Topic 5

Demand Estimation

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Outline
Introduction
Demand Equation
Demand Estimation approaches
-Market research approach
-Quantitative approach
Regression Analysis
-Simple regression Analysis
-Multiple regression Analysis
Interpretation of regression coefficients
Q&A Session
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Introduction
Demand
 Demand is a buyer’s willingness and ability to pay a price for a specific
quantity of a commodity. Demand refers to how much (quantity) of a
product or a service is desired by buyers at various prices
Demand Estimation
 Quantify the links between the level of demand and the variables which
determine it such as Price, Tastes and Preferences, Incomes, Ps/c, Size of
population, Advertising expenditures, Political stability, Geographical
location etc

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Demand Equation
QD = b0+ b1P + b2T + b3I + b4PS/C+ b5S+ b6A+ b7P+ b8G
Where:
QD: Quantity demanded in a particular year (period)
P:Average price of the commodity
T :Taste
I:Per capita disposable income
PS/C: Average price of substitutes / compliments
S: Size of the population
A:Amount spent on advertising and other variables.
P:Political stability
G: Geographical location
Parameters bi(b1,b2 etc) are estimated by econometricians, by using
statistical techniques
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Demand Estimation
• Demand estimation seeks to answer below questions:
1. How much will the revenue of the firm change after increasing the
price of the commodity?
2. How much will the quantity demanded of the commodity increase if
consumers’ income increases?
3. What if the firms double its expenditure
4. What if the competitors lower their prices?

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Demand Estimation Approaches
 Two main approaches:
Market research approach
Quantitative approach

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Market Research Approaches
 Consumer Surveys
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
 Observational Research
It refers to gathering information on consumer preferences by watching
them buying and using product. Observation research relies on product
scanners which are increasingly formed in stores and on people meters
in homes

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Market Research Approaches
 Market experiments
Actual-Under the actual experiment, shops are opened in different
localities (places) and then consumer’s reactions are observed and
recorded
Simulated-Involves providing token money to a set of consumers and
asking them to shop around in simulated market. The prices of various
goods, their quality, packaging etc. vary during the experiment to observe
consumer’s reactions to such changes
 Consumer clinics-These are laboratory experiments in which the
participants are given a sum of money and asked to spend it in simulated
store to see how they react to changes in the commodity price, product
packaging, displays, price of competitor products and other factors
affecting demand
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Quantitative Approaches
Regression Analysis
 This is the most used method for demand estimation followed by
economists. In regression method, the demand function for a product is
estimated where demand is dependent variable and variables that
determine the demand are independent variable.
Two types of regression methods
Simple regression
 If only one variable affects the demand
Multiple regression
 If demand is affected by more than one/ many variables

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Regression Method
Regression Methods involve below steps
1. Identification of variables which influences the demand for the good
whose function is under estimation.
2. Collection of historical data on all the relevant variables
3. Choosing an appropriate form for the function
4. Estimation of the function

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Simple Regression

• Refers the relationship between two variables where one is independent

variable and the other is dependent variable.
• The equation to calculate simple regression is as follows:
• Y = a + bx
• Where,
• Y = (Dependent variable) Estimated value of Y for a given value of X
• a and b = Constants or estimators
• b = Amount of change in Y produced by a unit change in X
• x= Independent variable

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Simple Regression

• Determining a and b using method of least squares (OLS)

OR

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Simple regression Example

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Simple Regression-Example cont..
• b= 1.504
• back to compute value of ‘’a’’
• a= 10.889- 1.504(5.556)
• a= 2.536
• Regression equation
• Y= 2.536 + 1.504X
• This is the regression equation in which the researcher can take any
value of X to find the estimated value of Y.
• For example, if the value of X is 1, then the value of Y would be
calculated as follows:
• Y =2.536+1.504(1) = 4.039 millions of units
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Simple regression- Example Cont’-Graphical rep
Regression Equation Y= 2.536+ 1.504X

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Correlation coefficient (goodness of fit)

Correlation coefficient, also known as "R," which allows it to display

the degree of linear correlation between two variables. This
correlation is known as the "goodness of fit.“
 R=1 : Perfect fit
• Means the modeled equation is very reliable for future forecasts - indicates that the model
explains all of the variation observed.
R=0 : Indicates that the model fails to accurately model the data at all

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Goodness of Fit

• The goodness of fit, or the degree of linear correlation, measures the distance
between a fitted line on a graph and all the data points that are scattered around
the graph
• The tight set of data will have a regression line that's very close to the points and
have a high level of fit, meaning that the distance between the line and the data is
very small. A good fit has an R-squared that is close to 1

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Goodness of Fit
• Linear regression calculates an equation that minimizes the distance
between the fitted line and all of the data points. Technically, ordinary
least squares (OLS) regression minimizes the sum of the squared
residuals.

