Managerial Economics Thomas

ninth edition Maurice

Chapter 7
Demand Estimation &
Forecasting
McGraw-Hill/Irwin
McGraw-Hill/Irwin
Managerial Economics,
Managerial Economics, Copyright © 2008 by the McGraw-Hill Companies, Inc. All
 Managerial Economics
Direct Methods of Demand
Estimation
• Consumer interviews
• Range from stopping shoppers to speak with
them to administering detailed questionnaires
• Potential problems
 Selection of a representative sample, which is a
sample (usually random) having characteristics that
accurately reflect the population as a whole
 Response bias, which is the difference between
responses given by an individual to a hypothetical
question and the action the individual takes when
the situation actually occurs
 Inability of the respondent to answer accurately
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 Managerial Economics
Direct Methods of Demand
Estimation
• Market studies & experiments
• Market studies attempt to hold
everything constant during the study
except the price of the good
• Lab experiments use volunteers to
simulate actual buying conditions
• Field experiments observe actual
behavior of consumers

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 Managerial Economics

Empirical Demand Functions

• Demand equations derived from actual
market data
• Useful in making pricing & production
decisions
• In linear form, an empirical demand
function can be specified as
Q = a + bP + cM + dPR
where Q is quantity demanded, P is the price of the good
or service, M is consumer income, & PR is the price of some
related good R
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 Managerial Economics

Empirical Demand Functions

Q = a + bP + cM + dPR
• In linear form
• b = ∆ Q/∆ P
• c = ∆ Q/∆ M
• d = ∆ Q/∆ PR
• Expected signs of coefficients
• b is expected to be negative
• c is positive for normal goods; negative for inferior goods
• d is positive for substitutes; negative for complements

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 Managerial Economics

Empirical Demand Functions

Q = a + bP + cM + dPR
• Estimated elasticities of demand are
computed as
ˆ P
• Ê =b
Q

ˆ M
•E
M =
cˆ
Q

• ˆ PR
Ê XR =
d
Q
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 Managerial Economics
Nonlinear Empirical Demand
Specification
• When demand is specified in log-linear
form, the demand function can be written
as
Q = aP M P
b c d
R

• To estimate a log-linear demand

function, convert to logarithms
lnQ = ln a + b ln P + c ln M + d ln PR
In this
• form, elasticities are constant
Ê = bˆ Eˆ M = cˆ Ê XR = dˆ
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 Managerial Economics

Demand for a Price-Setter

• To estimate demand function for a
price-setting firm:
• Step 1: Specify price-setting firm’s
demand function
• Step 2: Collect data for the variables
in the firm’s demand function
• Step 3: Estimate firm’s demand using
ordinary least-squares regression
(OLS)
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 Managerial Economics

Time-Series Forecasts
• A time-series model shows how a time-
ordered sequence of observations on a
variable is generated
• Simplest form is linear trend forecasting
• Sales in each time period (Qt ) are
assumed to be linearly related to time (t)
Qt = a + bt

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 Managerial Economics

Linear Trend Forecasting

• Use regression analysis to estimate
values of a and b
Qˆ t = aˆ + bt
ˆ
• If b > 0, sales are increasing over time
• If b < 0, sales are decreasing over time
• If b = 0, sales are constant over time
• Statistical significance of a trend is
determined by testing b̂ or by examining
the p-value for bˆ
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 Managerial Economics
A Linear Trend Forecast
(Figure 7.1)
Q
Estimated trend
Q̂ 2009
12
line •
Q̂ 20047 •
• •
Sales

•
• •
•
• • •
•
t

2006
2004
2005

2007
2000
1997

1999

2001
1998

2002
2003

2012
Time
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 Managerial Economics
Forecasting Sales for Terminator
Pest Control (Figure 7.2)

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 Managerial Economics

Seasonal (or Cyclical) Variation

• Can bias the estimation of parameters
in linear trend forecasting
• To account for such variation, dummy
variables are added to the trend
equation
• Shift trend line up or down depending on the
particular seasonal pattern
• Significance of seasonal behavior
determined by using t-test or p-value for
the estimated coefficient on the dummy
variable

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 Managerial Economics
Sales with Seasonal Variation
(Figure 7.3)

• •
• •
•
• • • • • •
•
•
•
••

2004 2005 2006 2007

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 Managerial Economics

Dummy Variables
• To account for N seasonal time
periods
• N – 1 dummy variables are added
• Each dummy variable accounts for
one seasonal time period
• Takes value of 1 for observations that
occur during the season assigned to
that dummy variable
• Takes value of 0 otherwise
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 Managerial Economics
Effect of Seasonal Variation
(Figure 7.4)

Qt
Qt = a’ + bt

Qt = a + bt
Sales

c
a’

a
t
Time

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 Managerial Economics

Some Final Warnings

• The further into the future a forecast is
made, the wider is the confidence
interval or region of uncertainty
• Model misspecification, either by
excluding an important variable or by
using an inappropriate functional form,
reduces reliability of the forecast
• Forecasts are incapable of predicting
sharp changes that occur because of
structural changes in the market
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