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technique that calculates the Beta-hats -- estimated

parameters or coefficients of the model so as to

minimize the sum of the squared residuals.

e

i

2

= (Y

i

Yhat)

2

Where

e = = the residual

Yhat is the predicted value of Y

Why OLS?

1. OLS is relative easy to use. For a model

with one or two independent variables you

one can run OLS with a simple spreadsheet

(without using the regression function).

2. The goal of minimizing the sum of squared

residuals is appropriate from a theoretical

point of view.

3. OLS estimates have a number of useful

characteristics.

Why not minimize residuals?

Residuals can be positive and negative. Just

minimizing residuals can produce an

estimator with large positive and negative

errors that cancel each other out.

Minimizing the absolute value of the sum of

residuals poses mathematical problems. Plus,

we wish to minimize the possibility of very

large errors.

Useful Characteristics of OLS

1. Estimated regression line goes through the

means of Y and X. In equation form Mean

of Y =

0

+

1

(Mean of X)

2. The sum of residuals is exactly zero.

3. OLS estimators, under a certain set of

assumptions (which we discuss later), are

BLUE (Best Linear Unbiased Estimators).

Note: OLS is the estimator, the coefficients or

parameters are the estimates.

Classical Assumption 1

The error term has a zero population mean.

We impose this assumption via the constant

term.

The constant term equals the fixed portion of

the Y that cannot be explained by the

independent variables.

The error term equals the stochastic portion

of the unexplained value of Y.

Classical Assumption 2

The error term has a constant variance

Heteroskedasticity

Where does this most often occur? Cross-

sectional data

Why does this occur in cross-sectional data?

Classical Assumption 3

Observations of the error term are

uncorrelated with each other.

Serial Correlation or Autocorrelation

Where does this most often occur? Time-

series data

Why does this occur in time-series data?

Classical Assumption 4-5

The data for the dependent variable and

independent variable(s) do not have

significant measurement errors.

The regression model is linear in the

coefficients, is correctly specified, and has an

additive error term.

Classical Assumption 6

The error term is normally distributed

This is an optional assumption, but a good

idea. Why?

One cannot use the t-statistic or F-statistic

unless this holds (will explain these later).

Five More Assumptions

1. All explanatory variables are uncorrelated with the error term.

When would this not be the case? Then a system of equations is

needed (i.e. supply and demand).

What are the consequences? Estimation of slope coefficient for

correlated X terms is biased.

2. No explanatory variable is a perfect linear function of any other

explanatory variable.

Perfect collinearity or multicollinearity

Consequence: OLS cannot distinguish the impact of each X on Y.

3. X values are fixed in repeated sampling.

4. The number of observations n must be greater than the number of

parameters to be estimated.

5. There must be variability in X and Y values.

The Gauss-Markov Theorem

Given Classical Assumptions, the OLS

estimator

k

is the minimum variance

estimator from among the set of all linear

unbiased estimators of

k

.

In other words, OLS is BLUE

Best Linear Unbiased Estimator

Where Best = Minimum Variance

Given assumptions

The OLS coefficient estimators will be

unbiased

have minimum variance

are consistent

are normally distributed.

The last characteristic is important if we wish

to conduct statistical tests of these

estimators, the topic of the next chapter.

Unbiased Estimator and Small Variance

Unbiased estimator an estimator whose

sampling distributions has as its expected

value the true value of .

In other words... the mean value of the

distribution of estimates equals the true

mean of the item being estimated.

In addition to an unbiased estimate, we also

prefer a small variance.

How does OLS Work?

The Univariate Model

Y =

0

+

1

X +

For Example: Wins =

0

+

1

Payroll +

How do we calculate

1

?

Intuition:

1

equals the joint variation of X and Y

(around their means) divided by the variation of X

around its mean. Thus it measures the portion of the

variation in Y that is associated with variation in X.

In other words, the formula for the slope is:

Slope = COV(X,Y)/V(X)

or the covariance of the two variables divided by

the variance of X.

How do we calculate

1

?

Some Simple Math

1

= [(Xi - mean of X) * (Yi - mean of Y)] /

(Xi - mean of X)

2

If

xi = Xi - mean of X and

yi = Yi - mean of Y

then

1

= [(xi*yi)] / (xi)

2

How do we calculate

0

?

Some Simple Math

0

= mean of Y

1

*mean of X

0

is defined to ensure that the

regression equation does indeed pass

through the means of Y and X.

Multivariate Regression

Multivariate regression an equation with more than

one independent variable.

Multivariate regression is necessary if one wishes to

impose ceteris paribus.

Specifically, a multivariate regression coefficient

indicates the change in the dependent variable

associated with a one-unit increase in the

independent variable in question holding constant the

other independent variables in the equation.

Omitted Variables, again

If you do not include a variable in your model, then

your coefficient estimate is not calculated with the

omitted variable held constant.

In other words, if the variable is not in the model it

was not held constant.

Then again.... there is the Principle of Parsimony or

Occams razor (that descriptions be kept as simple as

possible until proven inadequate).

So we dont typically estimate regressions with

hundreds of independent variables.

The Multivariate Model

Y =

0

+

1

X

1

+

2

X

2

+ .......

n

X

n

+

For Example, a model where n=2:

Wins =

0

+

1

PTS +

2

DPTS +

Where

PTS = Points scored in a season

DPTS = Points surrendered in a season

How do we calculate

1

and

2

?

Some Less Simple Math

Remember:

xi = Xi - mean of X and

yi = Yi - mean of Y

1

= [(x

1

*yi)*(x

2

)

2

- (x

2

*yi)*(x

1

*x

2

)

] /

[(x

1

)

2

* (x

2

)

2

- (x

1

*x

2

)

2

]

2

= [(x

2

*yi)*(x

1

)

2

- (x

1

*yi)*(x

1

*x

2

)] /

[(x

1

)

2

* (x

2

)

2

- (x

1

*x

2

)

2

]

0

= mean of Y

1

*mean of X

2

*mean of X

Issues to Consider when reviewing

regression results

1. Is the equation supported by sound theory?

2. How well does the estimated regression fit the data?

3. Is the data set reasonably large and accurate?

4. Is OLS the best estimator for this equation?

5. How well do the estimated coefficients correspond to our

expectations?

6. Are all the obviously important variables included in the

equation?

7. Has the correct functional form been used?

8. Does the regression appear to be free of major econometric

problems?

NOTE: This is just a sample of questions one can ask.

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