Business Economics BUSINESS ECONOMICS. PAPER No. : 8, FUNDAMENTALS OF ECONOMETRICS MODULE No. : 3, GAUSS MARKOV THEOREM

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1 Subject Business Economics Paper No and Title Module No and Title Module Tag 8, Fundamentals of Econometrics 3, The gauss Markov theorem BSE_P8_M3 1

2 TABLE OF CONTENTS 1. INTRODUCTION 2. ASSUMPTIONS OF GAUSS MARKOV THEOREM 3. GAUSS MARKOV THEOREM AND PROOF 3.1. PROOF THAT OLS ESTIMATOR ARE LINEAR AND UNBIASED 3.2. PROOF THAT OLS ESTIMATOR IS EFFICIENT 3.3. PROOF THAT OLS ESTIMATOR IS CONSISTENT 4. GOODNESS OF FIT 4.1. MEASURES OF VARIATION 4.2. COEFFICIENT OF DETERMINATION 4.3. COEFFICIENT OF CORRELATION 5. SUMMARY 2

3 1. INTRODUCTION Using OLS we estimate the parameters from the sample regression function. However this estimates of are from the sample regression function. So we need to make some assumptions about the population regression function so that the sample estimates of can be used to make inferences about the population estimate. These sets of assumptions are known as Classical Linear Regression Model (CLRM) Assumptions. Under these assumptions the OLS estimators has very good statistical properties. So these assumptions are also known as the Gauss Markov Theorem assumptions. We now look at those Gauss Markov assumptions for the Classical Linear Regression (CLRM) Model. 2. ASSUMPTIONS OF GAUSS MARKOV THEOREM Assumption 1: (Linear Regression Model): The regression model is linear in the parameters. It need not be linear in explanatory variables = + + Assumption 2: ( Values are Non-Stochastic): The values taken by the explanatory variables remain unchanged in repeated samples. So the regression analysis is a conditional regression analysis because it is conditional on the given value of Assumption 3: (Conditional mean of disturbance term is zero): Given the value of explanatory variables the conditional mean of disturbance term is zero = If this assumption is violated then [ ] + which is certainly not desirable. This assumption also implies that information which are not captured by explanatory variable (s) and falls into the error term are not related to the explanatory variable (s) and hence do not systematically affect the dependent variable. 3

4 Assumption 4: (Homoscedasticity): The conditional variance of the disturbance term given the values of the explanatory variables are the same for all the observations. = By definition = [ ] Since by assumption 3: = we have = = Diagrammatically the concept of homoscedasticity is shown in figure 1 where the variation around the regression line is same for all values of. On the contrary the concept of heteroscedasticity is shown in figure 2 where the conditional variance of the population varies with. 4

5 Assumption 5: (No Autocorrelation): The correlation between any two disturbance terms and given any two values and are zero.,, = {[ ] }{[ ] } = [ ] = Assumption 6: Zero Covariance between disturbance term and explanatory variable or = = [ ][ ] = [ ] h = [ ] [ ][ ] Since = = This basically says that the explanatory variables are uncorrelated with the disturbance term. So the values of the explanatory variables has nothing to say about the disturbance term. Assumption 7: (Identification): To find unique estimates of the normal equations, the number of observations must be greater than the number of parameters to be estimated. Otherwise it would not be possible to find unique OLS estimates of the parameters. Assumption 8: < < 5

6 To find the OLS estimates there should be some variability in the value of the explanatory variables. In other words all the values of cannot be the same i.e. < < If all the values of are the same we have to estimates the OLS estimates. =. Thus it will not be possible Assumption 9: The disturbance term is assumed to be normally distributed ~, =,,., Where NID stands for Normal Independently Distributed. The normality assumption of the disturbance term implies that is also normally distributed. This assumption is necessary for constructing confidence intervals of and hence for conducting hypothesis testing. Assumption 10: (Correct functional form Specification) The functional form of the regression model need to correctly specify. Otherwise there will specification bias or error in the estimation of the regression model. Assumption 11: (No Multicollinearity). When the regression model has more than one explanatory variables there should not be any perfect linear relationship between any of these variables. The above assumptions about the regression models relates to the population regression function. Since we can only observed the sample regression function and not the population regression function we cannot really know if the above assumptions are actually valid. 3. GAUSS MARKOV THEOREM The Gauss Markov Theorem basically states that under the assumptions of the Classical Linear Regression Model (assumptions 1-8), the least squares estimators are the minimum variance estimators among the class of unbiased linear estimators; that is, they are BLUE. 6

