FALL 2012-13: by Assoc. Prof. Sami Fethi

Department of Business Administration
FALL 2012-13
Demand Estimation
by
Assoc. Prof. Sami Fethi
Ch 4 : Demand Estimation
Managerial Economics in a Global Economy Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved.
2
Demand Estimation
To use these important demand relationship in
decision analysis, we need empirically to
estimate the structural form and parameters of
the demand function-Demand Estimation.
Q
dx
= (P, I, P
c
, P
s
, T)
(-, + , - , +, +)
The demand for a commodity arises from the consumers
willingness and ability to purchase the commodity.
Consumer demand theory postulates that the quantity
demanded of a commodity is a function of or depends on the
price of the commodity, the consumers income, the price of
related commodities, and the tastes of the consumer.
3
Demand Estimation
In general, we will seek the answer for the
following qustions:

How much will the revenue of the firm change
after increasing the price of the commodity?
How much will the quantity demanded of the
commodity increase if consumers income
increase
What if the firms double its ads expenditure?
What if the competitors lower their prices?
Firms should know the answers the
abovementioned questions if they want to
achieve the objective of maximizing thier value.
4
The Identification Problem
The demand curve for a commodity is generally
estimated from market data on the quantity purchased
of the commodity at various price over time (i.e. Time-
series data) or various consuming units at one point in
time (i.e. Cross-sectional data).
Simply joinning priced-quantity observations on a graph
does not generate the demand curve for a commodity.
The reason is that each priced-quantity observation is
given by the intersection of a different and unobserved
demand and supply curve of commodity.
In other words, The difficulty of deriving the demand
curve for a commodity from observed priced-quantity
points that results from the intersection of different and
unobserved demand and supply curves for the
commodity is referred to as the identification
problem.
5
The Identification Problem
In the following demand
curve, Observed price-quantity
data points E
1
, E
2
, E
3
, and E
4
,
result respectively from the
intersection of unobserved
demand and supply curves D
1
and S
1
, D
2
and S
2
, D
3
and S
3
,
and D
4
and S
4
. Therefore, the
dashed line connecting
observed points E
1
, E
2
, E
3
, and
E
4
is not the demanded curve
for the commodity. The
derived a demand curve for the
commodity, say, D
2
, we allow
the supply to shift or to be
different and correct, through
regression analysis, for the
forces that cause demand
curve D
2
to shift or to be
different as can be seen at
points E
2
, E'
2
. This is done by
regression analysis.
6
Demand Estimation: Marketing Research Approaches
Consumer Surveys
Observational Research
Consumer Clinics
Market Experiments

These approaches are usually covered
extensively in marketing courses,
however the most important of these
are consumer surveys and market
experiments.

7
o Consumer surveys: These surveys require the
questioning of a firms customers in an
attempt to estimate the relationship between
the demand for its products and a variety of
variables perceived to be for the marketing
and profit planning functions.
These surveys can be conducted by simply
stopping and questioning people at shopping
centre or by administering sophisticated
questionnaires to a carefully constructed
representative sample of consumers by
trained interviewers.

8
Major advantages: they may provide the
only information available; they can be
made as simple as possible; the researcher
can ask exactly the questions they want
Major disadvantages: consumers may be
unable or unwilling to provide reliable
answers; careful and extensive surveys can
be very expensive.
9
Market experiments: attempts by the
firm to estimate the demand for the
commodity by changing price and
other determinants of the demand for
the commodity in the actual market
place.
10
Major advantages: consumers are in a real
market situation; they do not know that they
being observed; they can be conducted on a
large scale to ensure the validity of results.
Major disadvantages: in order to keep cost
down, the experiment may be too limited so the
outcome can be questionable; competitors
could try to sabotage the experiment by
changing prices and other determinants of
demand under their control; competitors can
monitor the experiment to gain very useful
information about the firm would prefer not to
disclose.

