A Practical Guide To

Using Econometrics

A. H. Studenmund

Chapter 4
The Classical Assumptions
• If Classical Assumptions are met, OLS estimators
are best available.
• There are seven Classical Assumptions:

I. The regression model is linear, is correctly

specified, and has an additive error term.

II. The error term has a zero population mean.

III. All explanatory variables are uncorrelated with

the error term.

β 4-2
The Classical Assumptions (continued)
IV. Observations of the error term are
uncorrelated with each other (no serial
correlation)
V. The error term has a constant variance (no
heteroskedasticity)
VI. No explanatory variable is a perfect linear
function of any other explanatory variable(s) (no
perfect multicollinearity).
VII. The error term is normally distributed (this
assumption is optional but usually is invoked)

β 4-3
Classical Assumption I
CA I: Regression model is linear, correctly
specified, and has an additive error term.
• Linearity assumption means coefficients must enter
the model linearly:

Yi = b0 + b1 X1i + b2 X2i +... + bK XKi + ei (4.1)

• Correctly specified means the functional form is

correct and there are no omitted variables.
• Additive error term means error term cannot be
multiplied or divided by any other variable.
β 4-4
Classical Assumption I (continued)
•Assumption a model must be linear does not require
underlying theory to be linear.
Example: an exponential function
b0 b1 ei
Yi = e X1 e (4.2)
• Applying natural logs:
ln(Yi ) = b0 + b1 ln(Xi ) + ei (4.3)

• Setting ln(Yi) = Yi* and ln(Xi) = Xi*, then:

Yi* = b0 + b1 Xi* + ei (4.4)

β 4-5
Classical Assumption II
CA II: The error term has a zero population mean.
• Error term (ε) is stochastic (or random).
• Value of each observation of the error term is
determined by chance.
• Some observations will be positive.
• Some observations will be negative.
• Mean of the distribution of the error term is zero.
• Convenient to think of each error term being drawn from
a random variable distribution such as Figure 4.1.

β 4-6
Classical Assumption II (continued)

β 4-7
Classical Assumption II (continued)
• For a small sample, mean is not likely to be exactly zero.
• As sample approaches infinity, mean approaches 0.
• Including a constant term insures CA II holds.

Example: Consider typical regression equation:

Yi = b0 + b1 Xi + ei (4.5)
• Suppose the mean of εi is 3.
• If we add 3 to constant and subtract 3 from error term:

Yi = (b0 + 3) + b1 Xi + (ei - 3) (4.6)

β 4-8
Classical Assumption II (continued)
• Equations (4.5) and (4.6) are equivalent and the
expected mean of (εi – 3) is 0
• Equation (4.6) can be rewritten as:

Yi = b0* + b1 Xi + ei* (4.7)

where β0* = (β0 + 3) and εi* = (εi – 3)

• Equation (4.7) conforms to CA II.

• If CA II is violated, model’s constant term absorbs the
non-zero mean of the error term and other coefficients
are unaffected.
β 4-9
Classical Assumption III
CA III: All explanatory variables are uncorrelated
with the error term.
• CA III states explanatory variables and error term are
independent.
• If CA III is violated, OLS estimates likely attribute some
of the variation in Y that is in the error term to X.
• This leads to bias in the coefficient estimate of X.
• CA III is frequently violated by omitting an important
independent variable correlated with an included
independent variable.
β 4-10
Classical Assumption IV
CA IV: Observations of the error term are
uncorrelated with each other.
• If a systematic correlation exists between observations
of the error term, OLS estimates will be inaccurate.
• Correlation between observations of the error term is
called serial correlation or autocorrelation.
• The violation of CA IV is most common in time-series
models.

β 4-11
Classical Assumption V
CA V: The error term has constant variance.
• Observations of error term are assumed to be drawn
from identical distributions (like Figure 4-1).
• If not, then the variance is non-constant—referred to as
heteroskedasticity.
• Non-constant variance of the error term leads OLS
estimates of standard errors to be inaccurate.
• Figure 4-2 displays a case where variance of error term
increases.

