4

Regression
Models
 Learning Objectives
After completing this chapter, students will be able to:

1. Identify variables and use them in a regression

model.
2. Develop simple linear regression equations.
from sample data and interpret the slope and
intercept.
3. Compute the coefficient of determination and
the coefficient of correlation and interpret their
meanings.
4. Interpret the F-test in a linear regression model.
5. List the assumptions used in regression and
use residual plots to identify problems.
4-2
 Learning Objectives
After completing this chapter, students will be able to:

6. Develop a multiple regression model and use it

for prediction purposes.
7. Use dummy variables to model categorical
data.
8. Determine which variables should be included
in a multiple regression model.
9. Transform a nonlinear function into a linear
one for use in regression.
10. Understand and avoid common mistakes made
in the use of regression analysis.

4-3
 Chapter Outline

4.1 Introduction
4.2 Scatter Diagrams
4.3 Simple Linear Regression
4.4 Measuring the Fit of the Regression
Model
4.5 Using Computer Software for Regression
4.6 Assumptions of the Regression Model

4-4
 Chapter Outline

4.7 Testing the Model for Significance

4.8 Multiple Regression Analysis
4.9 Binary or Dummy Variables
4.10 Model Building
4.11 Nonlinear Regression
4.12 Cautions and Pitfalls in Regression
Analysis

4-5
 Introduction
◼ Regression analysis is a very valuable
tool for a manager.
◼ Regression can be used to:
◼ Understand the relationship between
variables.
◼ Predict the value of one variable based on
another variable.
◼ Simple linear regression models have
only two variables.
◼ Multiple regression models have more
variables.
4-6
 Introduction
◼ The variable to be predicted is called
the dependent variable.
◼ This is sometimes called the response
variable.
◼ The value of this variable depends on
the value of the independent variable.
◼ This is sometimes called the explanatory
or predictor variable.
Dependent Independent Independent
variable
= variable
+ variable

4-7
 Scatter Diagram

◼ A scatter diagram or scatter plot is

often used to investigate the
relationship between variables.
◼ The independent variable is normally
plotted on the X axis.
◼ The dependent variable is normally
plotted on the Y axis.

4-8
 Triple A Construction
◼ Triple A Construction renovates old homes.
◼ Managers have found that the dollar volume of
renovation work is dependent on the area
payroll.
TRIPLE A’S SALES LOCAL PAYROLL
($100,000s) ($100,000,000s)
6 3
8 4
9 6
5 4
4.5 2
9.5 5
Table 4.1
4-9
 Triple A Construction
Scatter Diagram of Triple A Construction Company Data

Figure 4.1
4-10
 Simple Linear Regression
◼ Regression models are used to test if there is a
relationship between variables.
◼ There is some random error that cannot be
predicted.
Y =  0 + 1X + e

where
Y = dependent variable (response)
X = independent variable (predictor or explanatory)
0 = intercept (value of Y when X = 0)
 1 = slope of the regression line
e = random error

4-11
 Simple Linear Regression

◼ True values for the slope and intercept are not

known so they are estimated using sample data.

Yˆ = b0 + b1 X

where
Y^ = predicted value of Y
b0 = estimate of β0, based on sample results
b1 = estimate of β1, based on sample results

4-12
 Triple A Construction

Triple A Construction is trying to predict sales

based on area payroll.

Y = Sales
X = Area payroll
The line chosen in Figure 4.1 is the one that
minimizes the errors.

Error = (Actual value) – (Predicted value)

e = Y − Yˆ

4-13
 Triple A Construction
For the simple linear regression model, the values
of the intercept and slope can be calculated using
the formulas below.
Yˆ = b0 + b1 X

X=
 X
= average (mean) of X values
n

Y=
 Y
= average (mean) of Y values
n
b1 =
 ( X − X )(Y − Y )
(X − X ) 2

b0 = Y − b1 X
4-14
 Triple A Construction
Regression calculations for Triple A Construction

Y X (X – X)2 (X – X)(Y – Y)
6 3 (3 – 4)2 = 1 (3 – 4)(6 – 7) = 1
8 4 (4 – 4)2 = 0 (4 – 4)(8 – 7) = 0
9 6 (6 – 4)2 = 4 (6 – 4)(9 – 7) = 4
5 4 (4 – 4)2 = 0 (4 – 4)(5 – 7) = 0
4.5 2 (2 – 4)2 = 4 (2 – 4)(4.5 – 7) = 5
9.5 5 (5 – 4)2 = 1 (5 – 4)(9.5 – 7) = 2.5
ΣY = 42 ΣX = 24 Σ(X – X)2 = 10 Σ(X – X)(Y – Y) = 12.5
Y = 42/6 = 7 X = 24/6 = 4