11
Purpose of Regression Analysis
Regression Analysis is Used Primarily
to Model Causality and Provide
Prediction
Predict the values of a dependent
(response) variable based on values of at
least one independent (explanatory)
variable
Explain the effect of the independent
variables on the dependent variable
The relationship between X and Y can be
shown on a scatter diagram
12
Scatter Diagram
It is two dimensional graph of plotted points in
which the vertical axis represents values of the
dependent variable and the horizontal axis
represents values of the independent or
explanatory variable.
The patterns of the intersecting points of
variables can graphically show relationship
patterns.
Mostly, scatter diagram is used to prove or
disprove cause-and-effect relationship. In the
following example, it shows the relationship
between advertising expenditure and its sales
revenues.

Managerial Economics 2008/09, Sami Fethi, EMU, All Right Reserved.
13
Scatter Diagram
Scatter Diagram-Example
Year X Y
1 10 44
2 9 40
3 11 42
4 12 46
5 11 48
6 12 52
7 13 54
8 13 58
9 14 56
10 15 60
14
Scatter Diagram
Scatter diagram
shows a positive
relationship between
the relevant variables.
The relationship is
approximately linear.
This gives us a rough
estimates of the linear
relationship between
the variables in the
form of an equation
such as
Y= a+ b X

15
Regression Analysis
In the equation, a is the vertical
intercept of the estimated linear
relationship and gives the value of Y
when X=0, while b is the slope of the line
and gives an estimate of the increase in
Y resulting from each unit increase in X.
The difficulty with the scatter diagram is
that different researchers would probably
obtain different results, even if they use
same data points. Solution for this is to
use regression analysis.
16
Regression Analysis
Regression analysis: is a statistical
technique for obtaining the line that best
fits the data points so that all researchers
can reach the same results.
Regression Line: Line of Best Fit
Regression Line: Minimizes the sum of the
squared vertical deviations (e
t
) of each
point from the regression line.
This is the method called Ordinary Least
Squares (OLS).
17
Regression Analysis
In the table, Y
1
refers actual or observed
sales revenue of $44 mn associated with
the advertising expenditure of $10 mn in
the first year for which data collected.
In the following graph, Y
^
1

is the
corresponding sales revenue of the firm
estimated from the regression line for the
advertising expenditure of $10 mn in the
first year.
The symbol e
1
is the corresponding
vertical deviation or error of the actual
sales revenue estimated from the
regression line in the first year. This can
be expressed as e
1
= Y
1
- Y
^
1
.

Year X Y
1 10 44
2 9 40
3 11 42
4 12 46
5 11 48
6 12 52
7 13 54
8 13 58
9 14 56
10 15 60
18
Regression Analysis
In the graph, Y
^
1

is
the corresponding
sales revenue of the
firm estimated from
the regression line
for the advertising
expenditure of $10
mn in the first year.
The symbol e
1
is the
corresponding
vertical deviation or
error of the actual
sales revenue
estimated from the
regression line in
the first year. This
can be expressed as
e
1
= Y
1
- Y
^
1
.

19
Regression Analysis
Since there are 10
observation points, we
have obviously 10
vertical deviations or
error (i.e., e
1
to e
10
).
The regression line
obtained is the line that
best fits the data points
in the sense that the
sum of the squared
(vertical) deviations
from the line is
minimum. This means
that each of the 10 e
values is first squared
and then summed.

20
Simple Regression Analysis
Now we are in a position to calculate
the value of a ( the vertical intercept)
and the value of b (the slope
coefficient) of the regression line.
Conduct tests of significance of
parameter estimates.
Construct confidence interval for the
true parameter.
Test for the overall explanatory power
of the regression.
21
Simple Linear Regression Model
Regression line is a straight line that describes
the dependence of the average value of one
variable on the other
i i i
Y X | | c
0 1
+ + =
Y Intercept
Slope
Coefficient
Random Error
Independent
(Explanatory)
Variable
Regression
Line
Dependent
(Response)
Variable
22
Ordinary Least Squares (OLS)
Model:
t t t
Y a bX e = + +

t t
Y a bX = +
t t t
e Y Y =
23
Objective: Determine the slope and
intercept that minimize the sum of
the squared errors.
2 2 2
1 1 1

