Review of Mathematics

&
Statistics Essentials
BSP 4513 Econometrics 1
Econometrics

Lecture 2
References
2
(1) Principles of Econometrics :: Appendix A and Appendix B
1) Summation and Operators
2) Logarithm always natural
3) Linear Relationships
4) Nonlinear Relationships












Slide A-3
Notation
Summation


i
n
X
i
= X
1
+ X
2
+ + X
n
;

j
n
R
j
= R + R
2
+ R
3
+ + R
n


i
kX
i
= k.
i
X
i
; 0.8
j
n
R
j
= 0.8R + 0.8R
2
+ 0.8R
3
+ + 0.8R
n



i
(aX
i
+ bY
i
) = a
i
X
i
+ b
i
Y
i


Lag Operator
LX
t
= X
t-1
; L
n
X
t
= X
t-n
; Y
t
= a
0
X
t
+a
1
X
t-1
+ a
2
X
t-2

=(a
0
+a
1
L+a
2
L
2
)X
t
= A(L)X
t
.
Difference Operator
X
t
= X
t
X
t-1

X
t
= X
t
LX
t
= (1-L)X
t


= 1 L ; (aX
t
) = aX
t





Slide A-5
1 1 1 1
1 2
1 1 1
1 1 1 1
( , ) ( )
( , ) [ ( , ) ( , ) ( , )]
( , ) ( , )
m n m n
i j i j
i j i j
m n m
i j i i i n
i j i
m n n m
i j i j
i j j i
f x y x y
f x y f x y f x y f x y
f x y f x y
= = = =
= = =
= = = =
= +
= + + +
=



BSP 4513 Econometrics
dln(X
t
) = dX
t
/X
t
growth of X
Discrete approximation
Aln(X
t
) = ln(X
t
) ln(X
t-1
)
Slide A-6
( )
( )
ln ln
Rules:
ln( ) ln( ) ln( )
ln( / ) ln( ) ln( )
ln( ) ln( )
b
a
x e b
xy x y
x y x y
x a x
= =
= +
=
=

Slide A-7





The exponential function is the antilogarithm because we can recover
the value of x using it.
Slide A-8
( )
( )
ln
exp ln
x
x e x = = (








Slide A-9
(A.1)
(A.2)
1 2
y x =| +|
2
y x A =| A
1 2 1 2 1
0 y x =| +| =| +| =|









Figure A.1 A linear relationship
Slide A-10







Slide A-11
(A.3)
(A.4)
2
dy
dx
= |
1 2 2 3 3
y x x =| +| +|
(A.5)
2 3
2
3 2
3
given that is held constant
given that is held constant
y
x
x
y
x
x
A
| =
A
A
| =
A







Slide A-12
(A.6)
1 2 3
Q L K =| +| +|
2
given that capital is held constant
, the marginal product of labor input
L
Q
K
L
MP
A
| =
A
=
2 3
2 3
,
y y
x x
c c
=| =|
c c







Slide A-13
(A.7)

y/y = the relative change in y, which is a decimal
%y = percentage change in y
(A.8a)

(A.8b)

(A.8c)
yx
y y y x x
slope
x x x y y
A A
c = = =
A A
% 100
y
y
y
A
A =









Figure A.2 A nonlinear relationship
Slide A-14







Slide A-15
(A.9)
(A.10)
2
dy dx =|
yx
dy y dy x x
slope
dx x dx y y
c = = =







Slide A-16










Figure A.3 Alternative Functional Forms
Slide A-17


If
3
> 0, then the curve is U-shaped, and representative of average or
marginal cost functions, with increasing marginal effects. If
3
< 0,
then the curve is an inverted-U shape, useful for total product curves,
total revenue curves, and curves that exhibit diminishing marginal
effects.
Slide A-18
2
1 2 3
y x x =| +| +|
2 3 2 3
2 0, or / (2 ) dy dx x x =| + | = = | |



Example: the Phillips Curve
Slide A-19
1
1 2 1 2
1
y x
x

=| +| =| +|
1
1
1 2
% 100
1
%
t t
t
t
t
t
w w
w
w
w
u

A =
A = | +|



In order to use this model all values of y and x must be positive. The
slopes of these curves change at every point, but the elasticity is
constant and equal to
2
.
Slide A-20
1 2
ln( ) ln( ) y x =| +|


Both its slope and elasticity change at each point and are the same
sign as
2
.


