Ka-fu Wong © 2003 Chap 11- 1 Dr. Ka-fu Wong ECON1003 Analysis of Economic Data.

Dr. Ka-fu Wong

ECON1003Analysis of Economic Data

1. Draw a scatter diagram.2. Understand and interpret the terms dependent

variable and independent variable.3. Calculate and interpret the coefficient of correlation,

the coefficient of determination, and the standard error of estimate.

4. Conduct a test of hypothesis to determine if the population coefficient of correlation is different from zero.

5. Calculate the least squares regression line and interpret the slope and intercept values.

6. Construct and interpret a confidence interval and prediction interval for the dependent variable.

7. Set up and interpret an ANOVA table.

Chapter ElevenLinear Regression and CorrelationLinear Regression and Correlation

Correlation Analysis

Correlation Analysis is a group of statistical techniques used to measure the strength of the association between two variables.

A Scatter Diagram is a chart that portrays the relationship between the two variables.

The Dependent Variable is the variable being predicted or estimated.

The Independent Variable provides the basis for estimation. It is the predictor variable.

Types of Relationships

Direct vs. InverseDirect - X and Y increase together Inverse - X and Y have opposite

directions Linear vs. Curvilinear

Linear - Straight line best describes the relationship between X and Y

Curvilinear - Curved line best describes the relationship between X and Y

Direct vs. Inverse Relationship

Advertising

Anti-Pollution ExpendituresP

Positive Slope

Negative Slope

Direct Relationship Inverse Relationship

Example

Suppose a university administrator wishes to determine whether any relationship exists between a student’s score on an entrance examination and that student’s cumulative GPA. A sample of eight students is taken. The results are shown below

Student Exam Score GPA

A 74 2.6

B 69 2.2

C 85 3.4

D 63 2.3

E 82 3.1

F 60 2.1

G 79 3.2

H 91 3.8

Scatter Diagram: GPA vs. Exam Score

| | | | | | | | | |

50 55 60 65 70 75 80 85 90 95

Exam Score

4.00 -3.75 -3.50 -3.25 -3.00 -2.75 -2.50 -2.25 -2.00 -

Possible relationships between X and Y in Scatter Diagrams

(a) Direct linearY

(b) Inverse linear

(f) No relationship

(c) Direct curvilinear

(d) Inverse curvilinearY

(e) Inverse linearwith more scattering

The Coefficient of Correlation, r

The Coefficient of Correlation (r) is a measure of the strength of the linear relationship between two variables. It requires interval or ratio-scaled data. It can range from -1.00 to 1.00. Values of -1.00 or 1.00 indicate perfect and

strong correlation. Values close to 0.0 indicate weak

correlation. Negative values indicate an inverse

relationship and positive values indicate a direct relationship.

Formula for r

)yy()xx(

)yy)(xx(

We calculate the coefficient of correlation from the following formulas.

Sample covariance between x and y

Sample standard deviation of x

Sample standard deviation of y

Perfect Negative Correlation (r = -1)

0 1 2 3 4 5 6 7 8 9 10

10 9 8 7 6 5 4 3 2 1 0

Perfect Positive Correlation (r = +1)

10 9 8 7 6 5 4 3 2 1 0

0 1 2 3 4 5 6 7 8 9 10

Zero Correlation (r = 0)

0 1 2 3 4 5 6 7 8 9 10

10 9 8 7 6 5 4 3 2 1 0

Strong Positive Correlation (0<r<1)

10 9 8 7 6 5 4 3 2 1 0

0 1 2 3 4 5 6 7 8 9 10

Coefficient of Determination

The coefficient of determination (r2) is the proportion of the total variation in the dependent variable (Y) that is explained or accounted for by the variation in the independent variable (X). It is the square of the coefficient of correlation. It ranges from 0 to 1. It does not give any information on the direction

of the relationship between the variables.

Special cases: No correlation: r=0, r2=0. Perfect negative correlation: r=-1, r2=1. Perfect positive correlation: r=+1, r2=1.

