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# 2.1 the simple regression model

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### 2.1 the simple regression model

1. 1. IMPORTATNT NOTE: Most of the equations have (hats) as an intercept. However in thegraphs you will see the intercept are (hats). This is my mistake but since I really do nothave time to make changes due to time constraints kindly corporate with me on this issue.For simplicity please read as and and on ONLY FOR GRAPHS.The Simple Regression Model:Regression Analysis:Y and X are two variables representing population and we areinterested in explaining y in terms of x.Where Y = Dependent on X, which is the independent variable.How to make a choice between the independent and the dependentvariable?Income is the cause for consumption. Thus the income is theindependent variable and consumption is the effect, dependentvariable.It is also called the two-variable linear regression model or bivariatelinear regression modelbecause it relates the two variables x and y.Regression Analysis is concerned with the study of dependent variableon one or more independent or explanatory variables with a view ofestimating or predicting population mean, in terms of the known orfixed (in repeated sampling) value of the latter i.e,The variable u, called the error termor disturbance in the relationship,represents factors other than that affect y, the “unobserved” factor.If the other factors in u are held fixed, so that the change in u is zero, , then x has a linear effect on y:
2. 2. Thus, the change in y is simply multiplied by the change in x.Terminology- Notation:Dependent Variable Independent Variable Explained Variable Explanatory Variable Predicted Predicator RegressandRegressor Response Stimulus Endogenous Exogeneous Outcome Covariate Controlled Control Variables are two unknown but fixed parameters known as theregression coefficients.Eg: Suppose in a "total Population" we have 60 families living in acommunity called XYZ and their weekly income (X) and weeklyconsumption (Y) are both in dollars. X 80 100 120 140 160 180 200 220 240 260 Y 55 65 79 80 102 110 120 135 137 150 60 70 84 93 107 115 136 137 145 152 65 74 90 95 110 120 140 140 155 175 70 80 94 103 116 130 144 152 165 178 75 85 98 108 118 135 145 157 175 180 0 88 0 113 125 140 0 160 189 185 0 0 0 115 0 0 0 162 0 191Total 325 462 445 707 678 750 685 1043 966 1211ConditionalMeans ofY, E(Y/X) 65 77 89 101 113 125 137 149 161 173The 60 families of X are divided into 10 income groups from \$80-\$260.The values of X are "fixed" and 10 Y subpopulation.There is a considerable variation in each income group
3. 3. Geometrically, then a population regression curve is simply the locus ofthe conditional means of the dependent variable for the fixed valuesof the explanatory variable (s).The conditional meanWhere denotes some function of the explanatory variable X.E(Y/ ) is a linear function of say of a type:E =Meaning of term Liner: 1. Liner in Variables i.e. X i.e. E(Y/ is not Liner. 2. Liner in Parameters i.e. . E = is not linear.
4. 4. Eg: Linear in Parameters:But for now whenever we refer to the term "linear" regression we onlymean linear in parameters theTwo way scatter plot of income and consumption Population Regression Line
5. 5. The Population Regression Line passes between the "Average" valuesof consumption E(Y/X) which is also known as the conditionalexpected value.The CEV tells us the expected value of weekly consumption expenditureor a family whose income is \$80, \$100…Unconditional Expected Value: The unconditional expected value ofweekly consumption expenditure is given by E(Y) it disregards theincome levels of various families.E(Y) = 7272/60 = \$121.20It tells us the expected value of weekly consumption expenditure of"any" family.Thus;Conditional mean E(Y/X) is a function of where = , and so on.It is a liner function, AND is also known asthe conditional ExpectedFunction, Population Regression Function or Population Function.E =Where are two unknown but fixed parameters known asthe regression coefficients.And is the intercept and is the slope.The main objective of the regression analysis is to estimate the valuesof the unknowns on the basis of observations Y and X.We saw previously that as familys income increases, familysconsumption expenditure on average increases too.But what about the individual family?
6. 6. For example see that as income increases from \$80 to \$100 we seeparticular families consumption is \$65, which is less than consumptionexpenditure of two families whose weekly income is \$ 80.Thus we express this deviation of an individual as: or ) or .The expenditure of an individual family given its income level can beexpressed as: 1. E = Systematic or deterministic and 2. = Nonsystematic and cannot be determined =Taking the expected value on both sides: / )+ / ).Before we make any assumption of u and x. We make an importantassumption i.e. as long as we include the intercept in the equation;nothing is lost by assuming that the average value of u in the"population" is zero.i.e. E(u) = 0.Relationship between u and x:We assume u and x are not correlated or u and x are not linearly related.
7. 7. It is possible for u to be uncorrelated with x while being correlated withthe functions of x such as the .Thus the better assumption involves that the expected value of u givenx is zero or E ( / = E(u) = 0.This is called the zero conditional mean assumption.The sample regression function:So far we have only talked about the population of Y valuescorresponding to the fixed Xs.When collecting data it is almost impossible to collect data on the entirepopulation.Thus for most practical situations we have is a sample of Y valuescorresponding to some fixed Xs.Thus our task is to estimate PRF based on the sample information.
