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Estimation of Demand
Demand analysis, the previous chapter we have studied, was an introduction of
tools of managerial decision-making.
For example, the knowledge of price and cross elasticity can assist the
manager in pricing and strategizing business. The income elasticity too can
provide useful insight into macroeconomic conditions and future planning.

But to know the elasticities, one must develop data sets and use statistical
methods to estimate the demand equation from which the elasticities can be
calculated and used in production decision.
Then, the estimated equation can be used to predict and forecast demand for
the product, based on certain assumptions and estimates about prices, income,
and other factors. Accordingly, managers can take decisions and predict
outcomes of each decision they take.

The estimation of demand some times is easy to find, while others, it is highly difficult
involving mathematical experiments, statistical models, etc.
In common, it involves many steps in estimating demand.
1. Development of a theoretical model
Since, the objective is to estimate a demand equation, it would be reasonable to assume
that the quantity demand is a function of the price of the good, income, prices of related
goods, and tastes and preferences.

Qx = f ( Px , Y , Py , T )

Where, Q x is quantity demand for a commodity X,

Px is price of good X,
Y is income of the consumer,
Py is price of related commodity,
T is tastes and preferences of the consumer.

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2. Data collections
The data may be collected from surveys, market experiments, or existing secondary sources such as
historical records of the firms or government publications, etc.
3. Choice of a Method and a Functional Form
Choice of a method is based on the objective in hand and type of data available. Choice of a
functional form such as: linear, quadratic, cubic, logarithmic, etc. is based on observation and
experience as to which form is most likely to be suitable.
Linear functional form of a demand function for tea, for example would be.

QT = a0 + a1 PT + a 2 Y + a3 Pc + a y W + a5 T + U
Where, QT = Quantity demanded of tea(kg )
PT = Pr ice of tea
Y = Income of the consumer
Pc = Pr ice of coffee
W = Weather
T = Tastes and preferences of the consumer
U = Error term (ommissions and commissions)

4. Estimation and interpretation of results

The next task is to estimate the demand function. The most popular method of estimating demand
is the least squares method. In this method a best-fit is found which minimizes the square distance
between the actual points and the corresponding points on the estimated lines.
After we have obtained the estimated equation, we need to interpret the results of the coefficients
in the equation.

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Regression Technique and Demand Estimation

QT = a0 + a10 + a2Y + a3Pc + a4W + a5T + U

PX
Intercept:
a0 + a2Y + a3Pc + a4W + a5T + U

Slope:
QX/PX = a1

QX

Thus, consider a simple demand equation where other things remaining constant as ‘a’:

The manager is interested to know the estimated values of ‘a’ and ‘b’ known as â and b̂
to know the estimated demand called Q̂d .

Hence, the estimated equation would appear as:

Qˆ d = aˆ + bˆ P − − − − − − − − − − − − − (2)

The difference between equations (1) and (2) i.e., between actual demand and estimated
demand would be clear from the figure below.

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The points represent actual demand at each price and quantity whereas the line represents
the estimated demand, which is a smooth curve of the scattered points.

There can be many values that might be selected as estimators of ‘a’ and ‘b’, but only one
of those sets defines a line that minimizes the sum of the squared deviations [i.e., that
minimizes  (Qd − Q ˆ ) ]. This technique is called the method of least squares.
d

In the least square method of estimating regression line, The values of â and b̂ can be
found with the help of the following normal equations.

Q d = N aˆ + bˆ  P − − − − − − − − − − − (1)

Q d P = aˆ  P + bˆ  P 2 − − − − − − − − − − − − ( 2)

By solving above normal equations (1) and (2) we get:

N  Pi Qi − ( Pi ) (  Qi )
bˆ =
N  Pi − ( Pi ) 2
2

And also, bˆ =
 pq where,
p = Pi − P
p 2
q = Qi − Q

And aˆ = Q − bˆ P

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Illustration: Estimating the demand for lobster dinners.

The business has collected information on prices and the average number of meals served
per day for a random of a sample of eight restaurants in the chain. The data are shown
below. Use regression analysis to estimate the coefficients of the demand function (
Qd = a + bP ).

Based on the estimated equation, calculate the point price elasticity of demand at the
mean value of the variables.

Restaurants 1 2 3 4 5 6 7 8
Meals served 100 90 85 110 120 90 105 100
per day
Price ($) 15 18 19 14 13 19 16 14

Hence, the estimated demand equation is:

Qˆ d = 170 − 4.375 P

dQ
since, = - 4.375, and using the mean values of price and quantity:
dP
dQ P 16
Price elasticity ( e p ) = = − 4.375 = − 0.7
dP Q 100

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Decision Problem 1:
Qx = 12,000 – 5,000 Px + 5 I + 500 Py
Where, Px is the price of good X
I is income per capita
Py is the price of good Y.
Assume initial values of Px = $ 5, I = $ 10,000, and Py = $ 6.
Given this information, as a Manager of the company:
a) Determine what effect a price increase of good X would have on its total revenues
b) Evaluate how sales of good X change when per capita income of the consumers is rising.
c) Assess the probable impact of a raise in the price of good Y on the sales of good X.
d) Using your findings of the above three questions, would you suggest increase in the price of good
X and analyse how the firm of good X would gain from your decision/action.

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Decision Problem 2
Qx = 1200 – 3 (Px) – 0.1 (Pz)
Where, Pz = $300
a) Find price elasticity of demand for commodity X at Px= $140. What will happen to the firm’s
revenue if it reduces its price below $140.
b) Find price elasticity of demand for good X at Px= $240. What will happen to the Firm’s
revenue, if it raises its price higher than $240.
c) What is cross-price elasticity of demand between good X and good Z. When Px= $140.
Answer if good X and good Z are substitutes or complements?