EXAMPLE 1

Dan Ireland, the student body president at Toledo State University, is concerned about the cost to students of textbooks. He believes there is a relationship between the number of pages in the text and the selling price of the book. To provide insight into the problem he selects a sample of eight textbooks currently on sale in the bookstore. Draw a scatter diagram. Compute the correlation coefficient.Book Page Price ($)

Intro to History 500 84

Basic Algebra 700 75

Intro to Psyc 800 99

Intro to Sociology 600 72

Bus. Mgt. 400 69

Intro to Biology 500 81

Fund. of Jazz 600 63

Princ. Of Nursing 800 93

Example 1 continued

400 500 600 700 800

Scatter Diagram of Number of Pages and Selling Price of Text

Price ($)

Example 1 continued

Book Page Price ($)

Intro to History 500 84

Basic Algebra 700 75

Intro to Psyc 800 99

Intro to Sociology

600 72

Bus. Mgt. 400 69

Intro to Biology 500 81

Fund. of Jazz 600 63

Princ. Of Nursing

800 93

Total 4,900

The correlation between the number of pages and the selling price of the book is 0.614. This indicates a moderate association between the variable.

)yy()xx(

)yy)(xx(r

EXAMPLE 1 continued

Is there a linear relation between number of pages and price of books?

Test the hypothesis that there is no correlation in the population. Use a .02 significance level.

Under the null hypothesis that there is no correlation in the population. The statistic

)2/()1( 2

follows student t-distribution with (n-2) degree of freedom.

EXAMPLE 1 continued

Step 1: H0: The correlation in the population is zero. H1: The correlation in the population is not zero.

Step 2: H0 is rejected if t>3.143 or if t<-3.143. There are 6 degrees of freedom, found by n – 2 = 8 – 2 = 6.

Step 3: To find the value of the test statistic we use:

905.1)614(.1

28614.

)2/()1( 22

Step 4: H0 is not rejected. We cannot reject the hypothesis that there is no correlation in the population. The amount of association could be due to chance.

Regression Analysis

In regression analysis we use the independent variable (X) to estimate the dependent variable (Y).

The relationship between the variables is linear.

Both variables must be at least interval scale.

Simple Linear Regression Model

Relationship Between Variables Is a Linear Function

iii XY 10

Y intercept Slope Random Error

Dependent (Response) Variable

Independent (Explanatory) Variable x

1 = Rise/Run

0 and 1 are unknown,therefore, are estimated from the data.

Finance Application: Market Model

One of the most important applications of linear regression is the market model.

It is assumed that rate of return on a stock (R) is linearly related to the rate of return on the overall market (Rm).

Rate of return on a particular stock

Rate of return on some major stock index

The beta coefficient measures how sensitive the stock’s rate of return is to changes in the level of the overall market.

R = 0 + 1Rm +

Assumptions Underlying Linear Regression

For each value of X, there is a group of Y values, and these Y values are normally distributed.

The means of these normal distributions of Y values all lie on the straight line of regression.

The standard deviations of these normal distributions are equal.

The Y values are statistically independent. This means that in the selection of a sample, the Y values chosen for a particular X value do not depend on the Y values for any other X values.

Choosing the line that fits best

The estimates are determined by drawing a sample from the population of interest, calculating sample statistics. producing a straight line that cuts into the data.

The question is:Which straight line fits best?

(3,1.5)

Sum of squared differences = (2 - 1)2 + (4 - 2)2 + (1.5 - 3)2 +

(4,3.2)

(3.2 - 4)2 = 6.89Sum of squared differences = (2 -2.5)2 + (4 - 2.5)2 + (1.5 - 2.5)2 + (3.2 - 2.5)2 = 3.99

Let us compare two lines

The second line is horizontal

The smaller the sum of squared differences the better the fit of the line to the data. That is, the line with the least sum of squares (of differences) will fit the line best.

The best line is the one that minimizes the sum of squared vertical differences between the points and the line.

Choosing the line that fits best

Choosing the line that fits bestOrdinary Least Squares (OLS) Principle

Straight lines can be described generally by Y = b0 + b1X

Finding the best line with smallest sum of squared difference is the same as

∑≡n

2i10i10

)]xb(b[y )b,S(bmin10

Let b0* and b1

* be the solution of the above

problem. Y* = b0* + b1

*Xis known as the “average predicted value” (or simply “predicted value”) of y for any X.

