Statistics For Business and Economics: Simple Regression

Statistics for
Business and Economics

8th Edition
Chapter 11
Simple Regression
Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 11-1
Chapter Goals
After completing this chapter, you should be
able to:
■ Explain the simple linear regression model
■ Obtain and interpret the simple linear regression
equation for a set of data
■ Describe R2 as a measure of explanatory power of the
regression model
■ Understand the assumptions behind regression
analysis
■ Explain measures of variation and determine whether
the independent variable is significant
Chapter Goals
(continued)
After completing this chapter, you should be
able to:
■ Calculate and interpret confidence intervals for the
regression coefficients
■ Use a regression equation for prediction
■ Form forecast intervals around an estimated Y value
for a given X
■ Use graphical analysis to recognize potential problems
in regression analysis
■ Explain the correlation coefficient and perform a
hypothesis test for zero population correlation
11.1
Overview of Linear Models
■ An equation can be fit to show the best linear

relationship between two variables:
Y = β0 + β1X
Where Y is the dependent variable and

X is the independent variable
β0 is the Y-intercept
β1 is the slope
Least Squares Regression
■ Estimates for coefficients β0 and β1 are found
using a Least Squares Regression technique
■ The least-squares regression line, based on sample
data, is
■ Where b1 is the slope of the line and b0 is the

y-intercept:
Introduction to
Regression Analysis
■ Regression analysis is used to:

■ Predict the value of a dependent variable based on
the value of at least one independent variable
■ Explain the impact of changes in an independent
variable on the dependent variable
Dependent variable: the variable we wish to explain
(also called the endogenous variable)
Independent variable: the variable used to explain
the dependent variable
(also called the exogenous variable)
11.2
Linear Regression Model
■ The relationship between X and Y is

described by a linear function
■ Changes in Y are assumed to be influenced
by changes in X
■ Linear regression population equation model
■ Where β0 and β1 are the population model

coefficients and ε is a random error term.
Simple Linear Regression
Model
The population regression model:
Population Random
Population Independent Error
Slope
Y intercept Variable term
Coefficient
Dependent
Variable
Linear component Random Error

component
Linear Regression Assumptions
■ The true relationship form is linear (Y is a linear function

of X, plus random error)
■ The error terms, εi are independent of the x values
■ The error terms are random variables with mean 0 and
constant variance, σ2
(the uniform variance property is called homoscedasticity)
■ The random error terms, εi, are not correlated with one
another, so that
Model
(continued)
Y
Observed Value
of Y for xi
εi Slope = β1
Predicted Value Random Error
of Y for xi
for this Xi value
Intercept = β0
xi X
Equation
The simple linear regression equation provides an
estimate of the population regression line
Estimated (or Estimate of Estimate of the
predicted) y the regression regression slope
value for intercept
observation i
Value of x for
observation i
The individual random error terms ei have a mean of zero
11.3
Least Squares
Coefficient Estimators
■ b0 and b1 are obtained by finding the values

of b0 and b1 that minimize the sum of the
squared residuals (errors), SSE:
Differential calculus is used to obtain the

coefficient estimators b0 and b1 that minimize SSE
Least Squares
Coefficient Estimators
(continued)
■ The slope coefficient estimator is
■ And the constant or y-intercept is
■ The regression line always goes through the mean x, y
Computer Computation of
Regression Coefficients
■ The coefficients b0 and b1 , and other

regression results in this chapter, will be
found using a computer
■ Hand calculations are tedious
■ Statistical routines are built into Excel
■ Other statistical analysis software can be used
Interpretation of the
Slope and the Intercept
■ b0 is the estimated average value of y

when the value of x is zero (if x = 0 is
in the range of observed x values)
■ b1 is the estimated change in the

average value of y as a result of a
one-unit change in x
Example
■ A real estate agent wishes to examine the

relationship between the selling price of a home
and its size (measured in square feet)
■ A random sample of 10 houses is selected

