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Statistical vs. Economic Significance

March 5, 2010 Leave a comment

Last week, I learned how to distinguish the statistical significance and economic significance while doing the regression analysis in my econometrics class.

-Statistical Significance: We will look at the t-tests or p-values to determine whether or not to reject the null hypothesis (which says that the parameter is equal to 0) at a certain level of significance.

+ Statistical significance can be driven from a large estimate or a small standard error (which may result from a large sample size, meaning there are more variance in x variables)

+ A lack of statistical significance may be driven from small sample size or multicollinearity (meaning that there are correlations between x variables)

-Economic significance: we will look at the magnitude and the sign of the estimated coefficient. If the number turns out to be so small, that x variable does not really affect y.

In short, an coefficient is

statistically significant when it is quite precisely estimated,

and

economically significant when it is important.

Here is one example from my class notes:

#cars: numbers of cars

inctotal: total annual income (in dollars)

familysize: the size of family (number of people)

age: measured in years

In the example above, all the parameters are statistically significant (the t-ratios are 8.81, 9.91, 2.26, 3.36, which is reasonable for us the reject the null hypothesis in a significance test).

However, the magnitude of “age” (measured in years) is really small (.0046911), which means a year increase in age will increase the number of cars owned by .0046911, on average, all else equal. In other words, all else equal, on average, in order to the number of cars owned to increase by 1, age must increase by over 200 years (=1/.0046911), which does not sound realistic!!

In conclusion, even though the estimated coefficient of “age” is statistically significant, it is NOT economically significant.


Note: The magnitude of “inctotal” is a small number too (.0000691), but it makes some sense. That means all else equal, a dollar increase in total income will increase the number of cars owed by .0000691, on average. That sounds possible, since if you had an extra dollar per year, you would not think of buying another car!! Well, it still does not make good sense to you, let’s put it this way: all else equal, on average, in order for a person to own another car, his/her annual income needs to increase by about $14,471 (=1/.0000691). Sounds reasonable, right? Therefore, the estimated coefficient of “inctotal” is both statistically and economically significant.

We need to watch out for the units as well. A small number doesn’t necessarily imply an economic insignificance.

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