Managerial Economics

Estimation of Demand
 How to estimate a demand
equation?
 How to calculate demand
elasticities?
 Is this how it’s done?
Last This %
Year Year Change Change
Price $4 $5 $1 +25%
Q 8 10 2 +25%

Ep = +25% / +25% = + 1
Questions:
1) Is Ep = + 1?
2) What’s the right way to do it?
Estimation of Demand
I. The Direct Methods
 Interviews and Surveys
 Market Experimentations and
Simulations

II. The indirect Methods

 Regression Estimation of Consumer
Demand
 Interviews and Surveys
Ask buyers or potential buyers about their
likely reactions to a change in each of the
demand determinants.

Practical Issues:
 Randomness of the sample
 Interviewer bias
 The best-of-intentions problem
 Confusing questions and confusing answers
 Simulation and Market
Experimentations

Simulation of consumer responses

in constructed market situations
Test-market experiments in
selected markets
 Regression Analysis
of Consumer Demand

A statistical technique that attempts

to "explain" or "predict" movements
in one economic variable, the
dependent variable, as a function of
the movements of a set of
independent (explanatory)
variables.
Desirable Characteristics
 It shows explicitly the association between the
dependent variable and the independent
variables.
 It also provides statistical reliability allowing
the researchers to measure the reliability of
the prediction.
 In Econometrics, the economists call it:
‘BLUE’ property.
 Procedure of Regression Analysis

1. Specifying the variables

2. Obtaining data on the variables
3. Specifying the form of the
estimation equation
4. Estimate the regression
parameters using the method of
least squares.
Demand and Elasticity Estimation
Step 1 - The model:

Q = f(A, Px, and Pq), where

Q = Number of 2-year contracts sold

A = Advertising expenditures (in dollars)

Px = Price of 1-year contract (in dollars)

Pq = Price of 2-year contract (in dollars)

 The Data

 Time-series data for 1986-97 and the

effect of inflation
 Time-series data and the effect of
serial correlation
 N=12, K=4, 8 degrees of freedom
Estimation of 2 Equations
The 1st Equation - Linear

Q = a + b 1 A + b 2 Px + b 3 Pq

The 2nd Equation - multiplicative

Q = aAb1Pxb2 Pqb3
 The Estimated 1st Equation

Q = 4,589.08 + 0.01015 A + 16.40334 Px - 10.82852 Pq

s.e. (0.00410) (5.35702) (3.77846)

t stat 2.47576 3.06202 -2.86586
p-value 0.00384 0.01553 0.02096

Adj R2 = 0.69127, F=9.20976 (p=0.00566)

SEE=52.98, N=12, K=4
 Evaluation of Regression Estimation
1. The coefficient of determination (R2) -
How well does the regression line fit the
data?
2. The F-Test - Does the estimated equation
have sufficient explanatory power?
3. The t-Test - Is each of the independent
variables statistically significant?
4. The Standard Error of the Estimate (SEE) -
Can the confidence interval of the predicted
value for the dependent variable be
estimated?
The Standard Error of the
Estimate (SEE)
How accurate is the predicted sales?
The SEE can be used to construct prediction intervals
If SEE = 53, then and approximate 95% prediction
interval for the sales of 2-year contracts is equal to
Q’ + 2(53)
 Uses of the 1st Equation
The demand curve for explaining demand
relationships and for predicting demand
Estimation of the arc elasticities of demand
using

Q1-Q2 Pq1 - Pq2

Ep = ----------- ---------------
Q1+Q2 Pq1+ Pq2

Estimation of the point elasticities of demand

using ep = (dQ/dPq)(Pq/Q)
The Multiplicative Equation

Q = aAb1Pxb2Pqb3
Two key questions:
What are the advantages of the
multiplicative form over the linear form
How to go about estimating this non-linear
equation?
See pp. 154-56 of McGuigan/Moyer/Harris,
10th ed. for details
The Advantages of the
Multiplicative Form
Q = a Ab1Pxb2 Pqb3

dQ/dPq = (b3) (aAb1Pxb2 Pqb3 -1)

Since epq = (dQ/dPq)(Pq/Q),

epq = (b3)(aAb1Pxb2 Pqb3 -1)(Pq/Q)

= (b3)[(aAb1Pxb2 Pqb3)/Q]

= b3
 How to estimate the parameters of
the multiplicative equation?

Converting the multiplicative equation

Q = a Ab1Pxb2 Pqb3

into the natural-log form, we have:

Ln Q = Ln a + b1 Ln A + b2 Ln Px + b3 Ln Pq