■ Dependent variable (Y) = house price in $1000s
■ Independent variable (X) = square feet
Sample Data for
House Price Model
House Price in $1000s Square Feet
(Y) (X)
245 1400
312 1600
279 1700
308 1875
199 1100
219 1550
405 2350
324 2450
319 1425
255 1700
Graphical Presentation
■ House price model: scatter plot
Regression Using Excel
■ Excel will be used to generate the coefficients and
measures of goodness of fit for regression
■ Data / Data Analysis / Regression
Regression Using Excel
(continued)
■ Data / Data Analysis / Regression
Provide desired input:
Excel Output
Excel Output
(continued)
Regression Statistics
Multiple R 0.76211 The regression equation is:
R Square 0.58082
Adjusted R Square 0.52842
Standard Error 41.33032
Observations 10
ANOVA
df SS MS F Significance F
Regression 1 18934.9348 18934.9348 11.0848 0.01039
Residual 8 13665.5652 1708.1957
Total 9 32600.5000
Coefficients Standard Error t Stat P-value Lower 95% Upper 95%

Intercept 98.24833 58.03348 1.69296 0.12892 -35.57720 232.07386
Square Feet 0.10977 0.03297 3.32938 0.01039 0.03374 0.18580
Graphical Presentation
■ House price model: scatter plot and
regression line
Slope
= 0.10977
Intercept
= 98.248
Intercept, b0
■ b0 is the estimated average value of Y when the

value of X is zero (if X = 0 is in the range of
observed X values)
■ Here, no houses had 0 square feet, so b0 = 98.24833
just indicates that, for houses within the range of
sizes observed, $98,248.33 is the portion of the
house price not explained by square feet
Slope Coefficient, b1
■ b1 measures the estimated change in the

average value of Y as a result of a
one-unit change in X
■ Here, b1 = .10977 tells us that the average value of a
house increases by .10977($1000) = $109.77, on
average, for each additional one square foot of size
11.4
Explanatory Power of a
Linear Regression Equation
■ Total variation is made up of two parts:
Total Sum of Regression Sum Error (residual)

Squares of Squares Sum of Squares
where:
= Average value of the dependent variable
yi = Observed values of the dependent variable
i
= Predicted value of y for the given xi value
Analysis of Variance
■ SST = total sum of squares

■ Measures the variation of the yi values around their
mean, y
■ SSR = regression sum of squares
■ Explained variation attributable to the linear
relationship between x and y
■ SSE = error sum of squares
■ Variation attributable to factors other than the linear
relationship between x and y
Analysis of Variance
(continued)
Y Unexplained
yi variation ∧
∧ 2 y
SSE = ∑(yi - yi )
_
SST = ∑(yi - y)2
Explained
∧
y ∧ _2 variation
_ SSR = ∑(yi - y) _
y y
xi X
2
Coefficient of Determination, R
■ The coefficient of determination is the portion
of the total variation in the dependent variable
that is explained by variation in the
independent variable
■ The coefficient of determination is also called
R-squared and is denoted as R2
note:
Examples of Approximate
r2 Values
Y
r2 = 1
Perfect linear relationship

between X and Y:
X
2
r =1
Y 100% of the variation in Y is
explained by variation in X
2 X
r =1
2
r Values
Y
0 < r2 < 1
Weaker linear relationships

between X and Y:
X
Some but not all of the
Y
variation in Y is explained
by variation in X
X
2
r Values
r2 = 0
Y
No linear relationship
between X and Y:
The value of Y does not

X depend on X. (None of the
r2 = 0
variation in Y is explained
by variation in X)
Excel Output
Multiple R 0.76211
R Square 0.58082
Adjusted R Square 0.52842 58.08% of the variation in
house prices is explained by
Observations 10
variation in square feet
ANOVA
Regression 1 18934.9348 18934.9348 11.0848 0.01039
Residual 8 13665.5652 1708.1957
Total 9 32600.5000

Intercept 98.24833 58.03348 1.69296 0.12892 -35.57720 232.07386
Square Feet 0.10977 0.03297 3.32938 0.01039 0.03374 0.18580
Correlation and R2
■ The coefficient of determination, R2, for a

simple regression is equal to the simple
correlation squared
Estimation of Model
Error Variance
■ An estimator for the variance of the population model

error is
■ Division by n – 2 instead of n – 1 is because the simple regression

model uses two estimated parameters, b0 and b1, instead of one
is called the standard error of the estimate
Excel Output
Multiple R 0.76211
R Square 0.58082
Observations 10
ANOVA
Regression 1 18934.9348 18934.9348 11.0848 0.01039
Residual 8 13665.5652 1708.1957
Total 9 32600.5000

