C05

Centre for Development, Environment and Policy

P545

Applied Econometrics

Prepared by Adam Prakash

This module is partially based on the earlier module Applied Econometrics for the
Agricultural and Food Sector prepared for the University of Londons External Programme
by Alison Burrell.

Updated by Laure Latruffe in 2010, 2011

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P545 Applied Econometrics Module Introduction

MODULE INTRODUCTION

ABOUT THIS MODULE

This module is about econometric methods and how they are applied to
estimate and test the unknown parameters of economic relationships. Priority
is given to both the statistical reasoning underlying the methodology and the
practical considerations involved in using this methodology with a variety of
models and real data.

The focus of the module is on the classical linear regression model. This is the
basis for much econometric methodology and it provides the framework for
organising the module.

The module covers

the principles of regression analysis and its statistical foundations

the simple linear regression model

the multiple linear regression model

departures from the assumptions of classical linear regression

modelling economic behaviour

There is a limit to the distance that can be covered in the study time available.
In an econometrics module, the trade-off between breadth and depth is low
since, without good groundwork and sufficient information at each stage, ideas
may be misunderstood and techniques misapplied. This module follows the
standard itinerary of most econometrics textbooks. It deals only with single-
equation models, but by the end of the module the student is ready to tackle
simultaneous equation models, which would be the next stop-over on this
itinerary.

The practical exercises designed to be done with the help of the free computer
software package R are an important element of the module.

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P545 Applied Econometrics Module Introduction

WHAT YOU WILL LEARN

Module Aims
The specific aims of the module are:

To explain the principles of econometric estimation and its statistical

foundations.

To present the theory of the classical linear regression model and explain why
the conditions in such a model provide an ideal environment for ordinary least
squares regression.

To explain the procedures of interval estimation and hypothesis testing in the

classical normal linear regression model.

To show how econometric models can be made more realistic through the use
of dummy variables and a dynamic specification.

To explain how linear restrictions can be imposed on parameters during

estimation and how these restrictions can be tested.

To investigate the consequences of heteroscedasticity and autocorrelation of

the disturbances of a regression model.

To encourage an appreciation of what constitutes a `good' econometric model,

and how to test that a model is well specified.

To develop practical skills of data analysis, use of regression techniques and

interpretation of regression results.

Module Learning Outcomes

By the end of this module, students should be able to:

understand and selectively and critically apply the basic principles of regression
analysis and statistical inference in the context of a single-equation regression
model

formulate a single-equation regression model, estimate its parameters, carry

out a variety of tests relating to model specification and critically interpret all
results

test hypotheses about economic behaviour and critically interpret the results of
these tests

specify and interpret models using dummy variables, different types of

dynamic specification and incorporate and test linear restrictions

test for heteroscedasticity and autocorrelation of the disturbances of a

regression model, and take appropriate action when these conditions are found
to be present based on critical interpretation.

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P545 Applied Econometrics Module Introduction

STUDY MATERIALS
The single textbook for the module is:

Gujarati D, Porter D (2010) The Essentials of Econometrics, 4th edn.

McGraw-Hill.

This book has been chosen for this self-study module because of its attention to full
explanations of concepts and procedures, its long introductory section presenting the
basic statistical concepts used in regression modelling, and its avoidance of
unnecessary algebra and difficult notation. At least part of every chapter is required
reading for the module, and you are also encouraged to read those parts that are not
specifically identified in the module texts, since all the material here should be within
your grasp and will reinforce your understanding of the subject. By the end of the
module, you will know this textbook well and will be ready for other more advanced
readings.

Each unit in the study guide follows the same format and we will say more about the
reasons for choosing their format in Unit 1. Each unit starts with a section on ideas
and issues where the main ideas of the unit are explained in a relatively non-
technical way. This is followed by a study guide section which takes you through
the relevant parts of the textbook, commenting on and reinforcing the material.
Next, there is a section (except in Unit 6 and in Unit 10) containing one or more
worked examples in which various techniques and their application and
interpretation are illustrated in the context of a practical modelling exercise. These
examples are an important tool for learning: follow them through carefully, and later
on, when doing the exercises, take care not to skip the question that asks you to
reproduce the results of the worked example yourself. The worked example is
followed by a set of questions whose answers are contained at the end of each unit
and a summary of the material in the unit. Last but by no means least, each unit
(except Unit 6 and Unit 10) also has a R guide explaining any new computer
commands and procedures that are necessary for answering the questions in that
unit.

The R guide of Unit 1 explains how to install and get started with
this free software.

When studying each unit, we suggest that you study the text at your own pace and
then work through the first few unit questions which are always designed to test your
basic understanding of the unit material. If these questions reveal some weak spots,
refresh them first before going on to the applied, data-based questions which you
will need to answer in conjunction with the R Guide. When you have finished the
questions and checked your answers, you should make a note of any additional
knowledge or insights you have gained by doing the questions that you missed when
studying the module text. The summary at the end of each unit briefly describes the
topics covered and lists what you should have learnt through your study.

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P545 Applied Econometrics Module Introduction

Applied statistics and econometrics are subjects with a great deal of specialised
jargon. It can be disconcerting to be faced with a number of unfamiliar new terms,
many of them quite long and often rather similar to each other. We recommend very
strongly that, right from the beginning of the module, you keep a glossary in which
you list each new term as you encounter it, together with an explanation of the
term in your own words. You should read through this glossary every few weeks,
updating your definitions if you find that, as the module progresses, your
understanding of the term develops along with your familiarity with the concept. A
space is provided at the back of the study guide for your glossary.

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FURTHER READING

Intermediate textbooks

Greene W (2000) Econometric Analysis, 4th edn. Prentice Hall, New Jersey.

Gujarati D (1979) Basic Econometrics. McGraw-Hill, Singapore.

Judge GG, Hill CR, Griffiths WE, Ltkepohl H, Lee T-C (1982) Introduction to the
Theory and Practice of Econometrics. John Wiley, Chichester.

Koutsoyiannis A (1973) Theory of Econometrics. Harper & Row, New York.

Advanced textbooks

Johnston J (1984) Econometric Methods, 3rd edn. McGraw-Hill, Singapore.

Maddala GS (1992) Introduction to Econometrics, 2nd edn. Macmillan, New York.

Other

Kennedy P (1985) Guide to Econometrics, 2nd edn. Blackwell, Oxford.

Helpful background reading about econometric methodology.

Hallam D (1990) Econometric Modelling of Agricultural Commodity Markets.

