Introduction To Econometrics, 5 Edition: Chapter 1: Simple Regression Analysis

Type author name/s here
Dougherty
Introduction to Econometrics,
5th edition
Chapter heading
Chapter 1: Simple Regression
Analysis
© Christopher Dougherty, 2016. All rights reserved.

INTERPRETATION OF A REGRESSION EQUATION
120
100
Hourly earnings ($)
80
60
40
20
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Years of schooling (highest grade completed)
The scatter diagram shows hourly earnings in 2011 plotted against years of schooling,
defined as highest grade completed, for a sample of 500 respondents from the National
Longitudinal Survey of Youth 1997–.
1
120
100
Hourly earnings ($)
80
60
40
20
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Highest grade completed means just that for elementary and high school. Grades 13, 14,
and 15 mean completion of one, two and three years of college.
2
120
100
Hourly earnings ($)
80
60
40
20
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Grade 16 means completion of four-year college. Higher grades indicate years of

postgraduate education.
3
. reg EARNINGS S
----------------------------------------------------------------------------
Source | SS df MS Number of obs = 500
-----------+------------------------------ F( 1, 498) = 46.57
Model | 6014.04474 1 6014.04474 Prob > F = 0.0000
Residual | 64314.9215 498 129.146429 R-squared = 0.0855
-----------+------------------------------ Adj R-squared = 0.0837
Total | 70328.9662 499 140.939812 Root MSE = 11.364
----------------------------------------------------------------------------
EARNINGS | Coef. Std. Err. t P>|t| [95% Conf. Interval]
-----------+----------------------------------------------------------------
S | 1.265712 .1854782 6.82 0.000 .9012959 1.630128
_cons | .7646844 2.803765 0.27 0.785 -4.743982 6.273351
----------------------------------------------------------------------------
This is the output from a regression of earnings on years of schooling, using Stata.
4
. reg EARNINGS S
----------------------------------------------------------------------------
-----------+------------------------------ F( 1, 498) = 46.57
Model | 6014.04474 1 6014.04474 Prob > F = 0.0000
-----------+------------------------------ Adj R-squared = 0.0837
Total | 70328.9662 499 140.939812 Root MSE = 11.364
----------------------------------------------------------------------------
-----------+----------------------------------------------------------------
S | 1.265712 .1854782 6.82 0.000 .9012959 1.630128
_cons | .7646844 2.803765 0.27 0.785 -4.743982 6.273351
----------------------------------------------------------------------------
For the time being, we will be concerned only with the estimates of the parameters. The
variables in the regression are listed in the first column and the second column gives the
estimates of their coefficients.
5
. reg EARNINGS S
----------------------------------------------------------------------------
-----------+------------------------------ F( 1, 498) = 46.57
Model | 6014.04474 1 6014.04474 Prob > F = 0.0000
-----------+------------------------------ Adj R-squared = 0.0837
Total | 70328.9662 499 140.939812 Root MSE = 11.364
----------------------------------------------------------------------------
-----------+----------------------------------------------------------------
S | 1.265712 .1854782 6.82 0.000 .9012959 1.630128
_cons | .7646844 2.803765 0.27 0.785 -4.743982 6.273351
----------------------------------------------------------------------------
In this case there is only one variable, S, and its coefficient is 1.27. _cons, in Stata, refers
to the constant. The estimate of the intercept is 0.76.
6
120
^
EARNINGS = 0.76 + 1.27 S
100
Hourly earnings ($)
80
60
40
20
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Here is the scatter diagram again, with the regression line shown.
7
120
^
EARNINGS = 0.76 + 1.27 S
100
Hourly earnings ($)
80
60
40
20
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
What do the coefficients actually mean?
8
120
^
EARNINGS = 0.76 + 1.27 S
100
Hourly earnings ($)
80
60
40
20
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
To answer this question, you must refer to the units in which the variables are measured.
9
120
^
EARNINGS = 0.76 + 1.27 S
100
Hourly earnings ($)
80
60
40
20
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
S is measured in years (strictly speaking, grades completed), EARNINGS in dollars per

