LECTURE 1

Research in Economics :The Econometric Approach

I.MEANING

At the cost of over simplification we may say that in economics

research means construction of an econometric model of the
following type:

Y=a +bX+ u………………. (1)

Here Y is the dependent variable.

X is the explanatory variable. (There can be more than one
explanatory variable).
u is a disturbance term. It is a random variable .
Equation (1) is the regression model. (It can be nonlinear also).
II.OBJECTIVES

This econometric model is used for three purposes:

1) Estimating the effect of X on Y.
2) Testing hypothesis /ses.
3) Forecasting.
One need not pursue all objectives for the research.

III. THE RESEARCH PROBLEM OF ECONOMICS

We must understand the core of the research problem a

researcher in Economics faces. For illustrating this problem, one
can for convenience distinguish between Experimental Method
(EM) and Correlation method (CM).In Economics the researcher
is forced to use the CM. Yet, she wants to draw valid
conclusions like EM.
Let us consider an example. Let there be two groups of land.
In one group irrigation facilities (called treatment in EM) are
provided. The other group does not get the treatment .The first
group is called experimental group. The second group is
called control group. Let us call yield of rice , per unit of
land,say acre, Y. There is Y for experimental group .We call
this YE. Similarly for control group we write YC . The
averages are called YEA and YCA. .The question is: can we
conclude, from the observation that YCA. is smaller than YEA ,
that irrigation facilities improve yield? Unfortunately, we
cannot. The experimental group may turn out to have a higher
proportion of skilled cultivators compared to the control
group .Similarly there can be many other factors, many of
which we may not have even thought about.
Is there a solution to this problem?
There is. It is called randomization. A truly revolutionary
idea! Ronald. A. Fisher contributed significantly in
developing the statistical theory (Design of Experiments,
1935).Randomization involves two aspects. One is selecting
the respondents or units of study or ‘subjects’ in such a
manner that each unit has equal probability of getting
selected. The second stage is assigning the units into control
group and experimental group in a manner where each unit
has equal probability of getting assigned in any one of the
groups. Now if one finds a difference in the two groups then
 the reason must the treatment alone and no other factor .This
is the logic behind randomization. The conclusions about
effect of treatment on the outcome are valid in this situation.

Let us try to analyse the implications of randomization using the

regression function. Let us write again:
Yi=a +bXi + u………………. (1)
We see that Y has three components .one is ‘a’. We will try to
see what it represents .The second is the treatment effect bX.
The third is ‘u’ .u is a random variable. This is the consequence
of selecting Y in a random manner with each Y having the same
probability of getting selected. We think that u is that
component of Y which varies randomly because of the influence
of the ‘other factors’. Let us push he analysis further .Let X take
two values, namely, 0 and 1. X is 1 when treatment is given and
0 when it is not given .For Y in the experimental group X is
1.For control group it is 0.If we take only control group then we
can write
Yi=a + u …………(2)

Now we can also add the Ys.

Thus we have
ΣYi=n a + Σu
Her n is the number of subjects studied If Σu=0 then, we have
ΣYi=n a
Or, ΣYi /n =a= YCA
Or, average Y of control group is ‘a’, the intercept term .
Moreover, u=Yi- YCA. .So Σu=0.Let us turn to the experimental
group. A little thinking will show that a +bXi= YEA. As a result ,
bXi is the treatment effect, YEA - YCA .Therefore we can say that
‘b’, the slope coefficient , is the treatment effect coefficient .If
b=0 then there is no effect of the treatment .
We see that the regression function states that
Observed Y= YCA+ Treatment Effect +Random Effect (of the
‘other factors’).
What has randomization achieved so far? It has helped us to
decompose Y into a systematic component and a random
component. It ha also helped us to see that the sum total of
random effect is zero only when we are speaking in terms of
averages .This leads us to a very important principle of
estimation , namely . the principle of least squares.
IV.ESTIMATION: THE PRINCIPLE OF LEAST SQUARES
Let us call the difference between observed Y and Estimated Y
an error, ‘e’ Thus
ei = Yi-Yc. ……………………… (3)
Here , Yi is observed Y and Yc is estimated Y. We square e and
add to get
Σe2= Σ(Yi-Yc.)2 We want minimize these sum of squares by
choosing a Yc..
The first order condition is that
2 Σ(Yi-Yc.) =0
or , Σ(Yi-Yc.) =0……………….. (4)
or, ΣY-n Yc=0
or, ΣY/n= Yc
or, Yc is the mean or average .
We minimize the sum of squares when we estimate Y as an
average.
We want Σ (Yi-Yc.) = Σ(ei.) =0.But note another fact.
If from the regression model we want to measure impact of X on
Y, then randomization ensures that the other factors are captured
by u. It is also required that Σu=0.By the principle of analogy,
this implies Σe=0 for the observed sample estimation .This is
fulfilled by the principle of least squares.

V. FROM ‘EM’ TO ‘CM’

The economics researcher rarely has the luxury of using data

generated by random experiments. Experiments can be immoral,
costly and time consuming. Yet the attempt is to get valid results
of the impact of X on Y like EM. Analysis based on non –
experimental method can study co-variation and correlation. But
correlation analysis does not go as far as EM in analyzing
causality. To get further the regression model has to fulfill
certain conditions which are fulfilled by experimental method
.These assumptions are precisely the assumptions of Classical
Linear Regression Model (CLRM).