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Feb 21, 2015

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Demand

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Demand

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Lecture objectives

encountered in deriving the demand curve for

a product from market data.

Chapter 4: Demand Estimation

approaches to demand estimation.

o To discuss regression analysis as the most

useful and common method of demand

estimation.

FE 0.55 (Economics Building)

College of Arts and Sciences

razani@uum.edu.my

04-928 3524

from market data on quantity purchased of

the commodity at various prices over time

(time series data) or for various consuming

units or markets at one point in time (crosssectional data).

What it is not:

Simply joining the price-quantity observations

on a graph does not generate the demand

curve for the commodity.

Reason:

Each price-quantity observations is given by

the intersection of a different (but observed)

demand and supply curve of the commodity.

3

differs because of changes in tastes, incomes,

price of related commodities, etc.

Supply curve shifts or differs because of

changes in technology, factor prices and

weather conditions (for agricultural

commodities).

demand and supply curves generates different

price-quantity points observed. Thus, by simply

joining the different price-quantity observations,

we do not generate demand curve for

commodity. It is not that simple. This is

referred to as the identification problem.

20-Jul-10

Demand Estimation

Consumer Surveys

data from survey questions

Observational Research

data from observed behavior

Consumer Clinics

data from laboratory experiments

Market Experiments

data from real market tests

7

demand estimation

demand estimation

Consumer surveys:

Involve questioning sample of consumers

about how they respond to changes in price of

commodity, income, price of related

commodities, advertising expenditures, credit

incentives and other determinants of demand.

Biased. Respondent cannot give accurate

answers to things that have not happen yet

(eg. Reaction to price change to commodity

consumption)

Can be very expensive.

demand estimation

10

demand estimation

Observational research:

Gathering of info on consumer preferences by

watching them buying and using products.

Using scanners at stores see how many

people normally buys the product or how

many people buys the product after the

commercial, etc.

11

Problems:

Observation alone not enough to understand

consumers response.

Cannot determine consumers demographic

characteristics age, sex, education, income,

etc.

12

20-Jul-10

demand estimation

demand estimation

Consumer clinics:

Laboratory experiments where participants

are given a sum of money and asked to spend

in a simulated store to see how they react to

changes in price, packaging, displays, price of

competing products, etc.

Participants can be selected to represent

socio-economic characteristics of the actual

market.

Problems:

Questionable results because its not real

market environment.

Cost of conducting experiments is high can

only use small sample. Cannot represent

market behavior.

13

demand estimation

14

demand estimation

Market experiments:

Conducted in actual marketplace.

Select several markets with similar socioeconomic characteristics and change product

price, packaging, promotion, etc. in different

stores; and record consumer responses

(purchases) in different markets.

Market experiments:

Can be conducted in large scale ensure

validity of the result.

Consumers not aware of the experiment,

would act naturally to changes.

Useful in process of introducing new product

where no data exist yet.

15

16

demand estimation

demand estimation

Problems:

Cost is high. Can be conducted on limited

scale or short period of time.

Cannot prevent extraneous occurrences bad

weather, may bias the result.

Competitors can sabotage the experiment by

changing price and other determinants under

their control.

Problems:

Competitors can also observe the experiment

and gain information that benefit them.

Firm might lose customer when they raise

price for their product in the experiment. The

customer may find another product that

he/she likes to replace the firms product.

17

18

20-Jul-10

Regression Analysis

Regression Analysis

relationship between the firms advertising

expenditures and its sales revenue.

test the hypothesis that higher advertising

expenditures lead to higher sales and estimate

strength of the relationship.

revenue:

Level of advertising expenditures (X)

independent variable.

Sales revenue (Y) dependent variable.

19

20

21

22

Regression Analysis

Regression Analysis

Year

10

44

40

11

42

12

46

11

48

12

52

13

54

13

58

14

56

10

15

60

Regression Analysis

Scatter diagram shows positive relationship

between level of firms advertising

expenditures and its sales revenue higher

advertisement associated with higher

revenue. The relationship is approximately

linear.

