Applied Econometrics for

Management

Teklebirhan Alemnew (Assistant Professor)

[email protected]
AAU, 2024
Course Map

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 Course Contents

Chapter 1 – Introduction

Chapter 2 - Regression Analysis

Chapter 3 - Violations of the Assumptions of CLRM

Chapter 4 - Discrete Choice Models

Chapter 5 – Panel Data Analysis

Chapter 6 - Time series Analysis

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 Evaluation
.

 Mid Exam /Project --------- 50%

 Final Exam – 50%

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 References
 Gujarati, D., Basic econometrics, 5th ed. 2008.

 Gujarati, D., Econometrics by example, 2011.

 Jeffrey Wooldridge 2009 or 2012, Introductory Econometrics, 4th

or 5th edition, Thomson South Western

 Marno Verbeek, (2004), A Guide to Modern Econometrics;2nd

edition (Wiley)

 William H. Greene (2008), Econometric Analysis. 6th edition

 Peijie Wang (2009), Financial econometric models. 2nd edition

 Carl F. Christ (1971), Econometric Models of the Financial Sector

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 Chapter One:
Introduction

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 1.1. What is Econometrics?

What is Econometrics?
 Different theories based on abstract reasoning have been
developed to understand complex phenomena

 Are these theories valid in the real world? (empirical validity?)

 Econometrics is a combination of economic theory, mathematical

economics and statistics, but it is completely distinct from each
one of these three branches of science.

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 Cont…
 Econometrics is based on statistical methods for

• Estimating, quantifying & checking the strength of the

relationship among variables,

• Testing the validity of theories in explaining the real world by

confronting them with real data,

• Evaluating (impact) and implementing government and

business policies.

 The last two points shows that econometrics methods go beyond

testing simple correlations.

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 Cont…
 Why study Econometrics?

 Unlike "hard" sciences, in social sciences, we have no experimental

data / Laboratories.

 The world around us is very complex, we cannot control

everything that happens outside of the question that we want to
study.

 To make statistical inference (draw conclusions for the whole

population) we have to deal with non-experimental data, based on
samples of a population.-- Survey data.

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 Cont…
 Some relevant variables are not always available/observable. This
may cause estimation bias. Econometrics provides solutions to
these problems.

 Three main goals of econometrics

a) Analysis: - Testing Theories – empirical testing
 It aims primarily at the verification/validity of theories.
b) Policy-Making
 Obtaining numerical estimates of the relationship between
variables for decision making.
 E.g: gov’t policy on currency devaluation (Imp/expo elasticity).
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 Cont…
c) Forecasting or Prediction

 Forecasting refers to obtaining future values of certain variable

 Enable us to reduce our uncertainty in the future

 It enables policy makers to judge whether it is necessary to take

any measure in order to influence the relevant variables.

 For instance, government’s decision on its current employment

policy may be influenced by forecasted level of employment for
the coming, say, ten years.

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 Cont…
 Succinctly, this means that to formulate current employment
policy the government has to know, (among others):

• What is the current situation of employment?

• What the level of employment will be, say in ten years’ time if
no measure is taken by the government?

 Finally, if the forecasted level of employment is lower than the

acceptable level of employment leading to high level of
unemployment.

 Hence, the government must take measures to reduce

unemployment over time. 12
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Cont…

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 1.2. Methodology of Econometric Analysis
 In any econometric research we may distinguish four stages:

a) Specification of the model

b) Estimation of the model

c) Evaluation of the estimates

d) Use the model for Prediction and Decision Making

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 Cont…
a) Specification of the model

 It means expressing the relationship that we want to estimate in

mathematical form.

 This step involves three important tasks:

 Identification of the relevant variables to be included in the

model

 Determination of the mathematical form of the model

 Determination of the expected signs and magnitudes of the

parameters of the model
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  Suppose that you are a researcher working for
National Bank of Ethiopia. As a financial policy
advisor of the office, suppose you are seeking to
identify the determinants of Lending Rate of
Private Commercial Banks In Ethiopia. At this
moment suppose also that you believed that
conducting an econometric research to address
this question is the most efficient way.

quantitatively
measure the
different main
determinants
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 Cont…
 Identification of the relevant variables

 In applied econometrics, there are three basic criteria for

identification of relevant variables to be included in an
econometric analysis. These are:

 Theory,

 Previous studies and

 Intuition.

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Cont…

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Cont…

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Cont…

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 Cont…
 The determination of the functional form of the relationship
requires understanding the actual functional relationship (linear,
quadratic, logarithmic, exponential, etc) between the variables.

 In this step it is hard to apply our knowledge of economic theories

 Thus, it is the task of the researcher to use his/her own mental

talent to determine about the mathematical form of the model s/he
is interested on.

 To do this, s/he has to put plausible assumptions regarding the way

that the dependent variable responds to the change in one or more
of the independent variables. By: Teklebirhan A. 21
Cont…

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Cont…

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Cont…

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Cont…

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 Cont…
 Conclusion:

 Specification of the model is the most important and the toughest

stage of any econometric analysis

 It is often the weakest point of most econometric applications.

