# Ch. 3 Simple Linear Regression

```Ch. 3 Simple Linear Regression
1.
To estimate relationships among
economic variables, such as
y = f(x) or c = f(i)
2.
relationships, such as: is the marginal
propensity to consume less than 1.0:
dc/di &lt; 1 (do people save?)
3.
To Forecast/predict the value of one
variable based on the value of another
variable, such as: what will consumer
spending be next year?
3.1
Population Regression Function
Y: dependent variable: the variable whose behavior we seek to
explain
X: independent variable: the variable that determines (in part)
the variation in the dependent variable
1) the deterministic portion:
β1 + β2 x
2) the stochastic portion: e
Population Regression Function is:
y = β1 + β 2 x + e
3.2
Example: Weekly Food Expenditures
yt = dollars spent each week on food items by household t
xt = weekly income of household t
Suppose we believe x and y have a linear, causal relationship
whereby variation in x “causes” variation in y:
y = β1 + β 2 x
However, it is unlikely that the relationship will be exact. We
need to allow for an error term, e:
y = β1 + β 2 x + e
3.3
The Error Term
3.4
The presence of the (unobservable) error term drives much of
what we do.
Suppose (incorrectly) the relationship between X and Y did not
have an error term.
Suppose β1 = 30 and β2 = 0.15
Then for families with x = \$480 
Y = β1 + β2x = 30 + 0.15(480) = \$102
This means all families with a weekly income of \$480 will
spend \$102 per week on food. Very unlikely.
More likely to see variation in weekly food expenditures for
the group of families who earn \$480 per week (or any other
\$\$ amount)
The Error Term (con’t)
3.5
Y is a random variable because it is the sum of non-random variable:
(β1 + β2x ) and a random variable: (e)
The error term (e) picks up:
1. Omitted variables (unspecified factors ) that influence the dependent
variable
2. Effects of a non-linear relationship between Y and X
3. Unpredictable random behavior that is be unique to that observation is in
error. (the model is one of behavior)
Use Rules of Mathematical Expectation
From Chapter 2, you learned the following rules of
mathematical expectation (the E(.) operator)
Suppose that Z is the random variable: E(Z + a) = E(Z) + a
where a is a constant (has no randomness)
Suppose that b is also a constant:
E(bZ + a) = bE(Z) + a
In both of these rules, we see how the E(.) operator moves thru
and stops on random variables, not on constants
3.6
Assumptions of the Model
1.
The value of y, for each value of x, is
y = 1 + 2x + e
the model is linear in the parameters ()
and the error term is additive
2.
The average value of the random error e is:
E(e) = 0 
3.
The variance of the random error e is:
var(e) = 2
var(y) = 2 Homosckedastic

4.
The error term is serially independent (uncorrelated with itself)
cov(ei ,ej) = cov(yi ,yj) = 0
(Serial independence)
3.7
Assumptions of the Model (con’t)
5.
The variable X is not random and must take at least two different
values
 COV(X,e) = 0 [or E(Xe) = 0 b/c E(e) = 0 by assumption 2]
6.
(optional) e is normally distributed with mean 0, var(e)=2
e ~ N(0,2)
3.8
3.9
f(yt)
.
.
x1=480
x2=800
income
The probability density function for yt at two
levels of household income, x t
xt
Goal of Regression Analysis
The economic model is …
E(y|x) = β1 + β2x
The econometric model is…
y = β1 + β2x + e
We want to estimate this mean.
This mean is just a line with an intercept and slope.
1 measures E(y|x = 0)
2 measures the change in E(y) from a change in x
E ( y | x) dE ( y | x)
2 

x
dx
3.10
f(.)
3.11
f(e)
f(y)
0
1+2x
Probability density function for e and y
The Framework
Population regression values:
y t = 1 + 2 x t + e t
(Data on yt are generated by this econometric model)
Population regression line is the mean of y
E(y t|x t) = 1 + 2x t
The parameters of the model are:
1 the intercept
2 the slope
2 the variance of the error term (et)
3.12
The Estimation:
3.13
• The parameters 1, 2, and 2 are unknown to us and must be
estimated.
