Introductory Econometrics: A Modern Approach (7e)

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Chapter 1
The Nature of Econometrics and
Economic Data

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 Introductory Econometrics: A Modern Approach (7e)
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The Nature of Econometrics and Economic Data (1 of 22)

• What is econometrics?
• Econometrics is the use of statistical methods to analyze economic data.
• Econometricians typically analyze nonexperimental data.
• Typical goals of econometric analysis:
• Estimating relationships between economic variables.
• Testing economic theories and hypotheses.
• Evaluating and implementing government and business policy.
• Common applications
• Forecasting macroeconomic variables (interest rates, inflation rates,
GDP).
• Forecasting non-macro variables (less visible).
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 Introductory Econometrics: A Modern Approach (7e)
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The Nature of Econometrics and Economic Data (2 of 22)

• Steps in econometric analysis
1) Economic model (this step is often skipped)
2) Econometric model

• Economic models
• Maybe micro- or macromodels
• Often use optimizing behaviour, equilibrium modeling, …
• Establish relationships between economic variables
• Examples: demand equations, pricing equations, …

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 Introductory Econometrics: A Modern Approach (7e)
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The Nature of Econometrics and Economic Data (3 of 22)

• Economic model of crime (Becker (1968))
• Derives equation for criminal activity based on utility maximization.

• Functional form of relationship not specified.

• Equation could have been postulated without economic modeling.
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 Introductory Econometrics: A Modern Approach (7e)
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The Nature of Econometrics and Economic Data (4 of 22)

• Model of job training and worker productivity
• What is the effect of additional training on worker productivity?
• Formal economic theory not really needed to derive equation:

• Other factors may be relevant, but these are the most important.

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 Introductory Econometrics: A Modern Approach (7e)
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The Nature of Econometrics and Economic Data (5 of 22)

• Econometric model of criminal activity
• The functional form has to be specified.
• Variables may have to be approximated by other quantities.

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 Introductory Econometrics: A Modern Approach (7e)
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The Nature of Econometrics and Economic Data (6 of 22)

• Econometric model of job training and worker productivity

• Most of econometrics deals with the specification of the error u.

• Econometric models may be used for hypothesis testing.
• For example, the parameter β3 represents the effect of training on wages.
• How large is this effect? Is it different from zero?

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 Introductory Econometrics: A Modern Approach (7e)
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The Nature of Econometrics and Economic Data (7 of 22)

• Econometric analysis requires data.
• There are several different kinds of economic data sets:
• Cross-sectional data
• Time series data
• Pooled cross sections
• Panel/Longitudinal data

• Econometric methods depend on the nature of the data used.

• Use of inappropriate methods may lead to misleading results.

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 Introductory Econometrics: A Modern Approach (7e)
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The Nature of Econometrics and Economic Data (8 of 22)

• Cross-sectional data sets
• These may include samples of individuals, households, firms, cities,
states, countries, or other units of interest at a given point of time or in a
given period.
• Cross-sectional observations are more or less independent.
• An example is pure random sampling from a population.
• Sometimes pure random sampling is violated, for example, people refuse
to respond in surveys, or sampling may be characterized by clustering.
• Cross-sectional data is typically encountered in applied microeconomics.

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 Introductory Econometrics: A Modern Approach (7e)
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The Nature of Econometrics and Economic Data (9 of 22)

• Table 1.1: Cross-sectional data set on wages and other characteristics

obsno wage educ exper female married

1 3.10 11 2 1 0
2 3.24 12 22 1 1
3 3.00 11 2 0 0
4 6.00 8 44 0 1
5 5.30 12 7 0 1
. . . . . .
. . . . . .
. . . . . .
525 11.56 16 5 0 1
526 3.50 14 5 1 0

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 Introductory Econometrics: A Modern Approach (7e)
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The Nature of Econometrics and Economic Data (10 of 22)

• Table 1.2: Cross-sectional data on growth rates and country characteristics

obsno country gpcrgdp govcons60 second60

1 Argentina 0.89 9 32
2 Austria 3.32 16 50
3 Belgium 2.56 13 69
4 Bolivia 1.24 18 12
. . . . .
. . . . .
. . . . .
61 Zimbabwe 2.30 17 6

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 Introductory Econometrics: A Modern Approach (7e)
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The Nature of Econometrics and Economic Data (11 of 22)

• Time series data
• This includes observations of a variable or several variables over time.
• Examples include stock prices, money supply, consumer price index,
gross domestic product, annual homicide rates, automobile sales, and so
on.
• Time series observations are typically serially correlated.
• Ordering of observations conveys important information.
• Data frequency may include daily, weekly, monthly, quarterly, annually,
and so on.
• Typical features of time series include trends and seasonality.
• Typical applications include applied macroeconomics and finance.

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 Introductory Econometrics: A Modern Approach (7e)
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The Nature of Econometrics and Economic Data (12 of 22)

• Table 1.3: Time series data on minimum wage, unemployment, and
related data for Puerto Rico

obsno year avgmin avgcov prunemp prgnp

1 1950 0.20 20.1 15.4 878.7
2 1951 0.21 20.7 16.0 925.0
3 1952 0.23 22.6 14.8 1015.9
. . . . . .
. . . . . .
. . . . . .
37 1986 3.35 58.1 18.9 4281.6
38 1987 3.35 58.2 16.8 4496.7

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 Introductory Econometrics: A Modern Approach (7e)
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The Nature of Econometrics and Economic Data (13 of 22)

• Pooled cross sections
• Two or more cross sections are combined in one data set.
• Cross sections are drawn independently of each other.
• Pooled cross sections are often used to evaluate policy changes.
• Example:
• Evaluating effect of change in property taxes on house prices.
• Random sample of house prices for the year 1993.
• A new random sample of house prices for the year 1995.
• Compare before/after (1993: before reform, 1995: after reform).