hour. So the slope coefficient implies that hourly earnings increase by $1.27 for each extra
year of schooling.
10
120
^
EARNINGS = 0.76 + 1.27 S
100
Hourly earnings ($)
80
60
40
20
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
We will look at a geometrical representation of this interpretation. To do this, we will

enlarge the marked section of the scatter diagram.
11
20
18
Hourly earnings ($)
$15.95
16
$14.69
$1.27
one year
14
12
10.5 11 12
The regression line indicates that completing 12th grade instead of 11th grade would
increase earnings by $1.27, from $14.69 to $15.95, as a general tendency. (Yes, there is a
discrepancy of 0.01, caused by rounding error.)
12
120
^
EARNINGS = 0.76 + 1.27 S
100
Hourly earnings ($)
80
60
40
20
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
You should ask yourself whether this is a plausible figure. If it is implausible, this could be
a sign that your model is misspecified in some way.
13
120
^
EARNINGS = 0.76 + 1.27 S
100
Hourly earnings ($)
80
60
40
20
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
For low levels of education it might be plausible. But for high levels it would seem to be an
underestimate.
14
120
^
EARNINGS = 0.76 + 1.27 S
100
Hourly earnings ($)
80
60
40
20
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
What about the constant term? (Try to answer this question yourself before continuing with
this sequence.)
15
120
^
EARNINGS = 0.76 + 1.27 S
100
Hourly earnings ($)
80
60
40
20
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Literally, the constant indicates that an individual with no years of education would earn
$0.76 per hour.
16
120
^
EARNINGS = 0.76 + 1.27 S
100
Hourly earnings ($)
80
60
40
20
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
This is an unreasonably small amount and does not make sense.
17
120
^
EARNINGS = 0.76 + 1.27 S
100
Hourly earnings ($)
80
60
40
20
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
A safe solution to the problem is to limit the interpretation to the range of the sample data,
and to refuse to extrapolate on the ground that we have no evidence outside the data range.
18
120
^
EARNINGS = 0.76 + 1.27 S
100
Hourly earnings ($)
80
60
40
20
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
With this explanation, the only function of the constant term is to enable you to draw the
regression line at the correct height on the scatter diagram. It has no meaning of its own.
19
120
^
EARNINGS = 0.76 + 1.27 S
100
Hourly earnings ($)
80
60
40
20
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Another solution is to explore the possibility that the true relationship is nonlinear (see the
red curve) and that we are approximating it with a linear regression. We will soon extend
the regression technique to fit nonlinear models.
20
Copyright Christopher Dougherty 2016.
These slideshows may be downloaded by anyone, anywhere for personal use.

Subject to respect for copyright and, where appropriate, attribution, they may be
used as a resource for teaching an econometrics course. There is no need to
refer to the author.
The content of this slideshow comes from Section 1.4 of C. Dougherty,

Introduction to Econometrics, fifth edition 2016, Oxford University Press.
Additional (free) resources for both students and instructors may be
downloaded from the OUP Online Resource Centre
http://www.oxfordtextbooks.co.uk/orc/dougherty5e/
Individuals studying econometrics on their own who feel that they might benefit
from participation in a formal course should consider the London School of
Economics summer school course
EC212 Introduction to Econometrics
http://www2.lse.ac.uk/study/summerSchools/summerSchool/Home.aspx
or the University of London International Programmes distance learning course
EC2020 Elements of Econometrics
www.londoninternational.ac.uk/lse.
2016.04.16

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Type author name/s here

© Christopher Dougherty, 2016. All rights reserved.

Grade 16 means completion of four-year college. Higher grades indicate years of

What do the coefficients actually mean?

S is measured in years (strictly speaking, grades completed), EARNINGS in dollars per

We will look at a geometrical representation of this interpretation. To do this, we will

This is an unreasonably small amount and does not make sense.

These slideshows may be downloaded by anyone, anywhere for personal use.

The content of this slideshow comes from Section 1.4 of C. Dougherty,

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