Econometrics: A Modern Approach (7e)
Chapter 2
The Simple Regression Model
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The Simple Regression Model (1 of 39)

• Definition of the simple regression model
• “Explains variable y in terms of variable x”

• Interpretation of the simple linear regression model
• Explains how y varies with changes in x
• The simple linear regression model is rarely applicable in practice but

its discussion is useful for pedagogical reasons.

• Example: Soybean yield and fertilizer
• Example: A simple wage equation

• When is there a causal interpretation?
• Conditional mean independence assumption
• Example: wage equation

• Population regression function (PFR)
• The conditional mean independence assumption implies that
• This means that the average value of the dependent variable

can be expressed as a linear function of the explanatory variable.

• Deriving the ordinary least squares estimates
• In order to estimate the regression model one needs data
• A random sample of n observations

• Deriving the ordinary least squares (OLS) estimators
• Defining regression residuals
• Minimize the sum of the squared regression residuals
• OLS estimators

• OLS fits as good as possible a regression line through the data points

• Example of a simple regression
• CEO salary and return on equity
• Fitted regression
• Causal interpretation?

• Wage and education

• Voting outcomes and campaign expenditures (two parties)

• Properties of OLS on any sample of data
• Fitted values and residuals
• Algebraic properties of OLS regression

obsno roe salary salaryhat uhat
1 14.1 1095 1224.058 -129.058 • This table presents fitted
2 10.9 1001 1164.854 -163.854 values and residuals for 15
3 23.5 1122 1397.960 -275.969
CEOs.
4 5.9 578 1072.348 -494.348
5 13.8 1368 1218.508 149.493
6 20.0 1145 1333.215 -188.215 • For example, the 12th CEO’s
7 16.4 1078 1266.611 188.611 predicted salary is $526,023
8 16.3 1094 1264.761 -170.761 higher than their actual
9 10.5 1237 1157.454 79.546
10 26.3 833 1449.773 -616.773
salary.
11 25.9 567 1442.372 -875.372
12 26.8 933 1459.023 -526.023 • By contrast the 5th CEO’s
13 14.8 1339 1237.009 101.991 predicted salary is $149,493
14 22.3 937 1375.768 -438.768
lower than their actual
15 56.3 2011 2004.808 6.192
salary.

• Goodness of fit
• How well does an explanatory variable explain the dependent variable?
• Measures of variation:

• Decomposition of total variation
• Goodness-of-fit measure (R-squared)

• CEO Salary and return on equity
• Voting outcomes and campaign expenditures
• Caution: A high R-squared does not necessarily mean that the regression
has a causal interpretation!

• Incorporating nonlinearities: Semi-logarithmic form
• Regression of log wages on years of education
• This changes the interpretation of the regression coefficient:


• Incorporating nonlinearities: Log-logarithmic form
• CEO salary and firm sales
• This changes the interpretation of the regression coefficient:

• CEO salary and firm sales: fitted regression
• The log-log form postulates a constant elasticity model, whereas the

semi-log form assumes a semi-elasticity model.

• Expected values and variances of the OLS estimators
• The estimated regression coefficients are random variables because
they are calculated from a random sample
• The question is what the estimators will estimate on average and how
large will their variability be in repeated samples

• Standard assumptions for the linear regression model
• Assumption SLR.1 (Linear in parameters)
• Assumption SLR.2 (Random sampling)

• Discussion of random sampling: Wage and education
• The population consists, for example, of all workers of country A
• In the population, there is a linear relationship between wages (or log wages)
and years of education.
• Draw completely randomly a worker from the population
• The wage and the years of education of the worker drawn are random because
one does not know beforehand which worker is drawn.
• Throw that worker back into the population and repeat the random draw n
times.
• The wages and years of education of the sampled workers are used to estimate
the linear relationship between wages and education.

• Assumptions for the linear regression model (cont.)
• Assumption SLR.3 (Sample variation in the explanatory variable)
• Assumption SLR.4 (Zero conditional mean)

• Theorem 2.1 (Unbiasedness of OLS)
• Interpretation of unbiasedness
• The estimated coefficients may be smaller or larger, depending on the sample
that is the result of a random draw.
• However, on average, they will be equal to the values that characterize the true
relationship between y and x in the population.
• “On average” means if sampling was repeated, i.e. if drawing the random
sample and doing the estimation was repeated many times.
• In a given sample, estimates may differ considerably from true values.

