Chapter 4: Demand Estimation

Managerial Economics Instructor: Maharouf Oyolola

Outline of the lecture

-Introduction Statistical estimation of the demand function Model OLS estimation techni ue Interpretation of the results !esting

 !he preceding chapter de"eloped the theory of demand# including the concepts of price elasticity# income elasticity# and cross-elasticity of demand$ % manager &ho is contemplating an increase in the price of one of the firm's products needs to (no& the impact of this increase on: )*+ uantity demanded ),+ total re"enue )-+ profits

.hat uestions should the manager ans&er/

- Is the demand elastic# inelastic# or unit elastic &ith respect to price o"er the range of contemplated price increase/ -.hat &ill happen to demand if consumer incomes increase or decrease as a result of an economic e0pansion or contraction$ Managers face these types of pro1lems e"eryday &hether in a profit-see(ing enterprises# not-for-profit organi2ations or go"ernments$

E0ample
.hat &ill 1e the impact of cigarette ta0es on my uantity demanded of my product/ .hat effect &ill a tuition increase ha"e on local state uni"ersity re"enues/ !hese are the types of uestions the empirical in"estigation attempt to ans&er

Statistical Estimation of the Demand 3unction

Econometrics is a collection of statistical techni ues a"aila1le for testing economic theories 1y empirically measuring relationships among economic "aria1les$ !he measurement of economic relationships is a necessary step in using economic theories and models to o1tain estimates of the numerical "alues of "aria1les that are of interest to the decision ma(er$

!he estimation of a demand function using econometric techni ues in"ol"es the follo&ing steps - Identification of the "aria1les - Collection of the data - 3ormulation of the demand model -Estimation of the parameters - De"elopment of forecasts )estimates+ 1ased on the model

Identification of the "aria1les

%s discussed in the pre"ious chapter# the demand function may 1e "ie&ed as the relationship 1et&een the uantity demanded )the dependent "aria1le+ and se"eral independent "aria1les$ !he first tas( in de"eloping a statistical demand model is to identify the independent "aria1les that are li(ely to influence uantity demanded$ !hese might include factors such as the price of the good in uestion# price of competing or su1stitute goods# population# per capita income# and ad"ertising and promotional e0penditures$

Collection of the data

Once the "aria1les ha"e 1een identified# the ne0t step is to collect data on the "aria1les$ Data can 1e o1tained from a num1er of different sources$

3ormulation of the model

!he ne0t step is to specify the form of the e uation# that indicates the relationship 1et&een the independent "aria1les and the dependent "aria1le$

E0ample
!he linear model# &hich is the most common form of estimation e uation:

Y = + 1 X1 + 2 X 2 + 3 X 3 +

Linear Model
4# 5*# 5,# 5-# 6 are the parameters of the model and 6 is the error term$ !he error term is included in the model to reflect the fact that the relationship is not an e0act one# i$e$# the o1ser"ed demand "alue may not al&ays 1e e ual to the theoretical "alue$

Interpretation of the "alue of 5

!he "alue of each 5 coefficient pro"ides an estimate of the change in uantity demanded associated &ith a one-unit change in the gi"en independent "aria1le# holding constant all other independent "aria1les$

Interpretation of the "alue of 5

!he 5 coefficients are e ui"alent to the partial deri"ati"es of the demand function:

Y 1 = X 1

Y 2 = X 2 Y 3 = X 3

Interpretation of the "alue of 5

ED ED

Y X2 = . X Y X2 = 2. Y

Simple Linear 7egression Model

!he analysis in this section is limited to the case of one independent and one dependent "aria1le )t&o-"aria1le case+# &here the form of the relationship 1et&een the t&o "aria1les is linear$

Estimating the simple linear regression coefficients

(X
n n i

i= 1 b =

X )(Yi Y)
i

(X
i= 1

X)

i= 1 b = n

X Y
i

n X Y nX
2

X
i= 1 i

E0ample *
Sher&in-.illiams company is attempting to de"elop a demand model for its line of e0terior house paints$ !he company's chief economist feels that the most important "aria1les affecting paint sales )8+ )measured in gallons+ are: )*+ promotional e0penditures)9*+ )measured in dollars+$ !hese include e0penditures on ad"ertising )radio# !:# and ne&spaper+# in-store displays and literature# and customer re1ate programs$

E0ample*
),+ Selling price )9,+ )measured in dollars per gallon+$ )-+ Disposa1le income per household )9-+ )measured in dollars+ !he chief economist decides to collect data on the "aria1les in a sample of ten company sales regions that are roughly e ual in population$ Data on paint sales# promotional e0penditures# and selling prices &ere o1tained from the company's mar(eting department$ Data on disposa1le income )per capita+ &as o1tained from the ;ureau of La1or Statistics

%ns&er
8< a = 1$9 8< *,>$?@ = >$4-49 Interpretation: !he coefficient of 9 )>$4-4+ indicates that for one-unit increase in 9 )A*#>>> in additional promotional e0penditures+# e0pected sales )8+ &ill increase 1y >$4-4 )9*#>>>+< 4-4 gallons in a gi"en sales region$

Bsing the regression e uation to ma(e predictions

% regression e uation can 1e used to ma(e predictions concerning the "alue of 8# gi"en any particular "alue of 9$ !his is done 1y su1stituting the particular "alue of 9# namely 9p# into the sample regression e uation

E0ample
Suppose one is interested in estimating Sher&in-.illiam's paint sales for a metropolitan area &ith promotional e0penditures e ual to A*C@#>>> )i$e$# 9p<*C@+$ 8<*,>$?@ = >$4-4)*C@+ 8<,>*$>4@ gallons or ,>*#>4@ gallons