Intercept 98.24833 58.03348 1.69296 0.12892 -35.57720 232.07386
Square Feet 0.10977 0.03297 3.32938 0.01039 0.03374 0.18580
Comparing Standard Errors
se is a measure of the variation of observed y
values from the regression line
Y Y
X X
The magnitude of se should always be judged relative to the size

of the y values in the sample data
i.e., se = $41.33K is moderately small relative to house prices in

the $200 - $300K range
11.5
Statistical Inference: Hypothesis
Tests and Confidence Intervals
■ The variance of the regression slope coefficient

(b1) is estimated by
where:
= Estimate of the standard error of the least squares slope
= Standard error of the estimate
Excel Output
Multiple R 0.76211
R Square 0.58082
Observations 10
ANOVA
Regression 1 18934.9348 18934.9348 11.0848 0.01039
Residual 8 13665.5652 1708.1957
Total 9 32600.5000

Intercept 98.24833 58.03348 1.69296 0.12892 -35.57720 232.07386
Square Feet 0.10977 0.03297 3.32938 0.01039 0.03374 0.18580
Comparing Standard Errors of
the Slope
is a measure of the variation in the slope of regression

lines from different possible samples
Y Y
X X
Inference about the Slope:
t Test
■ t test for a population slope
■ Is there a linear relationship between X and Y?
■ Null and alternative hypotheses
H0: β1 = 0 (no linear relationship)
H1: β1 ≠ 0 (linear relationship does exist)
■ Test statistic
where:
b1 = regression slope
coefficient
β1 = hypothesized slope
sb1 = standard
error of the slope
Inference about the Slope:
t Test
(continued)
House Price Estimated Regression Equation:

Square Feet
in $1000s
(x)
(y)
245 1400
312 1600
279 1700
308 1875 The slope of this model is 0.1098
199 1100
219 1550
Does square footage of the house
405 2350
significantly affect its sales price?
324 2450
319 1425
255 1700
Inferences about the Slope:
t Test Example
H 0: β 1 = 0 From Excel output: b1

H 1: β 1 ≠ 0 Coefficients Standard Error t Stat P-value
Intercept 98.24833 58.03348 1.69296 0.12892
Square Feet 0.10977 0.03297 3.32938 0.01039
t Test Example
(continued)
Test Statistic: t = 3.329
H 0: β 1 = 0 From Excel output: b1 t
Intercept 98.24833 58.03348 1.69296 0.12892
d.f. = 10-2 = 8 Square Feet 0.10977 0.03297 3.32938 0.01039
t8,.025 = 2.3060
Decision:
α/2=.025 α/2=.025 Reject H0
Conclusion:
Reject H0 Do not reject H0 Reject H0

There is sufficient evidence
-tn-2,α/2 0 tn-2,α/2 that square footage affects
-2.3060 2.3060 3.329 house price
t Test Example
(continued)
P-value = 0.01039
P-value
H 0: β 1 = 0 From Excel output:
Intercept 98.24833 58.03348 1.69296 0.12892
Square Feet 0.10977 0.03297 3.32938 0.01039
This is a two-tail test, so Decision: P-value < α so

the p-value is Reject H0
Conclusion:
P(t > 3.329)+P(t < -3.329)
= 0.01039 There is sufficient evidence
(for 8 d.f.) that square footage affects
house price
Confidence Interval Estimate
for the Slope
Confidence Interval Estimate of the Slope:
d.f. = n - 2
Excel Printout for House Prices:

Intercept 98.24833 58.03348 1.69296 0.12892 -35.57720 232.07386
Square Feet 0.10977 0.03297 3.32938 0.01039 0.03374 0.18580
At 95% level of confidence, the confidence interval for

the slope is (0.0337, 0.1858)
Confidence Interval Estimate
for the Slope
(continued)

Intercept 98.24833 58.03348 1.69296 0.12892 -35.57720 232.07386
Square Feet 0.10977 0.03297 3.32938 0.01039 0.03374 0.18580
Since the units of the house price variable is

$1000s, we are 95% confident that the average
impact on sales price is between $33.70 and
$185.80 per square foot of house size
This 95% confidence interval does not include 0.

