SCM Session 6

Correlation and
Regression
Analysis
 The product moment correlation, r, summarizes the strength of
association between two metric (interval or ratio scaled)
variables, say X and Y.

 It is an index used to determine whether a linear or straight-

line relationship exists between X and Y.

 As it was originally proposed by Karl Pearson, it is also known

as the Pearson correlation coefficient.
It is also referred to as simple correlation, bivariate correlation,
or merely the correlation coefficient.
From a sample of n observations, X and Y, the product
moment correlation, r, can be calculated as:
n
S (X i - X )(Y i - Y )
r= i=1
n n
S (X i - X )2 S (Y i - Y )2
i=1 i=1

D iv is io n o f th e n u m er ato r an d d en o m in ato r b y ( n - 1 ) g iv es

n
S ( X i - X )( Y i - Y )
n -1
r= i=1

S
n
( X i - X ) 2 Sn ( Y i - Y ) 2
n -1 n -1
i=1 i=1

C OV x y
=
SxSy
 r varies between -1.0 and +1.0.

 The correlation coefficient between two

variables will be the same regardless of
their underlying units of measurement.
Table 1.1
Respondent No Attitude Toward Duration of Importance
the City Residence Attached to
Weather
1 6 10 3

2 9 12 11

3 8 12 4

4 3 4 1

5 10 12 11

6 4 6 1

7 5 8 7

8 2 2 4

9 11 18 8

10 9 9 10

11 10 17 8

12 2 2 5
The correlation coefficient may be calculated as
follows:
= (10 + 12 + 12 + 4 + 12 + 6 + 8 + 2 + 18 + 9 + 17 + 2)/12
X = 9.333

= (6 + 9 + 8 + 3 + 10 + 4 + 5 + 2 + 11 + 9 + 10 + 2)/12
Y = 6.583
n = (10 -9.33)(6-6.58) + (12-9.33)(9-6.58)
S (X i - X )(Y i - Y ) + (12-9.33)(8-6.58) + (4-9.33)(3-6.58)
i =1 + (12-9.33)(10-6.58) + (6-9.33)(4-6.58)
+ (8-9.33)(5-6.58) + (2-9.33) (2-6.58)
+ (18-9.33)(11-6.58) + (9-9.33)(9-6.58)
+ (17-9.33)(10-6.58) + (2-9.33)(2-6.58)
= -0.3886 + 6.4614 + 3.7914 + 19.0814
+ 9.1314 + 8.5914 + 2.1014 + 33.5714
+ 38.3214 - 0.7986 + 26.2314 + 33.5714
= 179.6668
 n
S (X i - X )2 = (10-9.33)2 + (12-9.33)2 + (12-9.33)2 + (4-9.33)2
i =1 + (12-9.33)2 + (6-9.33)2 + (8-9.33)2 + (2-9.33)2
+ (18-9.33)2 + (9-9.33)2 + (17-9.33)2 + (2-9.33)2
= 0.4489 + 7.1289 + 7.1289 + 28.4089
+ 7.1289+ 11.0889 + 1.7689 + 53.7289
+ 75.1689 + 0.1089 + 58.8289 + 53.7289
= 304.6668

n
S (Y i - Y )2 = (6-6.58)2 + (9-6.58)2 + (8-6.58)2 + (3-6.58)2
i =1 + (10-6.58)2+ (4-6.58)2 + (5-6.58)2 + (2-6.58)2
+ (11-6.58)2 + (9-6.58)2 + (10-6.58)2 + (2-6.58)2
= 0.3364 + 5.8564 + 2.0164 + 12.8164
+ 11.6964 + 6.6564 + 2.4964 + 20.9764
+ 19.5364 + 5.8564 + 11.6964 + 20.9764
= 120.9168

Thus, r= 179.6668
(304.6668) (120.9168) = 0.9361
 E x p la in e d v a r ia tio n
r2 =
T o ta l v a r ia tio n

S S
= x
S S y

= T o ta l v a r ia tio n - E r r o r v a r ia tio n
T o ta l v a r ia tio n

S S y - S S e rro r
=
S S y
 When it is computed for a population rather than a
sample, the product moment correlation is denoted
by r , the Greek letter rho. The coefficient r is an
estimator of r .

