Hawassa University

College of Business and

Economics
Department of Economics

Introduction to Econometrics
Department: Management
Year: 3rd
Program: Regular
By: Destaw Akele
 CHAPTER: ONE

Contents
Definition and Scope of Econometrics
Goals of Econometrics
Division of Econometrics
Methodology of Econometrics
The Nature and Sources of Data for Econometrics
Analysis
Types of Data
The Sources of Data
 Definition and Scope of Econometrics
Econometrics: - Econometrics deals with measurement of economic relationships
between economic variables (dependent & independent variables).
The term ‘Econometrics’ is formed from two word of Greek origin “oikovoia” (economy)
and “uetpu” (measures). So, Econometrics means “economic measurement”.
“Econometrics is the positive interaction between data & ideas about the way the
economy works.”
but the scope of econometrics is much broader as described by leading econometricians.
In short, Econometrics can be considered as the integration of economics, mathematics and
statistics for the purpose of :
 providing numerical values for the parameters of economic variables and

 verifying economic theories.

Econometrics is a combination of economic theory, mathematical economics and
statistics, but it is completely distinct from each one of these three branches of science.
 Con’t
A. Economic theory states a qualitative relationship between the explanatory
& explained using Cetrus Peribus assumptions.
Ex. Microeconomic theory states that, other things remaining the same, a
reduction in the price of a commodity is expected to increase the quantity
demanded of that commodity.
Ex.1. Consumption depends up on current income () & previous income ()
of an individual other things being constant.
This theory does not give any insight how current income & previous
income will affect consumption by giving numerical values.
• But the theory itself does not provide any numerical measure of the
relationship between the two:
• it does not tell by how much the quantity will go up or down as a result of a
certain change in the price of the commodity.
• It is the job of econometrician to provide such numerical statements.
 Con’t
B. Mathematical Economics: It explains the economic theory in the equation or
mathematical forms. Or mathematical economics explain the theory of economics in
to mathematical relationship between variables. /we can explain the above
theoretical relationship in mathematical form as follows

