Econ 641

Review for the Midterm

1/31/2012 Office hour for Exam:
Today: after lecture, Wednesday: 2:00-3:00 Thursday: 10:00-11:00
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The Exam
In essay format:
Theoretical/conceptual question (Theorems, Assumptions, Graphs, Intuitions, Explanations,) Calculation questions (Good example would be the problems in the HW and Quiz, and the solved examples in the textbook.) Proofs (similar to those done in lecture, quizzes or problem sets)

You can use calculators You can bring and use a formula sheet
Size: Standard or A4 paper It must be handwritten It must be one-sided You must turn it in (otherwise youll lose credit from your exam)
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Steps in Empirical Economic Analysis

An empirical analysis uses data to test a theory or to estimate a relationship. First step : Careful formulation of the question of interest. Second step: Specify an economic model Third Step: Construct an econometric model Fourth Step: Using the model, various hypotheses of interest can be stated in terms of the unknown parameters
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What weve learnt so far: Econometric Model y=0+1x+u

Simple(only one indep var) Linear model u is a random variable, representing all the factors that affect y, besides x. 0 : the intercept parameter 1 : the slope parameter
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Assumptions on Error term

(1) E(u)=0 (2) E(u|x)=E(u)
Combining assumptions (1) and (2):

E(u|x)=0

Leila Farivar, OSU, Econ 641

Systematic vs. Unsystematic parts of y

0+1x : Systematic part of y. The part of y explained by independent variable(s). (Deterministic part of y) u: Unsystematic part of y. The part of y not explained by independent variable(s). (Stochastic part of y) Given E(u|x)=0 E(y|x)= 0+1x E(y|x) : Systematic part of y u : Unsystematic part of y
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y= 0+1x +u

E(y|x)= 0+1x

Leila Farivar, OSU, Econ 641

Estimating 0 & 1
Use the assumptions E(u)=0 and E(u|x)=E(u) 1) E(u)=0 E(y- 0-1x)=0 2) E(u|x)=E(u) E[x(y- 0-1x)]=0

Leila Farivar, OSU, Econ 641

Estimating 0 & 1

We call these Ordinary Least Squares (OLS) Estimates.

Leila Farivar, OSU, Econ 641

Fitted Value y^i

The value the model predicts for y when x=xi To get the fitted value,
Substitute ^0 & ^1 for 0 & 1 in the deterministic part of the model Evaluate at x=xi

y^i= ^0+^1xi y^i is the predicted (by model) part of yi The left over part of yi, is called the residual.
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Residual u^i
The residual for observation i is the difference between the actual yi and its fitted value. u^i=yi-y^i =yi- ^0-^1xi Ordinary Least Squares is a technique that estimates ^0 and ^1 by minimizing the sum of squares of these residuals.
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SST, SSE, SSR

Define Total Sum of Squares (SST or TSS) as:

Define Explained Sum of Squares (SSE or ESS):

Define Residual Sum of Squares (SSR or RSS):

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Goodness of Fit
It can be proved (in Problem Set 2) that

SST=SSE+SSR Need for a measure to say how well the OLS line fits the data: Coefficient of determination (R-squared)

R2=SSE/SST
R2 is the fraction of sample variation in y that is explained by x(s).
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Incorporating Nonlinearities

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Expectation and Variance of ^

The parameters 0 and 1 are derived from the population and are unique The statistics ^0 and ^1 are derived from sample, and are NOT unique. For each different sample, we get a new set of ^s.
^s are random variables. ^s have distribution, expected values, and variance. Sampling distribution
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Bias
Bias of an estimator: The difference between the Expected value of the estimator and the true (popuation) value of the parameter.
Consider ^ as a general estimator for the parameter ,

Bias(^)=E(^)- If Bias(^)=0, then ^ is called an unbiased estimator.

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SLR Assumptions (Gauss-Markov Assumptions)

Assumption SLR.1 (Linear in Parameters) Assumption SLR.2 (Random Sampling) Assumption SLR.3 (Sample Variation in the Explanatory Variable) Assumption SLR.4 (Zero Conditional Mean) Assumption SLR.5 (Homoskedasticity)

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Theorem: Unbiasedness of OLS

Given assumptions SLR1-SLR4 E(^0)= 0 and E(^1)= 1
In other words: distribution of ^0 is centered around 0. distribution of ^1 is centered around 1.

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Sampling variance of OLS estimators

Theorem: Under assumptions SLR1-SLR5, and conditioned on the sample values of {x1,,xn},

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Estimating the Error Variance (^2)

2 (error variance) is a population parameter, and thus often unknown to us. we need an estimator for it: ^2 Use residuals and estimated their variance The proposed estimator:

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Unbiasedness of ^2
Theorem: Under assumptions SLR1-SLR5, ^2 is an unbiased estimator for 2. E(^2 )=2

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Another interpretation of ^1 in MLR

(Partialling out)
Consider the MLR model of

y^ = ^0 + ^1x1 + ^2x2
An alternative formula for ^1 is

Where r^1 are the residual from the simple regression of x1 on x2

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Partialling out
To put this into simple steps:
1. Regress the one independent variable, x1, on the other independent variable, x2. 2. Obtain the residuals r^1 (The y plays no role here). 3. Do a simple regression of y on r^1 to obtain ^1.

r^1 is the part of x1 that is uncorrelated with x2 r^1 is x1 after the effects of x2 has been partialled out. Thus ^1 here, measures the relationship between y and x1 after the effect of x2 has been taken care of

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Connection bw 2 & 3 variable OLS

Consider these two models:

3 variables model: 2 variables model:

y^ = ^0 + ^1x1 + ^2x2 y~ = ~0 + ~1x1

Define ~ as the slope estimate in the auxiliary regression of x2 on x1: x~2 = ~0 + ~1 x1 We want to compare the estimators of 1 in these two models. The relationship bw the two estimators of 1 is:

~1 = ^1 + ^2 . ~1
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MLR Assumptions
Assumption MLR.1 Assumption MLR.2 Assumption MLR.3 Assumption MLR.4 Assumption MLR.5 Linear in Parameters Random Sampling No Perfect Collinearity Zero Conditional Mean Homoskedasticity

Assumption 1-5 are collectively known as Gauss-Markov Assumptions for cross-sectional analysis
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Thm: Sampling Variance of OLS Slopes

Under Assumptions MLR. 1 through MLR. 5, the sampling variance of ^ is

j= 1, 2, , k SSTj= ( xij _ xjbar)2 R2j is the R-squared from regressing xj on all other independent variables (including the intercept).
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Estimating 2
2 is a population parameter, and thus it is unknown to us. An estimator for 2 is

n-k-1 is degree of freedom (df) = (number of observation)-(number of estimated parameters)

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Estimating 2
Thm: Under the 5 classical assumptions, E(^2 )= 2
Standard Deviation of ^ : square root of
variance of ^

Standard Error of ^ : square root of variance of

^, when 2 is unknown and we use ^2 instead

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Efficiency of OLS
Efficiency of an estimator= It having a smaller variance. Gauss-Markov Thm (next slide) shows: In the class of linear unbiased estimators, OLS estimator have the least variance. They are most efficient (Best).

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Gauss-Markov Theorem
Under Gauss-Markov assumptions of
Assumption MLR.1 Assumption MLR.2 Assumption MLR.3 Assumption MLR.4 Assumption MLR.5 Linear in Parameters Random Sampling No Perfect Collinearity Zero Conditional Mean Homoskedasticity

OLS estimators for , are the Best Linear

Unbiased Estimators . OLS

Leila Farivar, OSU, Econ 641

is BLUE.
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Single Parameter Test

(Simple hypothesis)
We learned how to do hypothesis testing on just a single parameter at a time (Ho: j = jHo) when the population variance is unknown to us. t-Test This is called Simple Hypothesis Test. The hypothesis only involves a single parameter of the model. Simple=one statement in Ho
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Confidence Interval
An interval that contains the true value of the parameter, with some certain confidence level. Under the classical assumptions, we can construct a confidence Interval (C.I.) for the population parameter (j). The confidence level = 1- A 95% C.I. for j : ^j + - c.se(^j)
Where c is the 97.5% percentile in a tn-k-1 distribution
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Testing single linear combination of s

Example: Example: Example: Ho: 1 = 2

Ho: 1 2 =0

t= (^1 - ^2)/se(^1 - ^2 )
Ho: 1 + 2=1 Ho: 1 + 22=0

t= (^1 + ^2 -1)/se(^1 + ^2 ) t= (^1 +2 ^2)/se(^1 + 2^2 )

Once you get the t-statistic, the rest of the test is like before.
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MLR example: Consider the estimation output of the MLR model of log(wage)
Included observations: 6763 Variable C JC UNIV EXPER FEMALE HISPANIC R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood F-statistic Prob(F-statistic) Coefficient 1.705508 0.063786 0.071702 0.004041 -0.213527 -0.015440 0.266218 0.265675 0.417917 1180.139 -3692.744 490.2903 0.000000 Std. Error 0.023571 0.006636 0.002269 0.000159 0.010636 0.024178 t-Statistic 72.35610 9.611468 31.59688 25.33776 -20.07523 -0.638570 Prob. 0.0000 0.0000 0.0000 0.0000 0.0000 0.5231 2.248096 0.487692 1.093817 1.099867 1.095906 1.967646

Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion Hannan-Quinn criter. Durbin-Watson stat

Variance Matrix
C JC UNIV EXPER FEMALE HISPANIC C 0.000556 -1.81E-05 -1.82E-05 -3.45E-06 -0.000123 -4.33E-05 JC -1.81E-05 4.40E-05 1.85E-06 -9.68E-09 1.55E-06 -8.27E-07 UNIV EXPER -1.82E-05 -3.45E-06 1.85E-06 -9.68E-09 5.15E-06 4.86E-08 4.86E-08 2.54E-08 2.70E-06 4.79E-07 Leila Farivar, OSU, Econ 641 5.68E-06 2.41E-08 FEMALE -0.000123 1.55E-06 2.70E-06 4.79E-07 0.000113 4.33E-06 HISPANIC -4.33E-05 -8.27E-07 5.68E-06 2.41E-08 4.33E-06 35 0.000585

Considering the estimation output of the MLR model of log(wage) in the last slide, answer the following questions.
(For each hypothesis test, draw a distribution graph, and dont forget to do so for the exam as well.)

1.

What is the estimated wage of a single Hispanic woman with 2 years of education in JC who has no prior job experience? 2. Is the effect of job experience statistically significant? 3. Does being female have a role in how much one person earns? 4. Does being Hispanic have a role on how much one person earns? 5. Do you want to reconsider your answer to (1)? 6. Do you agree to this statement: The effect of 1 additional year in junior college balances the negative effect of being female? 7. What is the 99% confidence interval on the effect of junior college? 8. What are the SST, SSR, and SSE of regression? 9. Is the effect of being Hispanic statistically positive at 10%? What is the pvalue of this test? 10. You want to know if gender discrimination would decrease the wage of the woman by more than 10%. Then State and test the relevant hypothesis that answers this question.
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