ECONOMICS 351*-A
ANSWERS to Mid-Term Exam -- Fall 2002
Page 1 of 12 pages
QUEEN'S UNIVERSITY AT KINGSTON
Department of Economics
ECONOMICS 351* - Section A
Introductory Econometrics
Fall Term 2002
MID-TERM EXAM ANSWERS
M.G. Abbott
DATE:
Monday October 28, 2002.
TIME:
80 minutes; 2:30 p.m. - 3:50 p.m.
INSTRUCTIONS:
The exam consists of SIX (6) questions. Students are required to answer
ALL SIX (6) questions.
Answer all questions in the exam booklets provided. Be sure your name
and student number are printed clearly on the front of all exam booklets
used.
Do not write answers to questions on the front page of the first exam
booklet.
Please label clearly each of your answers in the exam booklets with the
appropriate number and letter.
Please write legibly.
A table of percentage points of the t-distribution is given on the last page
of the exam.
MARKING:
The marks for each question are indicated in parentheses immediately
above each question. Total marks for the exam equal 100.
QUESTIONS:
Answer ALL SIX questions.
All questions pertain to the simple (two-variable) linear regression model for which the
population regression equation can be written in conventional notation as:
Yi = β 1 + β 2 X i + u i
(1)
where Yi and Xi are observable variables, β 1 and β 2 are unknown (constant) regression
coefficients, and ui is an unobservable random error term. The Ordinary Least Squares (OLS)
sample regression equation corresponding to regression equation (1) is
Yi = β$ 1 + β$ 2 X i + u$ i
(i = 1, ..., N)
(2)
where β$ 1 is the OLS estimator of the intercept coefficient β 1 , β$ 2 is the OLS estimator of the
slope coefficient β , u$ is the OLS residual for the i-th sample observation, Ŷ = βˆ + βˆ X is
2
i
i
1
2
i
the OLS estimated value of Y for the i-th sample observation, and N is sample size (the number
of observations in the sample).
ECON 351*-A (Fall Term 2002): Answers to Mid-Term Exam
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ECONOMICS 351*-A
ANSWERS to Mid-Term Exam -- Fall 2002
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(15 marks)
1. State the Ordinary Least Squares (OLS) estimation criterion. State the OLS normal
equations. Derive the OLS normal equations from the OLS estimation criterion.
ANSWER:
(3 marks)
• State the Ordinary Least Squares (OLS) estimation criterion.
(3 marks)
The OLS coefficient estimators are those formulas or expressions for βˆ 1 and βˆ 2 that
minimize the sum of squared residuals RSS for any given sample of size N.
The OLS estimation criterion is therefore:
(
)
N
N
i =1
i=1
(
Minimize RSS βˆ 1 , βˆ 2 = ∑ û i2 = ∑ Yi − βˆ 1 − βˆ 2 X i
)
2
{ βˆ j }
(4 marks)
• State the OLS normal equations.
(4 marks)
The first OLS normal equation can be written in any one of the following forms:
∑ i Yi − Nβˆ 1 − βˆ 2 ∑ i X i = 0
− Nβˆ 1 − βˆ 2 ∑ i X i = − ∑ i Yi
Nβˆ + βˆ ∑ X = ∑ Y
1
2
i
i
i
(N1)
i
The second OLS normal equation can be written in any one of the following forms:
∑ i X i Yi − βˆ 1 ∑ i X i − βˆ 2 ∑ i X i2 = 0
− βˆ 1 ∑ i X i − βˆ 2 ∑ i X i2 = − ∑ i X i Yi
βˆ 1 ∑ i X i + βˆ 2 ∑ i X i2 = ∑ i X i Yi
ECON 351*-A (Fall Term 2002): Answers to Mid-Term Exam
(N2)
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ECONOMICS 351*-A
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ANSWERS to Mid-Term Exam -- Fall 2002
Question 1 (continued)
(8 marks)
• Show how the OLS normal equations are derived from the OLS estimation criterion.
(4 marks)
Step 1: Partially differentiate the RSS βˆ 1, βˆ 2 function with respect to βˆ 1 and βˆ 2 , using
(
û i = Yi − βˆ 1 − βˆ 2 X i
⇒
)
∂ û i
= −1
∂βˆ
∂ û i
= −X i .
