Chapter 5

Demand
Estimation and
Forecasting
Chapter Outline

• Regression analysis
• Limitation of regression analysis
• The importance of business forecasting
• Prerequisites of a good forecast
• Forecasting techniques

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Learning Objectives

• Understand the importance of forecasting in

business
• Know how to specify and interpret a
regression model
• Describe the major forecasting techniques
used in business and their limitations
• Explain basic smoothing methods of
forecasting, such as the moving average
and exponential smoothing

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Data Collection

• Statistical analyses are only as good as the

accuracy and appropriateness of the sample
of information that is used.
• Several sources of data for business
analysis:
– buy from data providers (e.g. ACNielsen, IRI)
– perform a consumer survey
– focus groups
– technology: point-of-sale data sources

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Regression Analysis

• Regression analysis: a procedure

commonly used by economists to estimate
consumer demand with available data

Two types of regression:

– cross-sectional: analyze several variables for a
single period of time
– time series data: analyze a single variable over
multiple periods of time

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Regression Analysis

• Regression equation: linear, additive

eg: Y = a + b1X1 + b2X2 + b3X3 + b4X4

Y: dependent variable
a: constant value, y-intercept
Xn: independent variables, used to explain Y
bn: regression coefficients (measure impact
of independent variables)

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Regression Analysis

• Steps for analyzing regression results

– check coefficient signs and magnitudes

– compute elasticity coefficient

– determine statistical significance

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Regression Analysis

• Steps for analyzing regression results

– check coefficient signs and magnitudes

– compute elasticity coefficient

– determine statistical significance

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Regression Analysis

• Interpreting the regression results:

Coefficients:
– negative coefficient shows that as the
independent variable (Xn) changes, the variable
(Y) changes in the opposite direction
– positive coefficient shows that as the
independent variable (Xn) changes, the
dependent variable (Y) changes in the same
direction
– The regression coefficients are used to compute
the elasticity for each variable

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Regression Analysis

• Steps for analyzing regression results

– check coefficient signs and magnitudes

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Regression Analysis

• Steps for analyzing regression results

– check coefficient signs and magnitudes

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Regression Analysis

• Steps for analyzing regression results

– check coefficient signs and magnitudes

– compute elasticity coefficient

– determine statistical significance

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 Regression Analysis

• Steps for analyzing regression results

– compute elasticity coefficient

Where
Q = quantity demanded
X = any variable that affects Q (e.g., price or
income).

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Regression Analysis

• Steps for analyzing regression results

– compute elasticity coefficient

To estimate elasticity, we need an estimate of quantity demanded.

Suppose we are interested in estimating demand at a nonresidential
college campus in an urban setting where tuition is $14,000 per year
and the average price of a slice of pizza is $1.00 and the average
price of a soft drink is $1.10. Estimated demand in this
instance is:

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Regression Analysis

• Steps for analyzing regression results

– compute elasticity coefficient

With these estimates, we can say that the demand for pizza is somewhat
price inelastic and that there is some degree of cross-price elasticity
between soft drinks and pizza. Judging from the rather low elasticity
coefficient of 0.076, tuition does not appear to have that great an impact
on the demand for pizza

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Regression Analysis

• Steps for analyzing regression results

– check coefficient signs and magnitudes

– compute elasticity coefficient

– determine statistical significance

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Regression Analysis

• Statistical evaluation of regression results:

– t-test (t-stat/ calculated/ computed t): test of

statistical significance of each estimated
coefficient (whether the coefficient is significantly
different from zero)
b̂
t
SE b̂
b = estimated coefficient
Seb = standard error of estimated
coefficient

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Regression Analysis
• Steps for analyzing regression results
– determine statistical significance

• We also need to know the number of degrees of freedom (df)

involved in the estimate.

• The term degrees of freedom is defined as n - k -1, where

“n” represents the sample size

“k” the number of independent variables
“1” represents the constant or intercept term.

Therefore, in our pizza example, we have 30 – 5 - 1, or 24

degrees of freedom.

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Regression Analysis

• Steps for analyzing regression results

– determine statistical significance

• Turning to the t-table shown in Table A.4 in Appendix A, we see that

the critical t-value at the .05 level of significance is 1.711 using a
one-tail test and 2.064 using a two-tail test.

