ECONOMETRICS I

Textbook: Damodar N. Gujarati, Basic Econometrics,

The McGraw-Hill Companies
 5.5 HYPOTHESIS TESTING:
GENERAL COMMENTS

1. Confidence interval approach

2. Test of significance approach

Both these approaches predicate that the variable (statistic or estimator) under
consideration has some probability distribution and that hypothesis testing
involves making statements or assertions about the value(s) of the parameter(s)
of such distribution.
Hypothesis Testing: Confidence Interval Approach (Two-Sided or Two-Tail Test)

To illustrate the confidence interval approach, once again we revert

to our wages-education example. From the regression results given
in Eq. (3.6.1), we know that the slope coefficient is 0.7240. Suppose
we postulate that

Null Hypothesis, : = 0.5 and

Alternative Hypothesis. : ≠ 0.5
Hypothesis Testing: Confidence Interval Approach (Two-Sided or Two-Tail Test)

Actually it is what is known as a two-sided hypothesis. Very often

such a two-sided alternative hypothesis reflects the fact that we do
not have a strong a priori or theoretical expectation about the
direction in which the alternative hypothesis should move from the
null hypothesis.
Hypothesis Testing: Confidence Interval Approach (Two-Sided or Two-
Tail Test)

Is the observed or estimated compatible

with ?
To answer this question we need to construct confidence Interval for
We will do this- by using t distribution. The t variable can be defined
as-

This t variable follows a t distribution with n-2 df.

 Two-Sided or Two-Tail Test
Now lets define the 100(1-α) % confidence interval for as follows:

Substituting the value of t it can be rewritten as follows:

Rearranging the above equation we can get,

Hypothesis Testing: Confidence Interval Approach (Two-Sided or Two-
Tail Test)

Or more compactly the 100(1-α) % confidence interval for is

Similarly the 100(1-α) % confidence interval for is

Notice an important feature of the confidence intervals given in Equations

5.3.6 and 5.3.8: In both cases the width of the confidence interval is
proportional to the standard error of the estimator. That is, the larger the
standard error, the larger is the width of the confidence interval. Put
differently, the larger the standard error of the estimator, the greater is
the uncertainty of estimating the true value of the unknown parameter.
Thus, the standard error of an estimator is often described as a measure
of the precision of the estimator (i.e., how precisely the estimator
measures the true population value).
Hypothesis Testing: Confidence Interval Approach (Two-Sided or Two-
Tail Test)

Now Suppose that ,

= 0.7240 , se ( )= 0.0700, α= 5% . So, 1-α =95%.
n=13, so degrees of freedom (df) = n-2=13-2=11
and α/2 =0.05/2=0.025 (since two tail test we should divide
alpha by 2)

Now at 11 df and 0.025 level of significance the critical value

of t which is defined as tα/2 can be obtained from t chart
given in the appendix.

t α/2 = 0.201
 Two-Sided or Two-Tail Test
Therefore the 95% confidence interval for

0.7240 - (2.20*0.070) ≤ ≤ 0.7240+(2.201*0.0700)

0.5700 ) ≤ ≤ 0.8780
The 95 cases out of 100 will contain the true value of β as described by
2

the above equation. If the value of β under null hypothesis falls within the
2

100(1-α) % confidence interval we do not reject null hypothesis. If it lies

outside the interval we reject the null hypothesis.
Two-Sided or Two-Tail Test
Hypothesis Testing: Confidence Interval Approach (Two-Sided or Two-
Tail Test)

• Following this rule our hypothetical example null hypothesis that H : =

0

0.5 clearly lies outside of the 95% confidence interval . So

reject the null hypothesis with 95 % confidence.
 One-Sided or One-Tail Test
Sometimes we have a strong a priori or theoretical expectation (or
expectations based on some previous empirical work) that the alternative
hypothesis is one-sided or unidirectional rather than two-sided, as just
discussed. Thus, for our wages-education example, one could postulate
that

• Null Hypotheis, H : ≤ 0.5 and Alternative Hypothesis, H : >

0 1

0.5

Perhaps economic theory or prior empirical work suggests that the slope is
greater than 0.5. Although the procedure to test this hypothesis can be
easily derived from Eq. (5.3.5), the actual mechanics are better explained
in terms of the test-of-significance approach discussed next
 Hypothesis Testing: The Test-of-
Significance Approach
Testing the Significance of Regression Coefficients: The t Test
An alternative but complementary approach to the confidence-
interval method of testing statistical hypotheses is the test-of-
significance approach developed along independent lines by
R. A. Fisher and jointly by Neyman and Pearson.10 Broadly
speaking, a test of significance is a procedure by which sample
results are used to verify the truth or falsity of a null
hypothesis. The key idea behind tests of significance is that of
a test statistic (estimator) and the sampling distribution of such
a statistic under the null hypothesis. The decision to accept or
reject is made on the basis of the value of the test statistic
obtained from the data at hand.
 Hypothesis Testing: The Test-of-Significance
Approach( single significance test)