The slope at any point is
2
y, which for
2
> 0

means that the marginal
effect increases for larger values of y.
Slide A-21
1 2
ln( ) y x =| +|
| |
1
exp ln( ) exp( ) y y x = = | +|
Random Variables
Probability Distributions
Joint, Marginal and Conditional Probability
Distributions
Properties of Probability Distributions












Slide B-22
Random Variables
A random variable is simply a variable whose values
are determine by some chance mechanism.
A random variable has a designated set of possible
values and associated probabilities.
A discrete random variable X consists of a set of
possible values X
1
, X
2
,X
k
and associated non-
negative fractions (probabilities) p
1
, p
2
,p
N
such that
p
1
+ p
2
+ . . .+ p
N
= p
N
= 1
Probability Distribution
A formula giving the probabilities for different
values of the random variable X is called a
probability distribution, and probability
density function for continuous random
variables.
Probability Distribution
Example: (a) Probability Function for outcome from
tossing 2 well-balanced coins:

Outcome (No of Heads) Probabilities X.P(X)
No Head X
1
= 0 0.25 = P(X
1
) 0 x 0.25 = 0.0
1 Head X
2
= 1 0.50 = P(X
2
) 1 x 0.50 = 0.5
2 Heads X
3
= 2 0.25 = P(X
3
) 2 x 0.25 = 0.5
Total 1.00 X.P(X) =1.00

H
T
H
H
T
T
2
1
1
0






Probability Distribution
Example: (b) Probability Function for outcome from tossing
a die with the numbers shown on its faces.
Probability Density Functions
Unlike a discrete random variable, a continuous
random variable is one that can assume an
uncountable number of values.
We cannot list the possible values because there
is an infinite number of them.
Because there is an infinite number of values, the
probability of each individual value is virtually 0.
Point Probabilities are Zero
Because there is an infinite number of values, the probability
of each individual value is virtually 0.
Thus, we can determine the probability of a range of values
only.

E.g. with a discrete random variable like tossing a die, it is
meaningful to talk about P(X=5), say.
In a continuous setting (e.g. with time as a random variable),
the probability the random variable of interest, say task
length, takes exactly 5 minutes is infinitesimally small, hence
P(X=5) = 0.
It is meaningful to talk about P(X 5).
Probability Density Function
A function f(x) is called a probability density function (over
the range a x b if it meets the following requirements:

1) f(x) 0 for all x between a and b, and




2) The total area under the curve between a and b is 1.0
f(x)
x b a
area=1
Uniform Distribution
Consider the uniform probability distribution (sometimes
called the rectangular probability distribution).
It is described by the function:
f(x)
x b a
area = width x height = (b a) x = 1
Example 2.1(a)
The amount of gasoline sold daily at a service station is
uniformly distributed with a minimum of 2,000 gallons and a
maximum of 5,000 gallons.





Find the probability that daily sales will fall between 2,500
and 3,000 gallons.
Algebraically: what is P(2,500 X 3,000) ?
f(x)
x 5,000 2,000
Example 2.1(a)
P(2,500 X 3,000) = (3,000 2,500) x = .1667







there is about a 17% chance that between 2,500 and 3,000
gallons of gas will be sold on a given day
f(x)
x 5,000 2,000
Probability Density Function
PDF of a Continuous Random Variable
Example: the Normal Distribution for values of a random variable
taking values in the interval ( - , + )
45 60 0
Weight in kilogram
P
r
o
b
a
b
i
l
i
t
y

