Estimating Demand

Chapter 4
• A chief uncertainty for managers is the future. They 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.
• Learn how to interpret the results of
Objective of the Chapter:
regression analysis based on demand data.

2005 South-Western Publishing 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 (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

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
2007
time 2004
• Plot it
2006
» Is it a demand curve or a 2003 2002 2005
supply curve? 2008
» 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 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 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
t 2= [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
• Spreadsheets - such as
1. The dependent variable
is random » Excel, Lotus 1-2-3, Quatro Pro,
or Joe Spreadsheet
2. A straight line
• Statistical calculators
relationship exists
3. error term has a mean • Statistical programs such as
of zero and a finite » Minitab
variance » SAS
4. the independent » SPSS
variables are indeed » ForeProfit
independent » Mystat

Slide 9
Sherwin-Williams Case (Table 4.1)
• 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 10
 • 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
• The estimated t = (b - 0) /  b
coefficients
• The critical t is:
• Test the » Large Samples, critical t2
hypothesis • N > 30

that coefficient » Small Samples, critical t is on Student’s t

Distribution, page B-2 at end of book, usually
equals zero column 0.05.
• D.F. = # observations, minus number of
» Ho: b = 0
independent variables, minus one.
» Ha: b 0 • N < 30

Slide 11
 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 only 8
• The standard error of the degrees of freedom
» D.F. = 10 – 1 independent variable – 1 for the
slope coefficient is . constant.
14763. (This is usually » Table B2 shows this to be 2.306 at the .05
available from any significance level
regression program used.)• Therefore, |2.939| > 2.306, so we reject the
null hypothesis.
• Test the hypothesis that
• We informally say, that promotional expenses
the slope is zero, b=0.
(X) is “significant.”

Slide 12
 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.
Y Y Y

r = -1 r = +1 r=0

X X X
Slide 13
 Coefficient of Determination: R 2

• R-square is the percentage of Y

the variation in dependent
variable that is explained Yt
^ – ^
Yt predicted
• R2 = [Yt -Yt] 2 / [Yt - Yt] 2 _
= SSR / SST Y
• As more variables are
included, R-square rises
• Adjusted R-square, however,
can decline _
X
Slide 14
 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
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 15
 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,
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 16
 Figure 4.8 on page 133
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
Promotion .008 0.204 0.038 .971
SellPrice -12.202 4.582 -2.663 .037
DispInc 2.677 3.160 0.847 .429

Slide 17
 Interpreting Multiple Regression Output
• Write the result as an equation:
Sales = 310.245 + .008 Promotion -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, sales decline. 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 4.9 to be -2.663
» 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 18