Coefficient estimates from the ordinary least squares (OLS) principle

Solving the minimization problem implies the first order conditions:

0))](-xxb(b-2[y b

)b,S(b

0)](-1)xb(b-2[y b

)b,S(b

)]xb(b -[y )b,S(b

1iii10i

1ii10i

2i10i10

∑∂

∑≡

Coefficient estimates from the ordinary least squares (OLS) principle

Solving the first order conditions implies

)y)(yx-(x

)x()xn(

yx)yxn(b

EXAMPLE 2 continued from Example 1

Develop a regression equation for the information given in EXAMPLE 1. The information there can be used to estimate the selling price based on the number of pages.

05143.)900,4()000,150,3(8

)636)(900,4()200,397(821

900,405143.0

6360 b

Example 2 continued from Example 1

The regression equation is:

Y* = 48.0 + .05143X

The equation crosses the Y-axis at $48. A book with no pages would cost $48.

The slope of the line is .05143. Each additional page costs about $0.05 or five cents.

The sign of the b value and the sign of r will always be the same.

Example 2 continued from Example 1

We can use the regression equation to estimate values of Y.

The estimated selling price of an 800 page book is $89.14, found by

Y* = 48.0 + .05143X = 48.0 + .05143(800) = 89.14

Standard Error of Estimate (denoted se or Sy.x)

Measures the reliability of the estimating equation A measure of dispersion Measures the variability, or scatter of the observed

values around the regression line

yxbyby

More Accurate Estimatorof X, Y Relationship

Less Accurate Estimatorof X, Y Relationship

Scatter Around the Regression Line

se measures the dispersion of the points around the regression line If se = 0, equation is a “perfect” estimator

se is used to compute confidence intervals of the estimated value

Assumptions: Observed Y values are normally

distributed around each estimated value of Y*

Constant variance

Interpreting the Standard Error of the Estimate

f(e)y values are normally distributed around the regression line.

For each x value, the “spread” or variance around the regression line is the same.

Regression Line

Variation of Errors Around the Regression Line

Independent Variable (X)

Y = b0 + b1X + 2se

Y = b0 + b1X + 1se

Y = b0 + b1X - 1se

Y = b0 + b1X - 2se

Y = b0 + b1X regression line

2se (95.5% Lie in this Region)

Scatter around the Regression Line

1se (68% Lie in this Region)

Example 3 continued from Example 1 and 2.

Find the standard error of estimate for the problem involving the number of pages in a book and the selling price.

408.1028

)200,397(05143.0)636(48606,51

yxbybys

Equations for the Interval Estimates

htsy e*

htsy e 1*

Confidence Interval for the Mean of y

Prediction Interval for the Mean of y

Confidence Interval Estimate for Mean Response

The following factors influence the width of the interval: Std Error, Sample Size, X Value

y* = b0+b1xi

Confidence Interval continued from Example 1, 2 and 3.

For books of 800 pages long, what is that 95% confidence interval for the mean price? This calls for a confidence interval on the

average price of books of 800 pages long.

31.1514.898

)4900(000,150,3

)5.612800(

1)408.10(447.214.89

ntsyhtsy

Prediction Interval continued from Example 1, 2 and 3.

For a book of 800 pages long, what is the 95% prediction interval for its price? This calls for a prediction interval on the price

of an individual book of 800 pages long.

72.2914.898

)4900(000,150,3

)5.612800(

11)408.10(447.214.89

ntsyhtsy

1. Slope (b1)

Estimated Y changes by b1 for each 1 unit increase in X

2. Y-Intercept (b0 ) Estimated value of Y when X = 0

Interpretation of Coefficients

1. Tests if there is a linear relationship between X & Y

2. Involves population slope

3. Hypotheses H0: = 0 (no linear relationship)

H1: 0 (linear relationship)

4. Theoretical basis is sampling distribution of slopes

Test of Slope Coefficient (b1)

Sampling Distribution of the Least Squares Coefficient Estimator

If the standard least squares assumptions hold, then b1 is an unbiased estimator of 1 and has a population variance

b snxx

and an unbiased sample variance estimator

Bias = E(b1) 1 “ Unbiasd” means E(b1) 1 =0

Basis for Inference About the Population Regression Slope

Let 1 be a population regression slope and b1 its least squares estimate based on n pairs of sample observations. Then, if the standard regression assumptions hold and it can also be assumed that the errors i are normally distributed, the random variable

is distributed as Student’s t with (n – 2) degrees of freedom. In addition the central limit theorem enables us to conclude that this result is approximately valid for a wide range of non-normal distributions and large sample sizes, n.

