# Chapter 4 Demand Estimation

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the quantity demand. maximise its value.

DEMAND ESTIMATION

In chapter three, we looked at the demand function model. A demand function model shows the relationship between the factors that influence the demand of a product and

Managers of a firm need to estimate the values of the coefficient of the demand function to reduce uncertainty in decision-making and to achieve the objective of the firm that is to

Large automobile manufacturers such as General Motors, Daimler Chrysler use empirical estimates of demand in making decisions about how many units of each model to produce and what price to charge for different car models.

Empirical demand functions are demand equations derived from actual market data. From these functions managers get quantitative estimates of the effect on sales of changes in the price, consumer income and other determinants of demand.

In this chapter we will see how the firm estimates the demand function of the product it sells.

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Chapter4 Demand Estimation

n Se = ∑ t=1 n - k (Yt - Y)2

Key terms for review:

Regression analysis Coefficient Parameters Independent variable Dependent variable Coefficient of determination Scatter diagram Standard error of estimation Degrees of freedom F - statistic t - statistics ‘t’ - test Linear model

Standard error of coefficient Time series Cross section Market experiments Consumer interview Multiplier regression Single regression Identification Multi-collinearity Heteroskedasticity Auto correlation Parameters

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Chapter 4 Demand Estimation

CHAPTER OVERVIEW

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Chapter4 Demand Estimation

Learning Objectives After reading this chapter, the students should be able to: 1. 2. 3. Estimate a demand function or any related function. Interpret and evaluate the function. Make the necessary adjustment to improve the estimated model.

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Chapter 4 Demand Estimation 4. In order to estimate a demand function for a product. When the values of the coefficients have been estimated. inflation and government regulation. Managers of a firm need to estimate the values of the coefficient of the demand function to reduce uncertainty in decision-making and to achieve the objective of the firm. β1 measures the change in quantity demanded when the price of the product change by one unit. In this chapter we will see how firms estimates and analyses its demand function of its product.eqn 4a Where Qs is the quantity demand for shoes. The form of uncertainty that is of concern to corporate economists is economic uncertainty. it is necessary to use a specific functional form For example. they can be used to make decision on optimality.0 INTRODUCTION TO DEMAND ESTIMATION A demand function model shows the relationship between the factors that influence the demand of a product and the quantity demand. I) Qs = α .β1 Ps + β2 A + β3 I ------. Managers are faced with various forms of uncertainty whenever decisions are made. how the intercept α and coefficients β1 to β3 are determined and tested. fluctuation in exchange rate. Ps is the price. For example. A is the advertising expenditure and I refers to household income. to maximise its value. A. That is. it will help to explain how much will the revenue of a firm change after increasing the price of its product by a 133 . Economic uncertainty includes recession. β2 measures the change in quantity demanded when advertising expenditure change by one unit β3 measures the change in quantity demanded when income change by one unit. The other reason for estimating the demand function is to achieve the objective of the firm. a linear demand function and determinant of demand can be simplified: Qs = f (Ps.

It involves interviewing customers or potential customers directly. The values represent a “cross-section” of observations taken from different entities. expert opinion. Though. Forecasting involves predicting future economic conditions affecting firms operation that is. The results may not be representative of the entire market’s reaction because clinics have to be kept small under pressures of monetary and time constraints.Chapter4 Demand Estimation certain amount or by how much the enrolment decline. introducing new products and investment decisions. let say by 10%. market experiments and indirect method that uses econometric techniques. The data collected could be time-series or cross-sectional data. The survey research is the most direct and simple way of estimation. 134 . consumer clinics. for planning production. They are direct method that is. confusing. Cross-section data provide information on a variable at a given period time. The estimated demand function can also be used for forecasting. whereby participants are given play money and asked on spend this money in a artificially created environment. Time series data provide information on one variable over a period of time.1 DEMAND ESTIMATION Demand estimation and forecasting requires a good set of data. it introduces new sets of problems such as differences that may exist between and among entities at a particular point of time. interviewer bias. if the fees of in college increase. There are three analytical tools available for doing empirical demand analysis. seemingly simple. observational research. 4. this approach is fraught with problems such as randomness of the sample. misinterpreting or unknown responses and best of intentions problem. A disadvantage of time-series data is the influences of uncontrollable variables on the results of the observations. marketing research approaches such as consumer survey. Simulated market situations are synonymous with consumer clinics. Though cross-section analysis eliminates the problem of uncontrollable variables that change over time.

Chapter 4 Demand Estimation Moreover. coefficient estimation. production and interest rates. SIMPLE REGRESSION ANALYSIS In a simple regression analysis the dependent variable (Y) is a function of only one independent variable (X). Results may be bias by extraneous occurrences. The objective of econometrics is to provide empirical contend to economic theory. Cost and time could be a constraint and experiment has to be conducted on a small scale over a short time period. Although this chapter use examples that are based on demand analysis. It derives an equation that can be used to estimate the unknown values of one variable on the basis of the known values of another variable. they are simple regression analysis and multiple regression analysis. one or more cities or regions would be chosen and experiments conducted in these test markets to gauge customers’ acceptance of the product or to identify impacts of changes in one or more controllable variables.2 REGRESSION ANALYSIS Regression analysis describes the way in which one variable is related to another. regression analysis is said to be the most useful and used method of estimating demand. Econometric methods integrate economics. The function is written as: 135 . There are two types of regression analysis. mathematics and econometrics to measure the relationship between variables. econometric techniques can also in other economic indicators of interest such as inflation. Given the limitation of these direct methods. Besides this. participants could react differently and they might behave as to conform to the desire of the experiments. validity and policy simulation The econometric technique discussed here will be regression analysis as the others are too complex. most economists have turned to a more practical approach that is econometrics. 4. Econometric modelling involves four distinct steps: namely model specifications. In direct market experiments.

