Chapter 26 Functional forms in econometric model building

This chapter discusses the criteria for the selection of functional forms and compatibility of the criteria for the selection of functional forms. In the discussion of functional forms, examples are drawn largely from the empirical analyses of production and consumer demand, because the restrictions implied by the respective theories on functional forms are richer. Neither economic theory nor available empirical knowledge provides, in general, a sufficiently complete specification of the economic functional relationship to determine its precise algebraic form. Consequently, the econometrician has wide latitude in deciding which one of many possible algebraic functional forms to use in building an econometric model. The chapter illustrates an example of the incompatibility of a global extrapolative domain of applicability and flexibility and an example of the incompatibility of computational facility and factual conformity. An impossibility theorem stating that there does not exist an algebraic functional form for a unit cost function, which has a global extrapolative domain of applicability and satisfies the criteria of flexibility and computational facility, is proved in the chapter.