The Nature of

Chapter 1
Econometrics
and Economic
Data
The Nature of Econometrics
and Economic Data
● What is econometrics?
• Econometrics = 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
• Forecasting economic variables
• Evaluating and implementing government and business policy
The Nature of Econometrics
and Economic Data
● 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, …
The Nature of Econometrics
and Economic Data
● Economic model of crime (Becker (1968))
• Derives equation for criminal activity based on utility maximization

Hours spent in
criminal activities

Age
“Wage” of cri-
minal activities Probability of Expected
Wage for legal
employment Other Probability of conviction if sentence
income getting caught caught

• Functional form of relationship not specified

The Nature of Econometrics
and Economic Data
● Model of job training and worker productivity
• What is effect of additional training on worker productivity?
• Formal economic theory not really needed to derive equation:

Hourly wage

Years of formal
education Weeks spent
Years of work- in job training
force experience
The Nature of Econometrics
and Economic Data
● Econometric model of criminal activity
• The functional form has to be specified
• Variables may have to be approximated by other quantities

Measure of cri- Wage for legal Other Frequency of

minal activity employment income prior arrests
Unobserved deter-
minants of criminal
activity

e.g. moral character,

wage in criminal activity,
Frequency of Average sentence Age family background …
conviction length after conviction
The Nature of Econometrics
and Economic Data
● Econometric model of job training and worker productivity

Unobserved deter-
minants of the wage

e.g. innate ability,

Hourly wage Years of formal Years of work- Weeks spent quality of education,
education force experience in job training family background …

● Most of econometrics deals with the specification of the error

● Econometric models may be used for hypothesis testing

• For example, the parameter represents “effect of training on
wage”
• How large is this effect? Is it different from zero?
The Nature of Econometrics
and Economic Data
● Econometric analysis requires data

● 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
The Nature of Econometrics
and Economic Data
● Cross-sectional data sets
• Sample of individuals, households, firms, cities, states, countries,
or other units of interest at a given point of time/in a given period
• Cross-sectional observations are more or less independent
• For example, pure random sampling from a population
• Sometimes pure random sampling is violated, e.g. units refuse to
respond in surveys, or if sampling is characterized by clustering
• Cross-sectional data typically encountered in applied
microeconomics
The Nature of Econometrics
and Economic Data
● Cross-sectional data set on wages and other characteristics

Indicator variables
(1 = yes, 0 = no)

Observation number Hourly wage Years of Years of

education experience
The Nature of Econometrics
and Economic Data
● Cross-sectional data on growth rates and country
characteristics

Average growth rate of real Government consumption Adult secondary

per capita GDP as a percentage of GDP education rates
The Nature of Econometrics
and Economic Data
● Time series data
• Observations of a variable or several variables over time
• For example, stock prices, money supply, consumer price index,
gross domestic product, annual homicide rates, automobile sales, …
• Time series observations are typically serially correlated
• Ordering of observations conveys important information
• Data frequency: daily, weekly, monthly, quarterly, annually, …
• Typical features of time series: trends and seasonality
• Typical applications: applied macroeconomics and finance
The Nature of Econometrics
and Economic Data
● Time series data on minimum wages and related variables

Average minimum Average Unemployment Gross national

wage for the given year coverage rate rate product
The Nature of Econometrics
and Economic Data
● 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 often used to evaluate policy changes
• Example:
• Evaluate 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)
The Nature of Econometrics
and Economic Data
● Pooled cross sections on housing prices
Property tax
Size of house
in square feet
Number of bedrooms
Number of bathrooms

Before reform

After reform
The Nature of Econometrics
and Economic Data
● 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
The Nature of Econometrics
and Economic Data
● Two-year panel data on city crime statistics

Each city has two time

series observations

Number of
police in 1986

Number of
police in 1990
The Nature of Econometrics
and Economic Data
● Causality and the notion of ceteris paribus
Definition of causal effect of on :

“How does variable change if variable is changed

but all other relevant factors are held constant”

● 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
The Nature of Econometrics
and Economic Data
● 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 etc. are held fixed

● Experiment:
• 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
The Nature of Econometrics
and Economic Data
● 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 etc. are held fixed

● Experiment:
• 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)
The Nature of Econometrics
and Economic Data
● 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:
• Randomly assign number of police officers to a large number of
cities
• In reality, number of police officers will be determined by crime rate
(simultaneous determination of crime and number of police)
The Nature of Econometrics
and Economic Data
● 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:
• Government randomly chooses minimum wage each year and
observes unemployment outcomes
• Experiment will 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
The Nature of Econometrics
and Economic Data
● 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-months T-bill

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