The Nature of Econometrics

and Economic Data

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 The Nature of Econometrics
and Economic Data
What is econometrics?

Econometrics = use of statistical methods to analyze

economic/business data

Econometricians typically analyze nonexperimental data

Typical goals of econometric analysis

Estimating relationships between economic variables

Testing economic theories and hypotheses

Forecasting economic variables

Evaluating and implementing government and business policy

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 The Nature of Econometrics
and Economic Data
Steps in econometric analysis

1) Economic model (this step is often skipped)

2) Econometric model

Economic models

Maybe micro- or macromodels

Often use optimizing behaviour, equilibrium modeling, …

Establish relationships between economic variables

Examples: demand equations, pricing equations, …

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 Steps involved in the formulation of
econometric models

Economic or Financial Theory (Previous Studies)

Formulation of an Estimable Theoretical Model

Collection of Data

Model Estimation

Is the Model Statistically Adequate?

No Yes

Reformulate Model Interpret Model

Use for Analysis

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 Choosing among Competing Models

• When a governmental agency collects economic data, it does not necessarily have
any economic theory in mind.
• How then does one know that the data really support the Keynesian theory of
consumption?
• Is it because the Keynesian consumption function (i.e., the regression line) shown in
Figure is extremely close to the actual data points?
• Is it possible that another consumption model (theory) might equally fit the data as
well? For example, Milton Friedman’s the permanent income hypothesis. Robert
Hall’s the life-cycle permanent income hypothesis. Could one or both of these
models also fit the data in Table?
• In short, the question facing a researcher in practice is how to choose among
competing hypotheses or models of a given phenomenon, such as the
consumption–income relationship.
 The Nature of Econometrics
and Economic Data
Economic model of crime (Becker (1968))
Derives equation for criminal activity based on utility maximization

Hours spent in
criminal activities

Age
„Wage“ of cri-
minal activities Probability of Expected
Wage for legal
Other Probability of conviction if sentence
employment
income getting caught caught

Functional form of relationship not specified

Equation could have been postulated without economic modeling

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 The Nature of Econometrics
and Economic Data
Model of job training and worker productivity
What is effect of additional training on worker productivity?
Formal economic theory not really needed to derive equation:

Hourly wage

Years of formal
education Weeks spent
Years of work- in job training
force experience

Other factors may be relevant, but these are the most important (?)

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 The Nature of Econometrics
and Economic Data
Econometric model of criminal activity
The functional form has to be specified
Variables may have to be approximated by other quantities

Measure of cri- Wage for legal Other Frequency of

minal activity employment income prior arrests
Unobserved deter-
minants of criminal
activity

e.g. moral character,

wage in criminal activity,
Frequency of Average sentence Age family background …
conviction length after conviction

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 The Nature of Econometrics
and Economic Data
Econometric model of job training and worker productivity

Unobserved deter-
minants of the wage

e.g. innate ability,

Hourly wage Years of formal Years of work- Weeks spent quality of education,
education force experience in job training family background …

Most of econometrics deals with the specification of the error

Econometric models may be used for hypothesis testing

For example, the parameter represents effect of training on wage

How large is this effect? Is it different from zero?

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 The Nature of Econometrics
and Economic Data
Econometric analysis requires data

Different kinds of economic data sets

Cross-sectional data

Time series data

Pooled cross sections

Panel/Longitudinal data

Econometric methods depend on the nature of the data used

Use of inappropriate methods may lead to misleading results

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 The Nature of Econometrics
and Economic Data
Cross-sectional data sets

Sample of individuals, households, firms, cities, states, countries,

or other units of interest at a given point of time/in a given period

Cross-sectional observations are more or less independent

For example, pure random sampling from a population

Sometimes pure random sampling is violated, e.g. units refuse to

respond in surveys, or if sampling is characterized by clustering

Cross-sectional data typically encountered in applied microeconomics

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 The Nature of Econometrics
and Economic Data
Cross-sectional data set on wages and other characteristics

Indicator variables
(1=yes, 0=no)

Observation number Hourly wage

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 The Nature of Econometrics
and Economic Data
Cross-sectional data on growth rates and country characteristics

Growth rate of real Government consumtion Adult secondary

per capita GDP as percentage of GDP education rates

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 The Nature of Econometrics
and Economic Data
Time series data
Observations of a variable or several variables over time

For example, stock prices, money supply, consumer price index,

gross domestic product, annual homicide rates, automobile sales, …

Time series observations are typically serially correlated

Ordering of observations conveys important information

Data frequency: daily, weekly, monthly, quarterly, annually, …

Typical features of time series: trends and seasonality

Typical applications: applied macroeconomics and finance

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 The Nature of Econometrics
and Economic Data
Time series data on minimum wages and related variables

