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**EC220 - Introduction to econometrics (chapter 1)**

Christopher Dougherty EC220 - Introduction to econometrics (chapter 1) Slideshow: interpretation of a regression equation Original citation: Dougherty, C. (2012) EC220 - Introduction to econometrics (chapter 1). [Teaching Resource] © 2012 The Author This version available at: Available in LSE Learning Resources Online: May 2012 This work is licensed under a Creative Commons Attribution-ShareAlike 3.0 License. This license allows the user to remix, tweak, and build upon the work even for commercial purposes, as long as the user credits the author and licenses their new creations under the identical terms.

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**INTERPRETATION OF A REGRESSION EQUATION**

The scatter diagram shows hourly earnings in 2002 plotted against years of schooling, defined as highest grade completed, for a sample of 540 respondents from the National Longitudinal Survey of Youth. 1

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**INTERPRETATION OF A REGRESSION EQUATION**

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

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**INTERPRETATION OF A REGRESSION EQUATION**

Grade 16 means completion of four-year college. Higher grades indicate years of postgraduate education. 3

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**INTERPRETATION OF A REGRESSION EQUATION**

. reg EARNINGS S Source | SS df MS Number of obs = F( 1, 538) = Model | Prob > F = Residual | R-squared = Adj R-squared = Total | Root MSE = EARNINGS | Coef. Std. Err t P>|t| [95% Conf. Interval] S | _cons | This is the output from a regression of earnings on years of schooling, using Stata. 4

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**INTERPRETATION OF A REGRESSION EQUATION**

. reg EARNINGS S Source | SS df MS Number of obs = F( 1, 538) = Model | Prob > F = Residual | R-squared = Adj R-squared = Total | Root MSE = EARNINGS | Coef. Std. Err t P>|t| [95% Conf. Interval] S | _cons | 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

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**INTERPRETATION OF A REGRESSION EQUATION**

. reg EARNINGS S Source | SS df MS Number of obs = F( 1, 538) = Model | Prob > F = Residual | R-squared = Adj R-squared = Total | Root MSE = EARNINGS | Coef. Std. Err t P>|t| [95% Conf. Interval] S | _cons | In this case there is only one variable, S, and its coefficient is _cons, in Stata, refers to the constant. The estimate of the intercept is 6

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**INTERPRETATION OF A REGRESSION EQUATION**

^ Here is the scatter diagram again, with the regression line shown. 7

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**INTERPRETATION OF A REGRESSION EQUATION**

^ What do the coefficients actually mean? 8

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**INTERPRETATION OF A REGRESSION EQUATION**

^ To answer this question, you must refer to the units in which the variables are measured. 9

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**INTERPRETATION OF A REGRESSION EQUATION**

^ S is measured in years (strictly speaking, grades completed), EARNINGS in dollars per hour. So the slope coefficient implies that hourly earnings increase by $2.46 for each extra year of schooling. 10

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**INTERPRETATION OF A REGRESSION EQUATION**

^ We will look at a geometrical representation of this interpretation. To do this, we will enlarge the marked section of the scatter diagram. 11

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**INTERPRETATION OF A REGRESSION EQUATION**

$15.53 $13.07 $2.46 One year The regression line indicates that completing 12th grade instead of 11th grade would increase earnings by $2.46, from $13.07 to $15.53, as a general tendency. 12

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**INTERPRETATION OF A REGRESSION EQUATION**

^ 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

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**INTERPRETATION OF A REGRESSION EQUATION**

^ For low levels of education it might be plausible. But for high levels it would seem to be an underestimate. 14

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**INTERPRETATION OF A REGRESSION EQUATION**

^ What about the constant term? (Try to answer this question yourself before continuing with this sequence.) 15

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**INTERPRETATION OF A REGRESSION EQUATION**

^ Literally, the constant indicates that an individual with no years of education would have to pay $13.93 per hour to be allowed to work. 16

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**INTERPRETATION OF A REGRESSION EQUATION**

^ This does not make any sense at all. In former times craftsmen might require an initial payment when taking on an apprentice, and might pay the apprentice little or nothing for quite a while, but an interpretation of negative payment is impossible to sustain. 17

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**INTERPRETATION OF A REGRESSION EQUATION**

^ 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

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**INTERPRETATION OF A REGRESSION EQUATION**

^ 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

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**INTERPRETATION OF A REGRESSION EQUATION**

^ Another solution is to explore the possibility that the true relationship is nonlinear and that we are approximating it with a linear regression. We will soon extend the regression technique to fit nonlinear models. 20

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**Copyright Christopher Dougherty 2011.**

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, fourth edition 2011, Oxford University Press. Additional (free) resources for both students and instructors may be downloaded from the OUP Online Resource Centre Individuals studying econometrics on their own and 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 or the University of London International Programmes distance learning course 20 Elements of Econometrics

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