By extending the line to the vertical axis. Once this is done we can analyse it in two ways.1The sales and advertising expenditure of Syarikat Mohd Rizal 136 . Year 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Sales (million dollars) 44 58 48 46 42 60 52 54 56 40 Advertising Expenditure (million dollars) 10 13 11 12 11 15 12 13 14 9 Table 4. The slope (b) is derived by dividing the change in y by the change in x.eqn 4b To estimate the relationship between these two variables we need to gather and analyse their historical data. For example. The easiest and most common way of analysing the data is to plot and visually study the data. we will get the value of the intercept (a). That is to get a scatter diagram.1. we shall use the data on sales and advertising from Table 4. to determine the relationship between sales and advertising expenditure. From the scatter diagram we can determine the relationship between two variables.Chapter4 Demand Estimation Y = a+ bX -----------. To get the linear relationship we can ‘eye-ball’ or draw a straight line that ‘bests’ fits between the data points (so that the date points are equally a part of both side of the line).

The equation is: ∧ Y= ∧ ∧ a + bX -----------.Chapter 4 Demand Estimation Y 65 60 55 50 45 40 35 30 25 20 5 7 9 11 13 15 17 Advertising Expenditure X Sales ∧ ∧ ∧ y=a +bx 4.eqn 4c the hat (^) above the variables and coefficient show it is an estimated value. And by dividing the change in sales by the change in advertising expenditure we can get the slope (b) of this line.1 Scatter diagram A relationship between these two variables can be seen by plotting the data points on a scatter diagram as in Diagram 4.1. One of the disadvantages of this method is that different researchers will fit a somewhat different line to the same data point and obtain somewhat different results. and then by drawing a straight line that best fits the data points and extending it to the vertical axis we can get the values of the intercept (a). Another 137 .

1 the results are You will notice both approaches have the same results. Based on the data given shown in Table 4. The method used is called ordinary least-squares method (OLS) and the regression line estimated is the line that best fits data points. The regression line is Y = 7. Where 7.60 million. whereas 3. It shows that when advertising expenditure increase by \$1 million. In our discussion we use SPSS. Besides this. 138 . Since the line represents the expected relation between Y and X. The other approach to determine the values of the constant and coefficient is to use Software packages such as Excel. there will be some discrepancy between the actual points and the line. It is quite handful and feasible if there is only one independent variable.53 X in Table 4. when there is more than one independent variable the calculation becomes tedious.60 + 3. which is a statistical technique for obtaining line that minimizes the sum of the squared vertical deviations of each point from the regression line.2. These packages make regression analysis easy to use.60 is the intercept that explains when advertising expenditure is zero the sales will be \$7.53 million. note that for any line drawn through the points. sales will increase by \$3. the first approach is to use formula to calculate the value for constant a and coefficient b. The distance of the dashed line gives the deviations (error term e) between the actual points and the line. SPSS and TSP.Chapter4 Demand Estimation major problem is the impossibility of drawing a line if there is more than one independent variable (multi-regression).53 is value of the slope or the coefficient. these deviations are analogous to the deviations from the mean used to calculate the variance of a random variable Econometrician uses regression analysis. (You may refer to econometric textbooks for further details) There are two approaches to get the estimated regression line using OLS.

Chapter 4 Demand Estimation ∧ Y denotes the estimated sales in millions given the value of X. Diagram 4. using the last observation from Table 4.37 million. 70 Y 60 50 40 Sales ∧ Y-Y [ 30 y = 7.1 if the value of X is \$9 million the sales will be \$39.53 x 20 10 0 0 2 4 6 8 10 12 14 Advertising Expenditure X 16 Diagram 4.2 The Regression Line 139 . For example.60 + 3.2 shows the estimated regression line.

Error 6. the next step is to evaluate and interpret the results.46667 45..5222813 T-Stat 1.3323245 0.3 MULTIPLE REGRESSION ANALYSIS A multiple regression analysis involves more than one independent variable.E.53 X ……. this is explain in part 4.000 Mean of dependent var Table 4.6 + 3.832614 S. eqn 4e(revisited) After estimating the regression line using the available data.6000000 3.224915 -23.58417 S.00000 Adjusted R-squared 0.860653 1.851212 Std.Chapter4 Demand Estimation LS // Dependent variable is SAL SMPL range 1986 .D of dependent var Sum of squared resid F-statistic 6. the regression equation will be: 140 For example. we want to determine how sales is influence by advertising expenditure and .5333333 0.2001912 6.76782 Coefficient 7. 0.751919 2-Tail Sig.992059 65. of regression Durbin-Watson stat Log likelihood 2.264 0. price.1995 Number of observation 10 Variable C ADV R-squared 50.2 Computer printout for single variable regression The equation can be written out as ∧ Y = 7.

3. expenditure on sales The process of estimating a multiple regression is the same as in simple regression When we regress sales using data in Table 4.4.3 Sales. the marginal effect of price on sales.8 2.4 2.2 2 1. Year Sales (Y) 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 44 58 48 46 42 60 52 54 56 40 Advertising expenditure(X1 ) 10 13 11 12 11 15 12 13 14 9 1 1. the marginal effect of advertising is ∆Y/ ∆X2.5 1.Chapter 4 Demand Estimation ∧ ∧ ∧ ∧ Y = a1 + b1X1 + b2X2 Where: Y is sales volume ∧ X1is advertising expenditures ∧ X2is price of the product a b1 b2 is the vertical intercept is ∆Y/ ∆X1.8 1.1 0. advertising expenditure and price 141 .0 1.0 Price (X2) Table 4. the results are as in Table 4.

