Econometrics: ] – Lecture 1
The Econometric Model:
Econometrics is about how we can use theory and data from economics, business and the
social sciences, along with tools from statistics, to answer “how much” type questions.
In economics we express our ideas about relationships between economics variables using the
mathematical concept of a function. An example of this is when expressing the price of a
house in terms of its size.
Price = f(size)
Hedonic Model: A model that decomposes the item being researched into its
constituent characteristics, and obtains estimates of the contributory value of
each characteristic An example of a hedonic model for house price might be
Price f (size,bedrooms,bathrooms, stories, age, pool, airconditioning)
Economic theory does not claim to be able to predict the specific behaviour of any individual
or firm, but rather is describes the average or systematic behaviour of many individuals for
Economic models = Generalisation
In fact we realise that there will be a random and unpredictable component e that we will call
random error. Hence the econometric model for price would be
Price f (size,bedrooms,bathrooms, stories,age, pool,airconditioning) e
The random error e, accounts for the many factors that affect sales that we have omitted from
this simplistic model, and it also reflects the intrinsic uncertainty in economic activity.
Take for example the demand relation:
qd f (p, ps, pc,i) 1 2p 3ps 4pc 5i
The corresponding econometric model is:
qd f (p, ps, pc, i) 1 2p 3ps 4pc 5i e
Econometric Models include the error term, e
In every model there are two parts:
1. A systematic portion – part we obtain from economic theory, includes assumptions
about the functional form.