Estimating Demand

Chapter 4
• A chief uncertainty for managers is the future. Managers
fear what will happen to their product.
» Managers use forecasting, prediction & estimation to
reduce their uncertainty.
» The methods that they use vary from consumer surveys
or experiments at test stores to statistical procedures on
past data such as regression analysis.
• Objective of the Chapter: Learn how to interpret the
results of regression analysis based on demand data.
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated,
or posted to a publicly accessible website, in whole or in part. Slide 1
 Demand Estimation
Using Marketing Research Techniques
• Consumer Surveys
» ask a sample of consumers their attitudes
• Consumer Focus Groups
» experimental groups try to emulate a market (but beware of the
Hawthorne effect = people often behave differently in when being
observed)
• Market Experiments in Test Stores
» get demand information by trying different prices
• Historical Data - what happened in the past is guide to the future using
statistics is an alternative

Slide 2
 Statistical Estimation of Demand Functions:
Plot Historical Data
Price Is this curve demand
• Look at the relationship or supply?
of price and quantity over
time 2004 2007
• Plot it
2010
» Is it a demand curve or a 2009
supply curve? 2008 2006 2005
» The problem is this does
not hold other things equal
or constant.
quantity
Slide 3
 Statistical Estimation of Demand Functions

• Steps to take:
» Specification of the model -- formulate the
demand model, select a Functional Form
• linear Q = a + b•P + c•Y
• double log log Q = a + b•log P + c•log Y
• quadratic Q = a + b•P + c•Y+ d•P2
» Estimate the parameters --
• determine which are statistically significant
• try other variables & other functional forms
» Develop forecasts from the model
Slide 4
 Specifying the Variables
• Dependent Variable -- quantity in units,
quantity in dollar value (as in sales revenues)
• Independent Variables -- variables thought
to influence the quantity demanded
» Instrumental Variables -- proxy variables for the
item wanted which tends to have a relatively high
correlation with the desired variable: e.g., Tastes
Time Trend

Slide 5
 Functional Forms: Linear

• Linear Model Q = a + b•P + c•Y

» The effect of each variable is constant, as in
Q/P = b and Q/Y = c, where P is price and Y is
income.
» The effect of each variable is independent of
other variables
» Price elasticity is: ED = (Q/P)(P/Q) = b•P/Q
» Income elasticity is: EY = (Q/Y)(Y/Q)= c•Y/Q
» The linear form is often a good approximation of
the relationship in empirical work.
Slide 6
 Functional Forms: Multiplicative or
Double Log
• Multiplicative Exponential Model Q = A • Pb • Yc
» The effect of each variable depends on all the other
variables and is not constant, as in Q/P = bAPb-1Yc and
Q/Y = cAPbYc-1
» It is double log (log is the natural log, also written as ln)
Log Q = a + b•Log P + c•Log Y
» the price elasticity, ED = b
» the income elasticity, EY = c
» This property of constant elasticity makes this approach
easy to use and popular among economists.
Slide 7
 A Simple Linear Regression Model

• Yt = a + b Xt + t Y
• time subscripts & error term
• Find “best fitting” line
a
 t = Yt - a - b X t
t2 = [Yt - a - b Xt] 2 . _
Y
• mint 2= [Yt - a - b Xt] 2 .
Solution:
Y
slope b = Cov(Y,X)/Var(X) and X
intercept a = mean(Y) - b•mean(X)
_
X
Slide 8
 Simple Linear Regression:
Assumptions & Solution Methods
1. The dependent • Spreadsheets - such as
variable is random. » Excel, Lotus 1-2-3, Quatro Pro,
or Joe Spreadsheet
2. A straight line • Statistical calculators
relationship exists.
• Statistical programs such as
3. The error term has a
» Minitab
mean of zero and a
» SAS
finite variance: the
» SPSS
independent
» For-Profit
variables are indeed
independent. » Mystat

Slide 9
Assumption 2: Theoretical
Straight-Line Relationship

Slide 10
 Assumption 3: Error Term Has A
Mean Of Zero And A Finite Variance

Slide 11
 Assumption 3: Error Term Has A
Mean Of Zero And A Finite Variance

Slide 12
FIGURE 4.4 Deviation of the Observations
about the Sample Regression Line

Slide 13
 Sherwin-Williams Case
• Ten regions with data on promotional expenditures (X) and
sales (Y), selling price (P), and disposable income (M)
• If look only at Y and X: Result: Y = 120.755 + .434 X
One use of a regression is to make predictions.
• If a region had promotional expenditures of 185, the
prediction is Y = 201.045, by substituting 185 for X
• The regression output will tell us also the standard error
of the estimate, se . In this case, se = 22.799
• Approximately 95% prediction interval is Y ± 2 se.
• Hence, the predicted range is anywhere from 155.447 to
246.643.
Slide 14
Sherwin-Williams Case

Slide 15
Figure 4.5 Estimated Regression Line
Sherwin-Williams Case

Slide 16
 RULE: If absolute value of the
T-tests estimated t > Critical-t, then
• Different REJECT Ho.
samples would » We say that it’s significant!

yield different
coefficients • The estimated t = (b - 0) / b
• The critical t is:
• Test the » Large Samples, critical t2
hypothesis that • N > 30
coefficient » Small Samples, critical t is on Student’s t
Distribution, page B-2 at end of book, usually
equals zero column 0.05, & degrees of freedom.
» Ho: b = 0 • D.F. = # observations, minus number of
independent variables, minus one.
» Ha: b 0 • N < 30

