Econometrics: the science and art of using economic theory and statistical
techniques to analyze economic data.
1.1 Economic Questions We Examine
Question #1 “Does reducing class size improve elementary school
o Reducing class sizes involves the need to hire more teachers and to
possibly build more classrooms.
o Decision maker contemplating hiring more teachers must weigh the
costs against the benefits.
They must have a precise quantitative understanding of the
Will smaller classes actually result in better performance or
will it have no effect?
o Data gathered from 420 California school districts in 1999 showed
that students in smaller classes performed better than those in bigger
But was it because the classroom was smaller or because of
some other variable?
I.e. smaller classes in a region will typically imply the
area is wealthy meaning students have more
opportunities to learn outside of school
Multiple regression analysis must be used to isolate the effects
of changes in class size from changes in other factors.
Question #2 “Is there racial discrimination in the market for home loans?”
o By law, U.S. lending institutions cannot take race into account when
deciding to grant or deny a request for a mortgage (identical
applicants with different races should be equally treated).
o Researchers at the Federal Reserve Bank of Boston found (using data
from the early ‘90s) that 28% of black applicants are denied
mortgages, while only 9% of white applicants are denied.
These data must be examined more closely to see if there is a
difference in the probability of being denied for otherwise
identical applicants and, if so, whether the difference is
To quantify the effect of race on the chance of obtaining a
mortgage, other applicant characteristics besides race must be
Question #3 “How much do cigarette taxes reduce smoking?”
o The percentage change in the quantity demanded resulting from a
percentage increase in price is the price elasticity of demand. o In order to come up with a numerical value of the price elasticity of
demand, data on cigarette consumption and prices needs to be
o Data regarding cigarette sales, prices, taxes, and personal income for
U.S. states in the ‘80s and ‘90s show that states with low taxes (thus
low prices) have high smoking rates and vice-versa.
Analysis of these data is complicated because causality runs
Low taxes -> high demand
High demand -> local politicians keeping taxes low to
satisfy their smoking constituents
Question #4 “What will the rate of inflation be next year?”
o Professional economists who rely on precise numerical forecasts use
econometric models to make those forecasts.
o A forecaster’s job is to predict the future using the past, and
econometricians do this by using economic theory and statistical
techniques to qua