Managerial Economics in a

Global Economy, 5th Edition

by
Dominick Salvatore

Chapter 4
Demand Estimation

Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 1
 The Identification Problem

Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 2
 Demand Estimation:
Marketing Research Approaches
Consumer Surveys
Observational Research
Consumer Clinics
Market Experiments
Virtual Shopping
Virtual Management

Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 3
 Regression Analysis
Year X Y
1 10 44
Scatter Diagram
2 9 40
3 11 42
4 12 46
5 11 48
6 12 52
7 13 54
8 13 58
9 14 56
10 15 60
Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 4
 Regression Analysis
Regression Line: Line of Best Fit

Regression Line: Minimizes the sum of

the squared vertical deviations (et) of
each point from the regression line.

Ordinary Least Squares (OLS) Method

Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 5
 Regression Analysis

Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 6
Ordinary Least Squares (OLS)

Model: Yt a bX t et

Yt a bX t

et Yt Yt

Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 7
Ordinary Least Squares (OLS)

Objective: Determine the slope and

intercept that minimize the sum of
the squared errors.

n n n

t t t t
e 2

t 1
(Y Y ) 2
(Y
a
t 1
)2
bX t
t 1

Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 8
Ordinary Least Squares (OLS)
Estimation Procedure
n

(X t X )(Yt Y )
b t 1
a Y bX
n

t
( X
t 1
X ) 2

Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 9
Ordinary Least Squares (OLS)
Estimation Example
Time Xt Yt Xt X Yt Y ( X t X )(Yt Y ) ( X t X )2
1 10 44 -2 -6 12 4
2 9 40 -3 -10 30 9
3 11 42 -1 -8 8 1
4 12 46 0 -4 0 0
5 11 48 -1 -2 2 1
6 12 52 0 2 0 0
7 13 54 1 4 4 1
8 13 58 1 8 8 1
9 14 56 2 6 12 4
10 15 60 3 10 30 9
120 500 106 30
n n n
n 10 X t 120
t 1
Yt 500
t 1
(X
t 1
t X ) 2 30 b
106
30
3.533

n n n
X t 120 Yt 500
X 12 Y 50 (X t X )(Yt Y ) 106 a 50 (3.533)(12) 7.60
t 1 n 10 t 1 n 10 t 1

Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 10
Ordinary Least Squares (OLS)
Estimation Example
n
X t 120
n 10 X 12
t 1 n 10
n
Yt 500
Y
n n

X
t 1
t 120 Y
t 1
t 500
t 1 n

10
50

n
106
(X
t 1
t X ) 302
b
30
3.533

(X
t 1
t X )(Yt Y ) 106 a 50 (3.533)(12) 7.60
Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 11
 Tests of Significance

Standard Error of the Slope Estimate

sb
(Yt Y )
2

e 2
t

( n k ) ( X t X ) 2
(n k ) ( X t X )2

Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 12
 Tests of Significance
Example Calculation
Time Xt Yt Yt et Yt Yt et2 (Yt Yt )2 ( X t X )2
1 10 44 42.90 1.10 1.2100 4
2 9 40 39.37 0.63 0.3969 9
3 11 42 46.43 -4.43 19.6249 1
4 12 46 49.96 -3.96 15.6816 0
5 11 48 46.43 1.57 2.4649 1
6 12 52 49.96 2.04 4.1616 0
7 13 54 53.49 0.51 0.2601 1
8 13 58 53.49 4.51 20.3401 1
9 14 56 57.02 -1.02 1.0404 4
10 15 60 60.55 -0.55 0.3025 9
65.4830 30

n n n (Y Y ) 2
65.4830
e (Yt Yt )2 65.4830 (X sb 0.52
t
2
X ) 30
2

t 1
t
t 1 t 1
t ( n k ) ( X X )
t
2
(10 2)(30)

Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 13
 Tests of Significance
Example Calculation
n n

t t t 65.4830
e 2

t 1
(Y Y ) 2

t 1
n

t
( X
t 1
X ) 2
30

sb
(Yt Y )

2
65.4830
0.52
( n k ) ( X t X ) 2
(10 2)(30)
Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 14
 Tests of Significance
Calculation of the t Statistic

b 3.53
t 6.79
sb 0.52

Degrees of Freedom = (n-k) = (10-2) = 8

Critical Value at 5% level =2.306

Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 15
 Tests of Significance
Decomposition of Sum of Squares

Total Variation = Explained Variation + Unexplained Variation

(Yt Y ) (Y Y ) (Yt Yt )
2
2 2

Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 16
 Tests of Significance
Decomposition of Sum of Squares

Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 17
 Tests of Significance
Coefficient of Determination

R2
Explained Variation

(Y Y ) 2

TotalVariation t
(Y Y ) 2

373.84
R 2
0.85
440.00

Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 18
 Tests of Significance
Coefficient of Correlation

r R2 withthe sign of b

1 r 1

r 0.85 0.92

Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 19
 Multiple Regression Analysis

Model: Y a b1 X1 b2 X 2 bk ' X k '

Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 20
 Multiple Regression Analysis

Adjusted Coefficient of Determination

(n 1)
R 2 1 (1 R 2 )
(n k )

Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 21
 Multiple Regression Analysis

Analysis of Variance and F Statistic

Explained Variation /(k 1)

F
Unexplained Variation /(n k )

R 2 /(k 1)
F
(1 R 2 ) /(n k )

Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 22
Problems in Regression Analysis
Multicollinearity: Two or more
explanatory variables are highly
correlated.
Heteroskedasticity: Variance of error
term is not independent of the Y
variable.
Autocorrelation: Consecutive error
terms are correlated.
Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 23
 Durbin-Watson Statistic
Test for Autocorrelation
n

t t 1
( e e ) 2

d t 2
n

t
e 2

t 1

If d=2, autocorrelation is absent.

Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 24
 Steps in Demand Estimation
Model Specification: Identify Variables
Collect Data
Specify Functional Form
Estimate Function
Test the Results

Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 25
Functional Form Specifications

Linear Function:

QX a0 a1PX a2 I a3 N a4 PY e

Power Function: Estimation Format:

QX a( PXb1 )( PYb2 ) ln QX ln a b1 ln PX b2 ln PY

Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 26