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3. The simple regression model

It is now time to leave the single variable analysis and move on to the main issue of the book, namely regression analysis. When looking at a single variable we could describe its behavior by using any summary statistic described in the previous chapters. Most often that would lead to a mean and a variance. The mean value would be a description of the central tendency, and the variance or the standard deviation a measure of how the average observation deviates from the mean. Furthermore, the kurtosis and skewness would say something about the distributional shape around the mean. But we can say nothing about the factors that make single observations deviate from the mean.

Regression analysis is a tool that can helps us to explain in part why observations deviate from the mean using other variables. The initial discussion will be related to models that use one single explanatory factor or variable X that explains why observations related to the random variable Y deviate from its mean. A regression model with only one explanatory variable is sometimes called the simple regression model. A simple regression model is seldom used in practice because economic variables are seldom explained by just one variable. However, all the intuition that we can receive from the simple model can be used in the multiple regression case. It is therefore important to have a good understanding of the simple model before moving on to more complicated models.

3.1. The population regression model

In regression analysis, just as in the analysis with a single variable, we make the distinction between the sample and the population. Since it is inconvenient to collect data for the whole population, we usually base our analysis on a sample. Using this sample, we try to make inference on the population, that is, we try to find the value of the parameters that correspond to the population. It is therefore important to understand the distinction between the population regression equation and the sample regression equation.

3.1.1. The economic model

The econometric model, as appose to models in statistics in general, is connected to an economic model that motivate and explains the rational for the possible relation between the variables included in the analysis. However, the economic model is only a logical description of what the researcher believes is true. In order to confirm that the made assumptions are in accordance with the reality, it is important to specify a statistical model, based on the formulation of the economic model, and statistically test the hypothesis that the economic model propose using empirical data. However, it is the economic model that allows us to interpret the parameters of the statistical model in economic terms. It is therefore very important to remember that all econometric work has to start from an economic model.

Let us start with a very simple example. Economic theory claims that there is a relationship between food consumption and disposable income. It is believed that the monthly disposable income of the household has a positive effect on the monthly food expenditures of the household. That means that if the household disposable income increases, the food expenditure will increase as well. To make it more general we claim that this is true in general, which means that when the average disposable income increase in the population, the average food expenditure will increase. Since we talk about averages we may express the economic model in terms of an expectation:

The conditional expectation given by (3.1) is a so called regression function and we call it the population regression line. We have imposed the assumption that the relationship between Y and X1 is linear. That assumption is made for simplicity only, and later on when we allow for more variables, we may test if this is a reasonable assumption, or if we need to adjust for it. The parameters of interest are B0 and B1. In this text we will use capital letters for population parameters, and small letters will denote sample estimates of the population parameters. B0 will represent the average food expenditure by households when the disposable income is zero (Xl = 0) and is usually referred to as the intercept or just the constant. The regression function also shows that if B1 is different from zero and positive, the conditional mean of Y on X1 will change and increase with the value of X1. Furthermore, the slope coefficient will represent the marginal propensity to spend on food:

 
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