β 4-12
Classical Assumption V (continued)

β 4-13
Classical Assumption VI
CA VI: No explanatory variable is a perfect linear
function of any other explanatory
variable(s).
• Perfect collinearity between two independent variables
implies they are really the same variable.
• Perfect multicollinearity is when more than two
independent variables are involved.
Example:
If sales tax rate is 7%, total taxes = 7% * sales.
You could not have sales tax and sales in a model.
β 4-14
Classical Assumption VII
CA VII: The error term is normally distributed.
• OLS estimation does not require normality assumption.
• Hypothesis testing and confidence intervals—topics
taken up in Chapter 5—do lean on the normality
assumption in small samples.
• CA VII states that the observations of the error term are
drawn from a normal distribution (that is, bell-shaped
and generally following the symmetrical pattern
portrayed in Figure 4.3).

β 4-15
Classical Assumption VII (continued)

β 4-16
Sampling Distribution of ̂
• Estimates of β follow a probability distribution too.

• A single sample produces a single estimate of b̂ .

• The probability distribution of b̂ values across different

samples is called the sampling distribution of b̂ .

• CA VII (normality of the error term) implies that the OLS

estimates of β are normally distributed as well.

β 4-17
Sampling Distribution of ̂ (continued)
Example: Height and weight sampling distribution

• Recall the height and weight example of Chapter 1.

+
WEIGHTi = b0 + b1 HEIGHTi + ei (4.8)
• You can estimate β1 with a sample of 6 students.
• A different 6-student sample will get a different estimate.
• If you choose 100 different samples of 6 students, you
will likely get 100 different estimates of β 1.
• Figure 4.4 is histogram graph of estimating equation
(4.8) on 100 different samples.
β 4-18
Sampling Distribution of ˆ (continued)

β 4-19
Sampling Distribution of ˆ (continued)
• Together, all estimates of β1 form a distribution with a
mean and variance.
• To be “good,” an estimation technique should be
unbiased.
• Unbiased is when the mean of the sampling distribution
is equal to the population mean.
• Moral of the story:
1. A single sample provides a single estimate.
2. That estimate comes from a sampling distribution
with a mean and variance.

β 4-20
Sampling Distribution of ˆ (continued)
• A desirable property of an estimator is to be unbiased.
• Formally:
An estimator b̂ is an unbiased estimator if its sampling
distribution has as its expected value the true value of b.

E(b̂ ) = b
• Even though only one estimate is obtained in practice, if
it is drawn from an unbiased distribution it is often more
likely to be accurate than an estimate drawn from a
biased distribution

β 4-21
Sampling Distribution of ˆ (continued)
• Another desirable property of an estimator is to be as
narrow (or precise) as possible.

• A distribution centered on truth with very high variance

might be of very limited use.

• Figure 4.5 provides examples of three distributions:

Distribution A: unbiased, large variance
Distribution B: unbiased, small variance
Distribution C: biased and small variance

β 4-22
Sampling Distribution of ˆ (continued)

β 4-23
 Sampling Distribution of ˆ (continued)

• Variance of the
distribution of b̂ can be
decreased by increasing
sample size (Fig 4.6)

• A powerful lesson is that

to maximize chances of
getting an estimate close
to the true value, apply
OLS to a large sample.

β 4-24
Sampling Distribution of ˆ (continued)
• The standard error of the estimated coefficient, SE(b̂ ), is
the square root of the variance.

• SE(b̂ ) is similarly affected by changes in the sample

size.

• An increase in sample size will cause SE(b̂ ) to fall.

• Thus, the larger the sample, the more precise our

coefficient estimates will be.

β 4-25
Gauss-Markov Theorem and the
Properties of OLS Estimators.
• The Gauss-Markov Theorem proves two important
properties of OLS estimators.

• It states:
Given Classical Assumptions I through VI, the OLS
estimator of βk is the minimum variance estimator
from among the set of all linear unbiased
estimators of βK, for K = 0,1, 2,…,K.

• Perhaps most easily remembered by stating that “OLS is

BLUE.”

β 4-26
Gauss-Markov Theorem and the
Properties of OLS Estimators (continued)
• If CA VII is added, the Gauss-Markov Theorem is
strengthened.

• Specifically, OLS estimates are:

1. Unbiased
2. Minimum variance
3. Consistent
4. Normally distributed

β 4-27
Standard Econometric Notation

β 4-28
 β

CHAPTER 4: the end