4 Multi-regression analysis From the results shown in table 4.9495316 T-Stat 1.2226999 2-Tail Sig.414870 -22.8788413 -1. Besides analysing the coefficients itself as seen in chapter three.04734 0.000 0.383 X2 --------.992059 53. the next step will be to interpret the results carefully.-eqn 4f 4.877397 0.3836921 Std.6665152 6.842367 2.Chapter4 Demand Estimation LS // dependent variable is SAL (Y) SMPL range : 1986 . of regression Durbin-Watson stat Log likelihood Coefficient 11.94549 25.2.776058 1.4 the regression equation is: Y = 11. In our study we shall discuss the following test 142 .5078770 1. 0.4936051 -2.E. there are a number of statistics that are of importance to evaluate the results.3 EVALUATION OF RESULTS Once the results have been derived either by using the software package or manually using formula.60403 3.9633945 0.61633 Mean of dependent var S. Error 6.140 0.D of dependent var Sum of squared resid F-statistic Table 4.604 + 3.00000 6.261 50.1995 Number of observation : 10 Variable C ADV(X1) PR(X2) R-squared Adjusted R-squared S.493 X1 .

It is a test of goodness of fit R2 measures the proportion of total variation in the dependent variable that is explained by the regression equation.2. If the value is ‘0’ it shows that none of the independent variables explain the changes in the dependent variable.3 shows regression line with different coefficient of determination. Diagram 4. (Rough sketch!). Testing the overall Explanatory Power .2 Y 143 R2 = 0.6. R2 = 0. The value of coefficient of determination ranges from ‘0’ to ‘1’.8 and R2 = 1.6 Y . When R2 = 1 the regression line is a perfect fit. Therefore a value closer to 1 is preferred. If the value is ‘1’ it shows that all the changes in the dependent variable is explained by the variation in independent variable used in the regression.Statistics We shall evaluate results from computer printout Table 4.2 based on simple regression analysis. F. X Y = f (x) X X X X Y = f(x) X X X X X X X X X X X X X X X X X R2 = 0. Nevertheless it can be extended to the multi-variable equations. that is R2 = 0. R2 = 0.Chapter 4 Demand Estimation a) b) c) d) Testing the overall Explanatory Power [Coefficient of determination (R2) ] Test of Significant of Coefficient Estimates [t-stats] Use the equation to predict the value of the dependent variable given the values of the independent variables.Coefficient of Determination (R2) a) The coefficient of determination (R2) is used to determine how well the regression line fits the data.

8 Diagram 4. the higher the explanatory power of the estimated equation and the more accurate for forecasting purposes.test is used to determine if there is a significant relationship between the dependent and each independent variable. This may due to the omission of some important b) Test of Significant of Coefficient Estimates (T – Stats) The t .85. advertising expenditure. From the computer printout (Table 4. ∧ t statistics = b ∧ Sb 144 . As a rule of thumb. The other 15% cannot be explained by the regression analysis.Chapter4 Demand Estimation X X X X X X X X XX X X X X X X Y = f(x) X PERFECT FIT Y= f(x) X X X X X R2 = 0. the higher the value of R2.3 Y R2 = 1 Y Regression line with different R2. It shows that 85% of changes in the dependent variable sales can be explained by the independent variables. To carry out this test we need the standard error of coefficient (Sb) to calculate the‘t’ statistics.2) we can get the value of R2 for the above data as 0. To calculate the t statistics we divide the estimated coefficient (b) by the standard error coefficient (Sb). independent variables.

than the independent variable is said to be statistically significant otherwise it is not statistically significant in explaining the dependent variable.306. we say advertising expenditure is statistically significant in explaining the variations is sales at 95% confidence interval. 145 . This means that a value predicted by the regression line will be subjected to error. For example using the data from 4.Chapter 4 Demand Estimation Next.37. t n-k-1. Actual data points usually do not lie on the The standard error of regression line but are dispersed above and below the line.05 is the significant level .76 and greater than the critical t value 2. to determine if there is a significant relationship between the dependent and each independent variable.0.306. If the value is greater than the value from the student t distribution.Sometimes Rule of thumb can be also be applied for t n – k–1.05 95% confidence interval the critical ‘t’ value is 2. where its the critical “t” value will be ‘2’ Finally..53 = 6. Since the value of‘t’ statistics is 6.0. estimation measures the probable error in the predicted value.79 n – k–1.05 = t8 at b = 0.1. k represents the number of independent variables estimated and 0. c) Predicting the Value of the Dependent Variable The standard error of estimation is a measure of the dispersion of the data points from the line of best fit (regression line). we get the critical’ value that is. If we use the regression results the sale is \$39. Where n is number of observation. From the computer printout (Table 4. the calculated‘t’ statistics is compare with the value from the student “t” distribution table.05. Therefore the value predicted will have an error. when the advertising expenditure is \$9 the sales is \$40.05 value from the student‘t’ distribution table.0.52.52 3.2) the standard error of coefficient of price is 0. 0. The‘t’ statistic is calculate by : ∧ Calculated t = ∧ Sb The critical value from the student‘t’ distribution table with t = t 10 – 1–.

0.05 SE ∧ Where Y is the predicted value of the dependent value based on the regression. When the range of Y is determine. The smaller the standard error of estimation the closer the data points are to the regressed line. The graph in diagram 4. the range within which the dependent variable will lie at a specified probability.5 SE = 1. when the rule of thumb is used. which can also be written as ∧ Y ± 2 SE.0 146 . The standard error of estimation is used to indicate the accuracy of a regression model. Y Y = f(x) X X X X X X Y= f(x) X X X X X X X X X SE = 1.Chapter4 Demand Estimation The standard error of estimation is useful in determining prediction interval that is. it will show that 95 percent of the time the actual value of Y will fall within the range calculated. At 95% probability the dependent variable will lie in the predicted interval of ∧ Y ± tn – k-1.4 shows regression line with different standard error of estimation.