Routledge, London.
Discussion of econometric modelling in agricultural economics.

Charemza WW, Deadman DF (1992) New Directions in Econometric Practice. Edward

Elgar, Cheltenham.
Useful introduction to cointegration analysis.

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P545 Applied Econometrics Module Introduction

STUDY METHODS
Remember that people learn in different ways (and at different speeds). The units of
the module follow a logical progression in setting out and elaborating the principles
of the subject, but you can move about between units and topics if this suits you.

There is no single rule about how best to learn the kind of material presented in this
study guide. Perhaps the best thing to do at the very beginning is to flick through the
materials, picking out what is most interesting to you, noting what seems more
difficult and what seems easier. You will notice that the module is activity-intensive.
There are many questions and exercises to help you acquire the necessary analytical
skills. Answers to questions and exercises are provided at the end of each relevant
unit. Try to answer them on your own first before consulting the answers we have
provided!

The wealth of material means that it is necessary to pace yourself through it. The
Indicative Study Calendar at the end of this introduction gives you guidance on this
and a series of study tips are included below, which may give you some hints on how
best to study the module material.

Learning is an iterative process. It is often useful to go back to something studied

earlier. It is always important to be clear about the aims and objectives of a
particular unit. What are you trying to achieve in completing the unit; what are you
expected to accomplish?

Reading and note taking

A key function of the units is to facilitate the activity of reading and learning. They
highlight key points from the assigned readings, pose questions and provide a means
of reinforcing, relating and applying the issues discussed in the readings.

In note taking, the activity of selecting what you think is most important, interesting
and relevant, and putting it into your own words, is a powerful means of acquiring
and developing a sound knowledge of the subject. As you read you should
simultaneously be

thinking about the content

making notes where appropriate
relating ideas and concepts
comparing information with your existing knowledge
considering the applications of what you are studying
Notes should be well organised and well structured (ie making use of headings,
indentations etc), and clearly convey the meaning of what they refer to. You should
always reference the notes to the relevant section or chapter; this will make it easier
to return to the relevant reading for clarification and so on. You may find it useful to
annotate the unit text and/or readings with connecting thoughts and ideas. This will
help to link the elements of the module.

There are some features in the text of each unit that invite you to take some specific
action before reading further:

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P545 Applied Econometrics Module Introduction

This is an instruction to turn to one of the readings.

This icon invites you to halt and think about the question given. So
cover up the rest of the page unread, and write down what you think is
a reasonable answer to the question before reading on. This is
equivalent to lecturers asking a question of their class and using the
answers as a springboard for further explanation. The explanation,
where appropriate, will be given in the following text, or may be gleaned
from the relevant reading.

This symbol indicates practical exercises which you are invited to

perform at this stage in your studies.

Q uestion 0.0

Numbered self-assessment questions on previous work within each unit are to be

found before the unit Summary. Write down your answers to the questions and then
look up the answers given at the end of each unit. If you are short of time at least
read the questions and look up the answers, for they offer valuable information.

Glossary
Key words and terms are often repeated at the end of each unit in the Summary.
You should ensure you know what they mean before moving on to the next unit.
Where you are not already familiar with the term from previous study, you should
include it in your own glossary. You should add other terms that are new to you to
your glossary whenever this seems likely to be helpful. Some key words are very
likely to be used in examination questions, and an explanation of the meaning of
relevant key words will nearly always attract credit in your answers.

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P545 Applied Econometrics Module Introduction

TUTORIAL SUPPORT

There are two opportunities for receiving support from tutors during your study, and
you are strongly advised to take advantage of both. These opportunities involve

(i) participating in the virtual learning environment (VLE)

(ii) completing the examined assignment (EA)

Virtual learning environment (VLE)

The virtual learning environment provides an opportunity, through the internet, for
you to interact with both other students and tutors. A Discussion Module area is
provided through which you can post questions regarding any study topic that you
have difficulty with, or for which you require further clarification. You can also
discuss more general issues that are central or topical for your module or degree.

Additional features of the VLE include a technical area if you have any access
problems, an administrative area for any relevant queries and profile areas where
students and staff may introduce themselves. A very popular feature is the student
caf where students may socialise and interact regarding any issue they choose
(tutors are not allowed entry).

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P545 Applied Econometrics Module Introduction

ASSESSMENT
This module is assessed by:

an examined assignment (EA) worth 20%

a written examination in October worth 80%

Since the EA is an element of the formal examination process, please note the
following:

(a) The EA questions and submission date will be available on the Virtual Learning
Environment.

(b) The EA is submitted by uploading it to the Virtual Learning Environment.

(c) The EA is marked by the module tutor and students will receive a percentage
mark and feedback.

(d) Answers submitted must be entirely the students own work and not a product
of collaboration. For this reason, the Virtual Learning Environment is not an
appropriate forum for queries about the EA.

(e) Plagiarism is a breach of regulations. To ensure compliance with the specific

University of London regulations, all students are advised to read the
guidelines on referencing the work of other people. For more detailed
information, see the User Resource Section of the Virtual Learning
Environment.

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P545 Applied Econometrics Module Introduction

INDICATIVE STUDY CALENDAR

Part/unit Unit title Study time

(hours)

PART I Introductory ideas and statistical concepts

Unit 1 Introduction to econometrics 10

Unit 2 Statistical review 15

PART II The simple regression model

Unit 3 The classical linear regression model 15

Unit 4 Hypothesis testing 15

PART III The multiple regression model

Unit 5 The multiple regression model 15

Unit 6 Dummy variables 10

Unit 7 Linear parameter restrictions 15

PART IV Non-classical disturbances

Unit 8 Heteroscedasticity 15

Unit 9 Autocorrelation 15

PART V Module summary

Unit 10 Module summary 10

Examined Assignment 15
Check the virtual learning environment for submission deadline

Examination entry July

Revision and examination preparation September

End-of-module examination October

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 Unit One: Introduction to Econometrics

Unit Information 1

Unit Overview 1
Unit Aims 1
Unit Learning Outcomes 1

1.0 What is econometrics? 2

2.0 Structure of module texts 6

3.0 Ideas: the concept of regression 8

4.0 Study guide 14

5.0 An example: the Keynesian consumption function 16

Self Assessment Questions 19

Unit Summary 21

Answers to Self Assessment Questions 23

P545 Applied Econometrics Unit 1

UNIT INFORMATION

Unit Overview
This unit introduces you to the study of econometrics. It begins by defining
econometrics and then explains how econometrics relates to and differs from other
branches of economics. The important roles of economic theory and data in
econometric work are emphasised. Regression analysis is identified as the basis of
econometric procedure. The aims and purpose of regression analysis are explained.
The main steps of a typical econometric investigation are described and illustrated
with an example.

