Econometrics To The Rescue

Economics is a social science defined as, “the branch of knowledge concerned with the

production, consumption, and transfer of wealth”. The activities of production, consumption and

exchange of goods and services form the base of any economy. An economist is a personnel

who observes and understands the relationship between a society’s inputs and the corresponding

output, where “society” may be anything, right from the smallest of local communities to an

entire nation or even the global economy. The problem starts with scarcity of resources that may

be monetary or non-monetary. There are several misconceptions attached with the concept of

scarcity. It does not indicate an absolute shortage of resources, but a relative one. Therefore,

even the richest of nations face scarcity, since their demands are relatively higher than the

resources available to satisfy them.

While every economist tries to maximize output from the limited resources in an economy, their

approaches towards the same differ. Where on one hand some tread on the mathematical path,

others stick to theoretical explanations. At the end of the day, economics aims to explain human

behaviour and since this is not uniform, they include certain assumptions in their models.

Assumptions form a major part of any economic theory or growth model, but sometimes work

counterintuitively. They help us understand the relationship between two variables in isolation.

Often, assumptions create a utopian world, and when economists are not able to explain

happenings in reality, it all boils down to the assumptions and how unreal they make the model.

Owing to these assumptions, economists have been highly criticized for years.

At this juncture, wherein economists were facing criticism, something amazing happened!

Ragnar Frisch introduced Econometrics in 1969, a branch of economics concerned with the use

of mathematical methods (especially statistics) in describing economic systems. The Nobel Prize

winner introduced a branch that mathematically expresses the economic system. Using tools like

regression, one was able to explain the dependency of the economic output on various internal

factors. This was path breaking, as now, we could quantify impact of various changes in the

economic system. Economists were in a position to quantify the extent to which a variable was

being explained using a set of explanatory variables. This scenario was preferable, as in the

pre-econometric era, assumptions sure did help decipher relationships, the only drawback being

that nobody knew if the model was complete enough to swear by.

Consider for example, that our model statistically explained only 20% of the cause-effect

relationship and we went by what the model predicts, we were sure in for major disappointments

and results that were far from our models’. Assumption based theories never appealed to the

world outside that of economics. They were not in a position to appreciate the advancement and

development in the subject where economists were working hard to explain human behaviour

that would benefit society at large. The world outside relied and understood numbers and the

lack of inclusion of statistical tools like the ones econometrics brought along, made them

oblivious to the world of economics. Therefore, it is safe to say, that econometrics bridged the

gap between economists and non-economists, that had developed due to assumptions underlying

the economic theories. It made non-economists appreciate the work and capabilities of

economists and brought back the lost confidence to the economic community.

While we must appreciate the clarity econometrics brings to the table, we must also understand

that not everything can be quantitatively measured. When on one hand, it makes sense to use

econometric tools to understand relationships coming from variables that are quantitatively

measurable, it does become difficult to put in quantitative terms, the data which has no set

standard measure. Happiness, is an abstract feeling and there is no fixed metric to measure the

difference between the happiness levels of two distinct individuals. There are various factors

involved and thus, we switch to proxy variables. There definitely is a reduction in the quality of

quantitative outcomes, derived from proxy variables, as compared to its theoretical counterpart,

based on a comprehensive set of questions and observations that carries the essence of the

problem along.

Although old school economists dislike this intervention of mathematical and statistical tools

into the subject citing a loss of the theoretical essence, they need to understand that limiting

economics to mere theory drastically restricts its scope of application in the real world.

Econometrics and the application of mathematical tools just add another dimension to the subject

and help universal applicability.