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Managerial Economics

By
Mr. Tahir Islam
Demand Estimation by regression
analysis
What is regression
The term regression was first introduced by Francis
Galton
In a famous paper Galton found that there was a
strong tendency for all tall parents to have tall children
and for short parents to have short children
Meaning that average height of children born tends
to move towards the average height of the parents
This is universal law of Galton and is confirmed by
his friend Karl Pearson
Regression means to move towards the center to
average


Regression analysis
Concerned with the study of the dependence of one
variable (dependent variable) on one or more other
variables (explanatory variables) with a view to estimate
or predict the average value of the dependent variable
Regression analysis used for observation of relationship
between two or more than two variables
Regression analysis
In order to introduce regression analysis,
suppose that a manager wants to determine the
relationship between the firms advertisement
expenditures and its sale revenue
The manager wants to test the hypotheses that higher
the advertising expenditures leads to higher sale for a
firm
Manager wants to estimate the strength of the
relationship (i.e. how much sales increase for each dollar
increase in advertising expenditures)
The manager collects data on advertising expenditure
and on sales revenue in specific period of time
Introduction to Regression analysis in
Managerial Economics
Suppose that advertising and sale data are given below
for 10 years

Year (t) 1 2 3 4 5 6 7 8 9 10

Advertising Exp (X) 10 9 11 12 11 12 13 13 14 15
Sales Revenue (Y) 44 40 42 46 48 52 54 58 56 60

If we now plot each pair of advertising-sales value on a
graph, with advertising expenditures measured along the
horizontal axis and sales revenue measured along
horizontal axis
Introduction to Regression analysis in
Managerial Economics ( cont)
Introduction to Regression analysis in
Managerial Economics ( cont)

9 10 11 13
12 14 15
40
45
50
55
60
Advertising
expenditure
Sales
Introduction to Regression analysis in
Managerial Economics ( cont)

9 10 11 13
12 14 15
40
45
50
55
60
Advertising
expenditure
Sales
^
Y
Introduction to Regression analysis in
Managerial Economics ( cont)
We gets points or dots in figure
This is known as a scatter diagram
It shows the spread of the points in the X-Y plane
There is a positive relationship between the level of
firms advertising expenditure and its sales revenue
Relationship between them is linear
One way to estimate the relationship is visual inspection
Draw a straight line among these points in such away
that these points are cluster around the straight line
By extending a line to the vertical axis, we can estimate
the firm sale revenue with zero advertisement

Introduction to Regression analysis in
Managerial Economics ( cont)
Where as the slop of line presents the linear relationship
between sale revenue and advertisement i.e. how much
sale revenue would increase for one dollar increase in
advertisement
This will give us a rough estimate of relationship
between these two variables
The manager could use this information to estimate how
much sale revenue of the firm would be if its
advertisement expenditure were anywhere between $9
million and $15 million



Regression analysis is a best statistical technique for
obtaining the line that best fits the data points

Regression line is obtain to minimize the
difference/deviations between each points and
regression line

This method is called method of least square

Introduction to Regression analysis in
Managerial Economics ( cont)
Y refers to actual or observed sale revenue of $44
million associated with advertising expenditure of $10
million in first year
Y is estimated sale for a firm for advertising
expenditures of $10 million in first year
The term e in the figure is the corresponding vertical
deviation or error and is equal to the difference between
the actual value and estimated value of the firm
The formula for error is e =Y-Y
Since there are 10 observation points in figure, we have
10 such vertical deviations or errors
Introduction to Regression analysis in
Managerial Economics ( cont)
^
^
Demand Estimation by regression analysis
As we know that demand plays a vital role in
managerial making decision, so correct
estimation about demand is important as well as
a problem
Although many techniques are used for
estimating demand but the most common
method for estimating demand in managerial
economic is regression analysis
This method is more objective , provide more
complete information and is generally less
expensive
Demand Estimation by regression analysis
In this section we summarize and review
the method of estimating demand by
regression analysis
We discuss
1. Model specification
2. Data requirements
3. Functional form
4. Evaluation of econometric results obtain

Demand Estimation by regression analysis
1. Model specification
Model specification is first step in estimating demand
function
This involves identifying most important variables that
affect the demand for a commodity
Usually we include explanatory variables
a. price of commodity
b. consumer income
c. numbers of members in a family
d. price of related goods
e. level of advertisement expenditure
f. availability of credit incentives and consumers price
expectation are
Demand Estimation by regression analysis
But specification of demand function for different
goods are different
Demand function for expensive durable goods, such
as automobiles and houses
Explanatory variables are
a. Credit terms
b. rate of interest
c. Income level
Demand Estimation by regression analysis
(cont)
Demand function for seasonal equipment, such as air
conditioner , swimming suits and cold beverages
Explanatory variables are
a. weather conditions
b. Income level of consumer
Demand Estimation by regression analysis
(cont)
Demand function for capital goods such as machinery
and factory buildings
Explanatory variables are
a. rate of profits
b. capital utilization
c. wage rate
d. Income level of investor

The researcher must avoid omitting important variables
Other wise he or she will obtain biased results


Demand Estimation by regression analysis
(cont)
2. Collecting data on variables

Collecting of data is another step to estimate the
demand function
Data can be collected for each variable over the time
(yearly, quarterly and monthly) is called time series
data
Data for different economic units (individuals,
households) at particular point of time i.e. for a
particular year, month or and year is called cross-
sectional data
Demand Estimation by regression analysis
(cont)
If data about variables are incorrect then researcher can
not make a best estimation

Specifying the form of the demand function

The third step in estimating demand by regression
analysis is to determine the functional form of the model

Linear model is the simplest and realist form of demand
function
Qx =ao +a1px + a2I +a3N +a4PY +)
In above equation as are parameters to be estimated
Demand Estimation by regression analysis
(cont)
Testing the Econometrics results

The fourth and final step in the estimation of demand by
regression analysis is to evaluate the regression results

First, the sign of each estimated coefficient must be
checked to confirm whether it matched economic theory

Tests are used to find the value of parameters , usually
we use t-statistic