Unit Aims
To define the nature and scope of econometrics

To identify the special characteristics of econometrics as a tool of applied

economics

To describe and illustrate the main steps of an econometric investigation

To identify some characteristics of economic data

To practise some basic techniques of data investigation

Unit Learning Outcomes

By the end of this unit, students should:

have an appreciation of econometrics as a method of empirical investigation

have an understanding of four major differences between econometric models

and economic models

have an understanding of the seven main steps of an econometric investigation

have a knowledge of essential terminology relating to regression analysis

know how to perform basic data analysis in R

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P545 Applied Econometrics Unit 1

1.0 WHAT IS ECONOMETRICS?

Welcome to this module. Its aim is to give you an introduction to econometric
methods or, more specifically, to linear regression which is the main statistical
foundation for econometric work. Throughout the module you will be working with
data; we hope you will find this interesting.

Economic theory is concerned with relationships between variables. You have already
met some of these, including demand and supply functions for agricultural products,
production functions, labour supply and demand functions, and so on. Economic
theory aims to explain economic behaviour; this involves studying the relationship
between economic variables and the factors that influence them.

The purpose of econometrics is to quantify economic relationships. Econometrics can

provide numerical estimates of the parameters of these relationships and a
framework for testing hypotheses about them. Broadly defined, econometrics is

the application of statistical and mathematical methods to the

analysis of economic data, with a purpose of giving empirical content to
economic theories and verifying them or refuting them

Source: Maddala GS (1988) Introduction to Econometrics. Macmillan, New York, Chapter 1

Other definitions are possible: in your textbook you will come across a number of
definitions that each has a slightly different emphasis. Common to all definitions,
however, is the stress on the empirical nature of econometric work.

The process of econometrics involves the confrontation between economic

theory and economic data in quantifying economic relationships.

Econometrics is not just a branch of mathematical economics. Mathematical

economics need not have any empirical content at all whereas in econometrics the
emphasis is on empirical analysis. At the same time, econometrics is not just a box
of tools to work with data. It requires, undoubtedly, a good training in statistical
techniques but these techniques need to be deployed in an interactive process
between theory and the data.

This module can be studied in its own right, but normally we would expect you to
take it as part of the MSc programme where, in Part I, you will have studied various
economic theories and models. You should therefore be familiar with a range of
questions raised in theoretical discussions and with the results of some applied
empirical studies. These are good foundations on which to build the study of
econometrics. If up to now you have approached empirical studies from the point of
view of theory or the consequences for policy making, we now invite you to look at
them from the point of view of an econometrician. What is the difference?

To give empirical content to economic theories, the econometrician is confronted with

four problems that hardly concern the economic theorist.

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Non-experimental data
Economic theory develops models using a priori reasoning applied to relatively simple
assumptions. This procedure involves abstracting from secondary complications by
assuming that other things remain equal (or ceteris paribus), in order to
investigate the links between a few key economic variables.
For example, in demand theory we say that the quantity demanded of a commodity
(that is not a Giffen good) will fall if its price rises, other things being equal. These
other things which we assume are held constant include consumers incomes and
income distribution, and the prices of substitutes and complementary goods.
This method is fruitful in economic theory but, unfortunately, it is rarely possible to
carry out controlled experiments to test such statements. Therefore, in empirical
economics the scope for observing such behaviour is severely limited. A researcher
cannot alter a commoditys price, holding other things constant, in order to see what
happens to its demand.
In general, economic data are not the outcome of experiments but rather are
observed and recorded in a non-experimental world where other things are never
equal. Therefore, econometrics involves untangling the effects of different factors
that act simultaneously rather than analysing the results of a laboratory experiment.

Stochastic relationships
Economic theory usually involves deterministic relationships between economic
variables. This can be explained with a simple example: the Keynesian consumption
function. In economic theory we assume that, if we know the level of aggregate real
income, consumption will be uniquely determined. That is, for each value of
aggregate real income there corresponds a given level of aggregate consumption.
In reality, however, we do not expect theoretical relationships to hold exactly. Even
when all the main factors that systematically affect the behaviour of an economic
variable are taken into account, there will still be some random variation due to non-
systematic, one-off factors and human variability.
Hence, in econometric work we deal with relationships between variables that
contain a random or stochastic element, and that are therefore not deterministic in
nature. We investigate functions between variables which we believe to be
reasonably stable on average, but there is always a degree of uncertainty about
them.
In econometrics we make explicit assumptions about these random components,
called disturbances. This is why econometrics draws heavily on probability theory
and statistical inference.

Observed variables
In economic theory we work with theoretical variables. Econometrics, in contrast,
deals with observed data.
Obviously, there is a certain correspondence between them: data collection is
inspired by some theoretical framework. For example, the framework for measuring
national income account data derives from Keynesian economics, which is centred on
the analysis of theoretical aggregates such as output, demand, employment and the
price level.

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However, observed variables do not fully correspond to their theoretical counterparts

because of differences in definition and coverage, and errors in measurement. For
example, the price level is an abstract concept that is usually represented
empirically by some aggregate price index; however, the values it takes depend on
the goods whose prices are covered by the index and the method of calculating the
index.

Another example concerns modelling technology. In agricultural supply functions, the

state of technology is an important variable: changes in supply over time are driven
both by price changes and by the pace of technological change. But how can
technological development be measured? Many researchers resort to a simple time
trend to represent this important variable.

Finally, management is a key input in the theoretical specification of an agricultural

production function but one that is always difficult to measure
empirically: econometricians sometimes resort to proxy variables for management
like the number of years of education the farmer has received but more often they
omit this variable altogether in applied work.

In econometrics we need to be aware of the discrepancy between theoretical

concepts and observed data, and its implications when quantifying theoretical
propositions.

The treatment of time

The econometrician must make explicit assumptions about the role of time in his
model. When economic theory postulates that consumption depends on disposable
income, ceteris paribus, it implies that when income takes different values so too
does consumption. Econometrics can quantify this dependency by using information
about how consumption changes as income takes different values. However, this
dependency could be observed empirically in two alternative ways:

(1) by recording how consumption and income move together over time, or

(2) by recording the consumption of households at different income levels during

the same time period

In the first case, we have a time-series model, requiring time-series data

(measured at intervals over time).

