Exercise 3 – Estimation and Forecasting

Instructions: Write down your answers in Word document. For short answer questions, you have a
maximum of 200 words only, written in English or Filipino. For problem solving, show full computations
in the same document. If asked to illustrate diagrams, you may illustrate using charts and smart arts or
paste a photo of your hand-drawn illustration in the same document. You may discuss the questions and
solutions with your classmates, but please do not copy-paste answers. Answer the requirements with
integrity and honesty. Encircle or highlight the final answer. (Total: 15 points)

Short Answer Questions

1. (2 points) To what extent do you agree with the following statements?

a. The best test of the performance of two different regression equations is their
respective values of R2.

b. Time-series regressions should be run using as many years of data as possible; more
data means more reliable coefficient estimates.
c. Including additional variables (even if they lack individual significance) does no harm and
might raise R2.
d. Equations that perform well in explaining past data are likely to generate accurate
forecasts.

2. (2 points) A water expert was asked whether increased water consumption in a California
community was lowering its water table. To answer this question, the expert estimated a linear
regression equation of the form

W = a + bt

where W = height of the water table and t = time measured from the start of the study period.
(He used 10 years of water-table measurements.) The estimate for b was b = - 0.4 with a t-value
of - 1.4.
a. From this evidence, would you conclude that the water table was falling?
b. A second expert suggests yearly rainfall also may affect the water table. The first expert
agrees but argues that total rainfall fluctuates randomly from year to year. Rainy years
would cancel out dry years and would not affect the results of the regression. Do you
agree?

3. (2 points) As the name suggests, a lagging indicator is an economic variable whose movements
occur after movements in the overall economy.
a. A number of employment measures are lagging indicators. Consider the following
variables: (1) increased use of temporary workers, (2) increases in new hires, (3) a
decline in the number of workers laid off, and (4) an increase in overtime hours. In an
economic recovery from a recession, which of these variables would have the shortest
and longest lags?
b. Top management of a company that produces luxury yachts has been waiting anxiously
for the end of the recession and a resurgence in orders. Why might the company pay
more attention to lagging indicators than to leading indicators? Explain.
Exercise 3 – Estimation and Forecasting

Problem Solving

1. (5 points) A food-products company has recently introduced a new line of fruit pies in six U.S.
cities: Atlanta, Baltimore, Chicago, Denver, St. Louis, and Fort Lauderdale. Based on the pie’s
apparent success, the company is considering a nationwide launch. Before doing so, it has
decided to use data collected during a two-year market test to guide it in setting prices and
forecasting future demand.

For each of the six markets, the firm has collected eight quarters of data for a total of 48
observations. Each observation consists of data on quantity demanded (number of pies
purchased per week), price per pie, competitors’ average price per pie, income, and population.
The company has also included a time-trend variable for each observation. A value of 1 denotes
the first quarter observation, 2 the second quarter, and so on, up to 8 for the eighth and last
quarter. A company forecaster has run a regression on the data, obtaining the results displayed
in the accompanying table.

a. Which of the explanatory variables in the regression are statistically significant? Explain.
How much of the total variation in pie sales does the regression model explain?
b. Compute the price elasticity of demand for pies at the firm’s mean price ($7.50) and
mean weekly sales quantity (20,000 pies). Next, compute the cross-price elasticity of
demand. Comment on these estimates.
c. Other things equal, how much do we expect sales to grow (or fall) over the next year?
d. How accurate is the regression equation in predicting sales next quarter? Two years
from now? Why might these answers differ?
e. How confident are you about applying these test-market results to decisions concerning
national pricing strategies for pies?

2. (4 points) Studies of automobile demand suggest that unit sales of compact cars depend
principally on their average price and consumers’ real personal income. Consider the historical
record of sales shown in the table.
Exercise 3 – Estimation and Forecasting

a. Estimate the point elasticity of demand with respect to price. (Be sure to choose two
years in which all other factors are constant.)
b. Estimate the income elasticity of demand.
c. Given the elasticities in parts (a) and (b), what change in sales do you expect between
2009 and 2010? How closely does your prediction match the historical record?
d. Estimate a linear demand equation that best fits the data using a regression program.
Comment on the accuracy of your equation. Is this degree of accuracy realistic?