20-Jul-10

SEEG 5013 Managerial Economics
Topic 3: Demand Estimation Chapter 4: Demand Estimation

Lecture objectives
o To examine some general difficulties encountered in deriving the demand curve for a product from market data.

Dr. Hj. Mohd Razani Hj. Mohd Jali FE 0.55 (Economics Building) College of Arts and Sciences razani@uum.edu.my 04-928 3524

o To discuss some marketing research approaches to demand estimation. o To discuss regression analysis as the most useful and common method of demand estimation.
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The identification problem
• Demand curve for commodity – estimated 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).

The identification problem
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.
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The identification problem
Over time - Demand for the commodity shifts or 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).

The identification problem
The equilibrium of different but unknown 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”.

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20-Jul-10 Marketing Research Approaches to 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 8 Market research approaches to demand estimation Consumer surveys: • Involve questioning sample of consumers about how they respond to changes in price of commodity. income. Respondent cannot give accurate answers to things that have not happen yet (eg. • Cannot determine consumers demographic characteristics – age. income. credit incentives and other determinants of demand. 11 12 2 . education. sex. • Using scanners at stores – see how many people normally buys the product or how many people buys the product after the commercial. Market research approaches to demand estimation Problem with consumer surveys: • Biased. advertising expenditures. etc. price of related commodities. etc. Market research approaches to demand estimation Problems: • Observation alone not enough to understand consumer’s response. Reaction to price change to commodity consumption) • Can be very expensive. 9 10 Market research approaches to demand estimation Observational research: • Gathering of info on consumer preferences by watching them buying and using products.

Cannot represent market behavior. 14 Market research approaches to demand estimation Market experiments: • Conducted in actual marketplace. 18 3 . promotion. 13 Market research approaches to demand estimation Problems: • Questionable results because its not real market environment. and record consumer responses (purchases) in different markets. etc. 15 16 Market research approaches to demand estimation Problems: • Cost is high. The customer may find another product that he/she likes to replace the firm’s product.20-Jul-10 Market research approaches to 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. • Useful in process of introducing new product where no data exist yet. • Select several markets with similar socioeconomic characteristics and change product price. etc. Market research approaches to demand estimation Market experiments: • Can be conducted in large scale – ensure validity of the result. packaging. • Participants can be selected to represent socio-economic characteristics of the actual market. would act naturally to changes. in different stores. may bias the result. • Cost of conducting experiments is high – can only use small sample. 17 Market research approaches to demand estimation Problems: • Competitors can also observe the experiment and gain information that benefit them. • Consumers not aware of the experiment. • Firm might lose customer when they raise price for their product in the experiment. • Competitors can sabotage the experiment by changing price and other determinants under their control. • Cannot prevent extraneous occurrences – bad weather. Can be conducted on limited scale or short period of time. displays. price of competing products.

Scatter Diagram 24 4 . – Sales revenue (Y) – dependent variable. Regression Analysis • Rate on advertising expenditures and sales revenue: – Level of advertising expenditures (X) – independent variable. → test the hypothesis that higher advertising expenditures lead to higher sales and estimate strength of the relationship. 19 20 Regression Analysis 21 22 Regression Analysis Year 1 2 3 4 5 6 7 8 9 10 X 10 9 11 12 11 12 13 13 14 15 Y 44 40 42 46 48 52 54 58 56 60 23 Regression Analysis • Scatter diagram shows positive relationship between level of firm’s advertising expenditures and its sales revenue – higher advertisement associated with higher revenue.20-Jul-10 Regression Analysis • Assume that a manager wants to determine relationship between the firm’s advertising expenditures and its sales revenue. The relationship is approximately linear.

while b is slope of line and gives estimate of increase in Y resulting from each unit increase in X. 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. 29 30 5 . Regression Analysis Problem: • Different researcher/manager would fit a somewhat different line to the same data point and obtain different results. • Ordinary Least Squares (OLS) Method Regression Analysis • To estimate the approximate linear relationship between firm’s advertising expenditures and sales revenue – draw in “line that best fit” between data points. This gives rough estimate of linear relationship between sales revenue (Y) and advertising expenditures (X).20-Jul-10 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. Y = a + bX 27 28 Regression Analysis Y = a + bX a is vertical intercept of linear relationship and gives the value of Y when X = 0.

experiments tend to be of small scale and of short duration. Thus. 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. 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). rather than indicating preferences and behavior. all researchers looking at the same data would get exactly the same result. so that accuracy is limited. 35 36 6 . and may not respond accurately. A drawback is that subjects know they are part of an experiment.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. 34 Exercise What are the major advantages and drawbacks of using controlled customer experiments to determine demand? Solution An advantage is that experiments require subjects to make actual decisions. The results are more likely to reflect true preferences. Second. 31 32 Exercise You are a newly hired marketing trainee for a corporation in the local community. • 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). Senior management has wondered how other local firms view your company’s reputation. non-random sample of the population of all local firms. How reliable is this kind of survey method? 33 Solution Using the firm’s own contact list is a very limited.

this is not always possible. The method can generate valuable information about pricing and advertising policy. In addition. the analysis provides statistics that measure the accuracy (goodness of fit) of the equation.20-Jul-10 Exercise What are the major advantages and drawbacks of using controlled market studies to estimate demand? 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. competitor prices) must be comparable. consumer incomes. or were changed in a different manner. from time t=1 to t=n. 37 38 Exercise How can regression analysis use uncontrolled data to estimate demand? 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. The main drawback is that all other factors (including population size and demographics. 41 42 7 . tastes. Of course.  n n 2 t 2 n t 1 ˆ ) ˆ  bX  e   (Y  Yˆ )   (Y  a t 1 t 1 t t t 1 t t n 2 • t 1 is the sum of all observations. Accordingly. Controlled market studies are also expensive to conduct. 39 40 Simple Regression Analysis Ordinary Least-Squares (OLS) Model: Yt  a  bX t  et ˆ ˆ a ˆ  bX Y t t ˆ et  Yt  Y t n Simple Regression Analysis The Ordinary Least-Squares (OLS) Method • Objective: Determine the slope and intercept that minimize the sum of the squared errors. the regression approach can produce the same kinds of results as a carefully controlled market study.