In the second case, we have a cross-section model, requiring cross-section data

(measured for different individuals or micro-units at the same point or during the
same period in time). The choice between a time-series and a cross-section model
often depends on data availability, although this choice is less straightforward than it
may seem.

First, we may need to modify our theory for explaining consumption changes over
time before it can be applied to cross-sectional consumption analysis.

Second, there may be data considerations; for example, a time-series approach is

hardly appropriate for studying how consumption varies with income during periods
in which there has been virtually zero income growth.

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P545 Applied Econometrics Unit 1

These four elements give econometric work its distinctive flavour:

the fact that we cannot hold other things constant in empirical analysis

the stochastic nature of relationships between variables

the discrepancies between theoretical variables and observed data

the need to make explicit assumptions about time

We cannot move straight from an economic model as formulated by economic theory

to parameter estimation without dealing with these issues. In empirical analysis, our
data never behave exactly as our theoretical models would lead us to believe. Simple
theoretical models are useful abstractions.

But in empirical work the relationships we wish to disentangle from the data may
involve a number of variables, and may be subject to uncertainties that our theories
could not possibly aim to explain. Econometric methodology therefore includes
approaches for dealing with these issues, as well as the statistical techniques of
parameter estimation.

Regression analysis provides us with an analytical framework for handling

relationships involving a number of causal factors, including stochastic (random)
elements. It seeks to establish statistical regularities among observed variables.
To do this we need to deal with the randomness inherent in the behaviour of our
variables. This requires the help of statistical theory, which allows us to model
randomness as an integral part of the relationship between variables. How this is
done, and how we should interpret the results, is the subject of this module.

The following are the main points to remember.

In econometrics we confront theory with economic data so as to quantify

economic relationships and to test hypotheses about them.

In practice, we deal with stochastic relationships between variables which we

can only observe in a non-experimental context.

Econometric methodology has been developed in order to deal with this

situation, and differs significantly from the way regression analysis is applied to
experimental data. There are many outstanding issues and unresolved
methodological problems in the practice of econometrics.

Moreover, conclusions we draw in a particular context will always involve a

considerable degree of uncertainty, even if our model is correctly specified. For
this reason, we rely on probability theory and statistical inference to deal with
uncertainty in assessing the results of empirical analysis.

Econometrics is concerned primarily with quantifying and testing relationships

between variables, and regression analysis is its main tool of statistical
analysis.

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2.0 STRUCTURE OF MODULE TEXTS

You may be worried about studying econometrics. After all, it involves working with
mathematics and statistics, and you may feel that this is not one of your strengths.
Or perhaps you welcome more emphasis on mathematics and statistics. Whichever is
the case, it is useful to be aware of a particular problem that may arise when
studying econometrics.

Teaching and learning econometrics involves a preoccupation with technical details

definitions of technical terms, mathematical derivations, step by step descriptions of
statistical procedures etc, all expressed in technical notation.

This is normal and, indeed, necessary. But this preoccupation with technical detail
often implies that students lose a perspective on What is it all about? and Why are
we doing this? That is, there is a need to keep a grip on the kinds of basic questions,
which give substance to the subsequent technical exercises, uncluttered by notation
and technical detail. We need to get an overview of a problem before we attack it
aided by our technical armoury. We need to know the simple questions and intuitive
insights which have prompted elaborate technical enquiries.

For this reason, as we explained in the module introduction, each unit of the module
text will always start with a section on ideas or issues, whose purpose is to explain,
in simple words and with a minimum of technical notation, the basic substance of the
unit.

The aim is to give you an intuitive feel for the subject matter before going into
technical detail. If you feel that mathematics and statistics is not your strongest suit,
this regular section will give you a few analytical handles to hold on to when
studying relevant techniques. But even if you are confident with mathematics and
statistics, it is important not to skip this section.

Technical expertise is not just a question of ones ability to work out the steps in a
technical procedure or to understand a mathematical derivation. It also involves
understanding the type of questions a technique tries to address and the
assumptions on which it is based as well as judging the appropriateness of particular
technical procedures in specific conditions.

Each section on ideas or issues is self-contained; no references will be made to the

textbook. Take your time to read each one carefully, and to consider whether you
understand the types of questions which will be addressed subsequently in technical
detail: get familiar with the forest before you start looking at the trees.

Next, the module units contain a study guide which guides your study of the
textbook. The purpose of this section is to structure your reading of the textbook as
well as to provide brief comments, elaborations and cross-references to exercises
and examples, and to suggest shortcuts in coping with the material.

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Following on from this, you will find a section containing an example (except Units 6
and 10). The purpose of this section is twofold.

First, the example highlights a specific aspect of the topic under study in a
particular unit of the module.

Second, the example also tries to give you a glimpse of econometrics in action.

Sometimes, you will be asked to participate in analysing the example. The examples
aim to highlight the links between economic theory and empirical investigation, and
to illustrate the problems that can arise when we work with real data.

Next you will find a set of self-assessment questions. It is most important that you
work through all of these. Their purpose is threefold:

to check your understanding of basic concepts and ideas

to verify your ability to execute technical procedures in practice

to develop your skills in interpreting the results of empirical analysis

This is followed by a section that gives a brief summary of the main issues raised in
the unit.

At the end of each unit you will find answers to the unit self-assessment questions
and (except in Units 6 and 10) a guide that explains how to use R the software
package you will use to carry out econometric exercises. This guide will help you to
master this particular econometrics software package.

To summarise

The section on ideas or issues aims to whet your appetite by giving you an overview
of the topic of the week, expressed in non-technical language.

The core of the module unit is the study guide. This guides you through your reading
of the textbook.

The example is meant to close off the study for that particular unit. It aims to
highlight a problem dealt with in the module material with real data.

The summary draws your attention to the main points made in the unit.

The self-assessment questions are important and you should always work through
them. They will help you to understand the module material, and the knowledge and
experience you gain from doing them will help you to write assignments and answer
examination questions.

The remainder of this unit presents an introduction to regression analysis. As you will
see, it is structured along the pattern outlined above.

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3.0 IDEAS: THE CONCEPT OF REGRESSION

What is regression?
Regression is the main statistical tool of econometrics. But what is regression?