∂βˆ
and
2
1
N
N
 ∂û  N
∂RSS N
= ∑ 2û i  i  = ∑ 2 û i (− 1) = −2 ∑ û i = −2 ∑ Yi − βˆ 1 − βˆ 2 X i
 ∂βˆ  i =1
∂βˆ 1
i =1
i =1
i =1
 1
(
∂RSS
=
∂βˆ
2
 ∂û
∑ 2û i  ˆ i
i =1
 ∂β 2
N
= −2

 =


N
N
i =1
i =1
(1)
∑ 2û i (− X i ) = −2 ∑ X i û i
∑ X i (Yi − βˆ 1 − βˆ 2 X i )
N
since û i = Yi − βˆ 1 − βˆ 2 X i
i =1
= −2
)
(2)
∑ (X i Yi − βˆ 1 X i − βˆ 2 X i2 ).
N
i =1
(4 marks)
Step 2: Obtain the first-order conditions (FOCs) for a minimum of the RSS function by
setting the partial derivatives (1) and (2) equal to zero and then dividing each equation
by −2 and re-arranging:
∂RSS
=0
∂βˆ
⇒ − 2 ∑ i û i = 0
(
)
⇒ − 2 ∑ i Yi − βˆ 1 − βˆ 2 X i = 0
1
(
)
⇒ ∑ i Yi − βˆ 1 − βˆ 2 X i = 0
⇒ ∑ i Yi − Nβˆ 1 − βˆ 2 ∑ i X i = 0
⇒ ∑ Y = Nβˆ + βˆ ∑ X
i
∂RSS
=0
∂βˆ
i
1
2
i
(N1)
i
(
)
⇒ − 2 ∑ i X i û i = 0 ⇒ − 2 ∑ i X i Yi − βˆ 1 − βˆ 2 X i = 0
2
(
)
⇒ ∑ i X i Yi − βˆ 1 − βˆ 2 X i = 0
⇒ ∑ i X i Yi − βˆ 1X i − βˆ 2 X i2 = 0
⇒ ∑ i X i Yi − βˆ 1 ∑ i X i − βˆ 2 ∑ i X i2 = 0
(
)
⇒ ∑ i X i Yi = βˆ 1 ∑ i X i + βˆ 2 ∑ i X i2
ECON 351*-A (Fall Term 2002): Answers to Mid-Term Exam
(N2)
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ECONOMICS 351*-A
ANSWERS to Mid-Term Exam -- Fall 2002
Page 4 of 12 pages
(15 marks)
2. Show that the OLS slope coefficient estimator β$ 2 is a linear function of the Yi sample
values. Stating explicitly all required assumptions, prove that the OLS slope coefficient
estimator β$ 2 is an unbiased estimator of the slope coefficient β 2 .
(5 marks)
• Show that the OLS slope coefficient estimator β$ 2 is a linear function of the Yi sample
values.
Y ∑i x i
∑ x y
∑ x (Y − Y )
∑ x Y
= i i2i −
βˆ 2 = i i 2 i = i i i 2
∑i x i
∑i x i
∑i xi
∑ i x i2
=
∑ i x i Yi
because ∑ i x i = 0
∑ i x i2
= Σ i k i Yi
where k i ≡
xi
Σ i x i2
(5 marks)
.
(10 marks)
• Stating explicitly all required assumptions, prove that the OLS slope coefficient estimator
β$ 2 is an unbiased estimator of the slope coefficient β 2 .
(1) Substitute for Yi the expression Yi = β1 + β 2 X i + u i from the population regression
(5 marks)
equation (or PRE).
βˆ 2 = ∑ i k i Yi
= ∑ i k i (β1 + β 2 X i + u i )
sin ce Yi = β1 + β 2 X i + u i by assumption (A1)
= ∑ i (β1k i + β 2 k i X i + k i u i )
= β1 ∑ i k i + β 2 ∑ i k i X i +∑ i k i u i
= β2 + ∑i k i u i ,
since ∑ i k i = 0 and ∑ i k i X i = 1
(2) Now take expectations of the above expression for βˆ 2 :
(5 marks)
E(βˆ 2 ) = E (β 2 ) + E[∑ i k i u i ]
= β 2 + ∑ i k i E(u i )
since β 2 is a constant and the k i are nonstochastic
= β2 + ∑i k i 0
since E(u i ) = 0 by assumption (A2)
= β2 .
