20-Jul-10

SEEG 5013 Managerial Economics

Topic 3: Demand Estimation Chapter 4: Demand Estimation

Lecture objectives
o To examine some general difficulties encountered in deriving the demand curve for a product from market data.

Dr. Hj. Mohd Razani Hj. Mohd Jali FE 0.55 (Economics Building) College of Arts and Sciences razani@uum.edu.my 04-928 3524

o To discuss some marketing research approaches to demand estimation. o To discuss regression analysis as the most useful and common method of demand estimation.
2

The identification problem

Demand curve for commodity estimated from market data on quantity purchased of the commodity at various prices over time (time series data) or for various consuming units or markets at one point in time (crosssectional data).

The identification problem

What it is not: Simply joining the price-quantity observations on a graph does not generate the demand curve for the commodity. Reason: Each price-quantity observations is given by the intersection of a different (but observed) demand and supply curve of the commodity.
3 4

The identification problem

Over time - Demand for the commodity shifts or differs because of changes in tastes, incomes, price of related commodities, etc. Supply curve shifts or differs because of changes in technology, factor prices and weather conditions (for agricultural commodities).

The identification problem

The equilibrium of different but unknown demand and supply curves generates different price-quantity points observed. Thus, by simply joining the different price-quantity observations, we do not generate demand curve for commodity. It is not that simple. This is referred to as the identification problem.

20-Jul-10

Marketing Research Approaches to Demand Estimation

Consumer Surveys
data from survey questions

Observational Research
data from observed behavior

Consumer Clinics
data from laboratory experiments

Market Experiments
data from real market tests
7 8

Market research approaches to demand estimation

Consumer surveys: Involve questioning sample of consumers about how they respond to changes in price of commodity, income, price of related commodities, advertising expenditures, credit incentives and other determinants of demand.

Market research approaches to demand estimation

Problem with consumer surveys: Biased. Respondent cannot give accurate answers to things that have not happen yet (eg. Reaction to price change to commodity consumption) Can be very expensive.

10

Market research approaches to demand estimation

Observational research: Gathering of info on consumer preferences by watching them buying and using products. Using scanners at stores see how many people normally buys the product or how many people buys the product after the commercial, etc.

Market research approaches to demand estimation

Problems: Observation alone not enough to understand consumers response. Cannot determine consumers demographic characteristics age, sex, education, income, etc.

11

12

20-Jul-10

Market research approaches to demand estimation

Consumer clinics: Laboratory experiments where participants are given a sum of money and asked to spend in a simulated store to see how they react to changes in price, packaging, displays, price of competing products, etc. Participants can be selected to represent socio-economic characteristics of the actual market.
13

Market research approaches to demand estimation

Problems: Questionable results because its not real market environment. Cost of conducting experiments is high can only use small sample. Cannot represent market behavior.

14

Market research approaches to demand estimation

Market experiments: Conducted in actual marketplace. Select several markets with similar socioeconomic characteristics and change product price, packaging, promotion, etc. in different stores; and record consumer responses (purchases) in different markets.

Market research approaches to demand estimation

Market experiments: Can be conducted in large scale ensure validity of the result. Consumers not aware of the experiment, would act naturally to changes. Useful in process of introducing new product where no data exist yet.

15

16

Market research approaches to demand estimation

Problems: Cost is high. Can be conducted on limited scale or short period of time. Cannot prevent extraneous occurrences bad weather, may bias the result. Competitors can sabotage the experiment by changing price and other determinants under their control.
17

Market research approaches to demand estimation

Problems: Competitors can also observe the experiment and gain information that benefit them. Firm might lose customer when they raise price for their product in the experiment. The customer may find another product that he/she likes to replace the firms product.

18

20-Jul-10

Regression Analysis
Assume that a manager wants to determine relationship between the firms advertising expenditures and its sales revenue. test the hypothesis that higher advertising expenditures lead to higher sales and estimate strength of the relationship.

Regression Analysis
Rate on advertising expenditures and sales revenue:
Level of advertising expenditures (X) independent variable. Sales revenue (Y) dependent variable.

