GOALS OF ECONOMETRICS
We can distinguish three main goals of econometrics, namely, i) Analysis, i.e., testing of
economic theory, ii) Policy making, ie., supplying numerical estimates of the coefficients
of economic relationships, which may be then used for decision making and iii)
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.
1. 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. The earlier economic theories started from a set of
observations concerning the behaviour of individuals as consumers or producers.
Some basic assumptions were set regarding the motivation of individual economic
units. 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 abstract level were not tested against economic reality. In
other words, no attempt was made to examine whether the theories explained
adequately the actual economic behaviour of individuals.
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 behaviour 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. Therefore, Econometrics is the science of
estimation and testing.
2. 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.
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For example, the decision of the government about devaluing the currency will depend
to a great extent on the numerical value of the marginal propensity to import, as well as
on the numerical values of the price elasticities 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, the price elasticity of demand for a product is less than one (inelastic
demand), it does not pay the manufacturer because to decrease its price, his receipts
would be reduced.
In a competitive market with linear demand and supply curves of the usual type
(downward-sloping demand and upward-sloping), the government should not impose a
specific excise tax (per unit of output) if its aim is to curb price increases, because such a
tax would raise the price, although less than the amount of the tax per unit, ceteris
paribus.
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.
3. Forecasting the Future Values of Economic Magnitudes
In formulating policy decisions it is essential 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 unemployment will be say, in 5 years' time, if no measure whatsoever is taken by the
government.
With econometric techniques we may obtain such an estimate of the level of
unemployment. If this level is too low, the government will take appropriate measures
to avoid its occurrence. If the forecast value of employment is higher than the expected
labour force, the government must take different measures in order to avoid inflation.
Forecasting is becoming increasingly important both for the regulation of developed
economies as well as for the planning of the economic development of developing
countries.
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