8. 8. OR; Where; is the estimator of and .Thenumerical value obtained by the estimator is known as the"Estimate".Expressing SRF is stochastic term can be written as: .Where is the residual term.Conceptually is analogus to and can be regarded as the estimate of .So far:PRF: andSRF:In terms of SRF:In terms of PRF: )+It is almost impossible for SRF and PRF to be the same due to samplingproblems thus our main objective is to choose so that itreplicates as close as possible.
9. 9. How is SRF itself determined since PRF is never known?Ordinary Least Square:PRF:SRF: = .Thus we should choose SRF in such a way that sum of the residuals = is as small as possible.Thus if we adopt the criterion of minimizing , then according to thediagram above we should give equal weights toIn other words all the residuals should receive equal weights no matterhow far ( ) or how close ( ) they are from the SRF.
10. 10. And such a minimization is possible by adopting least square criteriawhich states that SRF can be fixed in such a way that is as small as possible where; . Thus our goal is to choose in such a way that is as small as possible which is done by OLS. Let = So we want to minimize . Taking partial derivative with respect to . = -2 . = -2 . = .Plugging the values of ( -( - )- )=0Upon rearranging gives:
11. 11. ( - )= - - )( - –Provided that Thus = or equals the population covariance divided by the variance ofwhen .Which concludes: If and are positively correlated then is positive and If and are negatively correlated then is negative.Fitted Value and Residuals:We assume that the intercept and slope , have been obtainedfor a given sample of data.Given , we can obtain the fitted value for each observation.By definition each fitted value is on the OLS line.The OLS residuals associated with observation i, is the differencebetween and the its fitted value.
12. 12. If is positive the line under predicts if is negative the line overpredicts.The ideal case is for observation is when , but in every case OLSis not equal to zero.Algebraic Prosperities of OLS Statistics:There are several useful algebraic properties of OLS estimates and theirassociated statistics. We now cover the three most important of these.(1) The sum, and therefore the sample average of the OLS residuals, iszero. Mathematically,It follows immediately from the OLS first order condition.
13. 13. This means OLS estimates are chosen to make the residualsadd up to zero (for any data set). This says nothing about the residualfor any particular observation(2) The sample covariance between the regressor and the OLS residualsis zero. This can be written as:The sample average of the OLS residuals is zero.Example:Thus and u captures all the factors not included in themodel eg: aptitude, ability as so on.(3) The point ( is always on the OLS regression line.Writing each as its fitted value, plus its residual, provides another wayto interpret an OLS regression.For each i, write: .
14. 14. From property (1) above, the average of the residuals is zero;equivalently, the sample average of the fitted values, , is the same asthe sample average of the , or = .Further, properties (1) and (2) can be used to show that the samplecovariance between is zero.Thus, we can view OLS as decomposing each into two parts, a fittedvalue and a residual.The fitted values and residuals are uncorrelated in the sample.Precision Or Standard Errors of Least Square Estimates:Thus far we know that least square estimates are functions of SAMPLEdata.And our estimates will change with each change in sample.Therefore a proper measure of reliability and precision is needed. Andsuch precision/ reliability is measured by STANDARD ERROR.Define the total sum of squares (SST), the explained sum of squares(SSE), and the residual sum of squares (SSR) (also known as the sumof squared residuals), as follows:SST =SSE =SSR = .SST is a measure of the total sample variation in the ; that is, itmeasures how spread out the is in the sample.If we divide SST by n-1 we obtain the sample variance of y.
15. 15. Similarly, SSE measures the sample variation in the (where we use thefact that ), andSSR measures the sample variation in the .The total variation in y can always be expressed as the sum of theexplained variation and the unexplained variation SSR. Thus, SST = SSE +SSR.PROOF:Since the covariance between the residuals and the fitted value is zero.
16. 16. We have SST = SSE +SSR.Goodness of Fit:So far, we have no way of measuring how well the explanatory orindependent variable, x, explains the dependent variable, y.It is often useful to compute a number that summarizes how well theOLS regression line fits the data.Assuming that the total sum of squares, SST, is not equal to zero—whichis true except in the very unlikely event that all the equal the samevalue—we can divide SST on both sides to obtain:Alternatively:
17. 17. The R-squared of the regression, sometimes called the coefficient ofdetermination, is ASLO BE defined as or is the ratio of the explained variation compared to the total variation,and thus it is interpreted as the fraction of the sample variation in ythat is explained by x. is always between zero and one, since SSE can be no greater than SST.When interpreting , we usually multiply it by 100 to change it into apercent: 100* is the percentage of the sample variation in y that isexplained by x.