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Coefficient of Determination (R-Squared)
• The coefficient of determination is a measure used in statistical analysis that assesses
how well a model explains and predicts future outcomes.
• It is indicative of the level of explained variability in the data set. The coefficient of
determination, also commonly known as "R-squared," is used as a guideline to
measure the accuracy of the model. One way of interpreting this figure is to say that
the variables included in a given model explain approximately x% of the observed
variation. So, if the R2 = 0.50, then approximately half of the observed variation can
be explained by the model.

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Coefficient of determination
• Six regression lines :coefficient of determination R2 =0,0.2,0,4, 0.6,0.8 and
1.0

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Multiple Regression
• Refers to studying the relationship between more than one
independent and dependent variables
• This statistical tool allows you to examine how multiple independent
variables are related to a dependent variable
• Multiple regressions ordinarily are carried out on computers with the
aid of statistical software packages like Minitab, SAS, or SPSS

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Multiple regression
 Advantages of multiple regression
• Improves ability to make accurate predictions because more variables add
additional important information about the dependent variable.
• The Formula for Multiple Regression
• Y’ = a + b1 X1 + b2 X2
• Y’ = A predicted value of Y (which is your dependent variable)
• a = The “Y Intercept”.
• b1 = The change in Y for each 1 increment change in X
• b2 = The change in Y for each 1 increment change in \value of Y

• X= an X score (X is your Independent Variable) for which you are trying to

predict value of Y
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Multiple Regression-Formulas

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Multiple Regression- Example

Multiple Regression Analysis

Y = a1 + b 1 X 1 + b 2 X 2

where Y is sales volume

a1 is the intercept
X 1 is advertising expenditure
b1 is the Y/X1, marginal effect of advertisement on sales
X 2 is price of the product
b2 is the Y/X2, marginal effect of price on sales

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Multiple regression analysis
Above example can be calculated manually Mathematical formula or
computer programs/applications
Available computer software's packages
 SPSS
 SAS
 Minitab
 Eviews
 STATA
 etc

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Multiple regression-Example..
• The result from computer program print out :MiniTab
LS// Dependent variable is SAL
SMPL range 1986 - 1995
Number of observation 10

Variable Coefficient Std. Error T-Stat 2-Tail Sig.

C 11.60403 6.9633945 1.6665152 0.140

ADV 3.4936051 0.5078770 6.8788413 0.000
P -2.3836921 1.9495316 -1.2226999 0.261

R-squared 0.877397 Mean of dependent var 50.00000

Adjusted R-squared 0.842367 S.D of dependent var 6.992059
S.E. of regression 2.776058 Sum of squared resid 53.94549
Durbin-Watson stat 1.41 F-statistic 25.04734

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Multiple regression
 Using above results:
From Y = a1 + b1X1 + b2X2
a1 =11.6, b1=3.49 & b2=-2.38
Hence the demand equation -mathematical model will be
=> Y = 11.60 + 3.49X1 - 2.38X2

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Coefficient of determination-Interpretation

The value of R-Squared(R^2) ranges from ‘0’ to ‘1’

• R-Squared = ‘0’ (it shows that none of the independent variables
explain the changes in the dependent variable)
• R-Squared = ‘1’ (it shows that all the changes in the dependent
variable is explained by the variation in the independent variables)
• If R-squared = ‘0.85’ (it shows that 85% of the changes in the
dependent variables is explained by the variation in the independent
variables, advertising expenditure. The other 15% cannot be explained
by the regression analysis. This may be due to the omission of some
important independent variables
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Standard error of estimate (Se)-Interpretation

 It is a measure of dispersion of data points from the line of best fit

(regression line). Actual points do not lie on the regression line but are
dispersed above and below the line. Thus, the value predicted by
regression line will be subjected to error. Therefore, the Se measures
the probable error in the predicted value.

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END

Q&A

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