Question

Two of the most important econometric concepts are the "stochastic error term" and the "residual". Define both terms by explaining how they are similar and how they are different.

Answer 1

Soln. Stochastic error term - Any mathematical model when not able to establish the complete relationship between dependent and independent variable, is considered to be in stochastic error and the amount at which the model equation differs during empirical analysis is termed as stochastic error term.

Residual - The gap or difference between the observed value and the value predicted by model is termed as residual.

Differences between stochastic error term and residual

1. Stochastic error term is difference between the observed and the true value whereas residual is difference between the observed and the predicted value.

2. Error term is non-observable as it is a theoretical concept, where as, residual is real time value and observable.

3. The sum of residual is always zero, where as, sum of stochastic error term need not be always zero.

    Similarities between stochastic error term and residual

1. Both stochastic error term and residual are used for calculating deviation from observed values in the model

2. Both stochastic error term and residual are used in statistical model as concept of making the model more accurate in predicting the desired results.