D
e
n
s
i
t
y
f(x)
Probability that weight lies
between 45 and 60 kg is
given by area shaded
Normal Distribution
A bell-shaped distribution
Symmetrical about its mean,
median and mode
The uni-variate normal
probability density function
is:
with mean = and variance = o
2
f(X) = __1__ exp{-[(X-)/o]
2
}
\(2to
2
)
- +
Measure of Central Tendency
Mean (average); Median; Mode
Expectation Operator, E( . )
E(x) = } x.f(x)dx =
x
= mean of distribution
= } x.f(x)dx

More generally, for any function of x, g(x):
+
E[g(x)] = } g(x).f(x)dx.

In particular,
E[a+bx] = a+bE(x), when a and b are non-stochastic.
E[x-E(x)]
2
= variance of distribution
= E[x
2
+ (E(x))
2
-2xE(x)] = Ex
2
- (E(x))
2


& Note that E(XY) = E(X).E(Y), if X and Y are independent;
E(X/Y) E(X)/E(Y)
Measure of Dispersion
Range (max min); Variance (
2
) ; Standard
deviation (); coefficient of variation (CV =/).
Definition of variance:
Var(x) = (
2
)
= E[x-E(x)]
2

= E[x
2
+ (E(x))
2
-2xE(x)]
= Ex
2
- (E(x))
2

Var(X) = (X
i
-
X
)
2
P(X
i
)

Measure of Dispersion
Example: The variance of a random variable X,
the number shown on a die.

2
= 2.9167; = 1.708; CV = 0.488
Dispersion with same mean
Hypothetical PDFs of continuous random variables
all with the same expected value.
Joint Distribution; Marginal and Conditional
Distributions
Consider the 16 possible outcomes from tossing a coin four times.
X = number of heads obtained on the first three tosses;
Y = number of heads obtained on four tosses;
X
Y +
0 1 2 3
g(Y)
E(X|Y)
0 1/16 0 0 0 1/16 0.0
1 1/16 3/16 0 0

0.75
2 0 3/16 3/16 0 3/8 1.5
3 0 0 3/16 1/16

2.25
4 0 0 0 1/16 1/16 3.0
f(X)
1/8 3/8 3/8 1/8
E(Y|X)
0.5 1.5 2.5 3.5
Marginal distribution of X = f(X); E(X) = 12/8 = 3/2

Marginal distribution of Y = g(Y); E(Y)= 32/16 = 2

Conditional Probabilities and Conditional
Distribution
P(Y|X) = P(X,Y)/P(X)
Or P(X,Y) = P(Y|X).P(X) = P(X|Y).P(Y)
E.g. P(Y=3|X=2) = P(Y=3, X=2)/P(X=2)
= (3/16)/(3/8) = 0.5
Similarly, P(Y=4|X=2) = (3/16)/(3/8) = 0.5
The conditional distribution of Y given X = 2 is:
Values of Y given X = 2 Probabilities Y.P(Y|X)
Y = 2 0.5 = P(Y=3|X=2) 1.0
Y = 3 0.5 = P(Y=4|X=2) 1.5
Total 1.00 2.5 = E(Y|X=2)
Conditional Distribution
X=2 P(Y|X=2)

Y=0 0 0
Y=1 0 0
Y=2 3/16 0.5
Y=3 3/16 0.5
Y=4 0 0
3/8 1.0
E(Y|X=2) = 2.5
P(Y=3|X=2)
= P(X=2,Y=3)/P(X=2)
= (3/16)/(3/8)
= 0.5
Conditional Mean:
E(Y|X=2)=0.5*2+0.5*3 = 2.5
Conditional Variance:
V(Y|X=2)=0.5*(2-2.5)
2