It is another test of overall explanatory power of the regression is the analysis of variance.05.8) 39.53 (9) = 39. when the advertising expenditure is \$9 million. 39.25 Diagram 4.2 ) the SE is 2. With t table is 2.Chapter 4 Demand Estimation Y Y= f(x) X X XX X X XX X X XX X SE = 0.1–1 (2.0.913 million to \$45.37 ± 2.6 + 3. 95 percent of the time the sales will range from \$32.37 ± t 10 . The range in which the sales will fall at 95% confidence interval when advertising expenditure is \$9 is given by: ∧ Y ± t n – k–1 SE ∧ Y = 7. the critical t value from the student t distribution e) F – statistics The F statistic is used in a multiple regression analysis. 10-1-1.306.37 ± 6.4 Regression line with different SEs From the computer printout (Table 4.8.827 million.8) 39.457 Based on this statistical analysis.37 Where n is 10 and K is 1. which uses the F statistic 147 .306 (2.

04 is greater than the critical f value. F = explained variation / (k .4) the f-value is 25. heteroscedasticity. If the calculated F value is higher. we compare the calculated F values with the critical value from tabled F values. Using these two values the critical tabled F value is 5. we use the F distribution table which uses 5 percent significant level. we can conclude that there is a significant relationship between the independent variables and the dependent variable. 148 .Chapter4 Demand Estimation or the F ratio.1 which is 2 .32. among them are multicollinearity.R2) / (n . specification errors.k which is 10 . The F statistics can be calculated as shown below.1 = 1 and for the denominator is n . The F statistic is used to test the hypothesis that the variation in the independent variable explains a significant portion of the variation in the dependent variable. 4. measurement errors and identification problem.1) (1 . To determine the critical value of the F distributions. auto-correlation. Since the calculated (printout) result 25. The degree of freedom for the numerator is k . we say there is a statistically significant relationship between the independent and dependent variable.2 = 8.k) F = R2 / (k .4 PROBLEMS IN REGRESSION ANALYSIS Regression analysis may face some serious problems.04.k) To conduct the F test. From the computer printout (Table 4.1) unexplained variation / (n . The f distribution for each level of statistical significant is defined in terms of 2 degree of freedom that is the numerator and the denominator.

Multicollinearity would not pose a problem if estimated regression results are used for forecasting purposes but if researcher wishes to understand more about the underlying structure of the demand function.most software produce a correlation coefficient matrix). Multicollinearity will introduce a upward bias to the standard error of the coefficient and hence.7 or more would indicate the existence of multicollinearity .Chapter 4 Demand Estimation MULTICOLLINEARITY One of the assumptions in the regression analysis is that independent variables are not related to each other. then the problem has to be resolved. it is difficult to separate out the effect that each has on the dependent variables. If this assumption is not observed. Multicollinearity arises because if two variables are closely related. (ii) by looking at the correlation coefficient between pairs of independent variables (as a thumb of rule correlation coefficient of 0. then the estimated coefficient may give a distorted result of the impact of the change in the independent variables. Heteroscedasticity causes a systematic relationship (the residual of each X becomes larger as value of X becomes larger). reduce the t values and the variable to be insignificant. 149 . The problem can be resolved by (i) increasing the sample size data (ii) transform the functional relationship (iii) drop one of the highly collinear variables HETEROSCEDASTICITY Regression analysis presume homoscedasticity of the error terms (deviations from the line of best fit is constant for all values of the independent variables). This problem of often occurs in cross-sectional data. There are two ways of detecting multicollinearity problems : (i) if the regression result pass the F test but fails the t test.

It can also arise due to the existence of trends and cycles in economic variables. For example. a value of d = 2 indicates the absence of autocorrelation. by changing the functional form of the relationship. As a rule of thumb. and by transformation of the data. Most software will produce graphs for visual inspection. when important variables are excluded from the function or from nonlinearities in the data. The second specification error involves the omission of an important explanatory variable. SPECIFICATION ERROR This problem arises if a wrong functional form of the relationship is used. or exhibits a cyclical or any other pattern with respect to the X observations . AUTOCORRELATION It is indicated by a sequential pattern is the error term (i. the relationship is stated in linear form when in fact it should be nonlinear and vice versa. To overcome autocorrelation problem a researcher can include time as an additional variable to take into account trend patterns. To determine which functional form best explains the variance. Heteroscedasticity can be overcomed by respecifying the independent variables.meaning some other variables is changing systematically and influencing the dependent variable). simply plot the values of the resisuals against the values of the independent variables. The detect this problem. re-estimate the regression in a non-linear form or introduce ‘lag’ data in the time-series. This leads to unreliability of the regression coefficient.e. 150 . Autocorrelation problem usually appears when time-series data are used. A standard test for identifying the presence of autocorrelation is the Durbin-Watson test (it is presented automatically in the computer printout). the size of the error term becomes progressively larger or smaller. Autocorrelation gives a downward bias to the standard error of the estimated regression coefficient (t values are exaggerated) and hence the estimated coefficient are concluded to be statistically significant when in reality they are not. all functional forms should be tried and a comparison of the R2 be made.Chapter4 Demand Estimation Heteroscedasticity causes the standard error of the coefficient to biased and the R2 to be high.

accurately depicted. On the other hand. In many instances the actual price paid has not being IDENTIFICATION PROBLEM Regression analysis is conducted on the assumption that a single equation explains the entire relationship. This can be scouted from in depth knowledge of market conditions or Important variables should not be omitted. Data collection The next step involves collecting data of the variables used in the model. become bias. In the case of the demand estimation. In the case of time-series demand estimation. 151 .5 STEPS IN THE REGRESSION ANALYSIS The most common method of demand estimation is the regression analysis because it is more objective. price is the result of simultaneous equations of both demand and supply. Generally the four steps to follow are : Model specification The first step is to identify the factors important in determining the demand. otherwise there would be econometric difficulties. Where no data are available.Chapter 4 Demand Estimation MEASUREMENT ERROR A pitfall to be avoided is the improper measurement of the variables. the demand function cannot be expected to remain stable for long extended period of time. There is insufficient data in the regression analysis to identify the shifts of the demand curves. otherwise the results economic theory. variables should not be too many. Data can be in time-series or cross-section. inexpensive and provides more information. Data can be of primary or secondary source. proxy can be used. The most notorious being the price variable. 4.