Table 4.2

4-15
 Triple A Construction
Regression calculations

X=
 X 24
= =4
6 6

Y=
 Y 42
= =7
6 6

b1 =
 ( X − X )(Y − Y ) 12.5
= = 1.25
(X − X ) 2
10

b0 = Y − b1 X = 7 − (1.25 )(4 ) = 2

Therefore Yˆ = 2 + 1.25 X
4-16
 Triple A Construction
Regression calculations

X=
 X 24
= =4 sales = 2 + 1.25(payroll)
6 6

Y=
 Y 42
= =7
If the payroll next
year is $600 million
6 6

b1 =
 ˆ=
( X − X )(Y −YY + 1..525(6) = 9.5 or $ 950,000
) 2 12
= = 1.25
(X − X ) 2
10

b0 = Y − b1 X = 7 − (1.25 )(4 ) = 2

Therefore Yˆ = 2 + 1.25 X
4-17
 Measuring the Fit
of the Regression Model
◼ Regression models can be developed
for any variables X and Y.
◼ How do we know the model is actually
helpful in predicting Y based on X?
◼ We could just take the average error, but
the positive and negative errors would
cancel each other out.
◼ Three measures of variability are:
◼ SST – Total variability about the mean.
◼ SSE – Variability about the regression line.
◼ SSR – Total variability that is explained by
the model.
4-18
 Measuring the Fit
of the Regression Model
◼ Sum of the squares total:
SST =  (Y − Y )2

◼ Sum of the squared error:

SSE =  e 2 =  (Y − Yˆ )2

◼ Sum of squares due to regression:

SSR =  (Yˆ − Y )2

◼ An important relationship:
SST = SSR + SSE
4-19
 Measuring the Fit
of the Regression Model
Sum of Squares for Triple A Construction

^ ^ ^
Y X (Y – Y)2 Y (Y – Y)2 (Y – Y)2
6 3 (6 – 7)2 = 1 2 + 1.25(3) = 5.75 0.0625 1.563

8 4 (8 – 7)2 = 1 2 + 1.25(4) = 7.00 1 0

9 6 (9 – 7)2 = 4 2 + 1.25(6) = 9.50 0.25 6.25

5 4 (5 – 7)2 = 4 2 + 1.25(4) = 7.00 4 0

4.5 2 (4.5 – 7)2 = 6.25 2 + 1.25(2) = 4.50 0 6.25

9.5 5 (9.5 – 7)2 = 6.25 2 + 1.25(5) = 8.25 1.5625 1.563

^ ^
∑(Y – Y)2 = 22.5 ∑(Y – Y)2 = 6.875 ∑(Y – Y)2 = 15.625

Y=7 SST = 22.5 SSE = 6.875 SSR = 15.625

4-20
Table 4.3
 Measuring the Fit
of the Regression Model
◼ Sum of the squares total
For Triple A Construction
SST =  (Y − Y ) 2

SST = 22.5
◼ Sum of the squared error SSE = 6.875
SSRˆ=2 15.625
SSE =  e =  (Y − Y )
2

◼ Sum of squares due to regression

SSR =  (Yˆ − Y )2

◼ An important relationship
SST = SSR + SSE
4-21
 Measuring the Fit
of the Regression Model
Deviations from the Regression Line and from the Mean

Figure 4.2

4-22
 Coefficient of Determination
◼ The proportion of the variability in Y explained by
the regression equation is called the coefficient
of determination.
◼ The coefficient of determination is r2.
SSR SSE
r = 2
= 1−
SST SST
◼ For Triple A Construction:
15.625
r =
2
= 0.6944
22.5
◼ About 69% of the variability in Y is explained by
the equation based on payroll (X).
4-23
 Correlation Coefficient
◼ The correlation coefficient is an expression of the
strength of the linear relationship.
◼ It will always be between +1 and –1.
◼ The correlation coefficient is r.

r =  r2

◼ For Triple A Construction:

r = 0.6944 = 0.8333

4-24
 Four Values of the Correlation
Coefficient
Y Y
*
*
* ** *
*
* ** *
* * *
* *
(a) Perfect Positive X (b) Positive X
Correlation: Correlation:
r = +1 0<r<1
Y Y

* *
* * *
* * * * *
* *
* *** *
*
Figure 4.3 (c) No Correlation: X (d) Perfect Negative X
r=0 Correlation:
r = –1
4-25
 Using Computer Software
for Regression
Accessing the Regression Option in Excel 2010

Program 4.1A
4-26
 Using Computer Software
for Regression
Data Input for Regression in Excel

Program 4.1B
4-27
 Using Computer Software
for Regression
Excel Output for the Triple A Construction Example

Program 4.1C
4-28
Assumptions of the Regression Model

◼ If we make certain assumptions about the errors

in a regression model, we can perform statistical
tests to determine if the model is useful.
1. Errors are independent.
2. Errors are normally distributed.
3. Errors have a mean of zero.
4. Errors have a constant variance.