( ) ( )
n n n
t t t t t
t t t
e Y Y Y a bX
= = =
= =

24
Estimation Procedure
1
2
1
( )( )
( )
n
t t
t
n
t
t
X X Y Y
b
X X
=
=

=
a Y bX =
25
Estimation Example
1 10 44 -2 -6 12
2 9 40 -3 -10 30
3 11 42 -1 -8 8
4 12 46 0 -4 0
5 11 48 -1 -2 2
6 12 52 0 2 0
7 13 54 1 4 4
8 13 58 1 8 8
9 14 56 2 6 12
10 15 60 3 10 30
120 500 106
4
9
1
0
1
0
1
1
4
9
30
Time t
X
t
Y
t
X X
t
Y Y ( )( )
t t
X X Y Y
2
( )
t
X X
10 n =
1
120
12
10
n
t
t
X
X
n
=
= = =
1
500
50
10
n
t
t
Y
Y
n
=
= = =
1
120
n
t
t
X
=
=
1
500
n
t
t
Y
=
=
2
1
( ) 30
n
t
t
X X
=
=
1
( )( ) 106
n
t t
t
X X Y Y
=
=
106
3.533
30
b = =
50 (3.533)(12) 7.60 a = =
(Yt-Y)2=440
26
Estimation Example
10 n =
1
120
12
10
n
t
t
X
X
n
=
= = =
1
500
50
10
n
t
t
Y
Y
n
=
= = =
1
120
n
t
t
X
=
=
1
500
n
t
t
Y
=
=
2
1
( ) 30
n
t
t
X X
=
=
1
( )( ) 106
n
t t
t
X X Y Y
=
=
106
3.533
30
b = =
50 (3.533)(12) 7.60 a = =
27
The Equation of Regression Line
The equation of the regression line can be
constructed as follows:
Y
t
^
=7.60 +3.53 X
t

When X=0 (zero advertising expenditures),
the expected sales revenue of the firm is
$7.60 mn. In the first year, when X=10mn,
Y
1
^
= $42.90 mn.
Strictly speaking, the regression line should be
used only to estimate the sales revenues
resulting from advertising expenditure that are
within the range.
28
Crucial Assumptions
Error term is normally distributed.
Error term has zero expected value
or mean.
Error term has constant variance in
each time period and for all values
of X (i.e. Heteroscedasticity).
Error terms value in one time
period is unrelated to its value in
any other period (Autocorrelation).
29
Tests of Significance: Standard Error
To test the hypothesis that b is
statistically significant (i.e.,
advertising positively affects sales),
we need first of all to calculate
standard error (deviation) of b
^
.
The standard error can be
calculated in the following
expression:
30
Tests of Significance
Standard Error of the Slope Estimate
2 2
2 2
( )
( ) ( ) ( ) ( )
t t
b
t t
Y Y e
s
n k X X n k X X
= =

31
Example Calculation
2 2
1 1
( ) 65.4830
n n
t t t
t t
e Y Y
= =
= =

2
1
( ) 30
n
t
t
X X
=
=
( )
65.4830
0.52
( ) ( ) (10 2)(30)
t
b
t
Y Y
s
n k X X
= = =

1 10 44 42.90
2 9 40 39.37
3 11 42 46.43
4 12 46 49.96
5 11 48 46.43
6 12 52 49.96
7 13 54 53.49
8 13 58 53.49
9 14 56 57.02
10 15 60 60.55
1.10 1.2100 4
0.63 0.3969 9
-4.43 19.6249 1
-3.96 15.6816 0
1.57 2.4649 1
2.04 4.1616 0
0.51 0.2601 1
4.51 20.3401 1
-1.02 1.0404 4
-0.55 0.3025 9
65.4830 30
Time t
X
t
Y
t
Y

t t t
e Y Y =
2 2
( )
t t t
e Y Y =
2
( )
t
X X
Yt^=7.60 +3.53 Xt =7.60+3.53(10)= 42.90
(Yt-Y)2=440
(Yt-Y)2=373.8430
32
Example Calculation
2
( )
65.4830
0.52
( ) ( ) (10 2)(30)
t
b
t
Y Y
s
n k X X
= = =