Tests of the Population Regression Slope

If the regression errors i are normally distributed and the standard least squares assumptions hold (or if the distribution of b1 is approximately normal), the following tests have significance value :

1. To test either null hypothesis H0: 1 = 1

* or H0:1 1*

against the alternative H1: 1 > 1

The decision rule is to reject if

2),(n-b

* or H0:1 > 1*

against the alternative H1: 1 1

the decision rule is to reject if

2),(nb

* against the alternative H1: 1 1

the decision rule is to reject if

/22),(nb

*11 t-

t or t s

-- ≤≥

/22),(n-b

Equivalently

Confidence Intervals for the Population Regression Slope 1

If the regression errors i , are normally distributed and the standard regression assumptions hold, a 100(1 - )% confidence interval for the population regression slope 1 is given by

11 b/22),(n11b/22),(n-1 stbβst-b -

Significance Test and Estimation for Slope

If the regression assumptions hold, we can reject H0: 1 = 0 at the level of significance (probability of Type I error equal to ) if and only if the appropriate rejection point condition holds or, equivalently, if the corresponding p-value is less than .

where1

Test Statistic

isthat,

t, t/2 and p-values are based on n – 2 degrees of freedom.

Alternative Reject H0 if: p-Value

tofrightondistributit underarea Twice

tofleftondistributit underArea

tofrightondistributit underArea

100(1-)% Confidence Interval for 1

][12/1 bstb

Significance Test and Estimation for y-Intercept

If the regression assumptions hold, we can reject H0: 0 = 0 at the level of significance (probability of Type I error equal to ) if and only if the appropriate rejection point condition holds or, equivalently, if the corresponding p-value is less than .

where0

Test Statistic

isthat,

t, t/2 and p-values are based on n – 2 degrees of freedom.

Alternative Reject H0 if: p-Value

tofrightondistributit underarea Twice

tofleftondistributit underArea

tofrightondistributit underArea

100(1-)% Conf Interval for 0

][02/0 bstb

Some cautions about the interpretation of significance tests

Rejecting H0: b1 = 0 and concluding that the relationship between x and y is significant does not enable us to conclude that a cause-and-effect relationship is present between x and y.

Causation requires: Association Accurate time sequence Other explanation for correlation

Correlation Causation Correlation Causation

Some cautions about the interpretation of significance tests

Just because we are able to reject H0: 1 = 0 and demonstrate statistical significance does not enable us to conclude that there is a linear relationship between x and y.

Linear relationship is a very small subset of possible relationship among variables.

A test of linear versus nonlinear relationship requires another batch of analysis.

Variation Measures Coeff. Of Determination Standard Error of Estimate

Test Coefficients for Significance

yi* = b0 +b1xi

Evaluating the Model

Total Sum of Squares (Yi - Y)2

Unexplained Sum of Squares (Yi -Yi

Explained Sum of Squares (Yi

* - Y)2

yi* = b0 +b1xi

Variation Measures

Total Sum of Squares (SST)Measures variation of observed Yi

around the mean,Y Explained Variation (SSR)

Variation due to relationship between X & Y

Unexplained Variation (SSE)Variation due to other factors

SST=SSR+SSE

Measures of Variation in Regression

R2 (=r2, the coefficient of determination)

measures the proportion of the variation in y that is explained by the variation in x.

R2 takes on any value between zero and one. R2 = 1: Perfect match between the line and the data

points. R2 = 0: There are no linear relationship between x and

Variation in y (SST) = SSR + SSE

Summarizing the Example’s results (Example 1, 2 and 3)

The estimated selling price for a book with 800 pages is $89.14.

The standard error of estimate is $10.41. The 95 percent confidence interval for all

books with 800 pages is $89.14 ± $15.31. This means the limits are between $73.83 and $104.45.

The 95 percent prediction interval for a particular book with 800 pages is $89.14 ± $29.72. The means the limits are between $59.42 and $118.86.

These results appear in the following output.