7 We need to prove that the OLS estimators are (i) Unbiased (ii) Efficient and (iii) Consistent 3.1. Proofthat OLS estimator are linear and unbiased. The OLS estimator is unbiased if its expected value is equal to population parameter. The estimator is a random variable and takes on different values from sample to sample. However unbiasedness property implies that on average the value of is equal to the population parameter We know that the OLS estimates = = = = = = = = = = = = Where = = = The has the following properties = = = = = = [ = ] = = = = = = To prove the unbiasedness of the OLS estimator we need to rewrite our estimator in terms of population parameter. = = 7

8 = + + = = + + = = + = = = The OLS estimator is thus a linear function of.the explanatory variable (s) are assumed to be non-stochastic. So the are also non-stochastic as well. Taking expectation operator both the sides we have = + = = Therefore OLS estimator is an unbiased linear estimator of 3.2. Proof that OLS estimator is efficient The OLS estimator has the second desirable property of being an efficient estimator. This efficiency property relates to the variance of the estimator. We have to prove that the variance of OLS estimator has the smallest variance among all the possible estimators. To prove this we have to first define an arbitrary estimator which is linear in. Secondly we impose restrictions implied by unbiasedness. Lastly we will show that variance of arbitrary estimator is larger than (or atleast equal to) the variance of OLS estimator Let be an arbitrary estimator which is linear in. = = Next we substitute the Population Regression Function in = = = + + = 8

9 = + + = = = For the estimator to be unbiased we need the following restrictions to hold = = = = + = = The variance of this arbitrary estimator is [ ] = [ ] = [ = = [ = = = + = = ] = = ] + [ = = = + [ + ] = It can be shown that the last term in the above equation is zero [ + ] = = [ = = ] = = = Where = = = = = ] [ + ] = [ ] = [ ] + [ ] = The first term on the Right Hand Side is always positive except when = for all values of i. So [ ] [ ] 9

10 3.3. Proof that OLS estimator is consistent The property of consistency is a large sample property or an asymptotic property unlike the property of unbiasedness which holds for any sample size. By consistency we basically mean that as the sample size tends to infinity the density function of the estimator collapses to the parameter value. So an OLS estimator is said to be consistent if Plim = Where means probability limit. In other words converges in probability to The operator has an invariance property for any continuous function. So if is a consistent estimator of and if h ( ) is any continuous function of then Plim h ( ) = h. Therefore if is a consistent estimator of then are also consistent estimator of ln respectively. 10 ln This property of invariance does not hold valid for the expectation operator. For instance if is an unbiased estimator of ie ( ) =. However this does not mean that is an unbiased estimator of (ie. This is because the expectation ( ) operator applies only to linear functions of random variables while operator is valid for any continuous function. We know that = = = = = = = = = = = = + + = = = + = = = + = = = Take operator on both the sides Plim = Plim [ + = ] = + = =

11 = + Plim = Plim = We divide both the numerator and denominator in the second term by so that the summation does not goes to infinity when. Then next we apply the law of large numbers to both numerator and denominator. According to Law of Large number that under general conditions, the sample moments converge to their corresponding population moments., = + = Provided. Note that, = [ ] = [] = Therefore OLS estimator is a consistent estimator. 4. GOODNESS OF FIT We have estimated our model parameters using OLS and have seen how they have various desirable statistical properties under certain assumptions. But we are still not sure if the estimated model fits the data well. If all the observations of the sample lie on the regression line then we say that the regression model fits the data perfectly. Usually, we will have some negative and some positive residual term. We want that these residuals around the regression line as minimum as possible. The coefficient of determination provides a summary measure of how well the sample regression line fits the data. 4.1 Measures of variation Recall that the Sample Regression Function is = + + Summing both the sides and dividing it by the sample size we have = + Subtracting (2) from (1) we have = + Writing equation (3) in deviation form we have = + = + Squaring both the sides and taking summation over the sample we have 11

12 = + + = = = = The Last term is zero by the assumption that the covariance of fitted value and error is zero = ( ) + = = = = + Or, Total Sum of Squares (TSS) = Explained Sum of Squares (ESS) + Residual Sum of Squares (RSS) Where = = is the total variation of actual values about their sample mean = ( ) = = = = is the variation of estimated values about the sample mean = is the residual or unexplained variation of actual about regression line. = Therefore the Total Variation in can be decomposed into two parts (1) ESS which is the part accounted for by and (2) RSS which is the unexplained and unaccounted part. RSS is known as unexplained part of variation because the residual term captures the effect of variables other than the explanatory variable that are not included in the regression model Coefficient of Determination We have TSS = ESS + RSS Now divide both sides by TSS we have = + = ( ) = = + = = We define as follows = ( ) = = = = 12