2
1
( ) 30
n
t
t
X X
=
=
2 2
1 1
( ) 65.4830
n n
t t t
t t
e Y Y
= =
= =

33
Calculation of the t Statistic
3.53
6.79
0.52
b
b
t
s
= = =
Degrees of Freedom = (n-k) = (10-2) = 8
Critical Value (tabulated) at 5% level =2.306
34
Confidence interval
We can also construct confidence interval
for the true parameter from the estimated
coefficient.
Accepting the alternative hypothesis that
there is a relationship between X and Y.
Using tabular value of t=2.306 for 5% and
8 df in our example, the true value of b will
lies between 2.33 and 4.73
t=b
^
+/- 2.306 (s
b
^
)=3.53+/- 2.036 (0.52)
35
Decomposition of Sum of Squares
2 2 2

( ) ( ) ( )
t t t
Y Y Y Y Y Y = +

Total Variation = Explained Variation + Unexplained Variation
36
Decomposition of Sum of Squares
37
Coefficient of Determination
Coefficient of Determination: is defined
as the proportion of the total variation
or dispersion in the dependent variable
that explained by the variation in the
explanatory variables in the regression.
In our example, COD measures how
much of the variation in the firms sales
is explained by the variation in its
advertising expenditures.
38
Coefficient of Determination
2
2
2
( )
( )
t
Y Y
ExplainedVariation
R
Total Variation Y Y
= =
2
373.84
0.85
440.00
R = =
39
Coefficient of Correlation
Coefficient of Correlation (r): The
square root of the coefficient of
determination.
This is simply a measure of the degree
of association or co-variation that
exists between variables X and Y.
In our example, this mean that
variables X and Y vary together 92%
of the time.
The sign of coefficient r is always the
same as the sign of coefficient of b
^
.
40
Coefficient of Correlation
2

r R withthesignof b =
0.85 0.92 r = =
1 1 r s s
CC measures only degree of association or co variation
between the two variables. In this case there is a strong
and pozitive relationship between Y and X.
41
Multiple Regression Analysis
Model:
1 1 2 2 ' ' k k
Y a b X b X b X = + + + +
42
Relationship between 1 dependent & 2 or more
independent variables is a linear function
1 2 i i i k ki i
Y X X X | | | | c
0 1 2
= + + + + +
Y-intercept Slopes
Random error
Dependent (Response) variable
Independent (Explanatory) variables
43
X
2
Y
X
1
Y|X
= |
0
+ |
1
X
1i
+ |
2
X
2i
|
0
Y
i
= |
0
+ |
1
X
1i
+ |
2
X
2i
+ c
i
Response
Plane
(X
1i
,X
2i
)
(Observed Y)
c
i
44
Too
complicated
by hand!
Ouch!
45
Multiple Regression Model: Example
Develop a model for estimating
heating oil used for a single family
home in the month of January,
based on average temperature and
amount of insulation in inches.
Oil (Gal) Temp Insulation
275.30 40 3
363.80 27 3
164.30 40 10
40.80 73 6
94.30 64 6
230.90 34 6
366.70 9 6
300.60 8 10
237.80 23 10
121.40 63 3
31.40 65 10
203.50 41 6
441.10 21 3
323.00 38 3
52.50 58 10
46
Multiple Regression Model: Example
0 1 1 2 2
i i i k ki
Y b b X b X b X = + + + +
Coefficients
Intercept 562.1510092
X Variable 1 -5.436580588
X Variable 2 -20.01232067
Excel Output
1 2
562.151 5.437 20.012

i i i
Y X X =
For each degree increase in
temperature, the estimated
average amount of heating oil
used is decreased by 5.437
gallons, holding insulation
constant.
For each increase in one inch of
insulation, the estimated average use
of heating oil is decreased by 20.012
gallons, holding temperature
constant.
47
Adjusted Coefficient of Determination
2 2
( 1)
1 (1 )
( )
n
R R
n k
Regressi on S tati sti cs