+0.5*(3-2.5)
2
= 0.25
Statistical Independence
X and Y are said to be statistically
independent if
P(X,Y) = P(X).P(Y)
X g(Y)
1 2 3
Y 1 0.12 0.18 0.30 0.6
2 0.08 0.12 0.20 0.4
f(X) 0.2 0.3 0.5
Example:
P(X=1,Y=2)
= P(X=1).P(Y=2)
= 0.2*0.4 =0.08.
Conditional Distribution
Conditional density function: f(Y|x)

Conditional Expectation =
Y|X

=E(Y|X) =E
X
(Y)
= EY
i
P(Y
i
|X)
E.g.
Y|X=2
= E(Y|X=2) = 2 * 0.5 + 3 * 0.5
= 5/2 = 2.5
Conditional Variance = E
X
{Y-
Y|X
}
2

Conditional Expectation &
Regression Line
Note that the expectation of Y conditional on
X can be expressed as a function of X.
For the coin tossing example:
E(Y|X) = 0.5 + 1.0X regression line
Also notice that the variance of (Y|X) in the
coin-tossing example is the same for different
values of X:
Var(Y|X) = E
X
{Y-
Y|X
}
2
= 0.25
homoscedastic

Regression Line
X
Y|X
E(Y|X) = 0.5 + 1.0X
0
3
2
1
Covariance
Cov(X,Y) = E[(X-
X
)(Y-
Y
)] = E(XY) -
X

Y



=
x

y
[(X-
X
)(Y-
Y
)P(X,Y)

=
x

y
XYf(X,Y) -
X

Y
Cov(X,X) = Var (X)

Cov(a+bX, c+dY) = bdCov(X,Y)

Covariance as an average of area
(x
2
,y
2
)
(x
1
,y
1
)
(x
3
,y
3
)
y
x
Cov(X,Y)

= [(X-
X
)(Y-
Y
)f(X,Y)

= (1/n)xy
Let x = (X-
X
)
y = (Y -
Y
)

Correlation Between X and Y
Correlation Coefficient:
= Cov(X,Y)/ o
X
o
y

Computation formula:
(X-
X
)(Y-
Y
)
{(X-
X
)
2.
(Y-
Y
)
2
}

In the coin-tossing example, =0.5/(0.75*1.0)

= 0.5774

=
Properties of Correlation Coefficient
A measure of linear association between two
variables.
The correlation coefficients always lies
between -1 and +1.
Figure 3-3
Some typical patterns of the correlation coefficient, .
Skewness of Distribution
Measured y the third moment, S=E(X u
x
)
3
/
3

Skewness =0, when distribution is symmetric
Kurtosis
Measured by the normalized fourth moments, K = E(X-u
x
)
4
/
4

For normal distribution, K = 3.
Example
According to the Registry of Business in a small city, there
are 1,200 establishments. The tabulation below shows the
size of the establishment in terms of the number of
employees.
No of Employees
No of
Establishments
Relative
Frequency
0 - 50 768 0.640
51 - 100 180 0.150
101 - 200 180 0.150
201 - 500 72 0.060
Total 1200 1.000
Example: Distribution of Establishments
Size Ref Freq (p)
0 - 50 0.640
51 - 100 0.150
101 - 200 0.150
201 - 500 0.060
0 50 100
200 500
Area of Shaded = 1.0
Prob
Density
Number of Employees
Quick Quiz
Express the following using the L operator:

(a) Y
t
= 2 + 3X
t
+ 4X
t-1
+ 8 X
t-4


(b) Q
t
= 1 + 0.3Q
t-1
+ 0.4N
t
+ 0.2K
t-1

Quick Quiz
X
Y +
0 1 2 3
g(Y)
E(X|Y)
0 1/8 1/16 0 0 3/16 ?
1 1/8 1/8 0 0 1/4 ?
2 0 1/16 1/8 0 3/16 ?
3 0 0 1/16 1/16 1/8 ?
4 0 0 1/16 3/16 1/4 ?
f(X)
1/4 1/4 1/4 1/4
E(Y|X)
? ? ? ?
Fill in the blanks
E(X) = ____

E(Y) = ____