T.

RAMA KRISHANA RAO (8839271225)

T.RAMA KRISHANA RAO (8839271225)

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 T.RAMA KRISHANA RAO (8839271225)

Unit 1
Introduction of Econometrics, Methodology of Econometrics,
Objectives and Characteristics, Input-Output Analysis –
Introduction, Concepts and Features, Importance,
Assumptions, National Income Accounting Matrix, Hawkins-
Simon Method, Limitations of Input-Output Analysis.

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ECONOMETRICS

Econometrics is the application of statistical methods to economic data and is described as the
branch of economics that aims to give empirical content to economic relations. More precisely, it
is "the quantitative analysis of actual economic phenomena based on the concurrent
development of theory and observation, related by appropriate methods of inference." An
introductory economics textbook describes econometrics as allowing economists "to sift through
mountains of data to extract simple relationships." The first known use of the term
"econometrics" (in cognate form) was by Polish economist Paweł Ciompa in 1910. Ragnar Frisch
is credited with coining the term in the sense in which it is used today.

The basic tool for econometrics is the multiple linear regression model. Econometric theory uses
statistical theory and mathematical statistics to evaluate and develop econometric methods.
Econometricians try to find estimators that have desirable statistical properties including
unbiasedness, efficiency, and consistency. Applied econometrics uses theoretical econometrics
and real-world data for assessing economic theories, developing econometric models, analyzing
economic history, and forecasting.

BASIC CONCEPT OF ECONOMETRICS

Econometrics is a set of mathematical and statistical tools that allows describing or tests different
economic theories.

For example, Law of demand says that when prices increase the demand decreases and vice
versa. So we verify this theory by drawing a regression line, the mathematical and statistical tool
to analyse the theory.

Regression

 Qd=f(p)
 Qd= Quantity demand,
 f(p)= Function of price

Generally Econometrics means the economics theory and its measurement through
mathematical and statistical tools.

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METHODOLOGY / STEPS OF ECONOMETRICS

1. Statement of theory or hypothesis.

2. Specification of the mathematical model of the theory
3. Specification of the statistical, or econometric, model
4. Obtaining the data
5. Estimation of the parameters of the econometric model
6. Hypothesis testing
7. Forecasting or prediction
8. Using the model for control or policy purposes.

ECONOMETRICS OBJECTIVES AND CHARACTERISTICS

1. operationalize empirically economic theory. Economic theory is concerned with

relations between variables of economic interest and the factors believed to determine
those variables. A simple example of such a relationship is that of a demand function.
Economic theory would postulate, for example, that the quantity of a certain type of
automobile demanded depends on, among other things, the price of the vehicle. In
particular, theory would stipulate that fewer units of the automobile will be demanded,
the higher the price of the vehicle, other things being equal. Econometrics allows the
economist to gather data on automobile demand and automobile price and fit a
relationship between these two variables.

2. econometrics is to test economic theory. Returning to the automobile example, once a

relationship has been established between demand for the automobile and its price, the
economist can then use the methods of statistical inference to determine whether price
and demand are related to each other in the hypothesized inverse direction. Moreover, the
economist can use tools of statistical inference to estimate the responsiveness of the
variable of interest to a change in the determining variable.

3. econometrics is to predict future movements in the economic variable of interest on

the basis of the econometric model. In the automobile example, the fitted relationship
may suggest that a price increase of $1,000 will lead to a significant decline in demand and
therefore revenue. Based on this prediction, then, the manufacturer presumably would
decide to hold the line on future price increases.

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INPUT-OUTPUT ANALYSIS
Input-output is a novel technique invented by Professor Wassily W. Leontief in 1951. It is used to
analyse inter-industry relationship in order to understand the inter-dependencies and
complexities of the economy and thus the conditions for maintaining equilibrium between supply
and demand.

