NOTES ON CORRELATION AND REGRESSION

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NOTES ON CORRELATION AND REGRESSION

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Meaning

A correlation is fundamentally a comparison between two or more things. If you compare the performance of two

employees, you may find a correlation in that their performance increases when both are working on the same shift. In a

simplistic form, a correlation identifies a connection between two elements when they change status. Correlations are

scored in a three-number format with -1 as negative correlation, 0 for no correlation and 1 for a true, strong correlation.

Correlation is degree and type of relationship between any two or more quantities (variables) in which they vary

together over a period. A positive correlation exists where the high values of one variable are associated with the high

values of the other variable(s). A 'negative correlation' means association of high values of one with the low values of

the other(s). Correlation can vary from +1 to -1. Values close to +1 indicate a high-degree of positive correlation, and

values close to -1 indicate a high degree of negative correlation.

for example, variation in the level of expenditure or savings with variation in the level of income.

USES OF CORRELATION

1.Projection Tool

The most valuable use of a correlation is in predicting the future of a business direction. If marketers and salespeople

can identify a correlation between the behavior of consumers and events and a particular type of product or service,

they can take advantage of the relationship to boost business and ultimately profits.

2. Performance Measurement

Correlations in a business can also lead to identifying efficiencies that saves money. The same goes for employee

behavior. If a business finds that employee performance picks up with the implementation of a bonus-pay-for-

improvement system, the correlation of behavior can signal that a small bonus expense can make serious production

improvement.

Financial correlations are drawn to better understand and improve financial activities, such as investing, marketing,

stock market analysis. The end goal is to improve financial decision making, increasing profits and reducing losses.

4. Correlation in Economics

Economics is a social science, so any correlations would be a means of explaining human action. Almost all economic

analysis is done through correlation analysis to find out association between demand and supply.

SCATTER DIAGRAM

The scatter diagram is known by many names, such as scatter plot, scatter graph, and correlation chart. This diagram is

drawn with two variables, usually the first variable is independent and the second variable is dependent on the first

variable.

The scatter diagram is used to find the correlation between these two variables. This diagram helps you determine how

closely the two variables are related. After determining the correlation between the variables, you can then predict the

behavior of the dependent variable based on the measure of the independent variable. Usually the independent

variable is plotted along the horizontal axis (x-axis) and the dependent variable is plotted on the vertical axis (y-axis).

FOR EXAMPLE You are analyzing the pattern of accidents on a highway. You select the two variables: motor speed and

number of accidents, and draw the diagram. Once the diagram is completed, you notice that as the speed of vehicle

increases, the number of accidents also goes up. This shows that there is a relationship between the speed of vehicles

and accidents happening on the highway.

The scatter diagram can be categorized into several types ,

Scatter Diagram with Strong Positive Correlation

Scatter Diagram with Weak Positive Correlation

Scatter Diagram with Strong Negative Correlation

Scatter Diagram with Weak Negative Correlation

Scatter Diagram with Weakest (or no) Correlation

This type of diagram is also known as Scatter Diagram with Positive Slant.

In positive slant, the correlation will be positive, i.e. as the value of x increases,

the value of y will also increase. You can say that the slope of straight line drawn

along the data points will go up. The pattern will resemble the straight line.

For example, if the temperature goes up, cold drink sales will also go up.

Here as the value of x increases the value of y will also tend to increase, but the pattern will not closely resemble a

straight line

In negative slant, the correlation will be negative, i.e. as the value of x increases, the

value of y will decrease. The downward slope of a straight line drawn along the data

points will go down.

For example, if the temperature goes up, sales of winter coats goes down.

Here as the value of x increases the value of y will tend to decrease, but the pattern

will not be as well defined.

Scatter Diagram with No Correlation

This type of diagram is also known as “Scatter Diagram with Zero Degree of

Correlation”.

you are not able to see any kind of relationship between the two variables. In either

case, the independent variable has no effect on the second variable (it is not

dependent).

In this type of scatter diagram, data points are spread so randomly that you cannot

draw any line through them.

The following are a few limitations of a scatter diagram:

Scatter diagrams are unable to give you the exact extent of correlation.

Scatter diagram does not show you the quantitative measure of the relationship between the variable. It only

shows the quantitative expression of the quantitative change.

This chart does not show you the relationship for more than two variables.

The following are a few advantages of a scatter diagram:

It shows the relationship between two variables.

It is the best method to show you a non-linear pattern.

The range of data flow, i.e. maximum and minimum value, can be easily determined.

Observation and reading is straightforward.

Plotting the diagram is relatively simple.

REGRESSION

Regression Analysis is a tool to aid business decision making. Let us take an example: Hotel chain wants to decide where

to open next branch. The hotel collects the data of 57 existing hotel branches for 3 years-across-following-dimensions:

A. Profit (Dependent Variable)

B. Competitive Properties (Independent variable)

In Statistics, Linear regression refers to a model that can show relationship between two variables and how one can

impact the other. In essence, it involves showing how the variation in the “dependent variable” can be captured by

change in the “independent variables”.

In Business, this dependent variable can also be called the predicted variable for eg, sales of a product, pricing,

performance, risk etc. Independent variables are also called predictor variables as they can predict the effect that

influence the dependent variable along with the degree of the impact which can be calculated using “coefficients” i.e

Byx or Bxy.

Simple regression analysis: Used to estimate the relationship between a dependent variable and a single independent

variable; for example, the relationship between crop yields and rainfall.

Multiple regression analysis: Used to estimate the relationship between a dependent variable and two or more

independent variables; for example, the relationship between the salaries of employees and their experience and

education.

APPLICATION IN BUSINESS

Today, managers believe Linear Regression is a very powerful statistical technique and can be used to generate

prediction on consumer behavior, understanding business and factors influencing profitability.

Linear regressions can be used in business to evaluate trends and make estimates or forecasts.

Optimization - Another key use of regression models is the optimization of business processes.

for example,

A factory manager might build a model to understand the relationship between oven temperature and the shelf life

of the cookies baked in those ovens.

COEFFICIENT OF DETERMINATION

The coefficient of determination (denoted by R2) is a key output of regression analysis. It is interpreted as the

proportion of the variance in the dependent variable that is predictable from the independent variable.

The coefficient of determination is the square of the correlation (r) between predicted y scores and actual y scores;

thus, it ranges from 0 to 1.

An R2 of 0 means that the dependent variable cannot be predicted from the independent variable.

An R2 of 1 means the dependent variable can be predicted without error from the independent variable.

An R2 between 0 and 1 indicates the extent to which the dependent variable is predictable. An R2 of 0.10 means that

10 percent of the variance in Y is predictable from X; an R2 of 0.20 means that 20 percent is predictable; and so on.

R2 = Explained variance / Total Variance

R2 = byx * bxy

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