Conclusion: There is a significant relationship between
house price and square feet at the .05 level of significance
Hypothesis Test for Population
Slope Using the F Distribution
■ F Test statistic:
where
where F follows an F distribution with k numerator and (n – k - 1)

denominator degrees of freedom
(k = the number of independent variables in the regression model)
Hypothesis Test for Population
Slope Using the F Distribution
(continued)
■ An alternate test for the hypothesis that the

slope is zero:
H 0: β 1 = 0
H 1: β 1 ≠ 0
■ Use the F statistic
■ The decision rule is

reject H0 if F ≥ F1,n-2,α
Excel Output
Multiple R 0.76211
R Square 0.58082
Observations 10 With 1 and 8 degrees P-value for
of freedom the F-Test
ANOVA
Regression 1 18934.9348 18934.9348 11.0848 0.01039
Residual 8 13665.5652 1708.1957
Total 9 32600.5000

Intercept 98.24833 58.03348 1.69296 0.12892 -35.57720 232.07386
Square Feet 0.10977 0.03297 3.32938 0.01039 0.03374 0.18580
F-Test for Significance
(continued)
H 0: β 1 = 0 Test Statistic:
H 1: β 1 ≠ 0
α = .05
df1= 1 df2 = 8
Decision:
Critical Reject H0 at α = 0.05
Value:
F1,8,0.05 = 5.32
Conclusion:
α = .05
There is sufficient evidence that
0 F house size affects selling price
Do not Reject H0
reject H0
F.05 = 5.32
11.6
Prediction
■ The regression equation can be used to

predict a value for y, given a particular x
■ For a specified value, xn+1 , the predicted

value is
Predictions Using
Regression Analysis
Predict the price for a house
with 2000 square feet:
The predicted price for a house with 2000

square feet is 317.85($1,000s) = $317,850
Relevant Data Range
■ When using a regression model for prediction,
only predict within the relevant range of data
Relevant data range
Risky to try to
extrapolate far
beyond the range
of observed x
values
Estimating Mean Values and
Predicting Individual Values
Goal: Form intervals around y to express
uncertainty about the value of y for a given xi
Confidence
Interval for Y ∧
the expected y
value of y,
given xi
∧
y = b0+b1xi
Prediction Interval
for an single
observed y, given xi
xi X
Confidence Interval for
the Average Y, Given X
Confidence interval estimate for the
expected value of y given a particular xi
Notice that the formula involves the term

so the size of interval varies according to the distance
xn+1 is from the mean, x
Prediction Interval for
an Individual Y, Given X
Confidence interval estimate for an actual
observed value of y given a particular xi
This extra term adds to the interval width to reflect

the added uncertainty for an individual case
Example: Confidence Interval for
the Average Y, Given X
Confidence Interval Estimate for E(Yn+1|Xn+1)
Find the 95% confidence interval for the mean price

of 2,000 square-foot houses
∧
Predicted Price yi = 317.85 ($1,000s)
The confidence interval endpoints are 280.73 and 354.97,

or from $280,730 to $354,970
Example: Prediction Interval for
an Individual Y, Given X
∧
Confidence Interval Estimate for yn+1
Find the 95% confidence interval for an individual

house with 2,000 square feet
∧
Predicted Price yi = 317.85 ($1,000s)
The confidence interval endpoints are 215.57 and

420.13, or from $215,570 to $420,130
11.7
Correlation Analysis
■ Correlation analysis is used to measure
strength of the association (linear relationship)
between two variables
■ Correlation is only concerned with strength of the
relationship
■ No causal effect is implied with correlation
■ Correlation was first presented in Chapter 4
Correlation Analysis
■ The population correlation coefficient is
denoted ρ (the Greek letter rho)
■ The sample correlation coefficient is
where
Test for Zero
Population Correlation
■ To test the null hypothesis of no linear

association,
the test statistic follows the Student’s t

distribution with (n – 2 ) degrees of freedom:
Decision Rules
Hypothesis Test for Correlation
Lower-tail test: Upper-tail test: Two-tail test:

H 0: ρ ≥ 0 H 0: ρ ≤ 0 H 0: ρ = 0
H 1: ρ < 0 H 1: ρ > 0 H 1: ρ ≠ 0
α α α/2 α/2
-tα tα -tα/2 tα/2

Reject H0 if t < -tn-2, α Reject H0 if t > tn-2, α Reject H0 if t < -tn-2, α/2
or t > tn-2, α/2
Where has n - 2 d.f.
11.8
Beta Measure of Financial Risk
■ A Beta Coefficient is a measure of how the

returns of a particular firm respond to the
returns of a broad stock index (such as the S&P
500)
■ For a specific firm, the Beta Coefficient is the
slope coefficient from a regression of the firm’s
returns compared to the overall market returns
over some specified time period
Beta Coefficient Example
■ Slope coefficient is the Beta Coefficient
Information about
the quality of the
regression
model that
provides the
estimate of beta
11.9
Graphical Analysis
■ The linear regression model is based on

minimizing the sum of squared errors
■ If outliers exist, their potentially large squared
errors may have a strong influence on the fitted
regression line
■ Be sure to examine your data graphically for
outliers and extreme points
■ Decide, based on your model and logic, whether
the extreme points should remain or be removed
Chapter Summary
■ Introduced the linear regression model
■ Reviewed correlation and the assumptions of
linear regression
■ Discussed estimating the simple linear
regression coefficients
■ Described measures of variation
■ Described inference about the slope
■ Addressed estimation of mean values and
prediction of individual values
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Statistics for

Business and Economics

■ An equation can be fit to show the best linear

Where Y is the dependent variable and

■ Where b1 is the slope of the line and b0 is the

■ Regression analysis is used to:

■ The relationship between X and Y is

■ Where β0 and β1 are the population model

Linear component Random Error

■ The true relationship form is linear (Y is a linear function

The individual random error terms ei have a mean of zero

■ b0 and b1 are obtained by finding the values

Differential calculus is used to obtain the

■ The slope coefficient estimator is

■ And the constant or y-intercept is

■ The regression line always goes through the mean x, y

■ The coefficients b0 and b1 , and other

■ b0 is the estimated average value of y

■ b1 is the estimated change in the

■ A real estate agent wishes to examine the

■ A random sample of 10 houses is selected

■ Independent variable (X) = square feet

■ House price model: scatter plot

Provide desired input:

Coefficients Standard Error t Stat P-value Lower 95% Upper 95%

■ b0 is the estimated average value of Y when the

■ b1 measures the estimated change in the

■ Total variation is made up of two parts:

Total Sum of Regression Sum Error (residual)

■ SST = total sum of squares

Perfect linear relationship

Weaker linear relationships

The value of Y does not

Coefficients Standard Error t Stat P-value Lower 95% Upper 95%

■ The coefficient of determination, R2, for a

■ An estimator for the variance of the population model

■ Division by n – 2 instead of n – 1 is because the simple regression

is called the standard error of the estimate

Coefficients Standard Error t Stat P-value Lower 95% Upper 95%

The magnitude of se should always be judged relative to the size

i.e., se = $41.33K is moderately small relative to house prices in

■ The variance of the regression slope coefficient

= Standard error of the estimate

Coefficients Standard Error t Stat P-value Lower 95% Upper 95%

is a measure of the variation in the slope of regression

House Price Estimated Regression Equation:

H 0: β 1 = 0 From Excel output: b1

Reject H0 Do not reject H0 Reject H0

This is a two-tail test, so Decision: P-value < α so

Excel Printout for House Prices:

At 95% level of confidence, the confidence interval for

Coefficients Standard Error t Stat P-value Lower 95% Upper 95%

Since the units of the house price variable is

This 95% confidence interval does not include 0.

where F follows an F distribution with k numerator and (n – k - 1)

(k = the number of independent variables in the regression model)

■ An alternate test for the hypothesis that the

■ The decision rule is

Coefficients Standard Error t Stat P-value Lower 95% Upper 95%