Functional form
When we refer to incorrect functional form, we make reference to different
sources of problems.
In social sciences, business included, we do not have enough prior information
to decide a priori which is the correct functional form. Therefore, in
practice we estimate a model using an approximation to the real world problem
using a linear form. Then we provide a battery of diagnostic tests in order to
verify whether this functional form "performs" well.
Some of the problems that we refer as misspecification problems may be due to:
1. Incorrect functional form (e.g., we should have used a logarithmic
functional form instead of a linear form).
2. Omission of relevant variables (an important variables has been left out of
the estimated equation.
3. Inclusion of irrelevant variables. This problem may generate what is called
"multicollinearity," which basically is an indication that we are including
variables that provide the same type of information.