 In this stage there exists enormous degree of likelihood of

committing errors or incorrectly specifying the model.

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 Cont…
 Some of the common reasons for incorrect specification of the
econometric models are:

 The imperfections, looseness of statements in theories.

 The limitation of our knowledge of the factors which are

operative in any particular case.

 The formidable obstacles presented by data requirements in the

estimation of large models.

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 Cont…
 The most common errors of specification are:

 Omissions of some important variables from the function.

 Omissions of some equations (for example, in simultaneous

equations model).

 The mistaken mathematical form of the functions.

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 Cont…
b) Estimation of the Model

 It is the process of obtaining reliable numerical estimates of the

parameters of the model.

 This stage is purely technical stage of econometric analysis which

requires good knowledge of various econometric methods/models:
their assumptions and their economic implications on estimates of
the parameters

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 Cont…
 This stage involves the following specific tasks:

a) Gathering appropriate data of the variables included in the model.

• collecting d/t types of data for estimation of a model.

b) Examination of the identification conditions of the function.

• involves a careful investigation of which function we are actually
estimating
c) Examination of the aggregation problems involved in the variables
of the function.

• Aggregation over individuals, commodities, time period,

spatial/geography of data “Aggregation bias” --use index
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 Cont…
d) Examination of the degree of correlation between the explanatory
variables of the model.

• Known as multi-co linearity

• The case Multivariate econometric analysis

e) Choice of appropriate econometric method/techniques for

estimation.

• Econometric methods are rules (formulae) which govern the best

way of determining the optimal numerical values of the
parameter estimates under various ground realities one actually
confront with. 31
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 Cont…
 In econometrics, based on various criteria, it is possible to identify
appropriate econometrics method of estimations.

 Based on the number of equations to be estimated, Econometric

methods are classified into two broad categories as:

a) single equation techniques of estimation

- the cause-and-effect r/nship b/n Y and the X’s is unidirectional
e.g, OLS, MM, Maximum likelihood models
b) simultaneous equation techniques of estimation
- the cause-and-effect r/nship b/n Y and the X’s is bidirectional
- in such models there is more than one equation
e.g, Wage–Price models, Demand-Supply models, etc.
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 Cont…
 The econometrics techniques to handle simultaneous equations
include
• Indirect Least squares (ILS),
• Full information maximum likelihood,
• Two Stage Least Squares (2SLS),
• Instrumental variable (IV) estimation and so on.
 Based on the nature of the dependent variable (i.e.,
Quantitative/Continuous vs. Qualitative/Discrete), Econometric
methods are classified into two broad categories as:

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 Cont…
a) Quantitative Response Regression Models:
 Used to estimate models where the regressand is a quantitative
variable as consumption expenditure, income, etc.

• Examples: Ordinary Least Squares (OLS), Two Stage Least

Squares (2SLS), Instrumental variable (IV), etc.
b) Qualitative Response Regression Models:
 Used to estimate models where the dependent variable is a
qualitative/indicator variable as Labor Force Participation, Likert
scale observations (Job/employee Satisfaction, etc).
• Examples: Logit/probit models, Multinomial Logit/Probit, and
Ordered Logit/Probit models.
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Types of Regression Models

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 Cont…
c) Evaluation of the Estimates

 Evaluation of the parameter estimates means determination of the

statistical and theoretical reliability of the parameter estimates
obtained from the application of a particular econometric method.

 At this stage, we need to inspect whether the estimates of the

model are theoretically meaningful and statistically satisfactory

 There are various criteria which we may use to judge on the

reliability of the estimates of an estimated model.

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 Cont…

E.g. The Standard Error test, Z-test, t- test, Confidence Interval Test/Approach

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 Cont…
d) Use the Model for Prediction and Decision Making

 The last stage of econometric analysis is to use the estimated

model for prediction and/or forecasting values for the dependent
variable.

 Prediction and forecasting helps to reduce future uncertainty.

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 Cont…
 Desirable Properties of an Econometric Model

 The ‘goodness’ of an econometric model is judged customarily

according to the following desirable properties.

 Theoretical plausibility.

 Explanatory ability.

 Accuracy of the estimates of the parameters. (est. par vs true par)

 Forecasting ability.

 Simplicity.

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 1.7 Nature and Sources of Econometrics Data
 Data are the foundations of any research.

 The success of any econometric analysis ultimately depends on the

availability of the appropriate data.

 Therefore, proper data collection, retention, and sharing are vital

to the research enterprise.

 Data refers to any group of facts, measurements, or observations

used to make inferences about the problem of investigation.

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 Cont…
A) Nature of Econometrics Data

 Four major types of data may be available for empirical analysis:

• Time series data,

• Cross-sectional data,

• Pooled data, and

• Panel data.

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 Cont…
 Cross-Sectional Data
 This data set consists of a sample of individuals, households, firms,
cities, countries or variety of any other unit, taken at a given point
in time. - information gathered only at one point in time;

 This data sets record a single or various attributes of all members of

the cross-sectional unit at a specific time.

