Managerial Economics in a

Global Economy, 5th Edition

by
Dominick Salvatore

Chapter 4
Demand Estimation

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 1
 The Identification Problem

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 2
 Demand Estimation:
Marketing Research Approaches
• Consumer Surveys
• Observational Research
• Consumer Clinics
• Market Experiments
• Virtual Shopping
• Virtual Management

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 3
 Regression Analysis
Year X Y
1 10 44
Scatter Diagram
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
Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 4
 Regression Analysis
• Regression Line: Line of Best Fit

• Regression Line: Minimizes the sum of

the squared vertical deviations (et) of
each point from the regression line.

• Ordinary Least Squares (OLS) Method

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 5
 Regression Analysis

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 6
Ordinary Least Squares (OLS)

Model: Yt  a  bX t  et

ˆ
Yˆt  aˆ  bX t

et  Yt  Yˆt

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 7
Ordinary Least Squares (OLS)

Objective: Determine the slope and

intercept that minimize the sum of
the squared errors.

n n n

t  t t  t
e 2

t 1
 (Y  Yˆ ) 2
 (Y  ˆ
a
t 1
 ˆ )2
bX t
t 1

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 8
Ordinary Least Squares (OLS)
Estimation Procedure
n

(X t  X )(Yt  Y )
bˆ  t 1 ˆ
â  Y  bX
n

 t
( X
t 1
 X ) 2

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 9
Ordinary Least Squares (OLS)
Estimation Example
Time Xt Yt Xt  X Yt  Y ( X t  X )(Yt  Y ) ( X t  X )2
1 10 44 -2 -6 12 4
2 9 40 -3 -10 30 9
3 11 42 -1 -8 8 1
4 12 46 0 -4 0 0
5 11 48 -1 -2 2 1
6 12 52 0 2 0 0
7 13 54 1 4 4 1
8 13 58 1 8 8 1
9 14 56 2 6 12 4
10 15 60 3 10 30 9
120 500 106 30
n n n
n  10  X t  120
t 1
 Yt  500
t 1
(X
t 1
t  X ) 2  30 bˆ 
106
30
 3.533

n n n
X t 120 Yt 500
X    12 Y    50 (X t  X )(Yt  Y )  106 aˆ  50  (3.533)(12)  7.60
t 1 n 10 t 1 n 10 t 1

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 10
Ordinary Least Squares (OLS)
Estimation Example
n
X t 120
n  10 X    12
t 1 n 10
n
Yt 500
Y 
n n

X
t 1
t  120 Y
t 1
t  500
t 1 n

10
 50

n
106
(X
t 1
t  X )  302 ˆ
b
30
 3.533

(X
t 1
t  X )(Yt  Y )  106 aˆ  50  (3.533)(12)  7.60
Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 11
 Tests of Significance

Standard Error of the Slope Estimate

sbˆ 
 (Yt  Y )
ˆ 2


e 2
t

( n  k ) ( X t  X ) 2
(n  k ) ( X t  X )2

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 12
 Tests of Significance
Example Calculation
Time Xt Yt Yˆt et  Yt  Yˆt et2  (Yt  Yˆt )2 ( X t  X )2
1 10 44 42.90 1.10 1.2100 4
2 9 40 39.37 0.63 0.3969 9
3 11 42 46.43 -4.43 19.6249 1
4 12 46 49.96 -3.96 15.6816 0
5 11 48 46.43 1.57 2.4649 1
6 12 52 49.96 2.04 4.1616 0
7 13 54 53.49 0.51 0.2601 1
8 13 58 53.49 4.51 20.3401 1
9 14 56 57.02 -1.02 1.0404 4
10 15 60 60.55 -0.55 0.3025 9
65.4830 30

n n n  (Y  Yˆ ) 2
65.4830
 e   (Yt  Yˆt )2  65.4830 (X sbˆ    0.52
t
2
 X )  30
2

t 1
t
t 1 t 1
t ( n  k ) ( X  X )
t
2
(10  2)(30)

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 13
 Tests of Significance
Example Calculation
n n

 t  t t  65.4830
e 2

t 1
 (Y  Yˆ ) 2

t 1
n

 t
( X 
t 1
X ) 2
 30

sbˆ 
 (Yt  Y )

ˆ 2
65.4830
 0.52
( n  k ) ( X t  X ) 2
(10  2)(30)
Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 14
 Tests of Significance
Calculation of the t Statistic

bˆ 3.53
t   6.79
sbˆ 0.52

Degrees of Freedom = (n-k) = (10-2) = 8

Critical Value at 5% level =2.306

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 15
 Tests of Significance
Decomposition of Sum of Squares

Total Variation = Explained Variation + Unexplained Variation

 (Yt  Y )   (Y  Y )   (Yt  Yt )
ˆ 2 ˆ
2 2

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 16
 Tests of Significance
Decomposition of Sum of Squares

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 17
 Tests of Significance
Coefficient of Determination

R2 
Explained Variation

 (Yˆ  Y ) 2

TotalVariation  t
(Y  Y ) 2

373.84
R  2
 0.85
440.00

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 18
 Tests of Significance
Coefficient of Correlation

r  R2 withthe sign of bˆ

1  r  1

r  0.85  0.92

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 19
 Multiple Regression Analysis

Model: Y  a  b1 X1  b2 X 2   bk ' X k '

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 20
 Multiple Regression Analysis

Adjusted Coefficient of Determination

(n  1)
R 2  1  (1  R 2 )
(n  k )

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 21
 Multiple Regression Analysis

Analysis of Variance and F Statistic

Explained Variation /(k  1)

F
Unexplained Variation /(n  k )

R 2 /(k  1)
F
(1  R 2 ) /(n  k )

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 22
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.
Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 23
 Durbin-Watson Statistic
Test for Autocorrelation
n

 t t 1
( e  e ) 2

d t 2
n

t
e 2

t 1

If d=2, autocorrelation is absent.

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 24
 Steps in Demand Estimation
• Model Specification: Identify Variables
• Collect Data
• Specify Functional Form
• Estimate Function
• Test the Results

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 25
Functional Form Specifications

Linear Function:

QX  a0  a1PX  a2 I  a3 N  a4 PY  e

Power Function: Estimation Format:

QX  a( PXb1 )( PYb2 ) ln QX  ln a  b1 ln PX  b2 ln PY

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 26