Recall that the t variable can be defined as

It follows the t distribution with n − 2 df. If the value of true is specified under
the null hypothesis, the t value can readily be computed from the available
sample, and therefore it can serve as a test statistic.
 Hypothesis Testing: The Test-of-
Significance Approach
• We know that = 0.7240, se () = 0.0700, and df = 11. If we
assume α = 5%, tα/2 = 2.201.
• If we assume H : = = 0.5 and H : ≠ 0.5
0 1

• One can compute the t value in the middle of the double

inequality given by Eq. (5.7.1) and see whether it lies
between the critical t values or outside them. For our
example,
•
The value of t static is , t = (0.7240 − 0.5)/ 0.0700 = 3.2
And the critical value of t obtained from t table at 11 df and
α/2 level of significance is t = 2.201.
α/2

Decision Rules: If calculated t > critical value of t reject null

hypothesis and test is statistically significantly different
from null hypothesis.
 Hypothesis Testing: Confidence Interval VS
The Test-of-Significance Approach
• Once again let us return to our wages-education example. We know that =
0.7240, se () = 0.0700, and df = 11. If we assume α = 5%, tα/2 = 2.201. If
we assume H0: β2 = =0.5 and H1: β2 ≠ 0.5, Eq. (5.7.2) becomes
Pr (0.3460 ≤ ≤ 0.6540)
 Hypothesis Testing: Confidence Interval VS
The Test-of-Significance Approach
The value of t static is , t = (0.7240 − 0.5)/ 0.0700 = 3.2
which clearly lies in the rejection region.
 Hypothesis Testing: The Test-of-
Significance Approach
• Since we use the t distribution, the preceding testing procedure is called
appropriately the t test. In the language of significance tests, a statistic is
said to be statistically significant if the value of the test statistic lies in
the critical region. In this case the null hypothesis is rejected. By the
same token, a test is said to be statistically insignificant if the value of
the test statistic lies in the acceptance region. In this situation, the null
hypothesis is not rejected. In our example, the t test is significant and
hence we reject the null hypothesis.
Hypothesis Testing: The Test-of-Significance
Approach (One Tail Test)
Suppose that
: ≤ 0.5 and : > 0.5.
Although is still a composite hypothesis, it is now one-sided. To test this hypothesis, we use
the one-tail test.
The test procedure is the same as before except that the upper confidence limit or critical
value now corresponds to

t α= t 0.05,
that is, the 5 percent level. From t table the critical value of t at 5 % level of significance and
at 11 df is obtained as

t α= 1.796
Clearly t=3.2 is greater than critical t. so reject null hypothesis.
Hypothesis Testing: The Test-of-Significance
Approach (One Tail Test)
Hypothesis Testing: The Test-of-Significance Approach
Summary
 The “Zero” Null Hypothesis and the “2-t”
Rule of Thumb
• A null hypothesis that is commonly tested in empirical work is

Null Hypothesis, : = 0 and

Alternative Hypothesis. : ≠ 0

This “zero” null hypothesis is a kind of straw man, the objective being to find
out whether Y is related at all to X, the explanatory variable. If there is no
relationship between Y and X to begin with, then testing a hypothesis such as
β2 = 0.3 or any other value is meaningless. This null hypothesis can be easily
tested by the confidence interval or the t-test approach discussed in the
preceding sections. But very often such formal testing can be shortcut by
adopting the “2-t ” rule of significance, which may be stated as
The “Zero” Null Hypothesis and the “2-t”
Rule of Thumb
 The “Zero” Null Hypothesis and the “2-t”
Rule of Thumb
• Reject the null hypothesis if
|t| > tα/2 for the appropriate degrees of freedom for
two tail test
• Reject the null hypothesis if
|t| > tα for the appropriate degrees of freedom for
one tail test

Where |t| = ||
Since under the zero null hypothesis the hypothesized value of beta 2 is zero.
Choosing α, the Level of Significance
It should be clear from the discussion so far that whether we reject or do not reject
the null hypothesis depends critically on α, the level of significance or the
probability of committing a Type I error—the probability of rejecting the true
hypothesis. If we try to reduce a Type I error, a Type II error increases, and vice
versa. That is, given the sample size, if we try to reduce the probability of rejecting
the true hypothesis, we at the same time increase the probability of accepting the
false hypothesis. So there is a trade-off involved between these two types of errors
given the sample size. Now the only way we can decide about the trade-off is to
find out the relative costs of the two types of errors.