 In a pure cross-sectional analysis, we would ignore any minor

timing differences in collecting the data;

 For example, if a set of families were surveyed during different

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 Cont…
 Cross-sectional data set are widely used in social sciences.

 It is closely connected with micro -analysis (micro management

research )

 For example

 Management problems of public enterprises (a case of METEC)

 Impact of product quality on sales volume of an organization (a

case study of East African bottling company)

 Salaries and wages administration as a tool for improving

employee’s performance in an organization.

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 Cont…
Table: 1.1: Monthly Household Consumption Expenditure (Y) and
Total Monthly Household Income (X) for 20 sample observations.

Observations Observations
1 2500 3000 11 3000 4000
2 4000 5000 12 3000 4000
3 4000 6000 13 4000 6000
4 1000 1600 14 7500 10000
5 7000 9000 15 7200 11000
6 1600 2000 16 1200 1500
7 2250 3000 17 4000 6000
8 4000 6500 18 4200 6000
9 2000 2500 19 8000 12000
10 7800 12000 20 4000 6000

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 Cont…
 Time Series Data

 A time-series data set consists of observations on a variable or set of

variables over time.

 Time series data is collected at regular time intervals as on

 monthly (e.g., unemployment rate, CPI)

 quarterly (e.g., GDP),

 semi-annually and annually (e.g., GDP, government budgets).

 Unlike cross-sectional data set, the chronological ordering of

observations in a time-series conveys important information
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 Cont…
Table: 1.2: Annual Data on Real Gross Domestic Product (Y), Real Government
Expenditure (G), and Broad Money Supply (M2), from 2010-2016, all in Billions of Birr.

Year 2016 2017 2018 2019 2020 2021 2022

RGDP (Y) 466.2 517 568 627 692 747 1,577

Government Spending (G) 3.8 124.4 153.9 185.5 230.5 272.9 329.3

Money Supply (M2) 145.4 189.4 235.3 297.7 371.3 445.2 145.4

 In economics, time series data sets are closely linked with macro-
analysis (macro management research ).

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Cont…

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 Cont…
 For instance, to investigate questions like

 Determinants of current inflation in Ethiopia;

 How inflation affects the short and long-run economic growth

of the country?;

 What is the effect of devaluation on the trade balance of the

country?;

 How government expenditure and money supply affects growth

of a country?;

 What are the possible effects of financial market liberalization

in Ethiopia? By: Teklebirhan A. 48
 Cont…
 Pooled Data

 Pooled or combined data combines the elements of both time series

and cross-section data.

 An example is a data set where a number of firms are randomly

selected, say in 2009, and another sample is selected in 2010. (I.e.,
data consist of two different random samples). If in both samples
the same features are measured, combining both years forms a
pooled data.

 Usually the interest is whether there are some important changes

between the time points.
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 Cont…
 Panel Data (Longitudinal Data):

 This is a special type of pooled data in which the same cross-

sectional unit (say, a household or a firm) is surveyed over time.

 Panel data contain observations of multiple phenomena obtained

over multiple time periods for the same firms or individuals.

 By interviewing the same household periodically, the panel data

provides very useful information on the dynamics of household
behavior.

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 Cont…
Table: 1.3: Hypothetical Panel Data

Person Year Sex Age Income/Year Saving/Year Owned House

1 2000 Male 20 30000 6000 No
1 2005 Male 25 48000 18000 No
1 2010 Male 30 144000 72000 Yes
2 2000 Female 22 24000 8400 No
2 2005 Female 27 72000 30000 Yes
2 2010 Female 32 120000 60000 Yes
3 2000 Male 18 48000 19200 No
3 2005 Male 23 72000 24000 No
3 2010 Male 28 72000 30000 Yes

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 Cont…
 Dummy variable(s) data

 These variables are constructed by econometricians themselves.

 When the variables are qualitative in nature, which are difficult to

measure quantitatively, then researcher records the data in the
form of indicator/dummy/ variable.

 The values of the variables do not reflect the magnitude of data.

• They reflect only the presence/absence of a characteristic.

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 Cont…
 For example, in the analysis of the Determinants of Work
performance; along with relevant quantifiable variables, non-
quantifiable variables such as sex, race and religious background
are also important variables which possibly explain performance
variation across workers.

 But these variables cannot be measured quantitatively and hence

impossible to get quantitative data of such important variables for a
particular cross-sectional unit.

 The variable `sex’ takes two values - these values can be

represented as ‘1’ represents male and ‘0’ represents female.
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 Cont…
B) Sources of Data for Econometrics Analysis
 Data for econometrics analysis can be acquired from two sources:

 Secondary sources of data include data which has been collected by

someone else.
 Some examples include:
 The labor force survey of Central Statistical Agency,

 Quarterly financial sector reports of the National Bank of Ethiopia,

 Ethiopian economy databases of the Ethiopian Economic Association,

 Annual data of the Ethiopian Revenue and Customs authority,

 Data from international agencies (e.g., the International Monetary Fund (IMF),
the World Bank (WB), World Trade Organization (WTO), …etc.
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 Cont…
 Primary sources of data are a fresh collected by the researcher or
team of researchers for the first time (original).

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