◼ A plot of the residuals (errors) will often highlight

any glaring violations of the assumption.

4-29
 Residual Plots
Pattern of Errors Indicating Randomness
Error

Figure 4.4A

4-30
 Residual Plots
Nonconstant error variance
Error

X
Figure 4.4B

4-31
 Residual Plots
Errors Indicate Relationship is not Linear
Error

Figure 4.4C

4-32
 Estimating the Variance

◼ Errors are assumed to have a constant

variance ( 2), but we usually don’t know
this.
◼ It can be estimated using the mean
squared error (MSE), s2.

SSE
s = MSE =
2

n− k −1
where
n = number of observations in the sample
k = number of independent variables

4-33
 Estimating the Variance

◼ For Triple A Construction:

SSE 6.8750 6.8750

s = MSE =
2
= = = 1.7188
n − k − 1 6 − 1− 1 4

◼ We can estimate the standard deviation, s.

◼ This is also called the standard error of the
estimate or the standard deviation of the
regression.

s = MSE = 1.7188 = 1.31

4-34
Testing the Model for Significance

◼ When the sample size is too small, you

can get good values for MSE and r2 even if
there is no relationship between the
variables.
◼ Testing the model for significance helps
determine if the values are meaningful.
◼ We do this by performing a statistical
hypothesis test.

4-35
Testing the Model for Significance

◼ We start with the general linear model

Y =  0 + 1X + e

◼ If 1 = 0, the null hypothesis is that there is

no relationship between X and Y.
◼ The alternate hypothesis is that there is a
linear relationship (1 ≠ 0).

◼ If the null hypothesis can be rejected, we

have proven there is a relationship.
◼ We use the F statistic for this test.
4-36
Testing the Model for Significance
◼ The F statistic is based on the MSE and MSR:
SSR
MSR =
k
where
k = number of independent variables in the model

◼ The F statistic is:

MSR
F=
MSE
◼ This describes an F distribution with:
degrees of freedom for the numerator = df1 = k
degrees of freedom for the denominator = df2 = n – k – 1

4-37
Testing the Model for Significance

◼ If there is very little error, the MSE would

be small and the F-statistic would be large
indicating the model is useful.
◼ If the F-statistic is large, the significance
level (p-value) will be low, indicating it is
unlikely this would have occurred by
chance.
◼ So when the F-value is large, we can reject
the null hypothesis and accept that there is
a linear relationship between X and Y and
the values of the MSE and r2 are
meaningful.
4-38
 Steps in a Hypothesis Test
1. Specify null and alternative hypotheses:
H0 : 1 = 0
H1 : 1  0

2. Select the level of significance (). Common

values are 0.01 and 0.05.
3. Calculate the value of the test statistic using the
formula:
MSR
F=
MSE

4-39
 Steps in a Hypothesis Test
4. Make a decision using one of the following
methods:
a) Reject the null hypothesis if the test statistic is
greater than the F-value from the table in Appendix D.
Otherwise, do not reject the null hypothesis:
Reject if Fcalculated  F ,df1 ,df2
df1 = k
df2 = n − k − 1

b) Reject the null hypothesis if the observed significance

level, or p-value, is less than the level of significance
(). Otherwise, do not reject the null hypothesis:
p - value = P ( F  calculated test statistic)
Reject if p - value  
4-40
 Triple A Construction
Step 1.
H0: 1 = 0 (no linear relationship between X
and Y)
H1: 1 ≠ 0 (linear relationship exists between
X and Y)
Step 2.
Select  = 0.05
Step 3.
Calculate the value of the test statistic.
SSR 15.6250
MSR = = = 15.6250
k 1
MSR 15.6250
F= = = 9.09
MSE 1.7188
4-41
 Triple A Construction
Step 4.
Reject the null hypothesis if the test statistic
is greater than the F-value in Appendix D.
df1 = k = 1
df2 = n – k – 1 = 6 – 1 – 1 = 4

The value of F associated with a 5% level of

significance and with degrees of freedom 1
and 4 is found in Appendix D.
F0.05,1,4 = 7.71
Fcalculated = 9.09
Reject H0 because 9.09 > 7.71
4-42
 Triple A Construction
◼ We can conclude there is a
statistically significant
relationship between X and Y.
◼ The r2 value of 0.69 means
about 69% of the variability
in sales (Y) is explained by
local payroll (X).