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 Introductory Econometrics: A Modern Approach (7e)
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The Nature of Econometrics and Economic Data (14 of 22)

• Table 1.4: Pooled cross sections on two years of housing prices

obsno year hprice proptax sqrft bdrms bthrms

1 1993 85,500 42 1600 3 2
2 1993 67,300 36 1440 3 2
3 1993 134,000 38 2000 4 2
. . . . . . .
. . . . . . .
. . . . . . .
250 1993 243,600 41 2600 4 3
251 1995 65,000 16 1250 2 1
252 1995 182,400 20 2200 4 2
253 1995 97,500 15 1540 3 2
. . . . . . .
. . . . . . .
. . . . . . .
520 1995 57,200 16 1100 2 1

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 Introductory Econometrics: A Modern Approach (7e)
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The Nature of Econometrics and Economic Data (15 of 22)

• Panel or longitudinal data
• The same cross-sectional units are followed over time.
• Panel data have a cross-sectional and a time series dimension.
• Panel data can be used to account for time-invariant unobservables.
• Panel data can be used to model lagged responses.
• Example:
• City crime statistics; each city is observed in two years.
• Time-invariant unobserved city characteristics may be modeled.
• Effect of police on crime rates may exhibit time lag.

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The Nature of Econometrics and Economic Data (16 of 22)

• Table 1.5: Two-year panel data set on city crime statistics

obsno city year murders population unem police

1 1 1986 5 350,000 8.7 440
2 1 1990 8 359,200 7.2 471
3 2 1986 2 64,300 5.4 75
4 2 1990 1 65,100 5.5 75
. . . . . . .
. . . . . . .
. . . . . . .
297 149 1986 10 260,700 9.6 286
298 149 1990 6 245,000 9.8 334
299 150 1986 25 543,000 4.3 520
300 150 1990 32 546,200 5.2 493

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 Introductory Econometrics: A Modern Approach (7e)
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The Nature of Econometrics and Economic Data (17 of 22)

• Causality and the notion of ceteris paribus

• Ceteris paribus: “other relevant factors being equal.”

• Most economic questions are ceteris paribus questions.
• It is important to define which causal effect one is interested in.
• It is useful to describe how an experiment would have to be designed to
infer the causal effect in question.

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The Nature of Econometrics and Economic Data (18 of 22)

• Causal effect of fertilizer on crop yield
• “By how much will the production of soybeans increase if one increases
the amount of fertilizer applied to the ground.”
• Implicit assumption: all other factors that influence crop yield such as
quality of land, rainfall, presence of parasites, and so on are held fixed.

• Experiment = Feasible
• Choose several one-acre plots of land; randomly assign different amounts
of fertilizer to the different plots; compare yields.
• Experiment works because amount of fertilizer applied is unrelated to
other factors influencing crop yields.

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The Nature of Econometrics and Economic Data (19 of 22)

• Measuring the return to education
• “If a person is chosen from the population and given another year of
education, by how much will his or her wage increase?”
• Implicit assumption: all other factors that influence wages such as
experience, family background, intelligence, and so on are held fixed.

• Experiment ≠ Infeasable
• Choose a group of people; randomly assign different amounts of
education to them (infeasable!); compare wage outcomes.
• Problem without random assignment, amount of education is related to
other factors that influence wages (e.g. intelligence).

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The Nature of Econometrics and Economic Data (20 of 22)

• Effect of law enforcement on city crime level
• “If a city is randomly chosen and given ten additional police officers, by
how much would its crime rate fall?”
• Alternatively: “If two cities are the same in all respects, except that city A
has ten more police officers than city B, by how much would the two
cities’ crime rates differ?”
• Experiment ≠ Infeasable
• Randomly assign number of police officers to a large number of cities
(virtually impossible, as no two cities are alike in all respects except size
of police force!).
• More importantly, in reality, the number of police officers occurs
contemoraneously with determination of crime rate.
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The Nature of Econometrics and Economic Data (21 of 22)

• Effect of the minimum wage on unemployment
• “By how much (if at all) will unemployment increase if the minimum
wage is increased by a certain amount (holding other things fixed)?”

• Experiment ≠ Infeasable
• Government randomly chooses minimum wage each year and observes
unemployment outcomes.
• Experiment would theoretically work because level of minimum wage is
unrelated to other factors determining unemployment.
• In reality, the level of the minimum wage will depend on political and
economic factors that also influence unemployment.

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 Introductory Econometrics: A Modern Approach (7e)
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The Nature of Econometrics and Economic Data (22 of 22)

• Testing predictions of economic theories
• Economic theories are not always stated in terms of causal effects.
• For example, the expectations hypothesis states that long-term interest
rates equal compounded expected short-term interest rates.

• An implicaton is that the interest rate of a three-month T-bill should be equal to

the expected interest rate for the first three months of a six-month T-bill; this
can be tested using econometric methods.

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