. This involves (i) (ii) (iii) (iv) checking the signs of the coefficients to see if they conforms to the economic theory. heteroscedasticity and autocorrelation do not exists. 152 . for example in power form Qx = A Pxa Pyb Usually both forms are estimated and the one that gives the best result is reported. + e Model can also be non linear... The simplest model is the linear model.Chapter4 Demand Estimation Specifying Functional Form An appropriate functional form to be estimated has to be determined. conduct t test on the estimated parameters to determined if they are statistically significant evaluate the R2 run other econometric test to ensure that problems such as multicollinearity. Testing and evaluating econometric results The final step is to evaluate the regression results. example Qx = a + b1Px + b2Py = b3I + .

2 Px + 2. c) What can you say about the coefficient of determination? d) Given the values for advertising as \$13 million. coefficient of determination.9) . b) Using the results show which independent variable is significant at 95% in explaining the dependent variable. t . Assuming this results are taken from a computer printout. and (1.8 153 Write the equation.4 = 0. You are given the following data of a company selling T-shirts. and quality control as \$7 million.8) = 6.5 .81 (0.statistics. at 95% confidence interval in what range will actual sales fall? 2. Qx Se R2 = 12.Chapter 4 Demand Estimation QUESTIONS 1.I.SPx + 3.0) (1. Year 1 2 3 4 5 6 7 8 9 10 \$ Million Advertising Exp 10 9 11 12 11 12 13 13 14 15 \$ Million Quality Control 3 4 3 3 4 5 6 7 7 8 \$ Million Sales revenue 44 40 42 46 48 52 54 58 56 60 a) Use multiple regression analysis to estimate sales as a linear function of advertising and Quality Control.

5 4.018 1 3. Demand curve function Total revenue function. The figures in parenthesis are standard error of coefficient. Answer the following questions.89 154 .412 Income 1. is the price in RM .93 2.243 0. a) At 95% confidence interval state which variable is significant in explaining the dependent variables.814 1. Marginal revenue function. 1 = 3.5. Py is the price of related product in RM and I 'is the income level in RM. Py = 3.374 0.478 Variable Number of observation = 20 R2 Se = = 0. P. The results from a computer-printout for a linear demand -function is as follows.501 2. d) Using the information in (c) derive the (i) (ii) (iii) 3.statistics 1.248 0.203 0.742 Price of' other good Coefficient Standard error t .3.Chapter4 Demand Estimation where Q is the quality demanded in thousands for product x. b) c) What does the R2 in the question implies? Given the value of Px = 2. calculate at 95% confidence interval the range in which the quantity demanded will fall. Constant 0.778 Price -2.5.

coefficient of determination. d) Given marginal cost \$20. income and cross elasticity. Write down the equation. b) What will be the quantity demanded if the values of the independent variables are Price Income Price of other goods = = = \$10 \$90 \$12 c) Derive the demand curve function. Price (S) 0 1 2 3 4 5 6 7 8 Observation 1 2 3 4 5 6 7 8 9 a) Advertisement Expenses (Million S) 1 2 4 8 0 5 8 9 7 Sales (units) 4 6 8 14 12 10 16 16 12 Using the SPSS package. f) 4. estimate sales as a linear function of advertisement. and calculate the price. 155 . what is the profit maximizing quantity and price. price and quantity demanded for product X. t statistics.Chapter 4 Demand Estimation a) Write out the equation based on the above information. Give the data given in (b) e) At the profit-maximizing price. What can you say about the results? Will you accept the results? Given the following data on advertisement. calculate the range in which the quantity will fall at 95% confidence interval.

703 156 = 2.Chapter4 Demand Estimation b) Explain whether advertising expenditure is significant at 95% confidence in explaining the variation in sales. d) Is there any difference in the results between (a) and (c). If there is.87 0. c) Now estimate sales as a linear function of advertisement and price.61 R 2 Se=2.66) (2. we have to calculate the 't' value for each variable and compare it with the critical 't' value. SUGGESTED SOLUTIONS 1 (a) Sal = 17.statistics) (b) To determine the significance.09 = 0.93 : Sales : Advertising expenditure : Quality control Sal Adv QU (The values in parenthesis are t .873 Adv + 1.66 . standard error of estimation and t . explain. Write the equation coefficient of determination.915 Qu (2.81) F . Advertising Expenditure Calculate 't' = 1.943 + 1.statistics.statistic = 46.

834. tn -k.306 157 .9 + 1.306). Therefore we say there is statically significant relationship between dependent and independent variable. (d) Sales = = 17.915 (7) 55.812 Since both the calculate 't' values for advertising expenditure and quality control is above the critical 't' value (2.834 million and RM60. 0.93.473 At 95% confidence interval with the given values for advertising expenditure and quality control the sales will range between RM50.09) = 50.915 0.654 To calculate the range we use the following formula ^ Y ± t n-k.2. 55.306 = 2. (c) The R 2 is 0.873 (13) + 1. The f .471 million.74.306 (2.Chapter 4 Demand Estimation Quality control Calculated 't' = 1.statistics is 46.654± 2. 60. showing that 93% of the changes in sales is explained by the changes in advertising expenditure and quality control.681 The critical 't' value t10-2. we can say that at 95% confidence interval advertising expenditure and quality control Is significant in explain sales.6 whereas the critical 'F' value at 95% confidence interval is 4. 0 05 = 2.08 = . 0.05 (SE) .

(a) To test the significance of the variable we get the 't' statistics for all the variables.5) 29.8 (2. Variable : Px (Price) = 2.05 = 2 By comparing the value of 't' statistics with this value.36 ± = = 12. Where tn-k.8 't' statistics = 3. Py : 3.5 and I = 3.8 (b) The R 2 = 0.Chapter4 Demand Estimation 2.47 't' statistics = 1. we of thumb.36.2 't' statistics = 2.36 = 11.36 At 95% confidence interval given the figures where Px = 2.5 . 158 .0 Variable: 1. 31.2 (3.5) + 2.8 (3.2. In explaining the variation in quantity demanded at 95% confidence interval. the quantity demanded will range between RM11 and \$31.9 In this case.8 Variable: Py (Price of related product) =2 1.6 0. price of related product and (c) Qx ^ Y + 2 Se 2 (6. 0.3) + 3.3. 8.5) 29. It shows 80% of the variation in quantity demanded income.1. since the number of observation is not known. is explain by the chances in price. use rule I (Income) = 1. we see that price of the product and price Of related product is significant.

