Consumption theory tells us that in general, people increase their consumption
expenditure c as their disposable after tax income y increases, but not by as
much as the increase in their disposable income. This can be stated in explicit
linear equation form as.
Were b and b are unknown constants called parameters. The parameter b is the
slope coefficient representing the marginal propensity to consume MPC. Since
even people with identical disposable income are likely to have somewhat
different consumption expenditures the theoretically exact and deterministic
relationship represented by Eq. must be modified to include a random disturbance
or error term, u making it stochastic.
The Methodology of econometrics
Econometric research, in general, involves the following three stages:
1. specification of the model or maintained hypothesis in explicit stochastic
equation form together with the a priori theoretical expectations about the sign
and size of the parameters of the function.
2. collection of data on the variables of the model and estimation of the
coefficients of the function with appropriate econometric techniques presented
in Chaps. 6 to 8.
3. evaluation of the
estimated coefficients of the function on the basis of economic, statistical and