 The statistical significance of the relationship

between two variables measured by using r can be
conveniently tested. The hypotheses are:

H0 : r = 0
H1 : r  0
The test statistic is:
1/2
t = r n-2
1 - r2
which has a t distribution with n - 2 degrees of freedom.
For the correlation coefficient calculated based on the
data given in Table 1.1,
12-2 1 /2
t = 0. 9361
1 - (0. 9361) 2
= 8.414
and the degrees of freedom = 12-2 = 10. From the t distribution
table the critical value of t for a two-tailed test and a = 0.05 is
2.228. Hence, the null hypothesis of no relationship between X and
Y is rejected.
A partial correlation coefficient measures the
association between two variables after
controlling for, or adjusting for, the effects
of one or more additional variables.
rx y - (rx z ) (ry z )
rx y . z =
1 - rx2z 1 - ry2z
 Partial correlations have an order associated
with them. The order indicates how many
variables are being adjusted or controlled.
 The simple correlation coefficient, r, has a
zero-order, as it does not control for any
additional variables while measuring the
association between two variables.
 The coefficient rxy.z is a first-order partial
correlation coefficient, as it controls for the
effect of one additional variable, Z.

 A second-order partial correlation coefficient

controls for the effects of two variables, a
third-order for the effects of three variables,
and so on.

 The special case when a partial correlation is

larger than its respective zero-order
correlation involves a suppressor effect.
Regression analysis examines associative relationships
between a metric dependent variable and one or more
independent variables in the following ways:
 Determine whether the independent variables explain a
significant variation in the dependent variable: whether a
relationship exists.
 Determine how much of the variation in the dependent variable
can be explained by the independent variables: strength of the
relationship.
 Determine the structure or form of the relationship: the
mathematical equation relating the independent and dependent
variables.
 Predict the values of the dependent variable.

 Control for other independent variables when evaluating the

contributions of a specific variable or set of variables.
 Regression analysis is concerned with the nature and degree of
association between variables and does not imply or assume any
causality.
 Bivariate regression model. The basic regression
equation is Yi =b 0 + b 1 Xi + ei, where Y = dependent or
criterion variable, X = independent or predictor variable, b 0
= intercept of the line,b 1 = slope of the line, and ei is the
error term associated with the i th observation.

 Coefficient of determination. The strength of association

is measured by the coefficient of determination, r 2. It
varies between 0 and 1 and signifies the proportion of the
total variation in Y that is accounted for by the variation in
X.

 Estimated or predicted value. The estimated or predicted

value of Yi is Y i = a + b x, where Y i is the predicted value
of Yi, and a and b are estimators of b and b , respectively.
0 1
 Regression coefficient. The estimated parameter
b is usually referred to as the non-standardized
regression coefficient.
 Scattergram. A scatter diagram, or scattergram,
is a plot of the values of two variables for all the
cases or observations.
 Standard error of estimate. This statistic, SEE, is
the standard deviation of the actual Y values from
the predicted Y values.
 Standard error. The standard deviation of b, SEb,
is called the standard error.
 Standardized regression coefficient. Also termed the
beta coefficient or beta weight, this is the slope
obtained by the regression of Y on X when the data are
standardized.

 Sum of squared errors. The distances of all the points

from the regression line are squared and added
together to arrive at the sum of squared errors, which is
a measure of total error, 2
Sej
 t statistic. A t statistic with n - 2 degrees of freedom
can be used to test the null hypothesis that no linear
relationship exists between X and Y, or H0: β = 0,
where t=b /SEb
 A scatter diagram, or scattergram, is a plot of
the values of two variables for all the cases or
observations.

 The most commonly used technique for

fitting a straight line to a scattergram is the
least-squares procedure. In fitting the line,
the least-squares procedure minimizes the
sum of squared errors, Se 2.
j
 Plot the Scatter Diagram

Formulate the General Model

Estimate the Parameters

Estimate Standardized Regression Coefficients

Test for Significance

Determine the Strength and Significance of Association

Check Prediction Accuracy

Examine the Residuals

Cross-Validate the Model

In the bivariate regression model, the general form of a
straight line is: Y = b 0 + b 1 X

where
Y = dependent or criterion variable
X = independent or predictor variable
b 0 = intercept of the line
b 1 = slope of the line

The regression procedure adds an error term to account

for the
probabilistic or stochastic nature of the relationship:

Yi = b0 + b1 Xi + ei

where ei is the error term associated

with the i th observation.
 9
Attitude

2.25 4.5 6.75 9 11.25 13.5 15.75 18

Duration of Residence
 β0 + β1X
Y
YJ
eJ

eJ

YJ

X
X1 X2 X3 X4 X5
In most cases,b 0 and b 1 are unknown and are estimated
from the sample observations using the equation