243 (10) + I.203 ( 12) =116.2.55Q2 (ii) Total revenue = = = (iii) Marginal revenue δTR δQ =18.Chapter 4 Demand Estimation (d) (i) Demand curve Qd A = = = Qd Px = = A .004 Demand curve function Qd = = = Qd Px = = A .203(12) = 0.1.375 (90)+ 1.0.445 Qx 159 .2.1 203 (12) 138.375 (I) .2.5 + 3.6Q 0.248 .5) 335 33.5) + 2.71 .434 138.111 Q 3.2 (3.8Px 18.243 (10) + I. (a) (b) (c) Qx Qx = 0.2.248 .8 (3.55 Qx) Q 18.1.0.bPy 12.0.6 .6.375 (90) ).434.243 Px 61.6 -1.5 .243 (Px) +1.bPy 0.248 .55 Qx Px Qx ( 1 8.

004 = 1. I = δI P elasticity 1.0. 0.19 Cross elasticity δQ.05 (4.0.71 .89) 160 .89 Q The range is calculated by using the standard error of estimation 46-86+ tn-k.71 .0.004 = 0. Py = δPy Q (d) Total Revenue P TR MR = = = 61.445Q2 61.86 61.0.71 Q p = = = (e) 46. P = δP Q Income δQ.060 -2.375 x 90 116.445Qx 61.85 = = = MC 20 0.243 x 10 116-004 = 0.445 (46.Chapter4 Demand Estimation Price elasticity δQ.86) 40.203 x 12 116.71 .71Q .0.12 Profit maximizing quantity MR 61.89Q 41.71 .89Q 1.

243 0.203 0.110(4.7 = . 161 the dependent variable is explain by the changes in the independent variable.54 .0.statistics = 1. 0. price.89) 46.374 0.statistics Income t-statistics Price of other good t .54 to \$57. In terms of coefficient of determination only 50% of the variations in income and price of related goods.41 From the findings we see that only price and income are statistically significant at 95% confidence interval. Price t .89) 36.17 At 95% confidence interval at profit maximizing price the quantity demanded will range from \$36.477 = 1.0. and compare with the critical @t' value from the student 't' distribution table. .05(4.2.86 ± t 20-2.814 tn-k.17 (f) To reject or accept the regression we shall look at the 't' statistics and coefficient of determination.05 = 2.501 = 2.Chapter 4 Demand Estimation 46.86 + 2.93 = 2. 57.110 = 1. To measure the strength of the relationship we calculate the 't' statistics for each variable.05 = t20-3.

0991) (1. This is because in the second regression.61 million.806 216. Overall there is a slight improvement in the results. whereas tile critical t' value is t9-2. more variables should be added.4820 Adv Standard error of coefficient (0. (a) Sal = 2.365 value.61 that is when Adv Exp changes by RM1 million the sales earlier estimate we did not.5522 + 1. 162 increases by RM1.0.4261 The 't' statistics is 14.80 109.6097 Adv . 4. (c) Sal = 2. the estimated value of b.0310) Standard error of coefficient: (0.4763) + 1.5951 (10.Chapter4 Demand Estimation The results can be accepted with changes that is. 15939) 't' statistics R2 Se F = = = (d) Yes. we held price constant whereas the . (Adv Exp) changed from 1. 1 448 (Pr (0. 1007) 't' statistics (14.0. It is seen that the calculated 't' value is greater than the tabled 't' Therefore at 95% confidence interval advertisement expenditure is significant in explaining variation in sales.48 to 1.964 0.71 14) R2 Se F (b) = = = 0.969 0.05 = 2.1405) = 0.7 1 14.

5Ax + 1. coefficient of determination‘t’ statistic and ‘f’ statistic to evaluate the strength of variable in explaining the dependent variable and the forecasting power of the estimated model.1 F stat + 46.Chapter 4 Demand Estimation SUMMARY ♦ Demand estimation is important in order to help reduce uncertainty associated with decision making and to achieve the objective of the firm.1Pz + 2.56) (2.2. we can use the standard error of estimation. PRACTICE QUESTIONS Q1. ♦ There are basically two types of regression analysis. The econometric method used to estimate the coefficients of a function ordinary is least square method (OLS).3 Y (6. Cyber Corporation Sdn Bhd has estimated the demand function for its Banana computer using regression analysis to be: Qx = 251 – 20.9) (1. ♦ Once the regression coefficients are estimated.3) R2 = 0.3) (5.3 Px + 24. they are linear and multiple regression.93 Std error of estimate = 1260 DW stats =.2 Where Qx is the quantity of computers demanded per month 163 (-2.1) .

at what price and output should the corporation charge to maximize profit? d) At the profit maximizing price.Chapter4 Demand Estimation Px is the price of the computer Pz is the price of another competitor’s computer Ax is the advertising expenditures per month Y is the consumers’ average monthly income. what range of sales volume can be expected at the 95% confidence interval? Q2. calculate the price and cross elasticity of demand for Banana computers. Sports Masters Inc produces shuttle cocks. b) Given the current values of independent variables Px = RM2500 Pz = RM2300 Ax = RM1500 Y = RM 7000. What do these values indicate? c) Suppose that the marginal cost of Banana computer is constant at RM1800. The figures in parentheses are the t-statistic of standard error of coefficients. a) Interpret the above regression result and state whether the result can be accepted or rejected. Some of the results of the analysis are given below: 164 . It conducted regression analysis to estimate the demand for its product.