Thus it is a technique to explain the general equilibrium of the economy. It is also known as
“inter-industry analysis”. Before analysing the input-output method, let us understand the
meaning of the terms, “input” and “output”. According to Professor J.R. Hicks, an input is
“something which is bought for the enterprise” while an output is “something which is sold by it.”

FEATURES OF INPUT-OUTPUT ANALYSIS

(i) Input-output analysis deals with the problem of purely technological nature viz.,
production. The main objective of the analysis is to find the nature of output-mix, quantity of each
final product in the output-mix and the quantity of each intermediate product required to
produce the given quantity of the final product (given technology and resources).

(ii) Input-output analysis incorporates the nature of interdependence between various

sectors/industries in an economy i.e., each production sector is conceived to both as a receiver
as well as supplier of output. As an example, coal is an input for steel industry, while steel in turn
is an input for coal industry, though both are the outputs in their respective industries. The
production data is presented in a matrix form, known as the input-output table, in order to
account for the interdependence between sectors/industries.

(iii) The basic thrust of input-output analysis is empirical investigation rather than
theoretical finesse. The limitations of the availability of empirical material and the
computational problems have forced on input-output analysis a number of simplifying
assumptions as well as narrowness in the sense of its exclusive emphasis on production side.

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IMPORTANCE OF INPUT-OUTPUT ANALYSIS

(i) A producer can know from the input-output table, the varieties and quantities of goods
which he and the other firms buy and sell to each other. In this way, he can make the
necessary adjustments and thus improve his position vis-a-vis other

(ii) It is also possible to find out from the input-output table the interrelations among
firms and industries about possible trends towards combinations.

(iii) The repercussions of a prolonged strike, of a war and of a business cycle on an industry
can be easily understood from the input-output table.

(iv) The input-output model has come to be used for national income accounting because it
provides a more detailed breakdown of the macro aggregates and money flows.

(v) It provides for individual branches of the economy’s estimates of production and
import levels that are consistent with each other and with the estimates of final
demand.

(vi) The input-output model aids in the allocation of the investment required to achieve the
production levels in production programme.

(vii) The requirements for skilled labour can be evaluated in the same way.

(viii) The analysis of import requirements and substitution possibilities is facilitated by the
knowledge of the use of domestic and import materials in different branches of an
industry.

(ix) In addition to direct requirements of capital, labour and imports, the indirect
requirements in other sectors of an industry can also be estimated.

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ASSUMPTIONS OF INPUT OUTPUT ANALYSIS

(i) Two products are not produced jointly. Every industry produces one homogeneous
good. However, this assumption can be released if it is possible to consider the good as
a composite unit i.e., the good is made up of many items produced in a fixed
proportion, for example, a package of 100 bicycles, 20 motor-cycles, 30 scooters and
10 cars considered together as a unit of transport equipment.
(ii) All inputs are employed in rigidly fixed proportion in a productive process i.e., the use.
of inputs rises in strict proportion to the expansion in output. This condition imparts
linearity to input-output relationships.
(iii) Factor and commodity prices are specified.
(iv) Amount of factor services as well as the nature and extent of consumer demand is
specified.
(v) Industries do not enjoy external economics or diseconomies.
(vi) Pure competition exists in the producing factor.
(vii) Firms enjoy constant returns to scale.
(viii) Both inputs and outputs are described in monetary units, else there could arise the
problem of aggregating heterogeneous inputs and outputs.
(ix) Production. relations are linear by nature.
(x) Primary input is labour only.

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NATIONAL INCOME ACCOUNTING MATRIX

The national income accounting is otherwise called "Social accounting". The national income
accounting is a method to present statistically the inter-relationship between the different
sectors of the economy for a thorough understanding of the economic conditions of the entire
economy. There are three methods of presenting national income accounting. They are

(a) Double entry method:-

(b) Matrix method
(c) Circular flow method.

(a) Double entry method: -National income accounting is presented on the double entry basis like
private accounts. Under double entry systems every transaction involves two aspects such as
receipts and payments. The person who is involved in the transaction of goods and services acts
like a creditor and debtor. Thus every transaction is entered both on credit and debit sides of the
account.

