Chapter 1
Introduction
Introduction:
The Nature and Purpose of Econometrics
• What is Econometrics?
• Literal meaning is “measurement in economics”.
• “Econometrics is about how we can use theory and data from
economics, business and the social sciences, along with tools
from statistics, to answer “how much” type questions.”
(Hill, Griffiths, and Judge, Introduction to Econometrics,
2nd edition, John Wiley & Sons, Inc., 2001).
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Types of Data
• There are 3 types of data which econometricians might use for
analysis:
1. Time series data
2. Cross-sectional data
3. Panel data, a combination of 1. & 2.
• The data may be quantitative (e.g. Profit, price cost, demand), or
qualitative (e.g. Motivation, satisfaction, service quality, etc).
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Continuous and Discrete Data
• Continuous data can take on any value and are not confined
to take specific numbers. (Eg. Profit, )
• On the other hand, discrete data can only take on certain
values, which are usually integers (Eg. Number of
employees, quantity sold for countable)
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Cardinal, Interval, Ordinal and Nominal Numbers
• Another way in which we could classify numbers is according to
whether they are cardinal, ordinal, or nominal.
• Cardinal numbers are those where the actual numerical values that
a particular variable takes have meaning, and where there is an
equal distance between the numerical values with absolute zero.
• Interval numbers are those where the order has meaning, interval
between any two values has meaning but there is no absolute zero.
• Ordinal numbers can only be interpreted as providing a position or
an ordering.
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Cardinal, Ordinal and Nominal Numbers (Cont’d)
• Nominal numbers occur where there is no natural ordering
of the values at all.
• Cardinal, ordinal and nominal variables may require
different modeling approaches or at least different
treatments, as should become evident in the subsequent
chapters.
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Steps involved in the formulation of
econometric models
Already Existing Theory or Empirical Evidence
Formulation of an Estimable Theoretical Model
Collection of Data
Model Estimation
Is the Model Statistically Adequate?
No Yes
Reformulate Model Interpret Model
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Bayesian versus Classical Statistics
• The philosophical approach to model-building used here throughout
is based on ‘classical statistics’
• This involves postulating a theory and then setting up a model and
collecting data to test that theory
• Based on the results from the model, the theory is supported or
refuted
• There is, however, an entirely different approach known as
Bayesian statistics
• Here, the theory and model are developed together
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Bayesian versus Classical Statistics
• Under Bayesian approach the researcher starts with an
assessment of existing knowledge or beliefs formulated as
probabilities, known as priors
• The priors are combined with the data into a model
• The beliefs are then updated after estimating the model to form a
set of posterior probabilities
• Bayesian statistics is a well established and popular approach,
although less so than the classical one
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Bayesian versus Classical Statistics (Cont’d)
• Some classical researchers are uncomfortable with the Bayesian use
of prior probabilities based on judgement
• If the priors are very strong, a great deal of evidence from the data
would be required to overturn them
• So the researcher would end up with the conclusions that he/she
wanted in the first place!
• In the classical case by contrast, judgement is not supposed to enter
the process and thus it is argued to be more objective.
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Some Points to Consider When Reading papers
in the academic literature
1. Does the paper involve the development of a theoretical model
or is it merely a technique looking for an application, or an
exercise in data mining?
2. Is the data of “good quality”? Is it from a reliable source? Is the
size of the sample sufficiently large for asymptotic theory to be
invoked?
3. Have the techniques been validly applied? Have diagnostic tests
for violations of been conducted for any assumptions made in the
estimation of the model?
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Some Points to Consider when reading papers
in the academic literature (cont’d)
4. Have the results been interpreted sensibly? Is the strength of
the results exaggerated? Do the results actually address the
questions posed by the authors?
5. Are the conclusions drawn appropriate given the results, or has
the importance of the results of the paper been overstated?
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Additional points to consider in applied
econometrics
Use common sense and management theory
• The role of theory extends beyond the development of
the specification; it is crucial to the interpretation of the
results and to identification of predictions from the
empirical results that should be test.
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Additional points to consider in applied
econometrics
Know the context
• Do not try to model without understanding the non-
statistical aspects of the real-life system you are trying to
subject to statistical analysis. (Belsley and Welch, 1988).
• History, institutions, operating constraints, measurement
peculiarities, cultural customs.
• How were the data gathered?
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Additional points to consider in applied
econometrics
Keep it sensibly simple
• Econometricians employ the latest, most sophisticated
econometric techniques, often because such techniques are
novel and available, not because they are appropriate.
• Think first why you are doing before attacking the problem
with all the technical arsenal you have and churning out a
paper that may be mathematically imposing but of limited
practical use. (Maddala, 1999).
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Additional points to consider in applied
econometrics
Test the estimation
• To check that the results make sense.
• The signs of coefficients as expected? Important variables
statistically significant? Are coefficient magnitudes
reasonable? Are the results consistent with theory?
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Additional points to consider in applied
econometrics
Report a sensitivity analysis
• Are the results sensitive to the sample period, the
functional form, the set of explanatory variables, or
measurement of proxies for the variables?
• Are robust estimation results markedly different?
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End