47 48 8 .533)(12)  7. Tests of significance of parameter estimates • Estimate of slope coefficient from different sample of adverts sales data would obtain different result/estimate of slope coefficient. 46 n  10 X  t 1 n n X t 120   12 n 10 X t 1 n t 1 n n t  120  Y  500 t 1 t n Y  t 1 Yt 500   50 n 10 (X (X t 1 t  X ) 2  30  X )(Yt  Y )  106 ˆ  106  3. • The greater is the dispersion of the estimated value of b. – has zero expected value or mean. • 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. • These assumptions are required so as to obtain unbiased estimates of the slope coefficient and to be able to utilize probability theory to test for the reliability of estimates.60 a Ordinary Least Squares (OLS) Estimation Example Ordinary Least Squares (OLS) • Caution when using the regression line to estimate sales revenue of the firm for advertising expenditure very different from those used in the estimation of the regression line itself. – its value in one time period is unrelated to its value in any other period.533 b 30 X 120 X  t   12 10 t 1 n 43 Y 500 Y  t   50 10 t 1 n (X t 1 t ˆ  50  (3.60 a Ordinary Least Squares (OLS) Regression analysis is based on a number of assumptions: • The error term – is normally distributed. The value of b is given by ˆ b Ordinary Least Squares (OLS) Estimation Example (X t 1 n t 1 n Time Xt 10 9 11 12 11 12 13 13 14 15 120 Yt 44 40 42 46 48 52 54 58 56 60 500 Xt  X -2 -3 -1 0 -1 0 1 1 2 3 n Yt  Y -6 -10 -8 -4 -2 2 4 8 6 10 ( X t  X )(Yt  Y ) 12 30 8 0 2 0 4 8 12 30 106 ( X t  X )2 4 9 1 0 1 0 1 1 4 9 30 t  X )(Yt  Y ) t (X ˆ ˆ  Y  bX a  X) 2 1 2 3 4 5 6 7 8 9 10 n n  10 n X t 1 t  120 n  Y  500 t 1 t n (X t 1 n t  X ) 2  30  X )(Yt  Y )  106 ˆ  106  3.20-Jul-10 Ordinary Least Squares (OLS) The estimated values of a and b are obtained by minimizing the sum of the squared deviations. – has constant variance in each time period and for all values of X.533 b 30 t ˆ  50  (3.533)(12)  7. the smaller is the confidence that we have in our single estimated value of the b coefficient.

51 4.4830 (X t 1 n t  X )  30 2 sbˆ   (Y  Yˆ ) ( n  k ) ( X  X ) 2 t t sbˆ  2 65.4649 4.55 ˆ et  Yt  Y t 1. 54 t ˆ 3.10 0.02 60.55 ˆ )2 et2  (Yt  Y t 1.1616 0.4830   0.57 2.96 46.20-Jul-10 Tests of significance of parameter estimates • To test the hypothesis that b is statistically significant (adverts positively affects sales).96 53.4830 (X t 1 n t  X ) 2  30 65.43 49.96 1.51 -1. • Coefficient of determination is defined as the proportion of the total variation or dispersion in the dependent variable. denoted by R2 – the coefficient of determination.37 46.04 0.6249 15.306 9 .49 53. we need to calculate the standard error (deviation) of b. we can also test for the overall explanatory power of the entire regression.3969 19.0404 0.90 39.49 57.52 (10  2)(30)  (Y  Yˆ ) ( n  k ) ( X  X ) 2 t t 2  Tests of Significance Calculation of the t Statistic Tests of goodness of fit and correlation • Besides testing for statistical significance of particular estimated parameter.79 sbˆ 0.63 -4.53 b   6. • This can be done with regression analysis using computer programs.2100 0. Tests of Significance Standard Error of the Slope Estimate sbˆ   (Y  Yˆ ) ( n  k ) ( X  X ) 2 t t 2  e (n  k ) ( X 2 t t  X )2 49 Tests of Significance Example Calculation Time 1 2 3 4 5 6 7 8 9 10 Tests of Significance Example Calculation ( X t  X )2 4 9 1 0 1 0 1 1 4 9 30 Xt 10 9 11 12 11 12 13 13 14 15 Yt 44 40 42 46 48 52 54 58 56 60 ˆ Y t 42.6816 2.43 -3.3401 1.2601 20. • This is accomplished by calculating the coefficient of determination.3025 65.02 -0.4830  0.52 (10  2)(30)  e   (Y  Yˆ ) t 1 2 t t 1 t t n n 2  65. that is explained by the variation in the independent or explanatory variable in the regression.4830  e   (Y  Yˆ ) t 1 2 t t 1 t t n n 2  65.52 Degrees of Freedom = (n-k) = (10-2) = 8 Critical Value at 5% level =2.43 49.

the greater is the proportion of the variation in the firm’s sales explained by the variation in its adverts expenditures. and the larger is the value of the coefficient of determination. R2.20-Jul-10 Tests of goodness of fit and correlation • R2 measures how much of the variation in the firm’s sales is explained by the variation in its advertising expenditures. 4 10 . 55 Questions or comments? Reference: Salvatore (2008). Ch. • The closer the observed data points fall to the regression line.

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