024 -2478. write down the estimated regression equation.8435 Coefficient 425120. What is the estimated number of 165 . b) Does each independent variable have a significant effect on the dependent variable at 5% significance level/ give your reason. f) Sports Masters plans to charge a wholesale price of RM1.Chapter 4 Demand Estimation Variable Intercept P M Pr R2 = 0. P is the wholesale price it charges for a box of shuttle costs in (RM). The average price of a badminton racket is RM110 and consumers’ annual average household income is RM24600.0 -25930.6 1.65 per box.0 8774.0 Standard error of Coeffecient 220300. M is the consumer’s annual income (in RM) and Pr is the average price of badminton rackets (in RM) a) Based on the above information.0 Standard error of regression =26900 The dependent variable is Q which represents the number of boxes of shuttle cocks sold quarterly.251 785. c) Is the demand sign of the coefficient of each variable consistent with demand theory? d) Does the regression have a strong explanatory power? Why do you say so? e) Are regression results acceptable? Support your answer.0 0.

166 .91 Standard error of estimate F-value = 2.22 2.13 computer analysis are Coefficient of determination = 0.17 0.5 0. The results of the shown below.75 t-statistic 16 -1. estimate quantity demanded.8 = 311.32 0. A study was done to look at demand for “Mar and Mas” cheesecake.1 Std.67 2. Using the assumed values.94 0.12 0.1 1.5 0.43 a) Write down the estimated regression equation. Error 2. A regression analysis was conducted using the following Q = a + b1 P + b2 A + b3Y + b4 H + b5 Pc Where Q = quantity demanded in hundreds P A Y H Pc = price in RM (55) = advertising expenditures in thousand (20) = average household income in thousand (31) = total number of residential sales in thousand (10) = price of leading competitor in RM (50) model.Chapter4 Demand Estimation boxes of shuttle cocks demanded? Compute the 95% confidence interval estimate for your answer.5 0.9 0.6 0.5 2. Values in parentheses are the assumed values. Data were collected over 18 quarters. Q3. Variable Intercept P A Y H Pc Coefficient 40 -1.

Operating experience during the past year suggest the following demand function for its knife sets Q = 400 – 180P + 10N + 0.Chapter 4 Demand Estimation b) How concerned should this company be about price discounts by its leading competitor? Explain. which it markets on a nationwide basis. d) How effective do you think advertising is for this company? e) What type of good is “Mar and Mas” cheese cake? f) Describe the statistical significance of each individual independent variable included in the model. (SEI) is a producer of Polo Knives.5Y + 0. Sharp Edge Inc.22) (0. Y is 167 .14) R2 SEE = 0. Q4. N is the average Neilson rating of television programs during which the company advertise their knives. P is the price (RM).4A (101) (314) (0. or given away as promotional items. Their knife sees are either sold directly to the public through national television marketing programs.83 = 283 The value in the parenthesis is the standard error of coefficient. g) Comment on the coefficient of determination and F values. a set of kitchen cutlery. c) Should this company consider discounting its price in order to increase total revenue? Explain. Can this estimated regression equation be accepted? h) Indicate the 95 % confidence interval of the range o f forecasted demand and the range of total revenue for cheese cake. Given the t-value at 95% confidence interval as 1.96. Where Q is the quantity.

61Y (0. Based on 95% confidence interval.77) Q = quantity demanded (‘000 packets) A = advertising budget (RM’000) Y = disposable income per household (RM’000) 168 . What is the impact on demand during periods of recession? e) Which of the independent variables are statistically significant at 95% confidence interval in explaining quantity change? (use rule of thumb 2) f) g) Is the regression acceptable? Explain your answer.465A (0. b) c) Calculate the price necessary to sell 2.5. Q5.Chapter4 Demand Estimation average disposable income per household (RM ) and A is advertising expenditures (RM) The current values of the variables are P =20.47P ( 21.35) where + 1. estimated its demand function for its orange juice and achieved the following results: Q = 257.200 and A = 5.77) 121. and with price expressed as a function of quantity. Do you agree that a price increase will increase the total revenue of the company. N =18.36) + 0.000 a) Determine the demand curve equation faced by SEI in a typical market. compute the range of quantity demanded at the total revenue-maximising price. d) Calculate the income elasticity.650 and 3. State the demand curve with quantity expressed as a function of price. Y= 2.1 (80. Using a linear regression analysis Syarikat Juicy Sweet Sdn Bhd.190 sets of knives.

calculate the profit maximizing price for the orange juice. would you recommend a price increase for the orange juice if the firm wants to increase total revenue? Why? e) Using the income elasticity. identify the independent factors which have influence on sales of Syarikat Juicy Sweet Sdn. (Use the rule of thumb = 2) c) Given A = RM32..Square a) b) = = 12 0. inferior or luxury? Explain.80 per packet. Bhd’s orange juice. d) As the marketing manager of Syarikat Juicy Sweet Sdn Bhd. Calculate the range within which you would expect to find the actual quantity with 95% confidence interval.25. h. 250 and P = RM1. how would you categorise the orange juice – necessity.70 indicate? Using a 95% confidence interval criteria. 500. Y = RM6.70 What would an R-squared of 0. Q6. Would you recommend an increase in advertising budget? Explain. determine the demand function for Syarikat Juicy Sweet’s orange juice. g.Chapter 4 Demand Estimation P = price per packet of orange juice (RM) Standard errors are in parenthesis Standard error of estimate R. f) Compute the advertising elasticity of demand. An in-house study for 3 years revealed the following: 169 . Kintan cooler manufactures sells ice cubes. If the marginal cost of the orange juice is constant at RM0.

