CHAPTER ONE
INTRODUCTION
Outlines:
Definition and scope of Econometrics
Econometrics Vs Mathematics and Statistics
Economic models vs. Econometric models
Methodology of Econometrics
Goals of Econometrics
Types and sources of data
1.1 Definition and scope of econometrics
The economic theories we learn in various economics courses suggest many relationships
among economic variables. For instance, in microeconomics we learn demand and supply
models in which the quantities demanded and supplied of a good depend on its price. In
macroeconomics, we study „investment function‟ to explain the amount of aggregate
investment in the economy as the rate of interest changes; and „consumption function‟ that
relates aggregate consumption to the level of aggregate disposable income. Each of such
specifications involves a relationship among economic variables. As economists, we may be
interested in questions such as: If one variable changes in a certain magnitude, by how
much will another variable change? Also, given that we know the value of one variable;
can we forecast or predict the corresponding value of another? The purpose of studying
the relationships among economic variables and attempting to answer questions of the
type raised here is to help us understood the real economic world we live in.
However, economic theories that postulate the relationships between economic variables
have to be checked against data obtained from the real world. If empirical data verify the
relationship proposed by economic theory, we accept the theory as valid. If the theory is
incompatible with the observed behavior, we either reject the theory or in the light of the
empirical evidence of the data, modify the theory. To provide a better understanding of
economic relationships and a better guidance for economic policy making we also need to
know the quantitative relationships between the different economic variables. We obtain
these quantitative measurements taken from the real world. The field of knowledge which
helps us to carryout such an evaluation of economic theories in empirical terms is
econometrics.
WHAT IS ECONOMETRICS?
Literally interpreted, econometrics means “economic measurement”, but the scope of
econometrics is much broader as described by leading econometricians. Various
econometricians used different ways of wordings to define econometrics. But if we distill
the fundamental features/concepts of all the definitions, we may obtain the following
definition.
“Econometrics is the science which integrates economic theory, economic statistics, and
mathematical economics to investigate the empirical support of the general schematic law
established by economic theory. It is a special type of economic analysis and research in
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which the general economic theories, formulated in mathematical terms, is combined with
empirical measurements of economic phenomena. Starting from the relationships of economic
theory, we express them in mathematical terms so that they can be measured. We then use
specific methods, called econometric methods in order to obtain numerical estimates of the
coefficients of the economic relationships.”
Measurement is an important aspect of econometrics. However, the scope of econometrics
is much broader than measurement. As D. Intriligator rightly stated the “metric” part of the
word econometrics signifies „measurement‟, and hence econometrics is basically concerned
with measuring of economic relationships. In short, econometrics may be considered as the
integration of economics, mathematics, and statistics for the purpose of providing
numerical values for the parameters of economic relationships and verifying economic
theories.
1.2. Econometrics vs. mathematical economics
Mathematical economics states economic theory in terms of mathematical symbols. There
is no essential difference between mathematical economics and economic theory. Both
state the same relationships, but while economic theory use verbal exposition,
mathematical symbols. Both express economic relationships in an exact or deterministic
form. 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. Econometrics
differs from mathematical economics in that, although econometrics presupposes, the
economic relationships to be expressed in mathematical forms, it does not assume exact or
deterministic relationship. Econometrics assumes random relationships among economic
variables. Econometric methods are designed to take into account random disturbances
which relate deviations from exact behavioral patterns suggested by economic theory and
mathematical economics. Further more, econometric methods provide numerical values of
the coefficients of economic relationships.
1.3. Econometrics vs. statistics
Econometrics differs from both mathematical statistics and economic statistics. An
economic statistician gathers empirical data, records them, tabulates them or charts them,
and attempts to describe the pattern in their development over time and perhaps detect
some relationship between various economic magnitudes. Economic statistics is mainly a
descriptive aspect of economics. It does not provide explanations of the development of the
various variables and it does not provide measurements the coefficients of economic
relationships. Mathematical (or inferential) statistics deals with the method of
measurement which is developed on the basis of controlled experiments. But statistical
methods of measurement are not appropriate for a number of economic relationships
because for most economic relationships controlled or carefully planned experiments
cannot be designed due to the fact that the nature of relationships among economic
variables are stochastic or random. Yet the fundamental ideas of inferential statistics are
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applicable in econometrics, but they must be adapted to the problem economic life.
Econometric methods are adjusted so that they may become appropriate for the
measurement of economic relationships which are stochastic. The adjustment consists
primarily in specifying the stochastic (random) elements that are supposed to operate in
the real world and enter into the determination of the observed data.
1.4. Economic models vs. econometric models
i) Economic models:
Any economic theory is an observation from the real world. For one reason, the immense
complexity of the real world economy makes it impossible for us to understand all
interrelationships at once. Another reason is that all the interrelationships are not equally
important as such for the understanding of the economic phenomenon under study. The
sensible procedure is therefore, to pick up the important factors and relationships relevant
to our problem and to focus our attention on these alone. Such a deliberately simplified
analytical framework is called on economic model. It is an organized set of relationships
that describes the functioning of an economic entity under a set of simplifying
assumptions. All economic reasoning is ultimately based on models. 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
ii) Econometric models:
The most important characteristic of economic relationships is that they contain a random
element which is ignored by mathematical economic models which 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:
Q b0 b1 P b2 P0 b3Y b4 t
The above demand equation is exact. How ever, many more factors may affect demand. In
econometrics the influence of these „other‟ factors is taken into account by the introduction
into the economic relationships of random variable. In our example, the demand function
studied with the tools of econometrics would be of the stochastic form:
Q b0 b1 P b2 P0 b3Y b4 t u
Where u stands for the random factors which affect the quantity demanded.
1.5. Methodology of econometrics
Econometric research is concerned with the measurement of the parameters of economic
relationships and with the predication of the values of economic variables. The
relationships of economic theory which can be measured with econometric techniques are
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relationships in which some variables are postulated as causes of the variation of other
variables. 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. Evaluation of the forecasting power of the estimated model
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:
i) The dependent and independent (explanatory) variables which will be included in the model.
ii) The a priori theoretical expectations about the size and sign of the parameters of the function.
iii) The mathematical form of the model (number of equations, specific form of the equations, etc.)
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. 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.
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.
a. Gathering of the data on the variables included in the model.
b. Examination of the identification conditions of the function (especially for
simultaneous equations models).
c. Examination of the aggregations problems involved in the variables of the function.
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d. Examination of the degree of correlation between the explanatory variables (i.e.
examination of the problem of multicollinearity).
e. 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, Tobit
and Probit.
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 a priori criteria: These criteria are determined by economic theory and
refer to the size and sign of the parameters of economic relationships.
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. 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.
4) Evaluation of the forecasting power of the model:
Forecasting is one of the aims of econometric research. However, before using an
estimated model for forecasting by some way or another the predictive power of the
model. 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.
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.
1. Theoretical plausibility. The model should be compatible with the postulates of
economic theory. It must describe adequately the economic phenomena to which it
relates.
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2. Explanatory ability: The model should be able to explain the observations of he
actual world. It must be consistent with the observed behaviour of the economic
variables whose relationship it determines.
3. 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 he structural model. The estimates should if possible possess the
desirable properties of unbiasedness, consistency and efficiency.
4. Forecasting ability: The model should produce satisfactory predictions of future
values of he dependent (endogenous) variables.
5. 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).
1.6. Goals of Econometrics
Three main goals of Econometrics are identified:
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.
1.7. Types and sources of data
Cross Sectional Data
Time Series Data
Pooled Cross sectional Data
Panel/Longitudinal Data