ETC1000 / ETC9000 Business and Economic Statistics

Demonstration Lecture Week 4: Simple Regression

This lecture provides examples of the material taught in this weeks lectures, to help
you see its potential for real world application, and to reinforce the ideas being
communicated.

Case Study:
The Relationship Between Anonymous Revenue and GDP: Is It Stable?

Background:
We are looking at the performance a former Government-owned enterprise, which has
recently been privatised. Its name is Anonymous. Market analysts are very interested
in this company, as it is very large, and has many shareholders. Being able to predict
its future performance would be extremely valuable, as share traders could then act
accordingly.

A group of market analysts have undertaken research that shows a very strong
relationship between the total revenue of Anonymous and Australias Gross Domestic
Product (GDP). They argue that this relationship can be used to predict future
performance of Anonymous very accurately.

Our task is to assess whether the analysis that has been performed is sensible. How
will we do that?

First, lets redo their analysis.


Anonymous revenue
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This scatter plot of GDP (X axis) against company revenue (Y axis) shows a very
strong positive relationship.

The correlation analysis shows a very strong correlation of 98.9%.

GDP(nom)
Anonymous
revenue
GDP( nom) 1
Anonymous
r evenue 0. 98934 1


So, the evidence is there for a very strong relationship.

Now, lets do some critique.

1. Checking the Data

First, notice a big jump in revenue in 1991/92. Revenue grew by more than 28% in
just one year, compared to typical growth of about 10-15%. This is a sign of
something unusual happening, a one-off type event. To ignore this unusual jump will
potentially distort the rest of the analysis.

On enquiring further, we discover that in 1991/92, there was a change in definition of
total revenue of this company some subsidiary that was previously not included,
was now included in revenue. So this jump is just an anomaly associated with this
change in definition. We have to correct for this.

To do that, we use some extra information and statistical techniques (too complex to
go into here) that adjust the revenue data so that it is comparable across the whole
sample period.

Heres the scatter plot with the adjusted revenue data.


Adjusted anonymous revenue
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And now the correlation is even higher at 99.7%.



Adjusted
anonymous
revenue GDP(nom)
Adj ust ed anonymous
r evenue 1
GDP( nom) 0. 997573 1


2. Does correlation mean causality and forecastability?

Recall the motivation the analysts had for this work was to be able to predict future
company performance so they could plan share market trading. So the real test of the
analysis is in whether we can use information about GDP to predict the future.

Lets estimate a simple regression model first.

SUMMARY OUTPUT

Regression Statistics
Mul t i pl e R 0. 997573
R Squar e 0. 995151
Adj ust ed R
Squar e 0. 994931
St andar d Er r or 330. 1253
Obser vat i ons 24

ANOVA
df SS MS F
Significance
F
Regr essi on 1 4. 92E+08 4. 92E+08 4514. 997 5. 87E- 27
Resi dual 22 2397619 108982. 7
Tot al 23 4. 94E+08

Coefficients
Standard
Error t Stat P-value Lower 95%
Upper
95%
I nt er cept - 1330. 3 144. 4322 - 9. 21052 5. 27E- 09 - 1629. 83 - 1030. 76
GDP( nom) 0. 028052 0. 000417 67. 19373 5. 87E- 27 0. 027186 0. 028918


What do we learn from this?

Note first the Multiple R value of 0.997573. This is the same as the correlation
analysis. These are, in simple regression, the same quantity.

Next, look at the R squared value: 99.5% is very high!

Now we turn to the estimated coefficients (intercept and slope). To interpret these,
we need to be reminded of the units of the original data. Both GDP and revenue are
measured in billions of dollars.
b1=0.028052: the model predicts that a $1billion increase in GDP would on average
lead to an increase in company revenue of $0.028 billion ($28 million).

b0=-1330.3: the model predicts that if GDP was zero, revenue of this company would
be -$1330 billion. As is often the case, this is not very sensible: GDP is unlikely to be
anywhere near zero, and negative revenues are not possible!

Note also that the slope coefficient is clearly not zero: the p-value is extremely small,
indicating there is clearly a relationship between GDP and revenue.

