MM/EBM 2143 – Managerial Economics

03.
(Part II)

Demand Estimation & Forecasting

Ms. Sanduni Dilanka

1
Basic Estimation Techniques
 Simple Linear Regression
• Simple linear regression model relates
dependent variable Y to one independent
(or explanatory) variable X
Y  a  bX
•

• Slope parameter (b) gives the change in Y

associated with a one-unit change in X,
 Sample Regression Line

70,000 Si  60,000 Sam ple regression line

Ŝi  11, 573  4.9719 A
60,000 •
ei •
Sales (dollars)

50,000

40,000
•
Ŝi  46,376
30,000
• •
20,000
•
10,000
•
A
0 2,000 4,000 6,000 8,000 10,000

Advertising expenditures (dollars)

 Multiple Regression

• Uses more than one explanatory variable

• Coefficient for each explanatory variable measures the
change in the dependent variable associated with a one-
unit change in that explanatory variable
Estimation & Forecasting
 Direct Methods of Demand Estimation
• Consumer interviews
• Range from stopping shoppers to speak with them
to administering detailed questionnaires
• Potential problems
• Selection of a representative sample, which is a sample
(usually random) having characteristics that accurately
reflect the population as a whole
• Response bias, which is the difference between responses
given by an individual to a hypothetical question and the
action the individual takes when the situation actually
occurs
• Inability of the respondent to answer accurately
Direct Methods of Demand Estimation

• Market studies & experiments

• Market studies attempt to hold everything constant
during the study except the price of the good
• Lab experiments use volunteers to simulate actual
buying conditions
• Field experiments observe actual behavior of
consumers
 Empirical Demand Functions
• Demand equations derived from actual
market data
• Useful in making pricing & production
decisions
• In linear form, an empirical demand function
can be specified as
 Empirical Demand Functions

Q  a  bP  cM  dPR
• In linear form
• b = Q/P
• c = Q/M
• d = Q/PR
• Expected signs of coefficients
• b is expected to be negative
• c is positive for normal goods; negative for inferior goods
• d is positive for substitutes; negative for complements
 Empirical Demand Functions
Q  a  bP  cM  dPR
• Estimated elasticities of demand are
computed as
Nonlinear Empirical Demand Specification

• When demand is specified in log-linear form,

the demand function can be written as
 Demand for a Price-Setter

• To estimate demand function for a price-setting firm:

• Step 1: Specify price-setting firm’s demand function
• Step 2: Collect data for the variables in the firm’s demand
function
• Step 3: Estimate firm’s demand using ordinary least-squares
regression (OLS)
 Time-Series Forecasts
• A time-series model shows how a time-
ordered sequence of observations on a
variable is generated
• Simplest form is linear trend forecasting
• Sales in each time period (Qt ) are assumed to be linearly related
to time (t)
 Linear Trend Forecasting
 Use regression analysis to estimate
values of a and b

• If b > 0, sales are increasing over time

• If b < 0, sales are decreasing over time
• If b = 0, sales are constant over time
 A Linear Trend Forecast
Q
Estimated trend line
Q̂ 2009
12 
Q̂ 20047 
 

 

Sales

  

t
2006
2004
2005

2007
1997

1999
2000
1998

2001
2002
2003

2012
Time
Forecasting Sales for Terminator Pest Control
 Seasonal (or Cyclical) Variation

• Can bias the estimation of parameters in linear

trend forecasting
• To account for such variation, dummy variables
are added to the trend equation
• Shift trend line up or down depending on the
particular seasonal pattern
• Significance of seasonal behavior determined by
using t-test or p-value for the estimated coefficient on
the dummy variable
Sales with Seasonal Variation

 
 

     





2004 2005 2006 2007

 Dummy Variables

• To account for N seasonal time periods

• N – 1 dummy variables are added
• Each dummy variable accounts for one seasonal time
period
• Takes value of 1 for observations that occur during the season
assigned to that dummy variable
• Takes value of 0 otherwise
Effect of Seasonal Variation

Qt
Qt = a’ + bt

Qt = a + bt
Sales

c
a’

a
t
Time
 Some Final Warnings

• The further into the future a forecast is made, the

wider is the confidence interval or region of
uncertainty
• Model misspecification, either by excluding an
important variable or by using an inappropriate
functional form, reduces reliability of the forecast
• Forecasts are incapable of predicting sharp changes
that occur because of structural changes in the
market
Thank you…!!!

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