E0ample
9p<->> or A->>#>>> 7emar(: 9p falls outside of the series of o1ser"ations for &hich the regression line &as calculated$ !hus# 1ecause of the a1o"e remar(# &e cannot 1e certain that the prediction of paint sales 1ased on the regression model &ould reasona1le$

Standard Error of the estimate

!he error term ei is defined as the difference 1et&een the o1ser"ed and predicted "alue of the dependent "aria1le$ !he standard de"iation of the error terms is calculated as:

Se =

ei
n 2
i= 1

2 ( y a bx ) i i i= 1

n 2

 !he standard error of the estimate )Se+ can 1e used to construct prediction inter"als for 8$ %n appro0imate D@ percent prediction inter"al is e ual to

Y 2Se

7eturning to our pre"ious e0ample

Y 2S e = 201.045 2(22.7)
*@@$44? to ,4E$E4- )that is# from *@@#44? gallons to ,4E#E4- gallons+$

!esting
F>: 5<> ) Go relationship 1et&een 9 and 8+ Fa: 5H> ) linear relationship 1et&een 9 and 8+

!esting
!here are t&o &ays of doing the testing:

-+ Calculate the t statistic and compare it to the critical "alue 4+ Bse the p-"alue techni ue

Correlation Coefficient
n

r=

( x
i =1 n

x)( y y ) x ) ( yi y )
2 2

( x
i =1

Correlation Coefficient
!he correlation coefficient measures the degree to &hich t&o "aria1les tend to "ary together$ Correlation analysis is useful in e0planatory studies of the relationship among economic "aria1les$ !he information o1tained in the correlation analysis can then 1e used as a guide in 1uilding descripti"e models of economic phenomena that can ser"e as a 1asis for prediction and decision ma(ing$

Correlation Coefficient
!he "alue of the correlation coefficient I ranges from =* for the t&o "aria1les &ith perfect positi"e correlation to -* for t&o "aria1les &ith perfect negati"e correlation$

!he Coefficient of Determination

( y y)

2 2

( yi y )

!he Coefficient of Determination

It measures the proportion of the "ariation in the dependent "aria1le that is e0plained 1y the regression line )the independent "aria1le+$ !he coefficient of determination ranges from > ) &hen none of the "ariation in 8 is e0plained 1y the regression+ to *) &hen all the "ariation in 8 is e0plained 1y the regression$

E0ample
If r,<>$@*D ) from the Sher&in-.illiam's company e0ample+$ Interpretation: the regression e uation# &ith promotional e0penditures as the independent "aria1le# e0plains a1out @, percent of the "ariation in paint sales in the sample$ 7emar(: In the t&o-"aria1le linear regression model# the coefficient of determination is e ual to the s uare of the correlation coefficient# i$e$# r,<>$@*D<) r+,<)>$?,>@D+,$

3-ratio
It is used to test &hether the estimated regression e uation e0plains a significant proportion of the "ariation in the dependent "aria1le$ !he decision is to reJect the null hypothesis of no relationship 1et&een 9 and 8 ) that is# no e0planatory po&er+ at the ( le"el of significance if the calculated 3-ratio is greater than the 3(#*#n-, "alue o1tained from the 3-distri1ution$

E0ample
If 3<C$E4* !he "alue of 3>$>@#*#C from the 3-distri1ution )from the ta1le+ is @$-,$ .e reJect# at the >$>@ le"el of significance# the null hypothesis that there is no relationship 1et&een promotional e0penditures and paint sales$ In other &ords# &e conclude that the regression models does e0plain a significant proportion of the "ariation in paint sales in the sample$

%ssociation and Causation

!he presence of association )correlation+ does not necessarily imply causation$

Multiple Linear 7egression

% functional relationship containing t&o or more independent "aria1les is (no&n as a multiple linear regression model$

Y = + 1 X 1 + 2 X 2 + ...... + m X m +

7egression !echni ues

7egression techni ues

Consider a simple demand e uation K< a = 1L$ !he la& of demand implies that the coefficient 1 should 1e negati"e# indicating that less of the product is demanded at higher prices$

Estimating Coefficients
Consider a small restaurant chain speciali2ing in fresh lo1ster dinner$ !he 1usiness has collected information on prices and the a"erage num1er of meals ser"ed per day for a random sample of eight restaurants in the chain$ !hese data are sho&n 1elo&$ Bse regression analysis to estimate the coefficients of the demand function Kd< a =1L$ ;ased on the estimated e uation# calculate the point price elasticity of demand at the mean "alues of the "aria1les$

!he Least-S uares regression estimation

(X b=

X )(Y Y)
i

(X a=

Y bX

Estimating the demand for lo1sters dinners using the OLS

Ki *>> D> C@ **> *,> D> *>@ *>> Li *@ *C *D *4 **D *E *4 Ki-K)1ar+ > -*> -*@ *> ,> -*> @ > Li-L)1ar+ -* , -, -> -, )Li-L)1ar++, * 4 D 4 D D > 4 )Li-L)1ar++)Ki-K)1ar++ > -,> -4@ -,> -E> --> > >

4>

-*?@

-4$-?@

*?>

Estimating the demand for lo1ster dinners

Bsing the ordinary Least S uares regression# &e find the estimates of the demand for lo1sters$ .e can no& use our results to determine the point elasticity of demand for lo1sters$

.ritten assignment
Lro1lem ME page *C>