A useful gauge of the accuracy of a model is forecasting performance. This can give
quite a different picture to that suggested by such a good within-sample fit (R-
squared). In particular, it is of interest to assess how well the model can forecast
growth rates in Anonymous Revenue. The simple regression model of Revenue on
GDP was re-estimated with a sequence of moving samples 1975/76 to 1982/83 then
moving ahead a year each time and one-year ahead forecasts of revenue generated.
These forecasts were then used to calculate forecasts of the percentage growth in
revenue. The table below shows these forecasts compared to actual growth rates.
Whilst the forecasts are reasonable, they often vary quite substantially from actual
revenue growth. The story is of a much less accurate model than a 99.8% R
2
would
suggest.

Actual Revenue 1-Step Ahead
Forecast Revenue (%)
Relative Forecast
Error (%)
83/84 3903 4221 -7.5%
84/85 4765 4521 -5.1%
85/86 5472 5164 -5.6%
86/87 6047 5852 -3.2%
87/88 7199 6851 -4.8%
88/89 7977 7988 0.1%
89/90 8879 8818 -0.7%
90/91 9531 9144 -4.1%
91/92 10023 9499 -5.2%
92/93 10451 10166 -2.7%
93/94 11157 10817 -3.1%
94/95 11876 11544 -2.8%
95/96 13034 12528 -3.9%
96/97 13778 13256 -3.8%
97/98 15097 14254 -5.6%
98/99 15968 15211 -4.7%

Note also that the model is consistently under-predicting revenue.

3. What is the underlying behavioural relationship we need to quantify?

The industry we are studying has undergone significant changes in the past decades.
The opening up of the market to competition has had a massive impact on
Anonymous performance. Anonymous share of total market revenue has declined
from around 99.5% in 1991/92 to 81.5% in 1998/99. At the same time, the industry
has enjoyed unprecedented growth, with the creation of a wide range of new products
and growth in demand for services. Data on Total Market Revenue suggests that the
industry has grown steadily from 2.0% of GDP in 1976/77 to 2.7% in 1989/90, and
then leapt to 3.75% in 1998/99.

Such changes in the market are bound to have some impact on the relationship
between Anonymous Revenue and GDP. We would argue that the general level of
economic activity (GDP) is a key driver of the overall market (Total market revenue),
and that in turn within-market competition determines the market share which
Anonymous claims. These two behavioural links drive the reduced form relationship
between GDP and Anonymous revenue. This reduced form relationship can only be
adequately understood and assessed by evaluating the two component relationships.
The stability of the reduced form relationship is only as stable as the two component
relationships.

The graph below shows how market share has declined over the sample period as
more and more competition has entered.

Market Share
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The reason we are interested in the stability of relationships over time is that this is a
test of how robust they are. If there is a change in the relationship over time, then it
means there are other complexities that are not captured in the model. The model will
not forecast well in these cases.

To look at the question of stability, we estimate the model for various sub-samples,
much as we did to produce the 1-step ahead forecasts above. We then calculate
elasticities from our regression estimates: an elasticity tells us the % response in
revenue to a 1% change in GDP. The graph below shows the results:

Fi gure
El asti ci ti es of Revenue to GDP
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Anonymous
total


What do we learn from this graph? First, the elasticity of Anonymous revenue to GDP
appears quite stable at a little over 1%. This is what the market analysts found
initially.

BUT: what we also see is that total market revenue has a much bigger elasticity in the
latter half of the sample, and it has changed quite a lot during the sample period. Why
is this? As noted above, this is a dynamic and growing industry. During the 1990s
especially, it grew very rapidly, much faster than GDP. Changes in technology have
led this rapid growth.

What does all this mean for the relationship between revenue of Anonymous and
GDP?

The evidence suggests that the relationship between GDP and Anonymous Revenue,
which takes place via Total Market Revenue, comes from a confounding of two
quite unstable relationships, and hence is itself unstable.

The appearance of stability in relationship between Anonymous Revenue and GDP as
seen in the graph above, is a coincidence of these two unstable factors cancelling
each other out. This is why forecasts based on a belief in a stable relationship
between Anonymous Revenue and GDP are likely to be very poor.