• Again this mathematical relation does not capture other factors that affect
consumption expenditure.
• Then mathematical economics explain the exact relation ship between the
dependent variable () & the independent variables ( &) by ignoring other variables
that affects consumption expenditure.
Both economic theory and mathematical economics state the same relationships.
Economic theory uses verbal exposition but mathematical economics employs
mathematical symbolism.
 Neither of them allows for random elements which might affect the relationship
and make it stochastic.
 Con’t
Although econometrics presupposes the expression of
economic relationships in mathematical form, like
mathematical economics it does not assume that economic
relationships are exact(deterministic).
It assumes that relationships are not exact
Econometric methods are designed to take in to account random
disturbances which create deviations from the exact behavioral
patterns suggested by economic theory and mathematical
economics.
Econometrics provide numerical values of the coefficients
of economic phenomena.
 Con’t
C. Economic Statistics is mainly concerned with collecting, processing, and
presenting economic data in the form of charts and tables.
 It is mainly a descriptive aspect of economics.
 It does not provide explanations of the development of the various variables
and it does not provide measurement of the parameters of economic
relationships.
 The econometrician often needs special methods since the data are not
generated as the result of a controlled experiment.
 Moreover, such data are likely to contain errors of measurement, and the
econometrician may be called up on to develop special methods of analysis to
deal with such errors of measurement.
To Conclude: Econometrics is an amalgam of economic theory, mathematical
economics, economic statistics.
 GOALS OF ECONOMETRICS
Three main goals of econometrics
1. Analysis: - Testing Economic Theory
• Economists formulated the basic principles of the
functioning of the economic system using verbal exposition
and applying a deductive procedure.
• Economic theories thus developed in an abstract level were
not tested against economic reality.
• Econometrics aims primarily at the verification of economic
theories.
 Con’t
2. Policy-Making
• In many cases we apply the various econometric techniques in
order to obtain reliable estimates of the individual coefficients of
the economic relationships from which we may evaluate
elasticities or other parameters of economic theory (multipliers,
technical coefficients of production, marginal costs, marginal
revenues, etc.)
• The knowledge of the numerical value of these coefficients is
very important for the decisions of firms as well as for the
formulation of the economic policy of the government.
• It helps to compare the effects of alternative policy decisions.
 Con’t
3. Forecasting
• In formulating policy decisions it is essential to be able to
forecast the value of the economic magnitudes.
• Such forecasts will enable the policy-maker to judge whether
it is necessary to take any measures in order to influence the
relevant economic variables
DIVISION OF ECONOMETRICS
 Con’t
 Theoretical Econometrics is concerned with the development of
appropriate methods for measuring economic relationships
specified by econometric models.
 In this aspect, econometrics leans heavily on mathematical
statistics.
 For example, one of the tools that is used extensively is the
method of least squares.
 It is the concern of theoretical econometrics to spell out the
assumptions of this method, its properties, and what happens to
these properties when one or more of the assumptions of the
method are not fulfilled.
 Con’t
In applied Econometrics we use the tools of theoretical
econometrics to study some special field(s) of economics,
such as the production function, consumption function,
investment function, demand and supply functions, etc.
Applied econometrics includes the applications of econometric
methods to specific branches of economic theory.
 It involves the application of the tools of theoretical econometrics
for the analysis of economic phenomena and forecasting economic
behavior.
 METHODOLOGY OF ECONOMETRICS
@In any econometric research we may distinguish four stages:
A. Specification of the model
The first, and the most important, step the econometrician has to
take in attempting the study of any relationship between variables, is
to express this relationship in mathematical form, that is to specify
the model, with which the economic phenomenon will be explored
empirically.
This is called the specification of the model or formulation of the
maintained hypothesis. It involves the determination of:
 Con’t
I) the dependent and explanatory variables which will be included in the model.
The econometrician should be able to make a list of the variables that might
influence the dependent variable.
General economics theories,
Previous studies in any particular field and
Information about individual condition in a particular case, and the actual behavior of
the economic agents may indicate the general factors that affect the dependent variable.
II) The a priori theoretical expectations about the sign and the size of the
parameters of the function.
These a priori definitions will be the theoretical criteria on the basis of which the
results of the estimation of the model will be evaluated
 Economic theory
Other applied research
Information about possible special features of the phenomena being studied will
contain suggestions about the sign and size of the parameters.
 Con’t
Example: Consider the following simple consumption function:
C = B0 + B1Y+ U
Where: C=Consumption function & Y=level of
income
• In this function the coefficient B1 is the marginal propensity to
consume (MPC) and should be positive with a value less than
unity (0<B1<1).
• The constant intercept, Bo of the function is expected to be
positive.
• This is because when income is zero, consumption will assume a
positive value; people will spend past savings, will borrow or find
other means for covering their needs.
 Con’t
iii) the mathematical form of the model (number of equations liner or
non-linear form of these equations, etc).
• The specification of the econometric model will be based on economic
theory and on any available information relating to the phenomenon
being studied.
• The econometrics must know the general laws of economic theory,
and further more he must gather any other information relevant to
the particular characteristics of the relationship as well as all studies
already published on the subject by other research workers.
The most common errors of specification are:
 The omission of some variables from the functions
 The omission of some equations
 The mistaken mathematical form of the functions.
B. Estimation of the Model
• Having specified the econometric model, the next task of the econometrician is to
obtain estimates (numerical values) of the parameters of the model from the data
available; consider the Keynesian consumption function.
C = o + 1Y+ U Where C is consumption & Y is income
• If 1 = 0.8 this value provides a numerical estimates of the marginal propensity to
consume (MPC). If also supports Keynes’ hypothesis that MPC is less than 1.
• The stage of estimation includes the following steps.
Gathering of statistical observations (data) on the variables included in the model
Examination of the identification conditions of the function in which we are
interested.
 Examination of the aggregation problems involved in the variables of the function.
Examination of the degree of correlation between the explanatory variables.
Choice of the appropriate econometric technique for the estimation of the function
and critical examination of the assumptions of the chosen technique and of their
economic implications for the estimates of the coefficients.
C. Evaluation of Estimates
• The evaluation consists of deciding whether the estimates of the parameters are
theoretically meaningful and statistically satisfactory. Various criteria may be
used
i. Economic a prior criteria: – These are determined by the principles of
economic theory and refer to the sign and the size of the parameters of
economic relationships.
ii. Statistical criteria: The most widely used statistical criteria are the
correlation coefficient and the standard deviation( or the standard error)
of the estimates.
Note that the statistical criteria are secondary only to the a priori theoretical criteria.
The estimates of the parameters should be rejected in general if they happen to have
the wrong sign or size even though the pass the statistical criteria.
iii. Econometric criteria: –It aims at the investigation of whether the
assumptions of the econometric method employed are satisfied or not in
any particular case.
 Cont’t
Example . Suppose that we estimate the demand function for a given
commodity with a single equation model using time-series data for the
period 1950 – 68 as follows
= 100 + 5Yt – 30Pt
This equation is then used for ‘forecasting’ the demand of the commodity in the
year 1970, a period outside the sample data.
Given Y1970 = 1000 and P1970 = 5
= 100 + 5(1000) – 30(5) = 4, 950 units.
If the actual demand for this commodity in 1970 is 4, 500 there is a difference of
450 between the estimated from the model and the actual market demand for
the product.
The difference can be tested for significance by various methods.
 If it is found significant, we try to find out what are the sources of the error in the
forecast, in order to improve the forecasting power of our model.
D. valuation of the forecasting power of the estimated model
The final stage of any econometric research is concerned with the
evaluation of the forecasting validity of the model.
 Estimates are useful because they help in decision-making.
 A model, after the estimation of its parameters, can be used in
forecasting the values of economic variables.
The econometrician must ascertain how good the forecasts are
expected to be in other words he must test the forecasting power of
the model.
Therefore, the final stage of any applied econometric research is the
investigation of the stability of the estimates, their sensitivity to
changes in the size of the sample.
 THE NATURE AND SOURCES OF DATA FOR ECONOMETRIC ANALYSIS