Average minimum Average Unemployment Gross national

wage for given year coverage rate rate product

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 The Nature of Econometrics
and Economic Data
Pooled cross sections
Two or more cross sections are combined in one data set

Cross sections are drawn independently of each other

Pooled cross sections often used to evaluate policy changes

Example:

• Evaluate effect of change in property taxes on house prices

• Random sample of house prices for the year 1993

• A new random sample of house prices for the year 1995

• Compare before/after (1993: before reform, 1995: after reform)

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 The Nature of Econometrics
and Economic Data
Pooled cross sections on housing prices Property tax
Size of house
in square feet

Number of bathrooms

Before reform

After reform

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 The Nature of Econometrics
and Economic Data
Panel or longitudinal data
The same cross-sectional units are followed over time

Panel data have a cross-sectional and a time series dimension

Panel data can be used to account for time-invariant unobservables

Panel data can be used to model lagged responses

Example:

• City crime statistics; each city is observed in two years

• Time-invariant unobserved city characteristics may be modeled

• Effect of police on crime rates may exhibit time lag

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 The Nature of Econometrics
and Economic Data
Two-year panel data on city crime statistics

Each city has two time

series observations

Number of
police in 1986

Number of
police in 1990

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 The Nature of Econometrics
and Economic Data
Causality and the notion of ceteris paribus

Definition of causal effect of on :

„How does variable change if variable is changed

but all other relevant factors are held constant“

Most economic questions are ceteris paribus questions

It is important to define which causal effect one is interested in

It is useful to describe how an experiment would have to be

designed to infer the causal effect in question

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 The Nature of Econometrics
and Economic Data
Causal effect of fertilizer on crop yield
„By how much will the production of soybeans increase if one
increases the amount of fertilizer applied to the ground“
Implicit assumption: all other factors that influence crop yield such
as quality of land, rainfall, presence of parasites etc. are held fixed
Experiment:
Choose several one-acre plots of land; randomly assign different
amounts of fertilizer to the different plots; compare yields
Experiment works because amount of fertilizer applied is unrelated
to other factors influencing crop yields

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 The Nature of Econometrics
and Economic Data
Measuring the return to education
„If a person is chosen from the population and given another
year of education, by how much will his or her wage increase? “
Implicit assumption: all other factors that influence wages such as
experience, family background, intelligence etc. are held fixed
Experiment:
Choose a group of people; randomly assign different amounts of
eduction to them (infeasable!); compare wage outcomes
Problem without random assignment: amount of education is related
to other factors that influence wages (e.g. intelligence)

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 The Nature of Econometrics
and Economic Data
Effect of law enforcement on city crime level
„If a city is randomly chosen and given ten additional police officers,
by how much would its crime rate fall? “
Alternatively: „If two cities are the same in all respects, except that
city A has ten more police officers, by how much would the two cities
crime rates differ?“
Experiment:
Randomly assign number of police officers to a large number of cities
In reality, number of police officers will be determined by crime rate
(simultaneous determination of crime and number of police)

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 The Nature of Econometrics
and Economic Data
Effect of the minimum wage on unemployment
„By how much (if at all) will unemployment increase if the minimum
wage is increased by a certain amount (holding other things fixed)? “
Experiment:
Government randomly chooses minimum wage each year and
observes unemployment outcomes
Experiment will work because level of minimum wage is unrelated
to other factors determining unemployment
In reality, the level of the minimum wage will depend on political
and economic factors that also influence unemployment

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 The Nature of Econometrics
and Economic Data
Testing predictions of economic theories

Economic theories are not always stated in terms of causal effects

For example, the expectations hypothesis states that long term

interest rates equal compounded expected short term interest rates

An implicaton is that the interest rate of a three-months T-bill should

be equal to the expected interest rate for the first three months of a
six-months T-bill; this can be tested using econometric methods

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 The Accuracy of Data

• The quality of the data is often not that good. Some reasons for that are:
• First, as noted, most social science data are non-experimental in nature.
Therefore, there is the possibility of observational errors, either of omission or
commission.
• Second, even in experimentally collected data errors of measurement arise from
approximations and round-offs.
• Third, in questionnaire-type surveys, the problem of nonresponse can be
serious; a researcher is lucky to get a 40% response to a questionnaire.
• Fourth, the sampling methods used in obtaining the data may vary so widely
that it is often difficult to compare the results obtained from the various
samples.
• Fifth, economic data are generally available at a highly aggregate level. For
example, most macro-data (e.g., GNP, inflation, unemployment).
• The researcher should always keep in mind that the results of research are only as
good as the quality of the data.