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Managerial Economics

SEEG5013
Chapter 4
Datuk Prof. Mohd Yusof Kasim

Estimating Demand
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.

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

Statistical Estimation of Demand Functions:

Plot Historical Data


Price

Look at the relationship


of price and quantity
over time
Plot it
Is it a demand curve or a
supply curve?
The problem is this does
not hold other things
equal or constant.

Is this curve demand


or supply?
2004

2007

2010
2009
2008 2006

2005

quantity

Statistical Estimation of Demand Functions

Steps to take:
Specification of the model -- formulate the
demand model, select a Functional Form
linear
Q = a + bP + cY
double log
log Q = a + blog P + clog Y
quadratic
Q = a + bP + cY+ dP2

Estimate the parameters - determine which are statistically significant


try other variables & other functional forms

Develop forecasts from the model

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

Functional Forms: Linear


Linear Model Q = a + bP + cY
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) = bP/Q
Income elasticity is: EY = (Q/Y)(Y/Q)= cY/Q
The linear form is often a good approximation of
the relationship in empirical work.

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 + bLog P + cLog 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.

A Simple Linear Regression Model


Yt = a + b Xt + t

time subscripts & error term


Find best fitting line

t = Yt - a - b Xt
t2 = [Yt - a - b Xt] 2 .

mint 2= [Yt - a - b Xt] 2 .


Solution:
slope b = Cov(Y,X)/Var(X) and
intercept a = mean(Y) - bmean(X)

Y
a
_
Y
DY

_
X

DX

Simple Linear Regression:


Assumptions & Solution Methods
1. The dependent
variable is random.
2. A straight line
relationship exists.
3. The error term has a
mean of zero and a
finite variance: the
independent
variables are indeed
independent.

Spreadsheets - such as
Excel, Lotus 1-2-3, Quatro Pro,
or Joe Spreadsheet

Statistical calculators
Statistical programs such as

Minitab
SAS
SPSS
For-Profit
Mystat

Assumption 2: Theoretical
Straight-Line Relationship

Assumption 3: Error Term Has A


Mean Of Zero And A Finite Variance

Assumption 3: Error Term Has A Mean


Of Zero And A Finite Variance

FIGURE 4.4 Deviation of the Observations


about the Sample Regression Line

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.

Sherwin-Williams Case

Figure 4.5 Estimated Regression Line


Sherwin-Williams Case

T-tests
Different
samples would
yield different
coefficients
Test the
hypothesis that
coefficient
equals zero
Ho: b = 0
Ha: b 0

RULE: If absolute value of the


estimated t > Critical-t, then
REJECT Ho.
We say that its significant!

The estimated t = (b - 0) / b
The critical t is:
Large Samples, critical t2
N > 30
Small Samples, critical t is on Students t
Distribution, page B-2 at end of book, usually
column 0.05, & degrees of freedom.
D.F. = # observations, minus number of
independent variables, minus one.
N < 30

Sherwin-Williams Case
In the simple linear

regression:
Y = 120.755 + .434 X

The standard error of the


slope coefficient is .14763.
(This is usually available
from any regression
program used.)
Test the hypothesis that
the slope is zero, b=0.

The estimated t is:

t = (.434 0 )/.14763 = 2.939


The critical t for a sample of 10, has
only 8 degrees of freedom
D.F. = 10 1 independent variable 1 for
the constant.
Table B2 shows this to be 2.306 at the .05
significance level

Therefore, |2.939| > 2.306, so we reject


the null hypothesis.
We informally say, that promotional
expenses (X) is significant.

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).

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.

Analysis of Variance
R-squared is the percentage of
the variation in dependent
variable that is explained

As more variables are included,


R-squared rises
Adjusted R-squared, however,
can decline
Adj R2 = 1 (1-R2)[(N-1)/(N-K)]
As K rises, Adj R2 may decline.

^
Yt
^
Yt predicted

_
Y

_
X

FIGURE 4.7 Partitioning the Total


Deviation

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.

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

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
PromExp
.008
0.204
0.038
SellPrice
-12.202
4.582
-2.663
DispInc 2.677
3.160
0.847
.429

.017
.971
.037

Analysis of Variance
Source
Sum of Squares DF
Regression
6829.8 3
Residual
1820.1 6

p
.019

Mean Squares F
2276.6
7.5
303.4

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, thats reasonable.
As disposable income rises in a region, so does sales. Yup. Thats 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!

Soft Drink Demand Estimation


A Cross Section Of 48 States
Linear estimation yields:

Intercept
Price
Income
Temperature

Coefficients Standard Error


159.17
94.16
-102.56
33.25
1.00
1.77
3.94
0.82
Regression Statistics
Multiple R
0.736
R Square
0.541
Adjusted R Square
0.510
Standard Error
47.312
Observations
48

t Stat
1.69
-3.08
0.57
4.83

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 = (DQ/DP)(P/Q) = -102.56(2.19/200)= -1.123

The price elasticity in Nevada is = (DQ/DP)(P/Q) = -102.56(2.19/166) = -1.353


The price elasticity in Wisconsin is = (DQ/DP)(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.