Example 3 continued

Regression Analysis: Price versus Pages

The regression equation isPrice = 48.0 + 0.0514 Pages

Predictor Coef SE Coef T PConstant 48.00 16.94 2.83 0.030Pages 0.05143 0.02700 1.90 0.105

S = 10.41 R-Sq = 37.7% R-Sq(adj) = 27.3%

Analysis of VarianceSource DF SS MS F PRegression 1 393.4 393.4 3.63 0.105Residual Error 6 650.6 108.4Total 7 1044.0

Testing for Linearity

Key Argument: If the value of y does not change linearly

with the value of x, then using the mean value of y is the best predictor for the actual value of y. This implies is preferable.

If the value of y does change linearly with the value of x, then using the regression model gives a better prediction for the value of y than using the mean of y. This implies is preferable.

Three Tests for Linearity

Testing the Coefficient of Correlation

H0: = 0 There is no linear relationship between x and y.

H1: 0 There is a linear relationship between x and y.

Test Statistic:

iie xnxs

Testing the Slope of the Regression LineH0: = 0 There is no linear relationship between x and y.

H1: 0 There is a linear relationship between x and y.

Test Statistic:

)2/()1( 2

Three Tests for Linearity

The Global F-testH0: There is no linear relationship between x and y.

H1: There is a linear relationship between x and y.

Test Statistic:

)2/()(

[Variation in y] = SSR + SSE. Large F results from a large SSR. Then, much of the variation in y is explained by the regression model. The null hypothesis should be rejected; thus, the model is valid.Note: At the level of simple linear regression, the global F-test is equivalent to the t-test on b1. When we conduct regression analysis of multiple variables, the global F-test will take on a unique function.

PurposesExamine Linearity Evaluate violations of assumptions

Graphical Analysis of ResidualsPlot residuals versus Xi values

Difference between actual Yi & predicted Yi

Studentized residuals:Allows consideration for the

magnitude of the residuals

Residual Analysis

Residual Analysis for Linearity

Not Linear LinearOK

Heteroscedasticity OK Homoscedasticity

Using Standardized Residuals

Residual Analysis for Homoscedasticity

When the requirement of a constant variance (homoscedasticity) is violated we have heteroscedasticity.

Residual Analysis for Independence

Not Independent Independent

A time series is constituted if data were collected over time.

Examining the residuals over time, no pattern should be observed if the errors are independent.

When a pattern is detected, the errors are said to be autocorrelated.

Autocorrelation can be detected by graphing the residuals against time.

Non-independence of error variables

++ + +

Residual Residual

Note the runs of positive residuals,replaced by runs of negative residuals

Note the oscillating behavior of the residuals around zero.

Patterns in the appearance of the residuals over time indicates that autocorrelation exists.

21)( Should be close to 2.

If not, examine the model for autocorrelation.

Used when data is collected over time to detect autocorrelation (Residuals in one time period are related to residuals in another period)

Measures Violation of independence assumption

The Durbin-Watson Statistic

An outlier is an observation that is unusually small or large.

Several possibilities need to be investigated when an outlier is observed:There was an error in recording the value.The point does not belong in the sample.The observation is valid.

Identify outliers from the scatter diagram. It is customary to suspect an observation is

an outlier if its |standard residual| > 2

Outliers

+ + ++

The outlier causes a shift in the regression line

… but, some outliers may be very influential

++++++++++

An outlier An influential observation

Nonnormality or heteroscedasticity can be remedied using transformations on the y variable.

The transformations can improve the linear relationship between the dependent variable and the independent variables.

Many computer software systems allow us to make the transformations easily.

Remedying violations of the required conditions

A brief list of transformations

Y’ = log y (for y > 0) Use when the se increases with y, or

Use when the error distribution is positively skewed

y’ = y2

Use when the se2 is proportional to E(y), or

Use when the error distribution is negatively skewed

y’ = y1/2 (for y > 0) Use when the se

2 is proportional to E(y)

y’ = 1/y Use when se

2 increases significantly when y increases beyond some value.

Example: Transformation to get linearity

Not Linear OK

Linear

Yi = b0 + b Xi + ei Yi = b0 + b1 Xi + b2 Xi2 +

- END -

Chapter ElevenLinear Regression and CorrelationLinear Regression and Correlation

Ka-fu Wong © 2003 Chap 11- 1 Dr. Ka-fu Wong ECON1003 Analysis of Economic Data.

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