13 Therefore measures the percentage of the total variation in that is explained by the regression model. In other words, it is the proportion of Total Sum of Squares (TSS) which is explained by the Explained sum of squares (ESS). Alternatively, can also be defined in another form by little manipulation of formulae. = = = = So, is now equal to 1 minus the total sum of squares that is not explained by the regression model (Residual Sum of Squares). When the observed points are closer to the estimated regression line, then we say that the data fits the model very well. In such case ESS will be higher and RSS will be smaller. We want which is a measure of goodness of fit to be very high. When is low, this means that there are lots of variations in which cannot be explain by There are other interpretations for. It also measures the correlation between the observed value and the predicted value (, ). Therefore = (, ) ( ) = = So squaring the simple correlation between and gives the coefficient of determination. This result is valid for multiple regression models as well provided the regression model has a constant term. The question which commonly arises relates to the value of the goodness of fit. There is no rule which suggest what value of is considered as high and what is considered as low. For time series data the value of is usually high and above 0.9. However for cross-sectional data, value of 0.6 or 0.7 may be considered as good. We should be cautious not to depend too much on the value of. is simply one measure of model adequacy. We should be more concerned about the signs of the regression coefficients and whether they conform to economic theory or prior informations. Properties of 1. is a non-negative number. 2. It is unit free as both the numerator and the denominator have the same units 3. The following relationship will hold for coefficient of determination. 13

14 When there is perfect relationship between and we have = and hence =. So all the variation in is explained by the linear regression model and we have =. When there is no relationship between and we have = as =. Thus = and =. So all the variation in is left unaccounted for by the model Coefficient of Correlation The concept of Coefficient of Correlation is quite different from that of goodness of fit. However they are closely connected. The Coefficient of Correlation measures the degree of association between two variables. The sample correlation coefficient can be obtained as follows: = Alternatively the coefficient of correlation could be obtained as follows: Properties of Coefficient of Correlation = ± 1. The sign of Coefficient of Correlation can be positive or negative depending upon the sign of sample covariance between 2. It can lie between -1 and +1. So. 3. The Coefficient of Correlation is symmetrical in nature. So Coefficient of Correlation between is equal to Coefficient of Correlation between. 4. The change in origin and scale of measurement does not affect the measurement of the coefficient of correlation. Suppose = + and = + where,, are constants. The correlation coefficient between and the correlation coefficient between are the same. 5. If are statistically independent then the coefficient of correlation between them is zero. However if the correlation coefficient is zero, this does not necessary mean that are independent of each other. 6. The Coefficient of Correlation measure on linear association or dependence. So it is not meaningful to describe nonlinear relationships. 14

15 7. The Coefficient of Correlation does not imply any cause-and-effect relationship between variables. The goodness of fit is more meaningful than the coefficient of correlation in the regression context. The goodness of fit measures the proportion of variation in dependent variable that is caused by the explanatory variable. It provides up to what extent does the variation in one variable determined the variation in other variable. The coefficient of correlation does not have such significant meaning. 5. SUMMARY 1. The Classical Linear Regression Model is based on as set of assumptions known as the Gauss Markov assumptions. 2. The Gauss Markov assumptions include assumption of linearity in parameter, nonstochastic value of explanatory variable, expectation of disturbance term is zero, homoscedasticity of disturbance term, no auto correlation between error terms, no covariance between error term and disturbance term, identification of equation, variability of explanatory variables, normality of error term, correct functional form. 3. The assumptions under the Classical Linear Regression Model are necessary to prove the Gauss Markov Theorem. The Theorem basically states that under these assumptions, the least squares estimators are the minimum variance estimators among the class of unbiased linear estimators; that is, they are BLUE (Best Linear Unbiased Estimator) 4. The OLS estimator is unbiased if its expected value is equal to population parameter.the property of unbiasedness implies that on average the value of is equal to the population parameter 5. This efficiency property of estimator relates to the concept of the smallest variance of the estimator. The variance of OLS estimators has the smallest variance among all the possible estimators. 6. The property of consistency is a large sample property which basically means that as the sample size tends to infinity, the density function of the estimator collapses to the parameter value. 15

16 7. The Total Variation in (TSS) is a sum of two parts (1) Explained Sum of Squares (ESS) which is the part accounted for by and (2) Residual Sum of Squares (RSS) which is the unexplained and unaccounted part. 8. The coefficient of determination measures the overall goodness of fit of the regression model. It tells what proportion of the variation in the dependent variable is explained by the explanatory variable. 9. The coefficient of determination lies between 0 and 1.The closer it is to 1 the better is the overall goodness of fit of the model. There is no rule which says that such level of coefficient of determination is high and such level is low. The sign of regression coefficient is very important. 10. The Coefficient of Correlation measures the degree of association between two variables. It lies between. The statistical independence of two variables implies zero correlation coefficient but not necessarily vice-versa. 11. The Coefficient of determination and the Correlation Coefficient are related as follows: = ± 16

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