ECON 351*-A (Fall Term 2002): Answers to Mid-Term Exam
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ECONOMICS 351*-A
ANSWERS to Mid-Term Exam -- Fall 2002
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(10 marks)
3. Answer parts (a) and (b) below.
(a) Write the expression (or formula) for Var(βˆ 2 ) , the variance of β$ 2 .
(5 marks)
ANSWER:
Var (βˆ 2 ) =
σ2
N
∑
i =1
x i2
=
σ2
N
∑ (X i − X )
where
x i ≡ X i − X , i = 1, …, N
2
i =1
(b) Which of the following factors makes Var(βˆ 2 ) smaller?
(5 marks)
ANSWER: Correct answers are highlighted in bold.
(1) a smaller value of N, sample size
(2) smaller values of x i2 = (X i − X ) 2 , i = 1, …, N
(3) a larger value of σ 2 , the error variance
(4) a smaller value of σ 2 , the error variance
(5) a larger value of N, sample size
(6) larger values of x i2 = (X i − X ) 2 , i = 1, …, N
ECON 351*-A (Fall Term 2002): Answers to Mid-Term Exam
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ECONOMICS 351*-A
ANSWERS to Mid-Term Exam -- Fall 2002
Page 6 of 12 pages
(10 marks)
4. Explain what is meant by each of the following statements about the estimator θˆ of the
population parameter θ.
(a) θ̂ is an unbiased estimator of θ.
(b) θ̂ is an efficient estimator of θ.
ANSWER:
(5 marks)
ˆ is an unbiased estimator of θ.
• (a) θ
θ̂ is an unbiased estimator of θ if the mean, or expectation, of the estimator θ̂ equals the true
parameter value θ for any finite sample size n < ∞.
E( θ̂ ) = θ
⇒
Bias( θ̂ ) ≡ E( θ̂ ) − θ = 0.
The condition E( θ̂ ) = θ says that the sampling distribution of the estimator θ̂ is centered on
the true parameter value θ, that on average the estimator θ̂ is correct.
(5 marks)
• (b) θ̂ is an efficient estimator of θ.
The estimator θˆ is an efficient estimator if it is unbiased and has smaller variance than any
other unbiased estimator of the parameter θ.
~
If θ is any other unbiased estimator of θ, then θ̂ is an efficient estimator of θ if
~
Var( θˆ ) ≤ Var( θ )
~
where E( θˆ ) = θ and E( θ ) = θ.
Note: Answer must recognize that unbiasedness is a necessary condition for efficiency.
ECON 351*-A (Fall Term 2002): Answers to Mid-Term Exam
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ECONOMICS 351*-A
ANSWERS to Mid-Term Exam -- Fall 2002
Page 7 of 12 pages
(34 marks)
5. A researcher is using data for a sample of 25 business schools that offer MBA degrees to
investigate the relationship between the annual salary gain of graduates Yi (measured in
thousands of dollars per year) and annual tuition fees Xi (measured in thousands of dollars
per year). Preliminary analysis of the sample data produces the following sample
information:
N
N
∑ Yi = 1,034.97
N = 25
i =1
N
N
∑ X i = 528.599
∑ Yi2 = 45,237.19
i =1
i =1
N
N
∑ X i2 = 11,432.92
∑ X i Yi = 22,250.54
∑ x i y i = 367.179
∑ y i2 = 2,390.67
∑ x i2 = 256.241
∑ ŷ i2 = 526.147
i =1
N
i =1
i =1
N
i =1
N
i =1
i =1
where x i ≡ X i − X , y i ≡ Yi − Y and yˆ i ≡ Ŷi − Y for i = 1, ..., N. Use the above sample
information to answer all the following questions. Show explicitly all formulas and
calculations.
(10 marks)
(a) Use the above information to compute OLS estimates of the intercept coefficient β 1
and the slope coefficient β 2 .
•
∑ x y 367.179
βˆ 2 = i i 2 i =
= 1.4329 = 1.433
256.241
∑i x i
•
βˆ 1 = Y − βˆ 2 X
(5 marks)
N
Y =
∑ Yi
i =1
N
N
1034.97
=
= 41.3988
25
and
X =
∑ Xi
i =1
N
=
528.599
= 21.1440
25
Therefore
βˆ 1 = Y − β 2 X = 41.3988 − (1.4329)(21.1440) = 41.3988 − 30.2972 = 11.101
(5 marks)
ECON 351*-A (Fall Term 2002): Answers to Mid-Term Exam
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ECONOMICS 351*-A
ANSWERS to Mid-Term Exam -- Fall 2002
Page 8 of 12 pages
(6 marks)
(b) Interpret the slope coefficient estimate you calculated in part (a) -- i.e., explain in words
what the numeric value you calculated for β$ 2 means.
