Chapter 1 - DEFINITION, SCOPE AND DIVISION OF ECONOMETRICS

DEFINITION, SCOPE AND DIVISION OF ECONOMETRICS

DEFINITION AND SCOPE OF ECONOMETRICS
Econometrics deals with the measurement of economic relationships. The term
‘econometrics’ is formed from two words of Greek origin; o íkovou ía (economy), and
ué tpov (measure). Econometrics is a combination of economic theory, mathematical
economics and statistics, but it is completely distinct from each one of these three
branches of science.
Experience has shown that each of these three branches of science, that of
statistics, economic theory, and mathematics, is a necessary, but not by itself
sufficient, condition for a real understanding of the quantitative relations in modern
economic life. It is the unification of all three that is powerful. And it is this
unification that constitutes econometrics.
Thus econometrics may be considered as the integration of economics,
mathematics and statistics for the purpose of providing numerical values for the
parameters of economic relationships (e.g. elasticity, propensities, and marginal
values) and verifying economic theories.
The most important characteristic of economic relationships is that they contain a
random element, which, however, is ignored by economic theory and mathematical
economics which postulate exact relationships between the various economic
magnitudes. Econometrics has developed methods for dealing with the random
component of economic relationships.
For example, economic theory postulates that the demand for commodity depends
on its price, on the prices of other commodities, on consumers’ income and on
tastes. This is an exact relationship, because it implies that demand completely
determined by the above four factors. No other factor, except those explicitly
mentioned, influences the demand. In mathematical economics we express the
above abstract economic relationships of demand in mathematical terms. Thus we
may write the following demand equation
Q = b0 + b1p + b2p0 + b3Y + b4t where
Q = quantity demanded of a particular commodity
P = price of the commodity
P0 = prices of other commodities
Y = consumers’ income
t = taste
b0, b1, b2, b3, b4 = coefficients of the demand equation.
The above demand equation is exact, because it implies that the only determinants
of the quantity demanded are the four factors which appear in the right hand side of
the equation. Quantity demanded will change only if some of these factors change.
No other factor may have any effect on demand.
However, we know that other factors such as invention of a new product, a war,
professional changes, institutional changes, changes in law, changes in income
distribution, massive population movements, etc., can affect quantity demanded.
Furthermore, human behavior is inherently erratic. In econometrics the influence of
these ‘other’ factors is taken into account by the introduction into the economic
relationships of a random variable, with specific characteristics, which will be
discussed in later chapters. In our example the demand function studied with the
tools of econometrics would be of the (stochastic) form.
Q = b0 + b1p + b2p0 + b3Y + b4t +u where u stands for the random factors
which affect the quantity demanded.

It is essential to stress that econometrics presupposes the existence of a body of

economic theory. In testing a theory we start from its mathematical formulation,
which constitutes the model or the maintained hypotheses. In our example of the
demand function the maintained hypothesis is
Q = b0 + b1p + b2p0 + b3Y + b4t +u.
The next step is to confront the model with observational data referring to the
actual behavior of the economic units – consumers or producers. The aim of this
stage is to establish whether the theory is compatible with the facts. If the theory is
compatible with the actual data, we accept the theory as valid. If the theory is
incompatible with the observed behavior, we either reject the theory or, in the light
of the empirical evidence of the data, we may modify it.
The procedure to be followed when testing a theory may be schematically
presented as in fig. 1.1.
 Theory