Regression can best be explained by an example. Consider Engels famous empirical

law of consumer behaviour, which was based on a household budget survey of
Belgian working class families collected by the statistician Ducpetiaux in 1855. Engel
(a German economist and statistician) observed that the share of expenditure on
food in total household expenditure (= the -variable) was a declining function of
household income (= the -variable).

This is indeed what one would expect: on average, poorer families spend a higher
proportion of their income on food in comparison with better-off families. Note that
we refer to the proportion of total household expenditures spent on food and not
total food consumption of the family (one would expect better-off families to spend
more money on food even though these expenditures are generally a smaller
proportion of their total expenditure).

Hence, we expect that, on average, the share of food in household expenditures is

inversely related to household income. But we do not expect this relationship to be
exact. That is, if we were to sample 10 families with identical income (ie equal -
values), we would not expect to get 10 identical shares of food consumption in total
household expenditures (the -values).

Differences in the demographic composition of families, in consumption habits and in

tastes will account for differences in food expenditures. In fact, many budget studies,
in the past and in the present, reveal that there is considerable variation within
each income class with respect to the proportion of household expenditures spent on
food. But, nevertheless, it is still valid to say that, on average, the proportion of
household expenditures spent on food declines as the level of income increases.

This leads us to the concept of regression: Regression methods bring out this
average relationship between a dependent variable (the -variable) on the one hand
and one or more independent variables (the -variables, also called the explanatory
variables) on the other.

In our example, the average relationship between the share of food in household
expenditure and the level of household income is the regression of the former
variable on the latter.

Of course, we can always take an average of one or another aspect of a number of

individuals, but we rarely meet the average individual. The same holds for
regression as an average relationship: although the regression line will pass through
the sample means of and , individual observations will rarely conform with the
average line between and .

Hence, in regression analysis we seek to model the chance variation around the
average line as well as the average line itself.

In summary, we hope that our model captures the basic structure of interaction
between economic variables. We expect that the behavioural relationships are

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reasonably stable but we know that they do not hold exactly because of the random
component (the disturbance term). At most, we expect these relations to hold on
average.

Trying to determine this average relationship amidst the random variation in the data
is like trying to separate sound from noise when listening to a badly tuned radio.

Thus, a regression model has two components.

A regression line: this models the average relationship between the dependent
variable and its explanatory variable(s). This requires us to make an explicit
assumption about the shape of the regression line: the function that expresses it
may be linear, quadratic, exponential, etc.

Disturbances: we acknowledge the existence of chance fluctuations due to a

multitude of factors not explicitly recognised in the model. We model this element of
uncertainty (the noise) in the form of a disturbance term which constitutes an
integral part of our model. This disturbance term is a catch all for all the variables
considered irrelevant for the purpose of the model as well as all unforeseen events
(Maddala GS (1988) Introduction to Econometrics. Macmillan, New York, Chapter 1).
It is a random variable that we cannot observe or measure in practice.

We are not interested in the disturbance term as a variable per se, but we are keen
to remove its blurred messages that hamper our attempts to investigate the
behavioural relationship between the variables of our model. To do this, we need to
model the stochastic (probabilistic) nature of the disturbance term. This is no easy
task and we always need to think carefully about whether the assumptions we make
about the behaviour of the disturbance term are indeed appropriate for the
relationship under study. Not surprisingly, a great deal of econometric theory and
practice revolves around these assumptions.

It is useful to express these important ideas more formally. We start with the
population regression function. This is a theoretical construct representing a
hypothesis about how the data are generated. For the simple, two-variable linear
regression model we have

= 1 + 2 + (1.1)

where is the dependent variable (sometimes called the regressand)

is the explanatory variable or independent variable (or regressor)

is the disturbance term
the subscript indicates the -th observation

1 and 2 are the regression parameters: 1 is the intercept, or constant, and 2 is

the slope coefficient.

Typically, the variables and are observable for each observation , the
disturbance takes different values for each but is not observable, whereas the
parameters 1 and 2 are unknown but constant for all observations.

The presence of the random disturbance means that is stochastic: for each value of
the explanatory variable, , there is a distribution of -values.

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The population regression function may be viewed as comprising two components:

a systematic element represented by a straight line showing the statistical

dependence of on

a random, or stochastic, element represented by the disturbance term u

The systematic element can be expressed as

E(| ) = 1 + 2 (1.2)

that is, the average, or expected, value of conditional on a given value of X is a

linear function of .

Therefore, the population regression function joins the conditional means of .

The disturbance term, , accounts for the variation in Y around the population
regression line. In Unit 3 you will learn about the assumptions made concerning .

Regression enables us to quantify the unknown parameters 1 and 2 , and the

unknown disturbances { }, for = 1, ... , , in equation (1.1).

Using a sample of data on and , we obtain estimates, 1 and

2 , of the unknown
1 is beta one hat).
population parameters ( is read as hat, hence

We have the sample regression function

= 2 +
1 + (1.3)

in which 1 and 2 are random variables (the particular estimates obtained depend
on the particular sample of data on and used) that differ from the population
parameters 1 and 2 .

Consequently, the sample residuals, , differ from the unknown population

disturbances, .

Whereas the disturbance term accounts for the variation in around the
population regression line, the residuals give us the vertical deviations of the
observed -values from the estimated regression line derived from sample data.

The residuals, therefore, are not identical with the disturbances, but clearly they may
contain some information that can help us understand the behaviour of the
disturbances. How to analyse the information contained in the residuals is addressed
in later units.

The predicted value of the dependent variable is given by the sample

regression line

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P545 Applied Econometrics Unit 1

+
=
(1.4)
1 2

in which is the fitted value of the dependent variable, the estimator of (| ), that
is the estimator of the population conditional mean (cf. equation (1.2)). The sample
linear regression line is an estimator of the population regression line.

Linearity and log-linearity

Equation (1.1) is an example of a linear regression model. That is, is linear in
and in the parameters 1 and 2 . With the linear regression line

= 1 + 2 +

the interpretation given to 2 relies on the fact that

2 = (1.5)

This implies that an increase of 1 unit in (measured in units of ) results in an

increase of 2 units in (measured in units of ).

In theory, 1 is the predicted value of (in units of ) if = 0. In practice, this

interpretation of 1 is not recommended unless zero values of could reasonably
occur and sample values of are fairly close to .

Now consider the model

= 2 1 (1.6)

which, after taking natural logarithms of both sides of the equation, can be written as

log = 1 + 2 log + (1.7)

where 1 = log.

This model is also linear in the parameters 1 and 2 . We may view the model as

* = 1 + 2 * + (1.8)

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P545 Applied Econometrics Unit 1

where * = log and * = log .

