Introductory Econometrics: A Modern Approach (7e)

Chapter 4
The Simple Regression Model

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Introductory Econometrics: A Modern Approach (7e)

The Simple Regression Model (24 of 39)

• Standard assumptions for the linear regression model
• Assumption SLR.1 (Linear in parameters)

• Assumption SLR.2 (Random sampling)

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Introductory Econometrics: A Modern Approach (7e)

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• Discussion of random sampling: Wage and education
• The population consists, for example, of all workers of country A
• In the population, there is a linear relationship between wages (or log wages)
and years of education.
• Draw completely randomly a worker from the population
• The wage and the years of education of the worker drawn are random because
one does not know beforehand which worker is drawn.
• Throw that worker back into the population and repeat the random draw n
times.
• The wages and years of education of the sampled workers are used to estimate
the linear relationship between wages and education.

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Introductory Econometrics: A Modern Approach (7e)

The Simple Regression Model (26 of 39)

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Introductory Econometrics: A Modern Approach (7e)

The Simple Regression Model (27 of 39)

• Assumptions for the linear regression model (cont.)
• Assumption SLR.3 (Sample variation in the explanatory variable)

• Assumption SLR.4 (Zero conditional mean)

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Introductory Econometrics: A Modern Approach (7e)

The Simple Regression Model (28 of 39)

• Theorem 2.1 (Unbiasedness of OLS)

• Interpretation of unbiasedness
• The estimated coefficients may be smaller or larger, depending on the sample
that is the result of a random draw.
• However, on average, they will be equal to the values that characterize the true
relationship between y and x in the population.
• “On average” means if sampling was repeated, i.e. if drawing the random
sample and doing the estimation was repeated many times.
• In a given sample, estimates may differ considerably from true values.

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Introductory Econometrics: A Modern Approach (7e)

The Simple Regression Model (29 of 39)

• Variances of the OLS estimators
• Depending on the sample, the estimates will be nearer or farther away from
the true population values.
• How far can we expect our estimates to be away from the true population
values on average (= sampling variability)?
• Sampling variability is measured by the estimator‘s variances

• Assumption SLR.5 (Homoskedasticity)

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Introductory Econometrics: A Modern Approach (7e)

The Simple Regression Model (30 of 39)

• Graphical illustration of homoskedasticity

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Introductory Econometrics: A Modern Approach (7e)

The Simple Regression Model (31 of 39)

• An example for heteroskedasticity: Wage and education

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Introductory Econometrics: A Modern Approach (7e)

The Simple Regression Model (32 of 39)

• Theorem 2.2 (Variances of the OLS estimators)
• Under assumptions SLR.1 – SLR.5:

• Conclusion:
• The sampling variability of the estimated regression coefficients will be the
higher, the larger the variability of the unobserved factors, and the lower, the
higher the variation in the explanatory variable.

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Introductory Econometrics: A Modern Approach (7e)

The Simple Regression Model (33 of 39)

• Estimating the error variance

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Introductory Econometrics: A Modern Approach (7e)

The Simple Regression Model (34 of 39)

• Theorem 2.3 (Unbiasedness of the error variance)

• Calculation of standard errors for regression coefficients

The estimated standard deviations of the regression coefficients are called “standard errors.” They
measure how precisely the regression coefficients are estimated.

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Introductory Econometrics: A Modern Approach (7e)

The Simple Regression Model (35 of 39)

• Regression on a binary explanatory variable
• Suppose that x is either equal to 0 or 1

• This regression allows the mean value of y to differ depending on the

state of x

• Note that the statistical properties of OLS are no different when x is

binary
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Introductory Econometrics: A Modern Approach (7e)

The Simple Regression Model (36 of 39)

• Counterfactual outcomes, causality and policy analysis
• In policy analysis, define a treatment effect as:

• Note that we will never actually observe this since we either observe
yi(1) or yi(0) for a given i, but never both.

• Let the average treatment effect be defined as:

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Introductory Econometrics: A Modern Approach (7e)

The Simple Regression Model (37 of 39)

• Counterfactual outcomes, causality and policy analysis (contd.)
• Let xi be a binary policy variable.

• This can be written as:

• Therefore, regressing y on x will give us an estimate of the (constant)

treatment effect.
• As long as we have random assignment, OLS will yield an unbiased
estimator for the treatment effect τ.
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Introductory Econometrics: A Modern Approach (7e)

The Simple Regression Model (38 of 39)

• Random assignment
• Subjects are randomly assigned into treatment and control groups such that
there are no systematic differences between the two groups other than the
treatment.
• In practice, randomized control trials (RCTs) are expensive to implement and
may raise ethical issues.
• Though RCTs are often not feasible in economics, it is useful to think about the
kind of experiment you would run if random assignment was a possibility. This
helps in identifying the potential impediments to random assignment (that we
could conceivable control for in a multivariate regression).

© 2020 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a
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Introductory Econometrics: A Modern Approach (7e)

The Simple Regression Model (39 of 39)

• Example: The effects of a job training program on earnings
• Real earnings are regressed on a binary variable indicating
participation in a job training program.

• Those who participated in the training program have earnings $1,790

higher than those who did not participate.
• This represents a 39.3% increase over the $4,550 average earnings
from those who did not participate.
© 2020 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a
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