Note: β$ 2 = 1.433. Yi is measured in thousands of dollars, and Xi is measured in
thousands of dollars.
The estimate 1.433 of β2 means that an increase (decrease) in tuition Xi of 1,000 dollars
is associated on average with an increase (decrease) in MBA graduates' annual salary
gain equal to 1.433 thousand dollars, or 1,433 dollars.
(6 marks)
(c) Calculate an estimate of σ2, the error variance.
RSS =
N
∑ û i2 =
i =1
N
∑ yi2 −
i =1
N
∑ ŷ i2
= 2,390.67 − 526.147 = 1,864.523
i =1
N
σˆ 2 =
∑ û i2
RSS
1,864.523 1,864.523
= i=1
=
=
= 81.0662
N−2
N−2
25 − 2
23
(6 marks)
(d) Compute the value of R 2 , the coefficient of determination for the estimated OLS
sample regression equation. Briefly explain what the calculated value of R 2 means.
N
R2 =
∑ ŷi2
ESS
=
TSS
i =1
N
∑
i =1
=
y i2
526.147
= 0.220083 = 0.2201
2390.67
(4 marks)
Interpretation of R2 = 0.2201: The value of 0.2201 indicates that 22.01 percent of
the total sample (or observed) variation in Yi (annual salary gain of graduates) is
attributable to, or explained by, the regressor Xi (annual tuition fees).
(2 marks)
(6 marks)
(e) Compute the estimated variance of β$ 2 and the estimated standard error of β$ 2 .
Vâr (βˆ 2 ) =
σˆ 2
N
∑
i =1
sê(βˆ 2 ) =
x i2
=
81.0662
= 0.316367
256.241
Vâr (βˆ 2 ) =
0.316367 = 0.562465
ECON 351*-A (Fall Term 2002): Answers to Mid-Term Exam
(4 marks)
(2 marks)
Page 8 of 12 pages
ECONOMICS 351*-A
ANSWERS to Mid-Term Exam -- Fall 2002
Page 9 of 12 pages
(16 marks)
6. You have been commissioned to investigate the relationship between annual R&D
expenditures (Y) and total annual sales revenues (X) for chemical firms. You have assembled
data for a sample of 32 chemical firms, where Yi is annual R&D expenditures of the i-th firm
(measured in millions of dollars per year) and Xi is total annual sales revenues of the i-th firm
(measured in millions of dollars per year). Your research assistant has used the sample data
to estimate the following OLS sample regression equation, where the figures in parentheses
below the coefficient estimates are the estimated standard errors of the coefficient estimates:
Yi = − 0.5772 + 0.04063 X i + û i
(20.515) (0.0024487)
(i = 1, ..., N)
N = 32
(3)
(8 marks)
(a) Compute the two-sided 95% confidence interval for the slope coefficient β 2 .
The two-sided (1 − α)-level, or 100(1 − α) percent, confidence interval for β2 is
computed as
βˆ 2 − t α / 2 [ N − 2] sê(βˆ 2 ) ≤ β 2 ≤ βˆ 2 + t α 2 [ N − 2] sê(βˆ 2 )
(2 marks)
where
•
βˆ 2 L = βˆ 2 − t α 2 [ N − 2] sê(βˆ 2 ) = the lower 100(1 − α)% confidence limit for β2
βˆ 2 U = βˆ 2 + t α 2 [ N − 2] sê(βˆ 2 ) = the upper 100(1 − α)% confidence limit for β2
•
t α 2 [ N − 2] = the α/2 critical value of the t-distribution with N−2 degrees of
•
freedom.
