Department of Business Administration

SPRING 2019
Demand Estimation

Source (1. Managerial economics in global economy by Dominick Salvatore , 4 th edition

2. Basic Business Statistics by Berenson , Levine & Krehbiel 9 th edition )
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.

 Qdx= (P, I, Pc, Ps, 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.
 Demand Estimation
3

 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.
 
The Identification Problem In the following demand curve,
Observed price-quantity data
5 points E1, E2, E3, and E4, result
respectively from the
intersection of unobserved
demand and supply curves D1
and S1, D2 and S2, D3 and S3, and
D4 and S4. Therefore, the dashed
line connecting observed points
E1, E2, E3, and E4 is not the
demanded curve for the
commodity. The derived a
demand curve for the
commodity, say, D2, we allow
the supply to shift or to be
different and correct, through
regression analysis, for the
forces that cause demand curve
D2 to shift or to be different as
can be seen at points E2, E'2.
This is done by regression
analysis.
Demand Estimation: Marketing Research
Approaches
6

 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.
Demand Estimation: Marketing Research
Approaches
7

o Consumer surveys:
surveys These surveys require the
questioning of a firm’s 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.
Demand Estimation: Marketing Research
Approaches
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.
Demand Estimation: Marketing Research
Approaches
9

 Market experiments:
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.
Demand Estimation: Marketing Research
Approaches
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.
 Scatter Diagram-Example
13

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
 Scatter Diagram
14

 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 (et) of each
point from the regression line.
 This is the method called Ordinary Least
Squares (OLS).
 Regression Analysis
17
 In the table, Y1 refers actual or observed sales
Year X Y
revenue of $44 mn associated with the
1 10 44 advertising expenditure of $10 mn in the first
2 9 40 year for which data collected.
3 11 42  In the following graph, Y^1 is the corresponding
4 12 46
sales revenue of the firm estimated from the
regression line for the advertising expenditure of
5 11 48 $10 mn in the first year.
6 12 52  The symbol e1 is the corresponding vertical
7 13 54 deviation or error of the actual sales revenue
8 13 58 estimated from the regression line in the first
year. This can be expressed as e1= Y1- Y^1.
9 14 56
10 15 60
 Regression Analysis
18  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 e1 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
e1= Y1- Y^1.
 19 Regression Analysis

 Since there are 10

observation points, we have
obviously 10 vertical
deviations or error (i.e., e1 to
e10). 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.
 Simple Linear Regression Model
21

Regression line is a straight line that

describes the dependence of the average
value of one variable on the other
Slope Random Error
Y Intercept Coefficient

Yi     X i   i
Dependent Independent
Regression
(Response) (Explanatory)
Variable Line Variable
 Ordinary Least Squares (OLS)
22

Model: Yt a  bX t  et

ˆ
Yˆt aˆ  bX t

et Yt  Yˆt
 Ordinary Least Squares (OLS)
23

Objective: Determine the slope and

intercept that minimize the sum of
the squared errors.

n n n
ˆ )2
t  t t  t
e 2

t 1
 (Y 
t 1
Yˆ ) 2
 (Y
t 1
 ˆ
a  bX t
 Ordinary Least Squares (OLS)
24

Estimation Procedure
n

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

 t
( X
t 1
 X ) 2
 Ordinary Least Squares (OLS)
25 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 10 n n n

X t 120  Yt 500  (X t  X ) 2 30 bˆ 

106
3.533
t 1
t 1 t 1 30
n
n
X 120 n
Y 500  (X  X )(Yt  Y ) 106 aˆ 50  (3.533)(12) 7.60
X  t  12 Y  t  50 t

t 1 n 10 t 1 n 10 t 1
 Ordinary Least Squares (OLS)
26
Estimation Example

n
X t 120
n 10 X   12
t 1 n 10
n n n
Yt 500
 X t 120 Y t 500 Y   50
t 1 t 1 t 1 n 10

n
106
 (X t
2
 X ) 30 bˆ  3.533
t 1 30
n

 (X
t 1
t  X )(Yt  Y ) 106 aˆ 50  (3.533)(12) 7.60
27 The Equation of Regression Line

 The equation of the regression line can be

constructed as follows:
 Yt^=7.60 +3.53 Xt
 When X=0 (zero advertising expenditures), the
expected sales revenue of the firm is $7.60 mn.
In the first year, when X=10mn, Y1^= $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.
 Tests of Significance: Standard
28 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:
 Tests of Significance
29 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

 (Y  Yˆ ) 2
65.4830 n n n

 e  (Yt  Yˆt )2 65.4830  (X

t 2
sbˆ   0.52  X )2 30
( n  k ) ( X 
t X )2 (10  2)(30) t 1
t
t 1 t 1
t

Yt^=7.60 +3.53 Xt =7.60+3.53(10)= 42.90

 Tests of Significance
30

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)
 Tests of Significance
31

Calculation of the t Statistic

bˆ 3.53
t  6.79
sbˆ 0.52

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

Critical Value (tabulated) at 5% level =2.306
 Tests of Significance
32

Coefficient of Determination

2
R 
Explained Variation

 (Y  Y )
ˆ 2

TotalVariation  t
(Y  Y ) 2

2 373.84
R  0.85
440.00
33 Tests of Significance

Coefficient of Correlation

r  R 2 with the sign of bˆ

 1 r 1

r  0.85 0.92
34 Multiple Regression Analysis

Model:

Y a  b1 X 1  b2 X 2    bk ' X k '
 Multiple Regression Analysis
35

Relationship between 1 dependent & 2 or more

independent variables is a linear function
Y-intercept Slopes Random error

Yi     X 1i    X 2i     k X ki   i

Dependent (Response) variable

Independent (Explanatory) variables
 36 Multiple Regression Analysis

Adjusted Coefficient of Determination

2 2 (n  1)
R 1  (1  R )
(n  k )
SSR
Regression Statistics rY2,12 
SST
Multiple R 0.982654757
R Square 0.965610371
Adjusted R Square 0.959878766
Standard Error 26.01378323
Observations 15
Correlation Coefficient
y x x2 xy y2
2.0 1 1 2.0 4.0
3.0 3 9 9.0 9.0
2.5 4 16 10.0 6.25
2.0 2 4 4.0 4.0
2.0 1 1 2.0 4.0
3.5 7 49 24.5 12.25
Σy = 15.0 Σx = 18 Σx2 = 80 Σxy = 51.5 Σy2 = 39.5
38
The End

Thanks