0.05
F = 7.71 9.09
Figure 4.5
4-43
 Analysis of Variance (ANOVA) Table

◼ When software is used to develop a regression

model, an ANOVA table is typically created that
shows the observed significance level (p-value)
for the calculated F value.
◼ This can be compared to the level of significance
() to make a decision.

DF SS MS F SIGNIFICANCE
Regression k SSR MSR = SSR/k MSR/MSE P(F >
MSR/MSE)
Residual n-k-1 SSE MSE =
SSE/(n - k - 1)
Total n-1 SST
4-44
Table 4.4
 ANOVA for Triple A Construction

Program 4.1C
(partial)
P(F > 9.0909) = 0.0394
Because this probability is less than 0.05, we reject
the null hypothesis of no linear relationship and
conclude there is a linear relationship between X
and Y.
4-45
Multiple Regression Analysis
◼ Multiple regression models are
extensions to the simple linear model
and allow the creation of models with
more than one independent variable.
Y = 0 + 1X1 + 2X2 + … + kXk + e
where
Y = dependent variable (response variable)
Xi = ith independent variable (predictor or explanatory
variable)
0 = intercept (value of Y when all Xi = 0)
i = coefficient of the ith independent variable
k = number of independent variables
e = random error
4-46
Multiple Regression Analysis
To estimate these values, a sample is taken the
following equation developed

Yˆ = b0 + b1 X 1 + b2 X 2 + ... + bk X k

where
Ŷ = predicted value of Y
b0 = sample intercept (and is an estimate of 0)
bi = sample coefficient of the ith variable (and is
an estimate of i)

4-47
 Jenny Wilson Realty
Jenny Wilson wants to develop a model to determine
the suggested listing price for houses based on the
size and age of the house.

Yˆ = b0 + b1 X 1 + b2 X 2
where
Ŷ = predicted value of dependent variable (selling
price)
b0 = Y intercept
X1 and X2 = value of the two independent variables (square
footage and age) respectively
b1 and b2 = slopes for X1 and X2 respectively

She selects a sample of houses that have sold

recently and records the data shown in Table 4.5
4-48
 Jenny Wilson Real Estate Data
SELLING SQUARE
AGE CONDITION
PRICE ($) FOOTAGE
95,000 1,926 30 Good
119,000 2,069 40 Excellent
124,800 1,720 30 Excellent
135,000 1,396 15 Good
142,000 1,706 32 Mint
145,000 1,847 38 Mint
159,000 1,950 27 Mint
165,000 2,323 30 Excellent
182,000 2,285 26 Mint
183,000 3,752 35 Good
200,000 2,300 18 Good
211,000 2,525 17 Good
215,000 3,800 40 Excellent
Table 4.5 219,000 1,740 12 Mint
4-49
 Jenny Wilson Realty
Input Screen for the Jenny Wilson Realty Multiple
Regression Example

Program 4.2A
4-50
 Jenny Wilson Realty
Output for the Jenny Wilson Realty Multiple
Regression Example

4-51
Program 4.2B
Evaluating Multiple Regression Models

◼ Evaluation is similar to simple linear

regression models.
◼ The p-value for the F-test and r2 are
interpreted the same.
◼ The hypothesis is different because there
is more than one independent variable.
◼ The F-test is investigating whether all
the coefficients are equal to 0 at the
same time.

4-52
Evaluating Multiple Regression Models

◼ To determine which independent

variables are significant, tests are
performed for each variable.
H0 : 1 = 0
H1 : 1  0
◼ The test statistic is calculated and if the
p-value is lower than the level of
significance (), the null hypothesis is
rejected.

4-53
 Jenny Wilson Realty
◼ The model is statistically significant
◼ The p-value for the F-test is 0.002.
◼ r2 = 0.6719 so the model explains about 67% of
the variation in selling price (Y).
◼ But the F-test is for the entire model and we can’t
tell if one or both of the independent variables are
significant.
◼ By calculating the p-value of each variable, we can
assess the significance of the individual variables.
◼ Since the p-value for X1 (square footage) and X2
(age) are both less than the significance level of
0.05, both null hypotheses can be rejected.

