Introduction

other consumption model (theory) might equally fit the data as well? For example, Milton Friedman has developed a model of consumption, called the permanent income hypothesis.15 Robert Hall has also developed a model of consumption, called the life-cycle permanent income hypothesis.16 Could one or both of these models also fit the data in Table I.1?

In short, the question facing a researcher in practice is how to choose among competing hypotheses or models of a given phenomenon, such as the consumption-income relationship. As Miller contends:

No encounter with data is step towards genuine confirmation unless the hypothesis does a better job of coping with the data than some natural rival.. . . What strengthens a hypothesis, here, is a victory that is, at the same time, a defeat for a plausible rival.17

How then does one choose among competing models or hypotheses? Here the advice given by Clive Granger is worth keeping in mind:18

I would like to suggest that in the future, when you are presented with a new piece of theory or empirical model, you ask these questions:

(i) What purpose does it have? What economic decisions does it help with? and;

(ii) Is there any evidence being presented that allows me to evaluate its quality compared to alternative theories or models?

I think attention to such questions will strengthen economic research and discussion.

As we progress through this book, we will come across several competing hypotheses trying to explain various economic phenomena. For example, students of economics are familiar with the concept of the production function, which is basically a relationship between output and inputs (say, capital and labor). In the literature, two of the best known are the Cobb-Douglas and the constant elasticity of substitution production functions. Given the data on output and inputs, we will have to find out which of the two production functions, if any, fits the data well.

The eight-step classical econometric methodology discussed above is neutral in the sense that it can be used to test any of these rival hypotheses.

Is it possible to develop a methodology that is comprehensive enough to include competing hypotheses? This is an involved and controversial topic.

15Milton Friedman, A Theory of Consumption Function, Princeton University Press, Princeton, N.J., 1957.

16R. Hall, "Stochastic Implications of the Life Cycle Permanent Income Hypothesis: Theory and Evidence," Journal of Political Economy, 1978, vol. 86, pp. 971-987.

17R. W. Miller, Fact and Method: Explanation, Confirmation, and Reality in the Natural and Social Sciences, Princeton University Press, Princeton, N.J., 1978, p. 176.

18Clive W. J. Granger, Empirical Modeling in Economics, Cambridge University Press, U.K., 1999, p. 58.

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