M u l t i p l e R 0 . 9 8 2 6 5 4 7 5 7
R S q u a re 0 . 9 6 5 6 1 0 3 7 1
A d j u s t e d R S q u a re 0 . 9 5 9 8 7 8 7 6 6
S t a n d a rd E rro r 2 6 . 0 1 3 7 8 3 2 3
O b s e rva t i o n s 1 5
SST
SSR
r
, Y
=
2
12
48
Interpretation of Coefficient of Multiple Determination
2
12
.9656
Y
SSR
r
SST
-
= =
96.56% of the total variation
in heating oil can be explained
by temperature and amount
of insulation
95.99% of the total fluctuation
in heating oil can be explained
by temperature and amount of
insulation after adjusting for
the number of explanatory
variables and sample size
2
adj
.9599 r =
49
Testing for Overall Significance
Shows if Y Depends Linearly on All of the X
Variables Together as a Group
Use F Test Statistic
Hypotheses:
H
0
: |
1
= |
2
= = |
k
= 0 (No linear relationship)
H
1
: At least one |
i
= 0 ( At least one independent
variable affects Y )
The Null Hypothesis is a Very Strong Statement
The Null Hypothesis is Almost Always Rejected
50
Analysis of Variance and F Statistic
/( 1)
/( )
ExplainedVariation k
F
UnexplainedVariation n k
2
2
/( 1)
(1 ) /( )
R k
F
R n k
=

51
Test for Overall Significance
Excel Output: Example
ANOVA
df SS MS F Significance F
Regression 2 228014.6 114007.3 168.4712 1.65411E-09
Residual 12 8120.603 676.7169
Total 14 236135.2
k -1= 2, the number
of explanatory
variables and
dependent variable
n - 1
p-value
k = 3, no of
parameters
52
Test for Overall Significance:
Example Solution
0
3.89
o = 0.05
H
0
: |
1
= |
2
= = |
k
= 0
H
1
: At least one |
j
= 0
o = .05
df = 2 and 12
Critical Value:
Test Statistic:

Decision:

Conclusion:

F 168.47
Reject at o = 0.05.
There is evidence that at
least one independent
variable affects Y.
=
53
t Test Statistic
Excel Output: Example
Coefficients Standard Error t Stat P-value
Intercept 562.1510092 21.09310433 26.65094 4.77868E-12
Temp -5.436580588 0.336216167 -16.1699 1.64178E-09
Insulation -20.01232067 2.342505227 -8.543127 1.90731E-06
t Test Statistic for X
2

(Insulation)
t Test Statistic for X
1

(Temperature)
i
i
b
b
t
S
=
54
t Test : Example Solution
Does temperature have a significant effect on monthly
consumption of heating oil? Test at o = 0.05.
H
0
: |
1
= 0
H
1
: |
1
= 0
df = 12
Critical Values:
Test Statistic:
t Test Statistic = -16.1699
Decision:
Reject H
0
at o = 0.05.
Conclusion:
There is evidence of a significant
effect of temperature on oil
consumption holding constant the
effect of insulation.
Reject H Reject H
0 0
.025
.025
-2.1788 2.1788
0
55
Problems in Regression Analysis
Multicollinearity: Two or more explanatory
variables are highly correlated.
Heteroskedasticity: Variance of error term is not
independent of the Y variable.
Autocorrelation: Consecutive error terms are
correlated.
Functional form: Misspecified by the omission of
a variable
Normality: Residuals are normally distributed or
not
56
Practical Consequences of Multicollinearity
Large variance or standard error
Wider confidence intervals
Insignificant t-ratios
A high R
2
value but few significant t-
ratios
OLS estimators and their Std. Errors
tend to be unstable
Wrong signs for regression coefficients
57
Multicollinearity
How can Multicollinearity be overcome?
Increasing number of observation
Acquiring additional data
A new sample
Using an experience from a previous study
Transformation of the variables
Dropping a variable from the model
This is the simplest solution, but the worse
one referring an economic model (i.e., model
specification error)
58
Heteroskedasticity
Heteroskedasticity: Variance of error term is
not independent of the Y variable or
unequal/non-constant variance. This means
that when both response and explanatory
variables increase, the variance of response
variables does not remain same at all levels of
explanatory variables (cross-sectional data).
Homoscedasticity: when both response and
explanatory variables increase, the variance of
response variable around its mean value
remains same at all levels of explanatory
variables (equal variance).