4-54
 Binary or Dummy Variables

◼ Binary (or dummy or indicator) variables

are special variables created for
qualitative data.
◼ A dummy variable is assigned a value of
1 if a particular condition is met and a
value of 0 otherwise.
◼ The number of dummy variables must
equal one less than the number of
categories of the qualitative variable.

4-55
 Jenny Wilson Realty
◼ Jenny believes a better model can be developed if
she includes information about the condition of
the property.
X3 = 1 if house is in excellent condition
= 0 otherwise
X4 = 1 if house is in mint condition
= 0 otherwise
◼ Two dummy variables are used to describe the
three categories of condition.
◼ No variable is needed for “good” condition since
if both X3 and X4 = 0, the house must be in good
condition.
4-56
 Jenny Wilson Realty
Input Screen for the Jenny Wilson Realty Example
with Dummy Variables

4-57
Program 4.3A
 Jenny Wilson Realty
Output for the Jenny Wilson Realty Example with
Dummy Variables

4-58
Program 4.3B
 Model Building

◼ The best model is a statistically significant

model with a high r2 and few variables.
◼ As more variables are added to the model,
the r2-value usually increases.
◼ For this reason, the adjusted r2 value is
often used to determine the usefulness of
an additional variable.
◼ The adjusted r2 takes into account the
number of independent variables in the
model.

4-59
 Model Building
◼ The formula for r2
SSR SSE
r =
2
= 1−
SST SST

◼ The formula for adjusted r2

SSE /( n − k − 1)
Adjusted r = 1−
2

SST /( n − 1)

◼ As the number of variables increases, the

adjusted r2 gets smaller unless the increase due
to the new variable is large enough to offset the
change in k.
4-60
 Model Building

◼ In general, if a new variable increases the adjusted

r2, it should probably be included in the model.
◼ In some cases, variables contain duplicate
information.
◼ When two independent variables are correlated,
they are said to be collinear.
◼ When more than two independent variables are
correlated, multicollinearity exists.
◼ When multicollinearity is present, hypothesis
tests for the individual coefficients are not valid
but the model may still be useful.

4-61
 Nonlinear Regression

◼ In some situations, variables are not linear.

◼ Transformations may be used to turn a
nonlinear model into a linear model.

* * * *
*
** * * ** *
*
*** * ** *
Linear relationship Nonlinear relationship

4-62
 Colonel Motors
◼ Engineers at Colonel Motors want to use
regression analysis to improve fuel efficiency.
◼ They have been asked to study the impact of
weight on miles per gallon (MPG).

WEIGHT (1,000 WEIGHT (1,000

MPG LBS.) MPG LBS.)
12 4.58 20 3.18
13 4.66 23 2.68
15 4.02 24 2.65
18 2.53 33 1.70
19 3.09 36 1.95
19 3.11 42 1.92
Table 4.6
4-63
 Colonel Motors
Linear Model for MPG Data

Figure 4.6A

4-64
 Colonel Motors
Excel Output for Linear Regression Model with
MPG Data

Program 4.4 This is a useful model with a

small F-test for significance
and a good r2 value.
4-65
 Colonel Motors
Nonlinear Model for MPG Data

Figure 4.6B

4-66
 Colonel Motors
◼ The nonlinear model is a quadratic model.
◼ The easiest way to work with this model is to
develop a new variable.

X 2 = ( weight)2
◼ This gives us a model that can be solved with
linear regression software:

Yˆ = b0 + b1 X 1 + b2 X 2

4-67
 Colonel Motors

Yˆ = 79.8 − 30.2 X 1 + 3.4 X 2

Program 4.5
A better model with a
smaller F-test for
significance and a larger
adjusted r2 value 4-68
 Cautions and Pitfalls

◼ If the assumptions are not met, the

statistical test may not be valid.
◼ Correlation does not necessarily mean
causation.
◼ Multicollinearity makes interpreting
coefficients problematic, but the model
may still be good.
◼ Using a regression model beyond the
range of X is questionable, as the
relationship may not hold outside the
sample data.
4-69
 Cautions and Pitfalls
◼ A t-test for the intercept (b0) may be
ignored as this point is often outside the
range of the model.
◼ A linear relationship may not be the best
relationship, even if the F-test returns an
acceptable value.
◼ A nonlinear relationship can exist even if a
linear relationship does not.
◼ Even though a relationship is statistically
significant it may not have any practical
value.
4-70