• Take a sample of data on X and Y
• The idea is to fit a line through the data points. Call this line
the Sample Regression Line:
^y = b + b x
t
1
2 t
where b1 be the estimator for 1 and b2 the estimator for 2.
• Define a Residual as:
^e = y – ^y
t
t
t
it measures the difference between actual y value and the
“fitted” (or “predicted”) value.
3.14
y = expendture
Table 3.1 Food Expenditure Data
300
200
Y
100
0
0
500
1000
x = income
1500
Estimating the Population Regression Line:The Least
Squares Principle
• Any line through the data points will generate a set of residuals.
• We want the line that generates the smallest residuals.
• The smallest residuals are those whose sum of squares is the smallest.
We call it the Method of Least Squares
3.15
Obtaining the Least Squares Estimates
To obtain the Least Squares
estimates of 1 and 2 we will find
the values of the slope and intercept
of a line that minimizes the sum of
squared residuals using calculus.
This will provide us with formulas,
called the least squares estimators,
that we can use in any regression
problem.
3.16
3.17
yt  1   2 xt  et
et  yt  1   2 xt
The sum of squared deviations:
T
T
t 1
t 1
S ( 1 ,  2 )   et2   ( yt  1   2 xt ) 2
Minimize this sum with respect to 1 and 2 by
taking the first derivative twice: once with respect to
1 and again with respect to 2:
T
S ( 1 ,  2 )   ( yt  1   2 xt ) 2
t 1
S (.)
 2 ( yt  1   2 xt )
1
S (.)
 2 ( yt  1   2 xt )xt
 2
When these two terms are set to zero,
1 and 2 become b1 and b2 because they no longer
represent just any value of 1 and 2 but the special
values that correspond to the minimum of S() 
3.18
#1
 2 ( yt  b1  b2 xt )  0
3.19
#2  2 ( yt  b1  b2 xt ) xt  0
We have two equations and two unknowns (b1 and b2). Therefore,
solve these two equations for b1 and b2.
 2 ( yt  b1  b2 xt )  0
 ( yt  b1  b2 xt )  0
 yt   b1   b2 xt  0
 yt  Tb1  b2  xt  0
y
b1
t
 b2  xt  Tb1
y


T
t

b2  xt
T
Now solve #2 for b2 and substitute in our formula for b1
 2 ( yt  b1  b2 xt ) xt  0
 ( yt  b1  b2 xt ) xt  0
 ( yt xt  b1xt  b2 xt xt )  0
2
y
x

b
x

b
x
 t t  1 t  2 t 0
2
y
x

b
x

b
x
 t t 1 t 2  t  0
yt
xt


b
) x
y x (
t t
2
t
 b2  xt2  0
T
T
yt  xt
xt  xt


2
y
x


b

b
x
 t t
2
2 t  0
T
T
yt  xt
xt  xt


2
y
x


b
(

x
 t t

2
t )0
T
T
3.20
y x



xt  xt

2
 b2   xt 
 yt xt
T
T

yt  xt

 yt xt  T
b2 
xt  xt

2
 xt  T
T  yt xt   yt  xt
b2 
2
2
T  xt   xt 
t
or:
t
And from slide 3.25:
b1
y


T
t

b2  xt
T
 yt  b2 xt

0


3.21
Estimates for Food Expenditure Data
b2  0.1283
b1  40.7676
yˆ t  40.7676  .1283xt
How do we interpret these estimates?
3.22
3.23
Regression of food expenditure on
income
^y = 0.1283x + 40.768
300
200
Y
Y
100
0
0
500
1000
X
1500
Linear
(Predicted Y)
Regression Terminology
Concept
Definition
Dependent variable (y)
The variable whose behavior we
want to model
Independent variable (x)
The variable that we believe
determines the dependent variable
Parameters (coefficients) β1 and β2
Defines the nature of the relationship
between Y and X
Random error term (e)
We expect the relationship between
X and Y to have a random element.
Estimators b1 and b2
Formulas explaining how to combine
the sample data on X and Y to
estimate the intercept and slope
Fitted line ^yt = b1 + b2xt
Predicted values for Y, using the
estimates of intercept and slope
Residual ^et = yt - ^
yt
Difference between actual and
predicted values of Y
3.24
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