Mathematical expression of theory

Model or maintained hypothesis

Confrontation of model with data

Accept theory if compatible with data

Reject theory if incompatible with

Revise
data theory if incompatible with dat

Confrontation with new data

Fig. 1.1
The procedure outlined above is not intended to imply that when testing a theory
the researcher should restrict himself only to factors suggested by economic theory.
If these factors do not provide a satisfactory explanation of economic behavior, the
research worker is certainly entitled to look for other factors.
Econometrics and Mathematical Economics
Mathematical economics states economic theory in terms of mathematical symbols.
There is no essential difference between mathematical economics and economic
theory. Both states the same relationships, but while economic theory uses verbal
exposition, mathematical economics employs mathematical symbolism. Both
express the various economic relationships in an exact form. Neither economic
theory nor mathematical economics allows for random elements which might affect
the relationship and make it stochastic. Furthermore, they do not provide numerical
values for the coefficients of the relationships.
Econometrics differs from mathematical economics even though econometrics
presupposes the expression of economic relationships in mathematical form.
Mathematical economics like economic theory assume that economic relationships
are exact. On the contrary, econometrics assumes that relationships are not exact.
Econometric methods are designed to take into account random disturbances which
create deviation from the exact behavioral patterns suggested by economic theory
and mathematical economics. Furthermore, econometric methods provide
numerical values of the coefficients of economic phenomena.
Econometrics and Statistics
Econometrics differs both from mathematical statistics and economic statistics. An
economic statistician gathers empirical data, records them, tabulates them or
charts them, and then attempts to describe the pattern in their development over
time and perhaps detect some relationship between various economic magnitudes.
Economic statistics is mainly a descriptive aspect of economics. It does not provide
measurement of the parameters of economic relationships.
Mathematical (or inferential) statistics deals with methods of measurement, which
are developed on the basis of controlled experiments in laboratories. Statistical
methods of measurement are not appropriate for economic relationships, which
cannot be measured on the basis of evidence provided by controlled experiments,
because such experiments cannot be designed for economic phenomena.
In physics and some other sciences, the researcher can hold all other conditions
constant and change only one element in performing an experiment. He can then
record the results of such a change and apply the classical statistical method to
deduce the laws governing the phenomenon being investigated. In studying the
economic behavior of human beings one cannot change only one factor while
keeping all other factors constant. In the real world all variables change
continuously and simultaneously, so that controlled experiments are impossible. We
cannot change incomes, keeping prices, tastes and other factors constant, because
the latter will change as a result of income changes.
Econometrics uses statistical methods after adapting them to the problems of
economic life. These adopted statistical methods are called econometric methods.
In particular, econometric methods are adjusted so that they become appropriate
for the measurement of economic relationships which are stochastic, that is, they
include random elements.
GOALS OF ECONOMETRICS
We can distinguish three main goals of econometrics: (1) analysis, i.e. testing of
economic theory; (2) policy–making i.e. supplying numerical estimates of the
coefficients of economic relationships, which may be then used for decision-making;
(3) forecasting, i.e. using the numerical estimates of the coefficients in order to
forecast the future values of the economic magnitudes. Of course, these goals are
not mutually exclusive. Successful econometric applications should really include
some combination of all three aims.
Analysis; Testing Economic Theory
In the earlier stages of the development of economic theory economists formulated
the basic principles of the functioning of the economic system using verbal
exposition and applying a deductive procedure.
Thus in demand theory it was assumed that the consumer aims at the maximization
of his satisfaction (utility) from the expenditure of his income, given the prices of
the commodities. Similarly, producers were assumed to be motivated by
maximization of their profits. From these assumptions the economists by pure
logical reasoning derived some general conclusions (laws) concerning the working
processes of the economic system. Economic theories thus developed in an abstract
level were not tested against economic reality.
Econometrics aims primarily at the verification of economic theories. In this case we
say that the purpose of the research is analysis, i.e. obtaining empirical evidence to
test the explanatory power of economic theories, to decide how well they explain
the observed behavior of the economic units. Today any theory, regardless of its
elegance in exposition or its sound logical consistency, cannot be established and
generally accepted without some empirical testing.
Policy-Making; Obtaining Numerical Estimates of the Coefficients of
Economic Relationships for Policy Simulations
In many cases we apply the various econometric techniques in order to obtain
reliable estimates of the individual coefficients of the economic relationships from
which we may evaluate elasticities or other parameters of economic theory
(multipliers, technical coefficients of production, marginal costs, marginal revenues,
etc.).
The knowledge of the numerical value of these coefficients is very important for the
decisions of firms as well as for the formulation of the economic policy of the
government. It helps to compare the effects of alternative policy decisions.
For example, the decision of the government about devaluing the currency will
depend on a great extent on the numerical value of the marginal propensity to
import, as well as on the numerical value of the price elsticities of exports and
imports. If the sum of price elasticities of exports and imports is less than one in
absolute value, the devaluation will not help in eliminating the deficit in the balance
of payments.
Similarly, if the price elasticity of demand for a product is less than one (inelastic
demand); it does not pay the manufacturer to decrease its price, because his
receipt would be reduced.
Such examples show how important is the knowledge of the numerical values of the
coefficients of the economic relationships. Econometrics can provide such numerical
estimates and has become an essential tool for the formulation of sound economic
policies.
Forecasting: The Future Values of Economic Magnitudes
In formulating policy decisions it is essential to be able to forecast the value of the
economic magnitudes. Such forecasts will enable the policy maker to judge whether
it is necessary to take any measures in order to influence the relevant economic
variables.
For example, suppose that the government wants to decide its employment policy.
It is necessary to know what is the current situation of employment as well as what
the level of employment will be, say, in five years’ time, if no measure whatsoever
is taken by the government. With econometric techniques we may obtain such an
estimate of the level of employment. If this level is too low, the government will
take appropriate measures to avoid its occurrence.
Forecasting is becoming increasingly important both for the regulation of developed
economies as well as for the planning of the economic development of
underdeveloped countries.
DIVISION OF ECONOMETRICS
Econometrics may be distinguished into two branches, theoretical econometrics and
applied econometrics.
Theoretical econometrics includes the development of appropriate methods for the
measurement of economic relationships. Two features of economic reality render
the pure methods of mathematical statistics inappropriate for the measurement of
economic phenomena.
Firstly, the data which are used for the measurement of economic relationships are
observations of actual life and are not derived from controlled experiments. In
economic life laboratory experiments are not possible, because most of the
economic magnitudes change contemporaneously and each influences and is
influenced by all the other magnitudes.
Secondly, the economic relationships are not exact, as economic theory and
mathematical economics assume them to be. Economic behavior is to a certain
extent erratic, being influence by unpredictable events.
Econometric methods may be classified into two groups: (1) single-equation
techniques, which are methods that are applied to one relationship at a time; and
(2) simultaneous-equation techniques, which are methods applied to all the
relationships of a model simultaneously.
Applied econometrics includes the application of econometric methods to specific
branches of economic theory. It examines the problems encountered and the
findings of applied research in the fields of demand, supply, production, investment,
consumption, and other sectors of economic theory. Applied econometrics involves
the application of the tools of theoretical econometrics for the analysis of economic
phenomena and forecasting economic behavior.