Error term

The error term refers to the difference (a residual) between what is observed (ACTUAL) and what is measured or estimated (FITTED) using a regression model. This error term also referred to as the unsystematic component of the regression model.

ACTUAL - FITTED = ERROR (or residual)

The inclusion of an error term in the regression model is justified on the following grounds:

  1. As recognition of an imperfect model. That is, some variables that help to "explain" the behavior of the dependent variable might not be included, either because the analyst cannot measure them or simply because of ignorance.
  2. The included variables may have been measured with error.
  3. There is always some component in the variation of the dependent variable that is completely random.