This model is known by various names logarithmic, double log, log-log, log-linear
and constant elasticity and is frequently used in applied work to characterise the
form of the functional relationship between the variables. It has the property that the
slope coefficient measures the elasticity of with respect to because

log
2 = = (1.9)
log

Correlation analysis
Although regression analysis is related to correlation analysis, conceptually these two
types of analysis are very different.

The main aim of correlation analysis is to measure the degree of linear association
between two variables and this is summarised by a sample statistic, the correlation
coefficient.

The two variables are treated symmetrically:

both are considered random

there is no distinction between dependent and explanatory variables

there is no implication of causality in a particular direction from one variable to

the other.

Regression analysis, on the other hand, can deal with relationships between two or
more variables and the variables are not treated symmetrically:

the dependent and explanatory variables are carefully distinguished

the former is random whereas the latter are often assumed to take the same
values in different samples often referred to as fixed in repeated samples

the underlying economic theory implies that , an explanatory variable,

causes or determines , the dependent variable

moreover, with more than one explanatory variable, regression analysis

quantifies the influence of each explanatory variable on the dependent variable

It is important to note that the regression of on does not give the same
sample regression line as the regression of on .

The appropriate direction of causality is determined by the modeller according to a

priori reasoning, based on theory or common sense.

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Data and regression

Regression methods allow us to investigate associations between variables, but the
justification for these relationships comes from theory. Relationships have to be
meaningful and whether they are or not depends on theoretical argument.

This does not mean, however, that data play only a passive role in economic
analysis. Empirical investigation is an active part of theoretical analysis inasmuch as
it involves testing theoretical hypotheses against the data as well as, in many
instances, providing clues and hints towards new avenues of theoretical enquiry.
Theoretical insights have to be translated into empirically testable hypotheses that
we can investigate with observed data. Hence, theory and data are interactive:
theoretical propositions should be continually tested empirically and theoretical
insights can be improved with the aid of signals from the data.

Most of the data we use in applied economic analysis are not obtained from
experiments but are the result of surveys and observational programmes. National
income accounts, agricultural and industrial surveys, financial accounts, employment
surveys, population census data, household budget surveys, and price and income
data are collected by various statistical offices. They are records of unplanned
events; they are not the outcome of experiments. The nature of this economic data
makes an econometricians work quite different from that of a psychologist or an
agricultural scientist.

In the latter cases, experiments play a central role in empirical research, and much
emphasis is put on the careful design of experiments in order to single out the
stimulus-response relationship between two variables whilst controlling for the
influence of other variables (that is, by holding them constant).

In economics, the scope for experimentation is very limited. We cannot change the
price of a commodity, holding incomes and all other prices constant, just to see what
would happen to the demand for it. In economic theory, we assume that other
things are equal (ceteris paribus) and focus on cause and effect between the
remaining variables. But in empirical analysis other things are never equal, and we
have to observe the behaviour of economic agents from survey data. Multiple
regression techniques allow us to account for the influence of other variables whilst
investigating the interaction between two key variables, but this is not the same as
holding other variables constant.

A careful observer uses data not just to confirm his or her theories, but also to get
clues from empirical analysis to advance his/her theoretical grasp of a problem. It is
primarily this aspect that enables data to contribute to the process of analysis.

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P545 Applied Econometrics Unit 1

4.0 STUDY GUIDE

For this unit you are asked to study Chapter 1 of the module

textbook, Gujarati and Porters Essentials of Econometrics. This

chapter has three main sections. The first two of these address two
questions

What is econometrics?
Why study econometrics?

These sections are straightforward and can be read quite quickly.

Please read Sections 1.1 and 1.2 pages 1 to 3 of Gujarati and

Porters textbook now.

The next section of the textbook is particularly important as it explains how you
might proceed in a typical econometric study. Gujarati and Porter identify eight steps
associated with the typical econometric investigation. Each of the first seven steps is
illustrated in the context of the decisions to enter the labour force.

You will see that in this example the data are plotted in a scatter diagram (or
scatter plot) that helps to visualise the relationship between two variables in the
data. Notice also the central role of estimating the parameters of the model and so
obtaining the estimated regression line.

Gujarati and Porters discussion of the data steps distinguishes between time-series,
cross-section (or cross-sectional) and pooled data (one type being panel data).

Table 1.1 gives a summary of the key differences between our terminology and
notation, and that used by Gujarati and Porter throughout their textbook.

Table 1.1 Differences in terminology and notation

Item Module text Gujarati and Porters textbook

Unknown stochastic term disturbance term error term

Notation
Estimated stochastic term residual (term) residual (term)
Notation

Unknown parameters
Notation Greek letters upper-case Roman letters

Estimated parameters
Notation Greek letters with lower-case Roman letters

Logarithm to base e
Notation log ln

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P545 Applied Econometrics Unit 1

Although these differences are inconvenient, it is an unfortunate fact that

terminology and notation are not wholly standardised amongst econometricians and
such discrepancies are often encountered.

Now please carefully read Section 1.3, pages 3 to 13 of the textbook.

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P545 Applied Econometrics Unit 1

5.0 AN EXAMPLE: THE KEYNESIAN CONSUMPTION FUNCTION

The eight steps explained in the textbook are typical of any econometric
investigation. We shall now illustrate seven of them with another example, the
Keynesian consumption function.

Statement of the theory

The Keynesian theory of consumption is the basis of our model of consumption
expenditure. This theory states that real consumption expenditure depends on real
disposable income, other things held constant. (Keynes also identified many other
factors that potentially affect consumption expenditure whether or not they do is of
course an empirical question and he divided them into objective and subjective,
which he discusses in Chapters 8 and 9 respectively of his General Theory of
Employment, Interest and Money.) When income rises, consumption expenditure
rises, but changes in consumption expenditure are less than the change in income.
Also, as income rises, the average propensity to consume, that is, consumption per
unit of income, falls.

Mathematical model of the theory

Suppose we represent the Keynesian consumption function as a linear relationship

= 1 + 2 (1.10)

where is real consumption expenditure, is real disposable income, 1 is a

constant and 2 is the slope of the consumption function, that is, the marginal
propensity to consume out of disposable income. Because of our a priori expectations
concerning the average and marginal propensities to consume, we expect 1 > 0 and
0 < 2 < 1. (Note that the average propensity to consume is = (
1 ) + 2 . For this
to fall as income rises, we need 1 > 0.)