Types of Data: There are three types of data

1. Time series data
• This is a set of observations on the values that a variable takes at different times.
• Such data may be collected at regular time intervals: daily, weekly, monthly,
quarterly, annually etc.
Example. data on stock prices, unemployment rate, GDP etc
• Data may be qualitative or quantitative
Qualitative data are sometimes called dummy variables or categorical variable.
These are variables that cannot be quantified.
Example: male or female, married or unmarried, religion, etc
Quantitative data are data that can be quantified
Example. income, prices, money etc.
 Con’t
2. Cross-Section data
• These data give information on the variables concerning individual agents
(consumers or producers) at a given point of time.
Example: - The census of population conducted by CSA.
-Survey of consumer expenditure conducted by Hawassa city
• Note that due to heterogeneity, cross- sectional data have their own problems.
3. Pooled Data
These are repeated surveys of a single (cross-section) sample in different periods of
time.
• They record the behavior of the same set of individual microeconomic units over
time.
• There are elements of both time series and cross sectional data.
• The panel or longitudinal data also called micro panel data, is a special type of
pooled data in which the same cross-sectional unit is surveyed over time.
 The Sources of Data

A governmental agency, an international agency, a private organization

or an individual may collect the data used in empirical analysis.
Example.
Governmental in Ethiopia: - CSA, MOE, MOH, MOFED, EEA, NBE,
Ethiopian Economic Policy Research Institute (EEPRI)
International agencies: - International Monetary Fund (IMF),
World Bank (WB), united nations conference on trade and
development (UNCTAD), international labor organization
The individual (researcher) himself may collect data through
interviews or using questionnaire.
 Limitations

Although there is plenty of data available for economic research,

the quality of the data is often not that good. Reasons are:
Since most social science data are not experimental in nature,
there is the possibility of observational errors.
Errors of measurement arising from approximations and round
offs.
In questionnaire type surveys, there is the problem of non-
response
Respondents may not answer all the questions correctly
Sampling methods used in obtaining data
 Con’t

• Economic data is generally available at a highly aggregate level.

For example most macro data like GNP, unemployment, inflation etc
are available for the economy as a whole.
• Because of confidentiality, certain data can be published only in
highly aggregate form For example, data on individual tax,
production, employment e.t.c at firm level are usually available in
aggregate form.
Because of all these and many other problems, the researcher
should always keep in mind that the results of research are only as
good as the quality of the data.
Therefore, the results of the research may be unsatisfactory due to
the poor quality of the available data (may not be due to wrong
model)