Slide 17
 Sherwin-Williams Case

• In the simple linear • The estimated t is:

regression:
t = (.434 – 0 )/.14763 = 2.939
Y = 120.755 + .434 X
• The critical t for a sample of 10, has
• The standard error of the
only 8 degrees of freedom
slope coefficient is . » D.F. = 10 – 1 independent variable – 1 for
14763. (This is usually the constant.
available from any » Table B2 shows this to be 2.306 at the .05
regression program used.) significance level
• Test the hypothesis that • Therefore, |2.939| > 2.306, so we reject
the slope is zero, b=0. the null hypothesis.
• We informally say, that promotional
expenses (X) is “significant.”
Slide 18
USING THE REGRESSION EQUATION
TO MAKE PREDICTIONS

• A regression equation can be used to make

predictions concerning the value of Y, given
any particular value of X.
• A measure of the accuracy of estimation with
the regression equation can be obtained by
calculating the standard deviation of the
errors of prediction (also known as the
standard error of the estimate).
Slide 19
 Correlation Coefficient
• We would expect more promotional expenditures to be
associated with more sales at Sherwin-Williams.
• A measure of that association is the correlation coefficient, r.
• If r = 0, there is no correlation. If r = 1, the correlation is
perfect and positive. The other extreme is r = -1, which is
negative.

Slide 20
 Analysis of Variance
• R-squared is the percentage of the
variation in dependent variable Y
that is explained ^
Yt
• ^
Yt predicted
_
Y
• As more variables are included,
R-squared rises
• Adjusted R-squared, however,
can decline _
» Adj R2 = 1 – (1-R2)[(N-1)/(N-K)]
X
X
» As K rises, Adj R2 may decline.
Slide 21
FIGURE 4.7 Partitioning the Total
Deviation

Slide 22
Slide 23
 Association and Causation
• Regressions indicate association, but beware of jumping to the
conclusion of causation
• Suppose you collect data on the number of swimmers at a local beach
and the temperature and find:
• Temperature = 61 + .04 Swimmers, and R2 = .88.
» Surely the temperature and the number of swimmers is positively
related, but we do not believe that more swimmers CAUSED the
temperature to rise.
» Furthermore, there may be other factors that determine the
relationship, for example the presence of rain or whether or not it
is a weekend or weekday.
• Education may lead to more income, and also more income may lead
to more education. The direction of causation is often unclear. But
the association is very strong.
Slide 24
 Multiple Linear Regression
• Most economic relationships involve several
variables. We can include more independent
variables into the regression.
• To do this, we must have more observations (N) than
the number of independent variables, and no exact
linear relationships among the independent variables.
• At Sherwin-Williams, besides promotional expenses
(PromExp), different regions charge different selling
prices (SellPrice) and have different levels of
disposable income (DispInc)
• The next slide gives the output of a multiple linear
regression, multiple, because there are three
independent variables
Slide 25
 Figure 4.8 Computer Output:
Sherwin-Williams Company
Dep var: Sales (Y) N=10 R-squared = .790
Adjusted R2 = .684 Standard Error of Estimate = 17.417

Variable Coefficient Std error T P(2 tail)

Constant 310.245 95.075 3.263 .017
PromExp .008 0.204 0.038 .971
SellPrice -12.202 4.582 -2.663 .037
DispInc 2.677 3.160 0.847 .429

Analysis of Variance
Source Sum of Squares DF Mean Squares F p
Regression 6829.8 3 2276.6 7.5 .019
Residual 1820.1 6 303.4
Slide 26
 Interpreting Multiple Regression Output

• Write the result as an equation:

Sales = 310.245 + .008 ProExp -12.202 SellPrice
+ 2.677 DispInc
• Does the result make economic sense?
» As promotion expense rises, so does sales. That makes sense.
» As the selling price rises, so does sales. Yes, that’s reasonable.
» As disposable income rises in a region, so does sales. Yup. That’s reasonable.
• Is the coefficient on the selling price statistically significant?
» The estimated t value is given in Figure 4.8 to be -2.663 on SellPrice.
» The critical t value, with 6 ( which is 10 – 3 – 1) degrees of freedom in table
B2 is 2.447
» Therefore |-2.663| > 2.447, so reject the null hypothesis, and assert that the
selling price is significant!
Slide 27
 Soft Drink Demand Estimation
A Cross Section Of 48 States

Linear estimation yields:

  Coefficients Standard Error t Stat

Intercept 159.17 94.16 1.69
Price -102.56 33.25 -3.08
Income 1.00 1.77 0.57
Temperature 3.94 0.82 4.83

Regression Statistics
Multiple R 0.736
R Square 0.541
Adjusted R Square 0.510
Standard Error 47.312
Observations 48
Slide 28
 Find The Linear Elasticities

Linear Specification write as an equation:

Cans = 159.17 -102.56 Price +1.00 Income + 3.94 Temp

The price elasticity in Alabama is = (Q/P)(P/Q) = -102.56(2.19/200)= -1.123

( Q/P)(P/Q) = -102.56(2.19/166) = -1.353

The price elasticity in Nevada is = (

The price elasticity in Wisconsin is = (Q/P)(P/Q) = -102.56(2.38/97)= -2.516

The estimated elasticities are elastic for individual states.

We can estimate the elasticity from the whole samples as:

(Q/P)  (Mean P/Mean Q) = 102.56 x ($2.22/160) = -1.423,
which is also elastic.
Slide 29