•
Required results and intermediate calculations:
N − k = 32 − 2 = 30;
β$ 2 = 0.04063;
1 − α = 0.95 ⇒ α = 0.05 ⇒ α/2 = 0.025:
sê(βˆ 2 ) = 0.0024487
t α 2 [ N − 2] = t0.025[30] = 2.042
t α 2 [ N − 2] sê(βˆ 2 ) = t 0.025 [30] sê(βˆ 2 ) = 2.042(0.0024487) = 0.005000245
•
Lower 95% confidence limit for β2 is:
(3 marks)
βˆ 2 L = βˆ 2 − t α 2 [ N − 2] sê(βˆ 2 ) = βˆ 2 − t 0.025 [30] sê(βˆ 2 )
= 0.04063 − 2.042(0.002487) = 0.04063 − 0.005000245 = 0.035630 = 0.03563
ECON 351*-A (Fall Term 2002): Answers to Mid-Term Exam
Page 9 of 12 pages
ECONOMICS 351*-A
ANSWERS to Mid-Term Exam -- Fall 2002
Page 10 of 12 pages
Question 6(a) -- continued
•
Upper 95% confidence limit for β2 is:
(3 marks)
βˆ 2 U = βˆ 2 + t α 2 [ N − 2] sê(βˆ 2 ) = βˆ 2 + t 0.025 [30] sê(βˆ 2 )
= 0.04063 + 2.042(0.002487) = 0.04063 + 0.005000245 = 0.045630 = 0.04563
•
Result: The two-sided 95% confidence interval for β2 is:
[0.03563, 0.04563]
(8 marks)
(b) Perform a test of the null hypothesis H0: β 2 = 0 against the alternative hypothesis H1:
β 2 ≠ 0 at the 1% significance level (i.e., for significance level α = 0.01). Show how you
calculated the test statistic. State the decision rule you use, and the inference you would
draw from the test. Briefly explain what the test outcome means.
H0: β2 = 0
H1: β2 ≠ 0
a two-sided alternative hypothesis ⇒ a two-tailed test
•
βˆ − β 2
Test statistic is t (βˆ 2 ) = 2
~ t[ N − 2] .
sê(βˆ 2 )
•
β̂2 = 0.04063 and sê(βˆ 2 ) = 0.0024487.
•
Calculate the sample value of the t-statistic (1) under H0: set β2 = 0 in (1).
•
(1)
βˆ − β 2 0.04063 − 0.0
0.04063
= 16.5925 = 16.59
t 0 (βˆ 2 ) = 2
=
=
0.0024487
0.0024487
sê(βˆ 2 )
(3 marks)
Null distribution of t 0 (βˆ 2 ) is t[N − 2] = t[32 − 2] = t[30].
(1 mark)
Decision Rule: At significance level α,
•
(1 mark)
reject H0 if t 0 (βˆ 2 ) > t α 2 [30] ,
i.e., if either (1) t 0 (βˆ 2 ) > t α 2 [30] or (2) t 0 (βˆ 2 ) < − t α 2 [30] ;
•
retain H0 if t 0 (βˆ 2 ) ≤ t α 2 [30] , i.e., if − t α 2 [30] ≤ t 0 (βˆ 2 ) ≤ t α 2 [30] .
ECON 351*-A (Fall Term 2002): Answers to Mid-Term Exam
Page 10 of 12 pages
ECONOMICS 351*-A
ANSWERS to Mid-Term Exam -- Fall 2002
Page 11 of 12 pages
Question 6(b) -- continued
Critical value of t[30]-distribution: from t-table, use df = 30.
•
two-tailed 1 percent critical value = t α 2 [30] = t0.005[30] = 2.750
Inference:
♦
(1 mark)
(1 mark)
At 1 percent significance level, i.e., for α = 0.01,
t 0 (βˆ 2 ) = 16.59 > 2.750 = t0.005[30] ⇒ reject H0 vs. H1 at 1 percent level.
♦
Inference: At the 1% significance level, the null hypothesis β2 = 0 is rejected in
favour of the alternative hypothesis β2 ≠ 0.
Meaning of test outcome:
(1 mark)
Rejection of the null hypothesis β2 = 0 against the alternative hypothesis β2 ≠ 0 means
that the sample evidence favours the existence of a relationship between annual R&D
expenditures and total annual sales revenues.
ECON 351*-A (Fall Term 2002): Answers to Mid-Term Exam
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ECONOMICS 351*-A
ANSWERS to Mid-Term Exam -- Fall 2002
Page 12 of 12 pages
Percentage Points of the t-Distribution
ECON 351*-A (Fall Term 2002): Answers to Mid-Term Exam
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