• If the t-value computed (t-test/ t-stat/ calculated/ computed

t) for a particular estimated coefficient is greater than 1.711, we can
say that the estimate is “significant at the .05 level” using a one-tail
test.

• If it is greater than 2.064, then the same can be said, but with a two-
tail test.

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Regression Analysis
• Steps for analyzing regression results
– determine statistical significance

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Regression Analysis

• Steps for analyzing regression results

– determine statistical significance
Using the “rule of 2” as an approximation for the .05 level of significance,
we can say that P and PR are statistically significant because their t-values
are both greater than 2 (e.g., -7.8 and -6, respectively). Tuition, and
Urban are not statistically significant at the .05 level because its t-value is
only -1.73 and -1.29.
Coefficients Standard Error t Stat P-value
Intercept 29.16132 2.200961916 13.24935177 1.56645E-12
Pslice -0.09257 0.011826878 -7.82717791 4.63514E-08
Tuition 0.05976 0.034521997 1.730945333 0.096300329
Psoftdrink -0.08185 0.012899259 -6.345497187 1.46612E-06
Urban -0.74684 0.575019329 -1.298814793 0.206348359
Residential -3.04912 0.492581426 -6.190082861 2.13908E-06

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Regression Analysis

• Statistical evaluation of regression results:

– ‘rule of 2’: if absolute value of t is greater than 2,

estimated coefficient is significant at the 5%
level (for large samples-for small samples, need
to use a t table)

– if coefficient passes t-test, the variable has a

significant impact on demand

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Regression Analysis

• Statistical evaluation of regression results

– R2 (coefficient of determination): percentage of

variation in the variable (Y) accounted for by
variation in all explanatory variables (Xn)
R2 value ranges from 0.0 to 1.0
The closer to 1.0, the greater the explanatory power of
the regression.

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Regression Analysis

• Statistical evaluation of regression results

– F-test: measures statistical significance of the

entire regression as a whole (not each
coefficient)

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Regression Analysis

• Textbook example: Management lessons

from estimating demand for pizza
– demand for pizza affected by
1. price of pizza
2. price of complement (soda)
– managers can expect price decreases to lead to
lower revenue
– tuition and location are not significant

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Regression Analysis
– In statistical analysis, it is often as important to find out
what does not pass the t-test as much as it is to find out
what passes. In our example, we learned that tuition and
location do not have statistically significant impacts on
pizza demand. Moreover, the magnitudes of their
coefficients were relatively small.

– For managers of national chains such as Pizza Hut or

Domino’s, this would indicate that they would not have to
be very concerned about the type of college (private or
public) or its location (urban or rural) in deciding where to
open pizza franchises. They will, however, face competition
from dining halls at residential colleges.

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Regression Analysis

• Challenges
– Identification
– Multicollinearity
– Autocorrelation

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Regression Analysis

• Challenge 1: Identification problem:

– The estimation of demand may produce biased
results due to simultaneous shifting of supply
and demand curves.
– Solution: use of advanced correction techniques,
such as two-stage least squares and indirect
least squares may compensate for the bias

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Regression Analysis

• Challenge 2: Multicollinearity problem

– Two or more independent variables are highly
correlated, thus it is difficult to separate the
effect each has on the dependent variable.
– Solution: a standard remedy is to drop one of the
closely related independent variables from the
regression

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Regression Analysis

• Challenge 3: Autocorrelation problem

– Also known as serial correlation, occurs when the
dependent variable relates to the Y variable
according to a certain pattern
– Note: possible causes include omitted variables,
or non-linearity; Durbin-Watson statistic is used
to identify autocorrelation
– Solution: to correct autocorrelation consider
transforming the data into a different order of
magnitude or introducing leading or lagging data

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Summary

• Regression analysis is a primary tool used by

businesses to understand demand.
• Reliable input data and proper estimation and
evaluation are needed.
• Forecasting is an important activity in many
organizations. In business, forecasting is a
necessity.
• This chapter summarized and discussed six of the
major forecasting techniques used by businesses.

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