Y i = a + b xi
where Y i is the estimated or predicted value of Yi, and
a and b are estimators ofb 0 and b 1 , respectively.
COV xy
b=
S x2

n
S (X i - X )(Y i - Y )
= i=1
n 2
S (X i - X )
i=1

n
S X iY i - nX Y
= i=1
n
S X i2 - nX 2
i=1
The intercept, a, may then be calculated using:

a = Y- b X
For the data in Table 1.1, the estimation of parameters
may be illustrated as follows:
12
S XiYi
i =1

= (10) (6) + (12) (9) + (12) (8) + (4) (3) + (12) (10) + (6) (4)
+ (8) (5) + (2) (2) + (18) (11) + (9) (9) + (17) (10) + (2) (2)
= 917

12
S Xi2 = 102 + 122 + 122 + 42 + 122 + 62
i =1 + 82 + 22 + 182 + 92 + 172 + 22
= 1350
It may be recalled from earlier calculations of the simple
correlation that:
X = 9.333
Y = 6.583
Given n = 12, b can be calculated as:
917 - (12) (9.333) ( 6.583)
b=
1350 - (12) (9.333)2
= 0.5897

a = Y - bX
= 6.583 - (0.5897) (9.333)
= 1.0793
 Standardization is the process by which the raw data are
transformed into new variables that have a mean of 0
and a variance of 1 .
 When the data are standardized, the intercept assumes a
value of 0.
 The term beta coefficient or beta weight is used to
denote the standardized regression coefficient.

Byx = Bxy = rxy

 There is a simple relationship between the standardized

and non-standardized regression coefficients:

Byx = byx (Sx /Sy)

The statistical significance of the linear relationship
between X and Y may be tested by examining the
hypotheses:
H0 : b 1 = 0
H1 : b 1  0
A t statistic with n - 2 degrees of freedom can be
used, where t= b
SEb
SEb denotes the standard deviation of b and is called
the standard error.
Using a computer program, the regression of attitude on duration
of residence, using the data shown in Table 1.1, yielded the
results shown in table 1.2.The intercept, a, equals 1.0793, and
the slope, b, equals 0.5897. Therefore, the estimated equation
is:

Attitude ( Y) = 1.0793 + 0.5897 (Duration of residence)

The standard error, or standard deviation of b is estimated as

0.07008, and the value of the t statistic as t = 0.5897/0.0700 =
8.414, with n - 2 = 10 degrees of freedom.
From Statistical table , we see that the critical
value of t with 10 degrees of freedom and a = 0.05 is 2.228 for
a two-tailed test. Since the calculated value of t is larger than
the critical value, the null hypothesis is rejected.
The total variation, SSy, may be decomposed into the variation
accounted for by the regression line, SSreg, and the error or
residual variation, SSerror or SSres, as follows:

SSy = SSreg + SSres

where n
S S y = iS= 1 ( Y i - Y ) 2

n
S S reg = S (Y i - Y )2
i =1

n
S S res = iS ( Y i - Y i) 2
=1
Y
Residual Variation
SSres
Explained Variation
SSreg
Y

X
X1 X2 X3 X4 X5
The strength of association may then be calculated as
follows:
SS reg
r2 =
SS y

SS y - SS res
=
SS y

To illustrate the calculations of r2, let us consider again the effect of

attitude toward the city on the duration of residence. It may be recalled
from earlier calculations of the simple correlation coefficient that:
n
SS y = S (Y i - Y )2
i =1
= 120.9168
The predicted values ( Y) can be calculated using the regression
equation:

Attitude (Y ) = 1.0793 + 0.5897 (Duration of residence)

For the first observation in Table 1.1, this value is:

(Y ) = 1.0793 + 0.5897 x 10 = 6.9763.

For each successive observation, the predicted values are, in order,

8.1557, 8.1557, 3.4381, 8.1557, 4.6175, 5.7969, 2.2587,
11.6939, 6.3866, 11.1042, and 2.2587.
Therefore, n
S S reg = S (Y i - Y )
2

i =1
= (6.9763-6.5833)2 + (8.1557-6.5833)2
+ (8.1557-6.5833)2 + (3.4381-6.5833)2
+ (8.1557-6.5833)2 + (4.6175-6.5833)2
+ (5.7969-6.5833)2 + (2.2587-6.5833)2
+ (11.6939 -6.5833)2 + (6.3866-6.5833)2
+ (11.1042 -6.5833)2 + (2.2587-6.5833)2
=0.1544 + 2.4724 + 2.4724 + 9.8922 + 2.4724
+ 3.8643 + 0.6184 + 18.7021 + 26.1182
+ 0.0387 + 20.4385 + 18.7021