(b) Matrix Method: -Matrix Method is one of the important methods of national income
accounting. A matrix is defined as a rectangular array of elements arranged in rows and columns.
Receipts are shown in rows while payments are shown in columns. Thus matrix presents figures
of aggregate economic activities of a country in an organised and tabular form. The first step in
the presentation and preparation of such accounts is to classify transactions into two groups
namely 'firms' and 'households'. Firms are organizations using the services of factors of
production for producing goods and services. Households consisting of persons, wage earners,
salary earners, business men and property owners, receive payment for services rendered to the
firms. A transaction matrix is used for social accounts in which, each row contains payments to
other sectors. Every single entry is both in a particular row and in a particular column. For
balancing social accounts a row total must equal its corresponding column- total. From the matrix
it is clear that the two sectors are independent. The most important advantage of using the
matrix form of social accounting is that it is both brief and clear and gives at a glance the entire
picture of the economic activities.

(c) Circular flow Method:-The circular flow method rests on the assumption that different sectors
of an economy are interrelated. The income and expenditure of an economy flow in a circular
manner continuously through time. The various components of national income and expenditure
such as saving, investment, taxation, Govt, expenditure, exports, imports, etc. are in the form of
currents and gross currents in such a manner that national income equal, national expenditure.

Primarily there are two sectors in an economy households and business. The household sectors
own all the factors of production. This sector receives income by selling the services of these
factors to the business sector. The business sector consists of producers. Who produce and sell
for the household consumers. The home hold sector buys the products of the business sector.
Under circular flow payments go round in a circular manner from the business sector to the
house hold sector and from household sector to the business sector.

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LIMITATIONS OF INPUT-OUTPUT ACCOUNTING ANALYSIS:

1. Constancy of Input Coefficient Assumption Unrealistic:The input-output analysis has its

shortcomings. Its framework rests on the assumption of constancy of input co-efficient of
production. It tells us nothing as to how technical coefficients would change with changed
conditions.

2. Factor Substitution Possible:This assumption of fixed coefficients of production ignores the

possibility of factor substitution. There is always the possibility of some substitutions even in a
short period, while substitution possibilities are likely to be relatively greater over a longer
period.

3. Rigid Model:The rigidity of the input-output model cannot reflect such phenomena as
bottlenecks, increasing costs, etc.

4. Restrictive Model:The input-output model is severely simplified and restricted as it lays

exclusive emphasis on the production side for the economy. It does not tell us why the inputs and
outputs are of a particular pattern in the economy.

5. Difficulty in Final Demand:Another difficulty arises in the case of “final demand” or “bill of
goods.” In this analysis, the purchases by the government and consumers are taken as given and
treated as a specific bill of goods. Final demand is regarded as an independent variable. It might,
therefore, fail to utilize all the factors proportionately or need more than their available supply.
Assuming constancy of co-efficiency of production, the analysis is not in a position to solve this
difficulty.

6. Quantity of Inputs not Constant:This analysis operates on the basis of a fixed quantity of an
input for the production of per unit of output. As factors are mostly indivisible, the increases in
outputs are not expected to be in proportion to the increases in inputs.

7. Solution of Equations Difficult:The input-output model works on equations which cannot be

solved easily. First, the model of equations is prepared and then large numbers of data are
collected. Equations require thorough knowledge of higher mathematics and even the collection
of data is not so easy. This makes the construction of input-output model difficult.