Calculate the range within which you would expect to find actual monthly sales revenue with 95% confidence.7 Standard error of estimation = 18. derive the relevant demand curve function for Kintan ice cube. (t30.8) R2 = 0.Chapter4 Demand Estimation Qc = 588 – 6. average competitor’s price is RM780.α = 0.30.8 n = 36 observations Values in parentheses are standard errors Where.88 (2. α=0.8) (3.8Px + 18A + 88T + 18W (318) (2. which independent variables have influence on sales? (t30.05=2.α=0. advertising expenditures are RM880 and average monthly temperature is 800F.000 in revenue? e) Assuming preceding model and data given are relevant for the coming period. Assuming this was a typical observation. d) Given wholesale price is RM880. b) Using a 95% confidence interval criterion.01 = 3. is there a probability for Kintan ice cube to generate at least RM8. 888.042) c) In the 36th month.8Pc + 4.05=2.8) (18) (38) F5. the average price is RM880. Qc Pc Px A T W a) = = = = = = quantity of ice cube per plastic bag Price of ice cube per plastic bag Price of competitor’s product Advertising expenditures Time Weather Fully evaluate and interpret the empirical results based on R2.042) 170 . F-statistic and standard error of estimation.

A demand function had been estimated on 120 respondents using regression analysis. c) If the firm’s objective is to maximize total revenue from the sales of “Sutra XT200” tiles. “Sutra XT200”.65 = 35. The research department of Sutra Tiles Company wished to estimate the demand function for its new product. 000) Using a 95% confidence interval. interpret the regression result.29) + 1500A + 4Pc + 2I (525) (1.Chapter 4 Demand Estimation Q7.25 (2. “Sutra XT200”.234) R2 F = 0. 000) = Advertising expense.75) (1. = Price of “Sutra XT200” tiles (RM7. 000) = Average monthly income (RM4. The demand function is as follows : Q = 15. in thousands (RM54) = Price of competitor's product (RM8. b) Derive an expression for the firm’s conventional demand curve for the new product.5) Standard error of estimate = 565 Values in parentheses are standard errors Where Q P A Pc I a) = Quantity demanded for “Sutra XT200” tiles. Do you think the equation can be accepted and used for forecasting purpose? Explain.000 – 10P (5. at what price should the firm charge? d) At that price. what range of sales volume can be expected at the 95% confidence interval? 171 .

normal or necessity good? g) Calculate the cross elasticity of demand. Are “Sutra XT200” tiles and competitor’s tiles substitutes or complement? STUDY NOTES 172 . f) Calculate income elasticity of demand.Chapter4 Demand Estimation e) Should Sutra Tiles Company consider reducing its price in order to increase its total revenue? Explain. Is the “Sutra XT200” a luxury.

Chapter 4 Demand Estimation APPENDIX 173 .

267 0.539 2. for the probability of 0.797 2.271 0.228 2.390 2. Edinburgh).260 0.706 4.315 1.289 1.771 1.863 0.534 0.941 0.750 2.277 0.415 1.257 0.807 2.920 2.143 2. 174 .258 0.265 0..861 2.747 3.318 1.256 0.05 12.323 1.179 2.311 1.086 2.262 2.254 0. Thus.527 0.854 0.771 2.569 0.701 1.314 2.854 0.721 1.05 and 21 df.895 1.842 .473 2.012 2.725 1.727 0.256 0.341 1.708 1.660 2.860 1.40 1.718 2.856 0.256 0.257 0.078 1.350 1.316 1.740 1.857 0.358 2.080 2.943 1. For example.602 2.337 1.479 2.862 0.306 2.530 0.499 3.533 0.518 2.584 0.529 0.833 1.319 1.819 2. Agricultural and Medical Research.169 3.703 1.263 0.080.657 9.257 0.851 0.879 0.831 2.325 1. 6th ed.714 1.532 0.321 1.645 .345 1.541 3.980 1.533 1.549 0.262 0.303 .671 1.365 3.328 1.855 0.706 1.531 0.0182 2.363 1.060 2.042 2..447 2. London (previously by Oliver & Boyd.120 2.583 2.858 0.250 3.314 3.947 2.861 0.530 0.878 2.000 1.528 2.681 2.704 2.876 0.069 2.896 0.201 2.397 1. Source: From table III of Fisher and Yates.289 0.532 0.567 2.638 1.717 1.650 2.920 0.604 4.707 3.658 1.500 2.531 0.462 2.106 3.383 1.260 0.254 0.886 1.536 0.256 0.845 0.032 3.756 2. Statistical Tables for Biological.531 0.258 0.542 0.457 2.261 0.074 2.906 0.05 allows for 0.372 1.60 0.779 2.052 2.476 1.998 2.729 1.330 1.684 1.365 2.532 0.376 1.492 2.467 2.764 2.256 0.508 2.296 1.866 0.101 2.787 2.860 0.259 0.355 3.5 percent to the left of t = 22.131 2.883 0.256 0.746 1.796 1.553 0.255 0.848 0.960 .538 0.303 1.132 2.056 2. published by Longman Group Ltd.055 3.015 1.256 0.858 0.543 0.256 0.711 1. t = 2.524 .258 0.821 2.259 0.539 0.821 6.889 0.925 5.080.01 63.699 1.761 1.534 0.812 1.10 6.02 31.110 2.870 0.310 1.898 2.537 0.865 0.084 2.576 Note: The probabilities given in the table are for two-tailed tests.253 .540 0.868 0.025 in each tail.624 2.145 2.921 2.533 0.782 1.045 2.356 1.977 2.530 0.282 .093 2.978 0.080. and 2.845 2.855 0.326 .559 0.841 4.546 0. a probability of 0. This means that 2.859 0.617 2.526 0.353 2.440 1.896 2. 1974.Chapter4 Demand Estimation TABLE C-2 Probabilities Degree of Freedom 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 40 60 120 ∞ .776 2.571 2.763 2.257 0.333 1.552 2.753 1.873 0.535 0.313 1.021 2.256 0.061 0.485 2.965 4.856 0.325 0.20 3.160 2.80 0.064 2.531 0.257 0. by permission of the authors and publishers.697 1.5 percent of the area under the distribution lies to the right of t = 2.617 0.423 2.734 1.