= 105.9524
 n
SS res = S (Y i - Y i ) = (6-6.9763)2 + (9-8.1557)2 + (8-8.1557)2
2

i =1 + (3-3.4381)2 + (10-8.1557)2 + (4-4.6175)2

+ (5-5.7969)2 + (2-2.2587)2 + (11-11.6939)2
+ (9-6.3866)2 + (10-11.1042)2 + (2-2.2587)2

= 14.9644

It can be seen that SSy = SSreg + SSres . Furthermore,

r 2 = SSreg /SSy
= 105.9524/120.9168
= 0.8762
Another, equivalent test for examining the significance of the
linear relationship between X and Y (significance of b) is the test
for the significance of the coefficient of determination. The
hypotheses in this case are:

H0: R2pop = 0

H1: R2pop > 0

The appropriate test statistic is the F statistic:

SS reg
F=
SS res /(n-2)
which has an F distribution with 1 and n - 2 degrees of freedom.
The F test is a generalized form of the t test . If a random
variable is t distributed with n degrees of freedom, then t2 is F
distributed with 1 and n degrees of freedom. Hence, the F test
for testing the significance of the coefficient of determination is
equivalent to testing the following hypotheses:

H0: b 1 = 0

or H1 : b 1  0

H0 : r = 0
H1 : r  0
From Table 1.2, it can be seen that:

r2 = 105.9522/(105.9522 + 14.9644)

= 0.8762

Which is the same as the value calculated earlier. The value of the
F statistic is:

F = 105.9522/(14.9644/10)
= 70.8027

with 1 and 10 degrees of freedom. The calculated F statistic

exceeds the critical value of 4.96 determined from Table 5 in the
Statistical Appendix. Therefore, the relationship is significant at
a = 0.05, corroborating the results of the t test.
Table 1.2
Multiple R 0.93608
R2 0.87624
Adjusted R2 0.86387
Standard Error 1.22329

ANALYSIS OF VARIANCE
df Sum of Squares Mean Square

Regression 1 105.95222 105.95222

Residual 10 14.96444 1.49644
F = 70.80266 Significance of F = 0.0000

VARIABLES IN THE EQUATION

Variable b SEb Beta (ß) TSignificance

of T
Duration 0.58972 0.07008 0.93608 8.414 0.0000
(Constant) 1.07932 0.74335 1.452 0.1772
To estimate the accuracy of predicted values, Y , it is useful to
calculate the standard error of estimate, SEE.

 (Y i - Yˆ i )
n 2

SEE = i =1

n-2

or
SEE = SS res

n-2

or more generally, if there are k independent variables,

SEE = SS res

n - k -1

For the data given in Table 17.2, the SEE is estimated as follows:

SEE = 14.9644/(12-2)
= 1.22329
 The error term is normally distributed. For each fixed
value of X, the distribution of Y is normal.

 The means of all these normal distributions of Y, given X,

lie on a straight line with slope b.

 The mean of the error term is 0.

 The variance of the error term is constant. This variance

does not depend on the values assumed by X.

 The error terms are uncorrelated. In other words, the

observations have been drawn independently.
The general form of the multiple regression model
is as follows:

Y = b 0 + b 1 X1 + b 2 X2 + b 3 X3+ . . . + b k X k + e
which is estimated by the following equation:

Y = a + b1X1 + b2X2 + b3X3+ . . . + bkXk

As before, the coefficient a represents the intercept,
but the b's are now the partial regression coefficients.
 Adjusted R2. R2, coefficient of multiple determination, is adjusted
for the number of independent variables and the sample size to
account for the diminishing returns. After the first few variables,
the additional independent variables do not make much
contribution.

 Coefficient of multiple determination. The strength of association

in multiple regression is measured by the square of the multiple
correlation coefficient, R2, which is also called the coefficient of
multiple determination.

 F test. The F test is used to test the null hypothesis that the
coefficient of multiple determination in the population, R2pop, is
zero. This is equivalent to testing the null hypothesis. The test
statistic has an F distribution with k and (n - k - 1) degrees of
freedom.
 Partial F test. The significance of a partial regression
coefficient,b i , of Xi may be tested using an incremental F
statistic. The incremental F statistic is based on the
increment in the explained sum of squares resulting from
the addition of the independent variable Xi to the
regression equation after all the other independent
variables have been included.