59
Residual Analysis for Homoscedasticity
Heteroscedasticity

Homoscedasticity
SR
X
SR
X
Y
X X
Y
60
Autocorrelation or serial correlation
Autocorrelation: Correlation between
members of observation ordered in
time as in time series data (i.e.,
residuals are correlated where
consecutive errors have the same
sign).
Detecting Autocorrelation: This can be
detected by many ways. The most
common used is DW statistics.
61
Durbin-Watson Statistic
Test for Autocorrelation
2
1
2
2
1
( )
n
t t
t
n
t
t
e e
d
e
=
=
If d=2, autocorrelation is absent.

62
Residual Analysis for Independence
The Durbin-Watson Statistic
Used when data is collected over time to detect
autocorrelation (residuals in one time period are
related to residuals in another period)
Measures violation of independence assumption
2
1
2
2
1
( )
n
i i
i
n
i
i
e e
D
e
=
=
Should be close to 2.
If not, examine the model
for autocorrelation.
63
Residual Analysis for Independence
Not Independent
Independent

e
e
Time
Time
Residual is Plotted Against Time to Detect Any Autocorrelation
No Particular Pattern Cyclical Pattern
Graphical Approach
64
Accept H
0
(no autocorrelation)
Using the Durbin-Watson Statistic
: No autocorrelation (error terms are independent)

: There is autocorrelation (error terms are not)
0
H
1
H
0 4 2 d
L
4-d
L
d
U
4-d
U

Reject H
0
(positive
autocorrelation)
Inconclusive
Reject H
0
(negative
autocorrelation)
65
Steps in Demand Estimation
Model Specification: Identify Variables
Collect Data
Specify Functional Form
Estimate Function
Test the Results
66
Functional Form Specifications
Linear Function:
Power Function:
0 1 2 3 4 X X Y
Q a a P a I a N a P e = + + + + + +
1 2
( )( )
b b
X X Y
Q a P P =
Estimation Format:
1 2
ln ln ln ln
X X Y
Q a b P b P = + +
67
Dummy-Variable Models
When the explanatory variables are
qualitative in nature, these are known
as dummy variables. These can also
defined as indicators variables, binary
variables, categorical variables, and
dichotomous variables such as
variable D in the following equation:
e D c I c P c c Q
x x
+ + + + + = ......
3 2 1 0
68
Categorical Explanatory Variable with 2 or More Levels
Yes or No, On or Off, Male or Female,
Use Dummy-Variables (Coded as 0 or 1)
Only Intercepts are Different
Assumes Equal Slopes Across Categories
Regression Model Has Same Form
Can the dependent variable be dummy?
69
0 1 1 2 0 1 1
(0)
i i i
Y b b X b b b X = + + = +
0 1 1 2 0 2 1 1
(1) ( )
i i i
Y b b X b b b b X = + + = + +
Given:
Y = Assessed Value of House
X
1
= Square Footage of House
X
2
= Desirability of Neighbourhood =
Desirable (X
2
= 1)
Undesirable (X
2
= 0)
0 if undesirable
1 if desirable
0 1 1 2 2
i i i
Y b b X b X = + +
Same
slopes
70
Simple and Multiple Regression Compared: Example
71
72
73
74
Regression Analysis in Practice
Suppose we have an Employment (Labor
Demand) Function as follows:
N=Constant+K+W+AD+P+WT
N: employees in employment
K: capital accumulation
W: value of real wages
AD: aggregate deficit
P: effect of world manufacturing exports on
employment
WT: the deviation of world trade from trend.
75
Output by Microfit v4.0w
Ordinary Least Squares Estimation
*******************************************************************************
Dependent variable is LOGN
39 observations used for estimation from 1956 to 1994
*******************************************************************************
Regressor Coefficient Standard Error T-Ratio[Prob]
CON 4.9921 .98407 5.0729[.000]
LOGK .040394 .012998 3.1078[.004]
LOGW .024737 .010982 2.2526[.032]
AD -.9174E-7 .1587E-6 .57798[.567]
LOGP .026977 .0099796 2.7032[.011]
LOGWT -.053944 .024279 2.2219[.034]
*******************************************************************************
R-Squared .82476 F-statistic F( 6, 33) 20.8432[.000]
R-Bar-Squared .78519 S.E. of Regression .012467
Residual Sum of Squares .0048181 Mean of Dependent Variable 10.0098
S.D. of Dependent Variable .026899 Maximum of Log-likelihood 120.1407
DW-statistic 1.8538
*******************************************************************************
76
Diagnostic Tests