• Variances of the OLS estimators
• Depending on the sample, the estimates will be nearer or farther away from
the true population values.
• How far can we expect our estimates to be away from the true population
values on average (= sampling variability)?
• Sampling variability is measured by the estimator‘s variances
• Assumption SLR.5 (Homoskedasticity)

• Graphical illustration of homoskedasticity

• An example for heteroskedasticity: Wage and education

• Theorem 2.2 (Variances of the OLS estimators)
• Under assumptions SLR.1 – SLR.5:
• Conclusion:
• The sampling variability of the estimated regression coefficients will be the
higher, the larger the variability of the unobserved factors, and the lower, the
higher the variation in the explanatory variable.

• Estimating the error variance

• Theorem 2.3 (Unbiasedness of the error variance)
• Calculation of standard errors for regression coefficients
The estimated standard deviations of the regression coefficients are called “standard errors.” They
measure how precisely the regression coefficients are estimated.

• Regression on a binary explanatory variable
• Suppose that x is either equal to 0 or 1
• This regression allows the mean value of y to differ depending on the

state of x
• Note that the statistical properties of OLS are no different when x is

binary

• Counterfactual outcomes, causality and policy analysis
• In policy analysis, define a treatment effect as:
• Note that we will never actually observe this since we either observe
yi(1) or yi(0) for a given i, but never both.
• Let the average treatment effect be defined as:

• Counterfactual outcomes, causality and policy analysis (contd.)
• Let xi be a binary policy variable.
• This can be written as:
• Therefore, regressing y on x will give us an estimate of the (constant)

treatment effect.
• As long as we have random assignment, OLS will yield an unbiased
estimator for the treatment effect τ.

• Random assignment
• Subjects are randomly assigned into treatment and control groups such that
there are no systematic differences between the two groups other than the
treatment.
• In practice, randomized control trials (RCTs) are expensive to implement and
may raise ethical issues.
• Though RCTs are often not feasible in economics, it is useful to think about the
kind of experiment you would run if random assignment was a possibility. This
helps in identifying the potential impediments to random assignment (that we
could conceivable control for in a multivariate regression).

• Example: The effects of a job training program on earnings
• Real earnings are regressed on a binary variable indicating
participation in a job training program.
• Those who participated in the training program have earnings $1,790

higher than those who did not participate.
• This represents a 39.3% increase over the $4,550 average earnings
from those who did not participate.

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Introductory Econometrics: A Modern Approach (7e)

The Simple Regression Model (1 of 39)

The Simple Regression Model (2 of 39)

• The simple linear regression model is rarely applicable in practice but

The Simple Regression Model (3 of 39)

• Example: A simple wage equation

The Simple Regression Model (4 of 39)

• Example: wage equation

The Simple Regression Model (5 of 39)

• This means that the average value of the dependent variable

The Simple Regression Model (6 of 39)

The Simple Regression Model (7 of 39)

The Simple Regression Model (8 of 39)

• Minimize the sum of the squared regression residuals

The Simple Regression Model (9 of 39)

The Simple Regression Model (10 of 39)

The Simple Regression Model (11 of 39)

The Simple Regression Model (12 of 39)

The Simple Regression Model (13 of 39)

The Simple Regression Model (14 of 39)

• Algebraic properties of OLS regression

The Simple Regression Model (15 of 39)

The Simple Regression Model (16 of 39)

The Simple Regression Model (17 of 39)

• Goodness-of-fit measure (R-squared)

The Simple Regression Model (18 of 39)

• Voting outcomes and campaign expenditures

The Simple Regression Model (19 of 39)

• This changes the interpretation of the regression coefficient:

The Simple Regression Model (20 of 39)

The Simple Regression Model (21 of 39)

• This changes the interpretation of the regression coefficient:

The Simple Regression Model (22 of 39)

• The log-log form postulates a constant elasticity model, whereas the

The Simple Regression Model (23 of 39)

The Simple Regression Model (24 of 39)

• Assumption SLR.2 (Random sampling)

The Simple Regression Model (25 of 39)

The Simple Regression Model (26 of 39)

The Simple Regression Model (27 of 39)

• Assumption SLR.4 (Zero conditional mean)

The Simple Regression Model (28 of 39)

The Simple Regression Model (29 of 39)

• Assumption SLR.5 (Homoskedasticity)

The Simple Regression Model (30 of 39)

The Simple Regression Model (31 of 39)

The Simple Regression Model (32 of 39)

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The Simple Regression Model (34 of 39)

• Calculation of standard errors for regression coefficients

The Simple Regression Model (35 of 39)

• This regression allows the mean value of y to differ depending on the

• Note that the statistical properties of OLS are no different when x is

The Simple Regression Model (36 of 39)

• Let the average treatment effect be defined as:

The Simple Regression Model (37 of 39)

• This can be written as:

• Therefore, regressing y on x will give us an estimate of the (constant)

The Simple Regression Model (38 of 39)