 Partial regression coefficient. The partial regression

coefficient, b1, denotes the change in the predicted value,
Y , per unit change in X1 when the other independent
variables, X2 to Xk, are held constant.
To understand the meaning of a partial regression coefficient,
let us consider a case in which there are two independent
variables, so that:

Y = a + b1X1 + b2X2

 First, note that the relative magnitude of the partial regression

coefficient of an independent variable is, in general, different
from that of its bivariate regression coefficient.
 The interpretation of the partial regression coefficient, b1, is
that it represents the expected change in Y when X1 is
changed by one unit but X2 is held constant or otherwise
controlled. Likewise, b2 represents the expected change in
Y for a unit change in X2, when X1 is held constant. Thus,
calling b1 and b2 partial regression coefficients is appropriate.
 It can also be seen that the combined effects of X1 and X2 on Y
are additive. In other words, if X1 and X2 are each changed by
one unit, the expected change in Y would be (b1+b2).

 Suppose one was to remove the effect of X2 from X1. This could
be done by running a regression of X1 on X2. In other words,
one would estimate the equation X 1 = a + b X2 and calculate the
residual Xr = (X1 -X 1). The partial regression coefficient, b1, is
then equal to the bivariate regression coefficient, br , obtained
from the equation Y = a + br Xr .
 Extension to the case of k variables is straightforward. The partial
regression coefficient, b1, represents the expected change in Y when X1
is changed by one unit and X2 through Xk are held constant. It can also
be interpreted as the bivariate regression coefficient, b, for the
regression of Y on the residuals of X1, when the effect of X2 through Xk
has been removed from X1.
 The relationship of the standardized to the non-standardized
coefficients remains the same as before:
B1 = b1 (Sx1/Sy)
Bk = bk (Sxk /Sy)

The estimated regression equation is:

(Y ) = 0.33732 + 0.48108 X1 + 0.28865 X2

or

Attitude = 0.33732 + 0.48108 (Duration) + 0.28865 (Importance)

Table 1.3
Multiple R 0.97210
R2 0.94498
Adjusted R2 0.93276
Standard Error 0.85974

ANALYSIS OF VARIANCE
df Sum of Squares Mean Square

Regression 2 114.26425 57.13213

Residual 9 6.65241 0.73916
F = 77.29364 Significance of F = 0.0000

VARIABLES IN THE EQUATION

Variable b SEb Beta (ß) T Significance
of T
IMPORTANCE 0.28865 0.08608 0.31382 3.353 0.0085
DURATION 0.48108 0.05895 0.76363 8.160 0.0000
(Constant) 0.33732 0.56736 0.595 0.5668
 SSy = SSreg + SSres

where
n
SSy = S (Y i - Y )2
i =1
n
S
2
S S reg = (Y i - Y )
i =1
n
S
2
S S res = (Y i - Y i )
i =1
The strength of association is measured by the square of the multiple
correlation coefficient, R2, which is also called the coefficient of
multiple determination.

2 SS reg
R =
SS y

R2 is adjusted for the number of independent variables and the sample

size by using the following formula:
k(1 - R 2 )
Adjusted R2 2
=R -
n-k-1
H0 : R2pop = 0

This is equivalent to the following null hypothesis:

H0: b 1 = b2 = b 3 = . . . = b k = 0

The overall test can be conducted by using an F statistic:

SS reg /k
F=
SS res /(n - k - 1)

= R 2 /k
(1 - R 2 )/(n- k - 1)

which has an F distribution with k and (n - k -1) degrees of freedom.

Testing for the significance of the b 's can be done in a
i
manner similar to that in the bivariate case by using t tests.
The significance of the partial coefficient for importance
attached to whether may be tested by the following equation:

t= b
SE
b

which has a t distribution with n - k -1 degrees of freedom.

 A residual is the difference between the observed value of Yi
and the value predicted by the regression equation Yi.

 Scattergrams of the residuals, in which the residuals are

plotted against the predicted values, Y i, time, or predictor
variables, provide useful insights in examining the
appropriateness of the underlying assumptions and regression
model fit.

 The assumption of a normally distributed error term can be

examined by constructing a histogram of the residuals.