******************************************************************************
*
* Test Statistics * LM Version * F Version
*

******************************************************************************
*
* * *
*
* A:Serial Correlation *CHI-SQ( 1)= .051656[.820]*F(1,30)=.039788[.843]*
* * *
*
* B:Functional Form *CHI-SQ( 1)= .056872[.812]*F(1,30)=.043812[.836]*
* * *
*
* C:Normality *CHI-SQ( 2)= 1.2819[.527]* Not applicable
*
* * *
*
* D:Heteroscedasticity *CHI-SQ( 1)= 1.0065[.316]*F( 1,37)=.98022[.329]*

******************************************************************************
*

A:Lagrange multiplier test of residual serial correlation
B:Ramsey's RESET test using the square of the fitted values
C:Based on a test of skewness and kurtosis of residuals
D:Based on the regression of squared residuals on squared fitted values

77
Dependent Variable: LOGN
Explanatory Variables

CON
4.9921
(5.07)

LOGK
0.40394
(3.10)

LOGW
0.0247
(2.25)
AD
-0.9174
(-0.577)
LOGP
0.0269
(2.70)
LOGWT
-0.0539
(-2.22)
R
2
0.87
0.83
DW 2.16
SER 0.021
X
2
SC
.05165[.820]
X
2
FF
05687[.812]
X
2
NORM
1.2819[.527]
X
2
HET
1.0065[.316]
R
2 bar
78
Interpretation
t-test (individual significance)
Lets first see the significance of each
variable;
n=39
k=6 and hence d.f.=39-6=33
o=0.05 (our confidence level is 95%).
With o=0.05 and d.f.=33, t
tab
=2.045
Our Hypothesis are:
H
o
:|s=0 (not significant)
H
1
: |s=0 (significant)

This is t- distribution and using this
distribution, you can decide whether
individual t-values (calculated or
estimated) of the existing variables are
significant or not according to the
tabulated t-values as appears in the fig
above.
79
F-test (overall significance)

Our result is F
(6,33)
=20.8432
k-1=5 and n-k=33
o= 0.05 (our confidence level is
95%).
With o= 0.05 and F
(6,33)
, the
F
tab
=2.34

Our hypothesis are
H
o
:R
2
s=0 (not significant)
H
1
: R
2
=0 (significant)

80
Diagnostic Tests:
Serial Correlation:
H
o
:=0(existence of
autocorrelation )
H
1
:=0 (no
autocorrelation)

Since CHI-
SQ(1)=0.051656<
X
2
=3.841, we reject H
o

that estimate regression
does not have first
order serial correlation
or autocorrelation.

81
Functional Form:
H
o
:=0 (existence
misspecification)
H
1
: =0 (no of
misspecification)

The estimated LM version of
CHI-SQ is 0.0568721 and
with o= 0.05 the tabular
value is X
2
=3.841. Because
CHI-SQ (1)=0.0568721<
X
2
=3.841, then we reject the
null hypothesis that there is
functional misspecification.

82
Normality:
H
o
:u
t
=0 (residuals are not
normally distributed)
H
1
:u
t
=0(residuals are
normally distributed)

Our estimated result of LM
version for normality is CHI-
SQ(2)=1.28191, and the
tabular value with 2
restrictions with o= 0.05 is
X
2
=5.991.
Since CHI-SQ(2)=1.28191<
X
2
=5.991, the test result
shows that the null
hypothesis of normality of
the residuals is accepted.
83

Heteroscedasticity:
H
o
:o
yt
2
=o
2

(heteroscedasticity)
H
1
:o
yt
2
=o
2
(homoscedasticity)

LM version of our result for the
heteroscedasticity is
CHI-SQ(1)=1.00651 and table
critical value with 1 restriction
with o= 0.05 is X
2
=3.841.
Since CHI-SQ(1)=1.00651<
X
2
=3.841, we reject the null
hypothesis that error term is
not constant for all the
independent variables.
84
The End

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FALL 2012-13: by Assoc. Prof. Sami Fethi

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If d=2, autocorrelation is absent.

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