Econometric model of the theory

The econometric model is stochastic. It includes a random disturbance, u, which

captures the influence of all the other variables that may influence consumption
expenditure.

= 1 + 2 + (1.11)

Collection of data
The data to be used are annual time-series data for the UK covering the period
19551991. They are aggregate consumption expenditure and personal disposable
income both measured in (1985) million. The source of the data is the Economic
Trends Annual Supplement 1991. Thus, our model represents a theory about the

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P545 Applied Econometrics Unit 1

behaviour of aggregate consumption over time. A scatter plot of these data is given
in Figure 1.1.

It is obvious from this scatter plot that the relationship is upward sloping and it
seems to be reasonably linear.

Figure 1.1 Scatter plot of aggregate consumption expenditure () and personal

disposable income ()

Source: Economic Trends Annual Supplement 1991

Parameter estimation
Using these data the parameters 1 and 2 can be estimated to obtain the average
relationship between and . Just how the coefficients of the population regression
function are estimated will be explained in Unit 3. The consumption function
estimated with our data is

= 3952 + 0.889 (1.12)

and this represents the average relationship between consumption expenditure and
personal disposable income.

The estimated value of 1 is 3952 and of 2 is 0.889.

Consequently if personal disposable income increases by 1 million, consumption

expenditure increases on average by 0.889 million.

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P545 Applied Econometrics Unit 1

The interpretation of the intercept is not so meaningful. Mechanical interpretation of

the estimate tells us that consumption expenditure is 3952 million if aggregate
personal disposable income is zero. However, this is not particularly helpful because
if aggregate personal disposable income is zero then the economy would be in chaos
and the Keynesian theory of consumption expenditure would not be appropriate. The
fact is that, in our sample, the -values are a long way from zero, and we really have
no idea what the consumption function might look like at low levels of income.

Tests of the hypothesims

Do the results conform to the theory of the consumption function?

With our theory we expect 1 > 0 and 0 < 2 < 1.

Is each of these hypotheses supported by the results? Clearly, our estimates are
consistent with what we expected to obtain, but we must wait until Unit 4 for a
discussion of formal hypothesis tests.

Prediction
We can use the estimated model to predict what consumption expenditure would be
if personal disposable income were a particular amount. Suppose personal disposable
income was 250 000 million. The predicted amount of consumption expenditure is

= 3952 + 0.889(250 000)

=226 202

That is, consumption expenditure is predicted to be 226 202 million if disposable

income is 250 000 million.

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P545 Applied Econometrics Unit 1

SELF ASSESSMENT QUESTIONS

Q uestion 1.1

What are the links between econometrics and both economic theory and mathematical
economics?

For the rest of the questions, you will need to use R software. Please turn to the
R Guide for Unit 1 now and follow the instructions given.

Q uestion 1.2

The data file u1q2.txt contains annual time-series data for the United States over the period
19591991 on aggregate consumption expenditure, , and disposable income, , both measured
per head of population and in billions of constant 1987$. The source of the data is Economic
Report of the President, 1992, table B-5, page 305.
Use R software to produce a scatter plot of on the vertical axis and on the horizontal
axis. Comment on the scatter plot: would a linear regression seem appropriate?

Use R software to obtain time-series plots of and . Describe the way consumption and
income have moved over the period 19581991.

Q uestion 1.3

The hypothesis that foreign direct investment is determined by demand suggests that foreign
direct investment and gross domestic product are positively related, other variables remaining
constant. The data file u1q3.txt contains annual time-series data for the period 19581985 on
foreign direct investment, FDI, and gross domestic product, GDP, for Taiwan. The source of these
data is Pan-Long Tsai, Determinants of foreign direct investment in Taiwan: an alternative
approach with time series data, World Development, 1991, Table A-1, page 285.

Use R software to obtain scatter plots of FDI on GDP and the logarithm of FDI on the logarithm
of GDP, both for the period 19581985. Comment on the two scatter plots. Which of the
following would you expect to be the more appropriate linear regression model:

(a) = 1 + 2 + ?
or

(b) logFDI = 1 + 2 log + ?

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Q uestion 1.4

The data file u1q4.txt contains cross-section data from a sample of 100 rural households on the
value of their consumption and income during a given month. Income () includes cash income
from all sources during the month concerned, plus the (imputed) market value of own production
consumed by the household. Consumption ( ) includes the value of all purchased items, plus the
value of own production consumed by the household. The units are measured in the local
currency rounded to the nearest whole number.
(a) Obtain the scatter plot of on . What is the main difference between this scatter plot
and the one constructed in Q 1.2?
(b) Use R software to obtain the histograms of and . Income has the usual positively
skewed distribution that we would expect, whereas the distribution of consumption is less
skewed. Can you suggest a reason for this?
(c) Use R software
(i) to obtain the average propensity to consume at the sample means
(ii) to compare the degree of skewness of the two variables
(iii) to obtain their correlation coefficient.

Q uestion 1.5

Weekly earnings can vary considerably in the case of casual dock labourers recruited on a day-to-
day basis. There are differences between workers as well as across weeks. Weekly earnings will
vary from week to week depending on the activity of the harbour which determines the demand
for labour. Daily recruitment will be high if demand is high, and vice versa. Earnings also vary
between workers in any given week. These depend on the numbers of days a worker manages to
get recruited for in a particular week, on whether he or she is recruited for the day shift or the
night shift, and on the number of hours of overtime he or she works in that week.
In this exercise you will look at data on the weekly earnings of casual workers, ECAS, and the
recruitment of casual workers, CASREC. The data file u1q5.txt contains paired observations on
the two variables ECAS and CASREC. The data were taken from a field study carried out in
1980/81 by the Centre of African Studies in Mozambique (Eduardo Mondlane University, Maputo)
on casual labour on the docks of Maputo harbour. The earnings data are in units of 100 MT, the
local currency being the Metical.
(a) Using R software, calculate the means, standard deviations, and minimum and maximum
values for both variables.
(b) A particular worker is randomly chosen from the labour force in a particular week in
1980/1981 that is also randomly chosen. Using the information in your answer to part (a),
what is your best estimate of the weekly earnings of this randomly selected worker?
(c) With R software, obtain the scatter plot of ECAS against CASREC. Write down what you
observe.

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UNIT SUMMARY
In this unit we have introduced some basic ideas on econometrics and regression
analysis. The most important points to remember are the following.