Scatter Diagram

23

24

20-Jul-10

Regression Analysis

Regression Analysis

Regression Line: Minimizes the sum of the

squared vertical deviations (et) of each point

from the regression line.

Ordinary Least Squares (OLS) Method

relationship between firms advertising

expenditures and sales revenue draw in line

that best fit between data points.

25

26

Regression Analysis

The slope of line will provide an estimate of

the increase in sales revenue that the firm can

expect with each $1 million increase in its

advertising expenditures. This gives rough

estimate of linear relationship between sales

revenue (Y) and advertising expenditures (X).

Y = a + bX

27

Regression Analysis

28

Regression Analysis

Y = a + bX

a is vertical intercept of linear relationship and

gives the value of Y when X = 0, while b is

slope of line and gives estimate of increase in

Y resulting from each unit increase in X.

Problem:

Different researcher/manager would fit a

somewhat different line to the same data

point and obtain different results.

29

30

20-Jul-10

Regression Analysis

Regression analysis is a statistical technique

for obtaining the line that best fit data points

according to an objective statistical criterion.

Thus, all researchers looking at the same data

would get exactly the same result.

Regression line is obtained by minimizing the

sum of the squared vertical deviations of each

points from the regression line called

ordinary least-squares method (OLS).

31

32

Exercise

Solution

corporation in the local community. Senior

management has wondered how other local

firms view your companys reputation. One

suggestion is to call a variety of managers from a

master contact list of firms that your firm has

done business with over the last 12 months and

ask them what they think of the company. How

reliable is this kind of survey method?

limited, non-random sample of the population

of all local firms. The list suffers from sample

bias (firms already doing business are likely to

favorably view the firm) and probably response

bias (respondents might provide ultra-favorable

responses, what they believe the firm wants to

hear).

33

Exercise

34

Solution

of using controlled customer experiments to

determine demand?

subjects to make actual decisions, rather than

indicating preferences and behavior. The results

are more likely to reflect true preferences. A

drawback is that subjects know they are part of

an experiment, and may not respond accurately.

Second, experiments tend to be of small scale

and of short duration, so that accuracy is

limited.

35

36

20-Jul-10

Exercise

Solution

The major advantage is that a firm can alter one or

more key decision variables in one market and

compare the outcome to another similar market in

which the variables did not change, or were

changed in a different manner. The method can

generate valuable information about pricing and

advertising policy. The main drawback is that all

other factors (including population size and

demographics, consumer incomes, tastes,

competitor prices) must be comparable. Of course,

this is not always possible. Controlled market

studies are also expensive to conduct.

of using controlled market studies to estimate

demand?

37

38

Exercise

Solution

Regression analysis uses uncontrolled data to

generate an equation that allows one to

measure the separate influences of multiple

explanatory variables (in the form of numerical

coefficients) on total demand. In addition, the

analysis provides statistics that measure the

accuracy (goodness of fit) of the equation.

Accordingly, the regression approach can

produce the same kinds of results as a carefully

controlled market study.

data to estimate demand?

39

40

The Ordinary Least-Squares (OLS) Method

Objective: Determine the slope and intercept

that minimize the sum of the squared errors.

Model:

Yt a bX t et

Yt a bX

t

n

t 1

)

e (Y Y ) (Y a bX

et Yt Yt

t 1

2

t

t 1

t 1

t=1 to t=n.

n

41

42

20-Jul-10

minimizing the sum of the squared deviations.