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ENDOGENOUS VARIABLES AND EXOGENOUS VARIABLES

ENDOGENOUS VARIABLES

Endogenous variables are used in econometrics and sometimes in linear regression. They are
similar to (but not exactly the same as) dependent variables. Endogenous variables have values
that are determined by other variables in the system (these “other” variables are called
exogenous variables). According to Daniel Little, University of Michigan-Dearborn, an
endogenous variable is defined in the following way:

Let’s suppose a manufacturing plant produces a certain amount of white sugar. The amount of
product (white sugar) is the endogenous variable and is dependent on any number of other
variables which may include weather, pests, price of fuel etc. As the amount of sugar is entirely
dependent on the other factors in the system, it’s said to be purely endogenous. However, in real
life purely endogenous variables are a rarity; it’s more likely that endogenous variables are only
partially determined by exogenous factors. For example, sugar production is affected by pests,
and pests are affected by weather. Therefore, pests in this particular system are partially
endogenous and partially exogenous

EXOGENOUS VARIABLES

An exogenous variable is a variable that is not affected by other variables in the system. For
example, take a simple causal system like farming. Variables like weather, farmer skill, pests, and
availability of seed are all exogenous to crop production. Exogenous comes from the Greek Exo,
meaning “outside” and gignomai, meaning “to produce.” In contrast, an endogenous variable is
one that is influenced by other factors in the system. In this example, flower growth is affected by
sunlight and is therefore endogenous.

Exogenous variables…

 are fixed when they enter the model.

 are taken as a “given” in the model.
 influence endogenous variables in the model.
 are not determined by the model.
 are not explained by the model.

The term “Exogenous variable” is almost exclusively used in econometrics. However, it is

sometimes used in linear regression to describe the independent variable x in the model. In other
words, an exogenous variable is one that isn’t affected by any other variables in the model
(although it could be affected by factors outside of the linear regression model being studied).

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THE HAWKINS–SIMON MODEL

The Hawkins–Simon condition refers to a result in mathematical economics, attributed to David
Hawkins and Herbert A. Simon, that guarantees the existence of a non-negative output vector that
solves the equilibrium relation in the input–output model where demand equals supply.

An economy in which the input requirements for production are directly proportional to the
levels of production can be described by a set of linear equations. . The linear equations can be
expressed in terms of matrices.

Suppose an economy has n industries each producing a single unique product. (There is a
generalization of input output analysis, called activity analysis, in which an industry may produce
more than one product, some of which could be pollutants.) Let the product input requirements
per unit of product output be expressed as an nxn matrix A. Let X be the n dimensional vector of
outputs and F the n dimensional vector of final demands. The amounts of production used up in
producing output X is AX. This is called the intermediary demand. The total demand is thus AX+F.
The supply of products is just the vector X. For an equilibrium between supply and demand the
following equations must be satisfied.

X = AX + F

The equilibium production is then given by

X = (I−A)-1F

A viable economy is one in which any vector of nonnegative final demand induces a vector of
nonnegative industrial productions. In order for this to be true the elements of (I−A)-1 must all be
positive. For this to be true (I−A) has to satisfy certain coditions.

A minor of a matrix is the value of a determinant. The principal leading minors of an nxn matrix
are evaluated on what is left after the last m rows and columes are deleted, where m runs from
(n-1) down to 0.

The condition for the n*n matrix of (I−A) to have an inverse of nonnegative elements is that its
principal leading minors be positive. This is known as the Hawkins-Simon conditions.

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 T.RAMA KRISHANA RAO (8839271225)

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 T.RAMA KRISHANA RAO (8839271225)

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 T.RAMA KRISHANA RAO (8839271225)

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 T.RAMA KRISHANA RAO (8839271225)

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 T.RAMA KRISHANA RAO (8839271225)

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 T.RAMA KRISHANA RAO (8839271225)

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 T.RAMA KRISHANA RAO (8839271225)

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 T.RAMA KRISHANA RAO (8839271225)

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 T.RAMA KRISHANA RAO (8839271225)

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 T.RAMA KRISHANA RAO (8839271225)

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 T.RAMA KRISHANA RAO (8839271225)

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 T.RAMA KRISHANA RAO (8839271225)

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 T.RAMA KRISHANA RAO (8839271225)

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 T.RAMA KRISHANA RAO (8839271225)

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