Econometrics is the application of statistical and mathematical methods to the

analysis of economic data, with the purpose of giving empirical content to
economic theories and testing them against reality.

The econometricians approach differs from that of the economic theorist

because

- we cannot hold other things constant in empirical analysis

- the random nature of relationships between variables means that the

results and conclusions of empirical analysis always contain an element of
uncertainty

- there is a discrepancy between theoretical variables and observed data in

terms of coverage and precision of measurement

- econometricians cannot avoid explicit assumptions about the time frame of

their model, since the data they use have been generated in a real-time
context

Regression analysis is the statistical basis of econometric theory and practice.

Its aim is to quantify relationships between variables, especially between
variables whose relationship is subject to chance variation.

Regression involves finding an average line that summarises the relationship

whereby depends on in the midst of random variation and uncertainty of
outcome.

The randomness inherent in conclusions and outcomes based on regression

analysis is formally modelled by introducing a disturbance term into our
behavioural equations. This is a stochastic variable which is not observable.
However, the residuals of a sample regression function may provide us with an
indication as to the behaviour of these unknown disturbances.

Regression allows us to investigate the association between variables, but it

cannot discover causality between them. To establish causality we need to
resort to economic theory.

Empirical work in economics cannot rely on experimentation. Econometric

analysis is therefore based on careful observation of data drawn from within a
context which we do not control.

In terms of practical skills, this unit requires that

you are familiar with the scatter plot as a practical tool of empirical analysis

you know how to load data into R software from a pre-existing data file

you know the R software commands to obtain a summary of descriptive

statistics of a variable, make a scatter plot and create logarithms of variables

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P545 Applied Econometrics Unit 1

ANSWERS TO SELF ASSESSMENT QUESTIONS

A 1.1

Economic theory can be viewed as a set of qualitative relationships between variables. Such
theory can frequently be written in the form of a mathematical model. An econometric model
may be obtained from an appropriate mathematical model with the addition of a random error
term. By using data to estimate the econometric model we can in effect quantify economic
relationships.

A 1.2

(a) The scatter plot of against for the United States data is given below.
13000
12000
11000
u1q2$C

10000
9000
8000
7000

7000 8000 9000 10000 11000 12000 13000 14000

u1q2$Y

The scatter plot shows that and have the expected positive association. Their
underlying relationship appears to be approximately linear and seems to be relatively
strong in that the observations would appear close to a regression line drawn in the
scatter plot.

(b) Real consumer spending has been on an upward trend over the whole period, with a
downturn in just three sub-periods, the first of which in 1974 was triggered by the first
OPEC oil price rise. Real income has also been following a long-run rising trend. It has
shown more variability around its long-term trend since the early 1970s than in the earlier
years.

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A 1.3

The scatter plots of FDI on GDP and logFDI on logGDP are given below.
350
300
250
u1q3$FDI

200
150
100
50
0

0 20000 40000 60000 80000

u1q3$GDP

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P545 Applied Econometrics Unit 1

6
5
u1q3new$LFDI

4
3
2

7 8 9 10 11

u1q3new$LGDP

When the variables FDI and GDP are used (equation (a)), it seems that an upward-sloping curve
may be more appropriate than a straight line. The point in the top right corner seems to lie a
long way from the linear function that one might eyeball through the other observations.
Moreover the points seem to spread out more as GDP increases. With the logarithms of the
variables, a positive relationship that is approximately linear is more clearly seen. Therefore,
equation (b) may be the more appropriate regression model.

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P545 Applied Econometrics Unit 1

A 1.4

(a) The scatter plot of on is given below.

70
60
u1q4$C

50
40
30

20 40 60 80 100

u1q4$Y

The most striking difference relative to the time-series scatter plot obtained in Q 1.2 is that
here, in the cross-section data set, there are a number of households with the same or
very similar income levels but with very different consumption levels, so that the data
points are more dispersed in the vertical dimension. On the other hand, with the time-
series data, values of income are not repeated and the data points lie quite close to a
(straight) line. During the period 19591991 the US economy was growing so that both
real income and consumption were upward-trending, thus making repeated values of real
income unlikely.

(b) The range (maximum value minus minimum value) of is much less (7325) than that for
(10322). This is due to the nature of the relationship between consumption and
income. If the average propensity to consume is declining, then high income households
will consume a smaller proportion of their income than low income households, and so
consumption will have a smaller positive skew than income.

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(c) (i) The average propensity to consume at the sample means is given by

Mean( )/Mean() = 47.8/48.43

= 0.98699

= (approx) 0.987

(ii) The coefficient of skewness is 0.961725 for income compared with 0.290131 for
consumption.

Note: for a perfectly symmetrical distribution, this coefficient equals zero, and for
negatively skewed distributions (ie with the tail to the left) it takes negative values.

(iii) The simple correlation coefficient (or Pearsons correlation coefficient) for and
is 0.7734, showing that the underlying correlation is positive. However, since the
coefficient is well below its maximum value of 1 (= perfect positive linear
correlation) this indicates that there is some scattering of the points around a
straight line.

A 1.5

(a) The means, standard deviations, and minimum and maximum values for both variables are
given below:

ECAS CASREC

Mean 17.12 887.6

Standard deviation 11.26 147.01

Minimum value 0 692

Maximum value 57 1226

(b) Your best estimator of the weekly earnings of a randomly selected worker would be the
overall mean of the sample. The reason is as follows: you have no way of knowing
whether a good or a bad week for average earnings of workers was selected, nor whether
the particular worker concerned performed better or worse than others in that (unknown)
week. If you want to give a good estimate, and not gamble on the outcome, your best
guess is to take the average of the whole sample. The best estimate is 17.12 or 1712 MT
since this is the arithmetic mean of the whole sample.

(c) The scatter plot is of particular interest to us. It is reproduced below.

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P545 Applied Econometrics Unit 1

50
40
u1q5$ECAS

30
20
10
0

700 800 900 1000 1100 1200

u1q5$CASREC

For each of the values of CASREC we have a number of values of ECAS.

There is considerable variation between workers in terms of their earnings in any particular
week. The ranges are wide: in some cases from 0 to nearly 60 (that is, 6000 MT).

On the whole, the scatter slopes upwards as we move from lower to higher levels of
recruitment, but the relatively modest slope is hidden behind a great deal of variation
within weeks.

Did you notice that the range in the variation between workers earnings tends to increase
when we move from the left to the right? That is, higher levels of recruitment go together
with a wider range in weekly earnings between workers.

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