Then, If the error of rejecting the null hypothesis which is in fact true (Error Type I)
is costly relative to the error of not rejecting the null hypothesis which is in fact
false (Error Type II), it will be rational to set the probability of the first kind of error
low. If, on the other hand, the cost of making Error Type I is low relative to the cost
of making Error Type II, it will pay to make the probability of the first kind of error
high (thus making the probability of the second type of error low).
 The Exact Level of Significance: The p
Value
The classical approach to hypothesis testing is its arbitrariness in selecting α. Once a
test statistic (e.g., the t statistic) is obtained in a given example, why not simply
go to the appropriate statistical table and find out the actual probability of
obtaining a value of the test statistic as much as or greater than that obtained in
the example?
This probability is called the p value (i.e., probability value), also known as the
observed or exact level of significance or the exact probability of committing a
Type I error. More technically, the p value is defined as the lowest significance
level at which a null hypothesis can be rejected.

To illustrate, let us return to our wages-education example. Given the null hypothesis
that the true coefficient of education is 0.5, we obtained a t value of 3.2 in Eq.
(5.7.4). What is the p value of obtaining a t value of as much as or greater than
3.2? Looking up the t table given in Appendix D, we observe that for 11 df the
probability of obtaining such a t value must be smaller than 0.005 (one-tail) or
0.010 (two-tail).
 Statistical Significance versus Practical
Significance
Read yourself from book
 The Choice between Confidence-Interval and
Test-of-
Significance Approaches to Hypothesis
Testing
Read yourself from book
 5.9 REGRESSION ANALYSIS AND ANALYSIS
OF VARIANCE
• TSS = ESS + RSS

• A study of these components of TSS is known as the analysis

of variance (ANOVA) from the regression viewpoint.
5.9 REGRESSION ANALYSIS AND ANALYSIS
OF VARIANCE
5.9 REGRESSION ANALYSIS AND ANALYSIS
OF VARIANCE
5.9 REGRESSION ANALYSIS AND ANALYSIS
OF VARIANCE
 5.9 REGRESSION ANALYSIS AND ANALYSIS
OF VARIANCE
The computed F value is seen to be 108.3026. The p value of this F statistic corresponding

to 1 and 11 df cannot be obtained from the F table given in Appendix D, but by using

electronic statistical tables it can be shown that the p value is 0.0000001, an

extremely small probability indeed. If you decide to choose the level-of significance

approach to hypothesis testing and fix α at 0.01, or a 1 percent level, you can see that

the computed F of 108.3026 is obviously significant at this level. Therefore, if we reject

the null hypothesis that β2 = 0, the probability of committing a Type I error is very

small. For all practical purposes, our sample could not have come from a population

with zero β2 value and we can conclude with great confidence that X, education, does

affect Y, average wages.

 5.11 Reporting the Results of Regression
Analysis
There are various ways of reporting the results of regression analysis, but in
this text we shall use the following format, employing the wages-education
example of Chapter 3 as an illustration:
 5.11 Reporting the Results of Regression
Analysis
• In Equation 5.11.1 the figures in the first set of parentheses
are the estimated standard errors of the regression
coefficients, the figures in the second set are estimated t
values computed from Eq. (5.3.2) under the null hypothesis
that the true population value of each regression coefficient
individually is zero (e.g., 10.3428 = 0.7240 0.0700 ), and
the figures in the third set are the estimated p values. Thus,
for 11 df the probability of obtaining a t value of 10.3428 or
greater is 0.00009, which is practically zero. By presenting
the p values of the estimated t coefficients, we can see at
once the exact level of significance of each estimated t
value.
 5.11 Reporting the Results of Regression
Analysis
• Thus, under the null hypothesis that the true population slope
value is zero (i.e., that is, education has no effect on mean
wages), the exact probability of obtaining a t value of 10.3428
or greater is practically zero. Recall that the smaller the p
value, the smaller the probability of making a mistake if we
reject the null hypothesis. Earlier we showed the intimate
connection between the F and t statistics, namely, F1,k = t2
k . Under the null hypothesis that the true β2 = 0, Eq. (5.11.1)
shows that the F value is 108.30 (for 1 numerator and 11
denominator df) and the t value is about 10.34 (11 df); as
expected, the former value is the square of the latter value,
except for the round off errors.
5.11 Reporting the Results of Regression
Analysis