 The assumption of constant variance of the error term can be

examined by plotting the residuals against the predicted
values of the dependent variable, Y i.
 A plot of residuals against time, or the sequence of
observations, will throw some light on the assumption that
the error terms are uncorrelated.
 Plotting the residuals against the independent variables
provides evidence of the appropriateness or
inappropriateness of using a linear model. Again, the plot
should result in a random pattern.
 To examine whether any additional variables should be
included in the regression equation, one could run a
regression of the residuals on the proposed variables.
 If an examination of the residuals indicates that the
assumptions underlying linear regression are not met, the
researcher can transform the variables in an attempt to
satisfy the assumptions.
Residuals

Predicted Y Values
Residuals

Predicted Y Values
 The purpose of stepwise regression is to select, from a large
number of predictor variables, a small subset of variables that
account for most of the variation in the dependent or criterion
variable. In this procedure, the predictor variables enter or are
removed from the regression equation one at a time. There are
several approaches to stepwise regression.
 Forward inclusion. Initially, there are no predictor variables in the
regression equation. Predictor variables are entered one at a
time, only if they meet certain criteria specified in terms of F ratio.
The order in which the variables are included is based on the
contribution to the explained variance.
 Backward elimination. Initially, all the predictor variables are
included in the regression equation. Predictors are then removed
one at a time based on the F ratio for removal.
 Stepwise solution. Forward inclusion is combined with the
removal of predictors that no longer meet the specified criterion
at each step.
 Multicollinearity arises when intercorrelations among the
predictors are very high.

 Multicollinearity can result in several problems, including:

◦ The partial regression coefficients may not be estimated
precisely. The standard errors are likely to be high.
◦ The magnitudes, as well as the signs of the partial
regression coefficients, may change from sample to
sample.
◦ It becomes difficult to assess the relative importance of
the independent variables in explaining the variation in
the dependent variable.
◦ Predictor variables may be incorrectly included or removed
in stepwise regression.
 A simple procedure for adjusting for multicollinearity consists
of using only one of the variables in a highly correlated set of
variables.

 Alternatively, the set of independent variables can be

transformed into a new set of predictors that are mutually
independent by using techniques such as principal components
analysis.

 More specialized techniques, such as ridge regression and

latent root regression, can also be used.
Unfortunately, because the predictors are correlated,
there is no unambiguous measure of relative
importance of the predictors in regression analysis.
However, several approaches are commonly used to
assess the relative importance of predictor variables.

 Statistical significance. If the partial regression coefficient of

a variable is not significant, as determined by an incremental F
test, that variable is judged to be unimportant. An exception
to this rule is made if there are strong theoretical reasons for
believing that the variable is important.
 Square of the simple correlation coefficient. This measure, r 2,
represents the proportion of the variation in the dependent
variable explained by the independent variable in a bivariate
relationship.
 Square of the partial correlation coefficient. This measure, R
yxi.xjxk, is the coefficient of determination between the
2
dependent variable and the independent variable, controlling
for the effects of the other independent variables.
 Square of the part correlation coefficient. This coefficient
represents an increase in R 2 when a variable is entered into a
regression equation that already contains the other
independent variables.
 Measures based on standardized coefficients or beta weights.
The most commonly used measures are the absolute values of
the beta weights, |Bi| , or the squared values, Bi 2.
 Stepwise regression. The order in which the predictors enter
or are removed from the regression equation is used to infer
their relative importance.
 The regression model is estimated using the entire data set.
 The available data are split into two parts, the estimation
sample and the validation sample. The estimation sample
generally contains 50-90% of the total sample.
 The regression model is estimated using the data from the
estimation sample only. This model is compared to the
model estimated on the entire sample to determine the
agreement in terms of the signs and magnitudes of the partial
regression coefficients.
 The estimated model is applied to the data in the validation
sample to predict the values of the dependent variable,Y i, for
the observations in the validation sample.
 The observed values Yi, and the predicted values, Yi, in the
validation sample are correlated to determine the simple r 2.
This measure, r 2, is compared to R 2 for the total sample and
to R 2 for the estimation sample to assess the degree of
shrinkage.
 Product Usage Original Dummy Variable Code
Category Variable
Code D1 D2 D3
Nonusers.............. 1 1 0 0
Light Users.......... 2 0 1 0
Medium Users...... 3 0 0 1
Heavy Users......... 4 0 0 0

Y i = a + b1D1 + b2D2 + b3D3

 In this case, "heavy users" has been selected as a reference category

and has not been directly included in the regression equation.
 The coefficient b1 is the difference in predicted Yi for nonusers, as
compared to heavy users.
In regression with dummy variables, the predicted Y for each
category is the mean of Y for each category.

Product Usage Predicted Mean

Category Value Value
Y Y
Nonusers............... a + b1 a + b1
Light Users........... a + b2 a + b2
Medium Users....... a + b3 a + b3
Heavy Users.......... a a