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Dougherty
Introduction to Econometrics,
5th edition
Chapter heading
Chapter 1: Simple Regression
Analysis
Y
Y 1 2 X
X1
X2
X3
X4
Y
Y 1 2 X
X1
X2
X3
X4
Y
Y 1 2 X
Q1
X1
Q2
X2
Q3
X3
Q4
X4
If the relationship were an exact one, the observations would lie on a straight line and we
would have no trouble obtaining accurate estimates of 1 and 2.
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P4
Y 1 2 X
P1
Q1
X1
Q2
P2
X2
Q3
Q4
P3
X3
X4
In practice, most economic relationships are not exact and the actual values of Y are
different from those corresponding to the straight line.
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P4
Y 1 2 X
P1
Q1
X1
Q2
P2
X2
Q3
Q4
P3
X3
X4
P4
Y 1 2 X
u1
P1
Q1
Q2
P2
Q3
Q4
P3
u = disturbance term
1 2 X1
X1
X2
X3
X4
Each value of Y thus has a nonrandom component, 1 + 2X, and a random component, u.
The first observation has been decomposed into these two components.
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P4
P1
P2
X1
X2
P3
X3
X4
P4
Y 1 2 X
P1
P2
X1
X2
P3
X3
X4
Obviously, we can use the P points to draw a line which is an approximation to the line
Y = 1 + 2X. If we write this line Y 1 2 X , 1 is an estimate of 1 and2 is an estimate of
2.
Y (actual value)
Y (fitted value)
P4
Y 1 2 X
P1
R1
X1
R2
P2
X2
R3
R4
P3
X3
X4
The line is called the fitted model and the values of Y predicted by it are called the fitted
values of Y. They are given by the heights of the R points.
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Y (actual value)
Y (fitted value)
P4
Y 1 2 X
u 4
u1 P1
R1
X1
R2
u 2
P2
X2
R3
R4
u 3
P3
X3
Y Y u (residual)
X4
The discrepancies between the actual and fitted values of Y are known as the residuals
denoted u .
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Y (actual value)
Y (fitted value)
P4
Y 1 2 X
P1
1
1
R1
X1
R2
P2
X2
R3
R4
Y 1 2 X
P3
X3
X4
Note that the values of the residuals are not the same as the values of the disturbance term.
The diagram now shows the true unknown relationship as well as the fitted line.
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Y (actual value)
Y (fitted value)
P4
Y 1 2 X
Y 1 2 X
P1
1
1
Q1
X1
Q2
P2
X2
Q3
Q4
P3
X3
X4
The disturbance term in each observation is responsible for the divergence between the
nonrandom component of the true relationship and the actual observation.
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Y (actual value)
Y (fitted value)
P4
Y 1 2 X
P1
1
1
R1
X1
R2
P2
X2
R3
R4
Y 1 2 X
P3
X3
X4
The residuals are the discrepancies between the actual and the fitted values.
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Y (actual value)
Y (fitted value)
P4
Y 1 2 X
P1
1
1
R1
X1
R2
P2
X2
R3
R4
Y 1 2 X
P3
X3
X4
If the fit is a good one, the residuals and the values of the disturbance term will be similar,
but they must be kept apart conceptually.
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Y (actual value)
Y (fitted value)
P4
Y 1 2 X
u4
Y 1 2 X
Q4
1 2 X 4
1
1
u = disturbance term
X1
X2
X3
X4
Both of these lines will be used in our analysis. Each permits a decomposition of the value
of Y. The decompositions will be illustrated with the fourth observation.
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Y (actual value)
Y (fitted value)
P4
Y 1 2 X
u4
Y 1 2 X
Q4
1 2 X 4
1
1
u = disturbance term
X1
X2
X3
X4
Using the theoretical relationship, Y can be decomposed into its nonstochastic component
1 + 2X and its random component u.
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Y (actual value)
Y (fitted value)
P4
Y 1 2 X
u4
Y 1 2 X
Q4
1 2 X 4
1
1
u = disturbance term
X1
X2
X3
X4
Y (actual value)
Y (fitted value)
P4
u 4
Y 1 2 X
R4
Y 1 2 X
1 2 X 4
1
1
Y Y u (residual)
X1
X2
X3
X4
The other decomposition is with reference to the fitted line. In each observation, the actual
value of Y is equal to the fitted value plus the residual. This is an operational
decomposition which we will use for practical purposes.
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To begin with, we will draw the fitted line so as to minimize the sum of the squares of the
residuals, RSS. This is described as the least squares criterion.
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u
i 1
u1 ... u n
Why the squares of the residuals? Why not just minimize the sum of the residuals?
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P4
P1
P2
X1
X2
P3
X3
X4
The answer is that you would get an apparently perfect fit by drawing a horizontal line
through the mean value of Y. The sum of the residuals would be zero.
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P4
P1
P2
X1
X2
P3
X3
X4
You must prevent negative residuals from cancelling positive ones, and one way to do this
is to use the squares of the residuals.
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P4
P1
P2
X1
X2
P3
X3
X4
Of course there are other ways of dealing with the problem. The least squares criterion has
the attraction that the estimators derived with it have desirable properties, provided that
certain conditions are satisfied.
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P4
P1
P2
X1
X2
P3
X3
X4
The next sequence shows how the least squares criterion is used to calculate the
coefficients of the fitted line.
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2015.12.18