The value of b is given by

n

(X

t 1

X )(Yt Y )

(X

t 1

X)

a Y bX

Estimation Example

Time

Xt

1

2

3

4

5

6

7

8

9

10

10

9

11

12

11

12

13

13

14

15

120

n 10

X

t 1

X 120

X t

12

10

t 1 n

Yt

44

40

42

46

48

52

54

58

56

60

500

n

Y 500

120

t 1

Y 500

Y t

50

10

t 1 n

Xt X

Yt Y

-2

-3

-1

0

-1

0

1

1

2

3

-6

-10

-8

-4

-2

2

4

8

6

10

n

(X

t 1

t 1

( X t X )2

12

30

8

0

2

0

4

8

12

30

106

4

9

1

0

1

0

1

1

4

9

30

X ) 2 30

106

b

3.533

30

X )(Yt Y ) 106

a 50 (3.533)(12) 7.60

(X

( X t X )(Yt Y )

43

estimate sales revenue of the firm for advertising

expenditure very different from those used in the

estimation of the regression line itself.

Regression line should be used only to estimate

the sales revenue of a firm resulting from

advertising expenditures that were within the

range or that at least near the advertising values

that are used in the estimation of the regression

line.

Estimation Example

n 10

n

X

t 1

(X

t 1

t 1

Y 500

t 1

Y

t 1

X t 120

12

n

10

Yt 500

50

n 10

X ) 2 30

106

b

3.533

30

X )(Yt Y ) 106

a 50 (3.533)(12) 7.60

(X

120

t 1

46

estimates

Regression analysis is based on a number of assumptions:

The error term

is normally distributed,

has zero expected value or mean,

has constant variance in each time period and for all values

of X,

its value in one time period is unrelated to its value in any

other period.

unbiased estimates of the slope coefficient and to be

able to utilize probability theory to test for the

reliability of estimates.

47

sample of adverts sales data would obtain

different result/estimate of slope coefficient.

The greater is the dispersion of the estimated

value of b, the smaller is the confidence that

we have in our single estimated value of the b

coefficient.

48

20-Jul-10

estimates

Tests of Significance

significant (adverts positively affects sales), we

need to calculate the standard error

(deviation) of b.

This can be done with regression analysis

using computer programs.

(Y Y )

( n k ) ( X X )

e

(n k ) ( X

sb

2

t

X )2

49

Tests of Significance

Tests of Significance

Example Calculation

Example Calculation

Time

Xt

Yt

Yt

et Yt Yt

et2 (Yt Yt ) 2

( X t X )2

10

44

42.90

1.10

1.2100

40

39.37

0.63

0.3969

11

42

46.43

-4.43

19.6249

12

46

49.96

-3.96

15.6816

11

48

46.43

1.57

2.4649

12

52

49.96

2.04

4.1616

13

54

53.49

0.51

0.2601

13

58

53.49

4.51

20.3401

14

56

57.02

-1.02

1.0404

10

15

60

60.55

-0.55

0.3025

65.4830

30

e (Y Y )

t 1

2

t

t 1

65.4830

(X

t 1

(Y Y )

( n k ) ( X X )

2

X ) 30

2

sb

Tests of Significance

Calculation of the t Statistic

b 3.53

6.79

sb 0.52

Critical Value at 5% level =2.306

t 1

2

t

t 1

(X

t 1

65.4830

0.52

(10 2)(30)

e (Y Y )

t

(Y Y )

( n k ) ( X X )

t

65.4830

X ) 2 30

sb

65.4830

0.52

(10 2)(30)

Besides testing for statistical significance of particular

estimated parameter, we can also test for the overall

explanatory power of the entire regression.

This is accomplished by calculating the coefficient of

determination, denoted by R2 the coefficient of

determination.

Coefficient of determination is defined as the

proportion of the total variation or dispersion in the

dependent variable, that is explained by the variation

in the independent or explanatory variable in the

regression.

54

20-Jul-10

R2 measures how much of the variation in the

firms sales is explained by the variation in its

advertising expenditures.

The closer the observed data points fall to the

regression line, the greater is the proportion

of the variation in the firms sales explained by

the variation in its adverts expenditures, and

the larger is the value of the coefficient of

determination, R2.

Questions or comments?

Reference:

Salvatore (2008), Ch. 4

55

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