19

20

Regression Analysis

21

22

Regression Analysis
Year 1 2 3 4 5 6 7 8 9 10 X 10 9 11 12 11 12 13 13 14 15 Y 44 40 42 46 48 52 54 58 56 60
23

Regression Analysis
Scatter diagram shows positive relationship between level of firms advertising expenditures and its sales revenue higher advertisement associated with higher revenue. The relationship is approximately linear.

Scatter Diagram

24

20-Jul-10

Regression Analysis
Regression Line: Line of Best Fit Regression Line: Minimizes the sum of the squared vertical deviations (et) of each point from the regression line. Ordinary Least Squares (OLS) Method

Regression Analysis
To estimate the approximate linear relationship between firms advertising expenditures and sales revenue draw in line that best fit between data points.

25

26

Regression Analysis
The slope of line will provide an estimate of the increase in sales revenue that the firm can expect with each $1 million increase in its advertising expenditures. This gives rough estimate of linear relationship between sales revenue (Y) and advertising expenditures (X). Y = a + bX

27

28

Regression Analysis
Y = a + bX a is vertical intercept of linear relationship and gives the value of Y when X = 0, while b is slope of line and gives estimate of increase in Y resulting from each unit increase in X.

Regression Analysis
Problem: Different researcher/manager would fit a somewhat different line to the same data point and obtain different results.

29

30

20-Jul-10

Regression Analysis
Regression analysis is a statistical technique for obtaining the line that best fit data points according to an objective statistical criterion. Thus, all researchers looking at the same data would get exactly the same result. Regression line is obtained by minimizing the sum of the squared vertical deviations of each points from the regression line called ordinary least-squares method (OLS).
31 32

Exercise
You are a newly hired marketing trainee for a corporation in the local community. Senior management has wondered how other local firms view your companys reputation. One suggestion is to call a variety of managers from a master contact list of firms that your firm has done business with over the last 12 months and ask them what they think of the company. How reliable is this kind of survey method?
33

Solution
Using the firms own contact list is a very limited, non-random sample of the population of all local firms. The list suffers from sample bias (firms already doing business are likely to favorably view the firm) and probably response bias (respondents might provide ultra-favorable responses, what they believe the firm wants to hear).
34

Exercise
What are the major advantages and drawbacks of using controlled customer experiments to determine demand?

Solution
An advantage is that experiments require subjects to make actual decisions, rather than indicating preferences and behavior. The results are more likely to reflect true preferences. A drawback is that subjects know they are part of an experiment, and may not respond accurately. Second, experiments tend to be of small scale and of short duration, so that accuracy is limited.
35 36

20-Jul-10

Exercise
What are the major advantages and drawbacks of using controlled market studies to estimate demand?

Solution
The major advantage is that a firm can alter one or more key decision variables in one market and compare the outcome to another similar market in which the variables did not change, or were changed in a different manner. The method can generate valuable information about pricing and advertising policy. The main drawback is that all other factors (including population size and demographics, consumer incomes, tastes, competitor prices) must be comparable. Of course, this is not always possible. Controlled market studies are also expensive to conduct.
37 38

Exercise
How can regression analysis use uncontrolled data to estimate demand?

Solution
Regression analysis uses uncontrolled data to generate an equation that allows one to measure the separate influences of multiple explanatory variables (in the form of numerical coefficients) on total demand. In addition, the analysis provides statistics that measure the accuracy (goodness of fit) of the equation. Accordingly, the regression approach can produce the same kinds of results as a carefully controlled market study.
39 40

Simple Regression Analysis

Ordinary Least-Squares (OLS) Model: Yt a bX t et
a bX Y t t et Yt Y t
n

Simple Regression Analysis

The Ordinary Least-Squares (OLS) Method Objective: Determine the slope and intercept that minimize the sum of the squared errors.

n n 2 t 2
n t 1

) bX e (Y Y ) (Y a
t 1 t 1 t t t 1 t t

t 1 is the sum of all observations, from time t=1 to t=n.

41 42

20-Jul-10

Ordinary Least Squares (OLS)

The estimated values of a and b are obtained by minimizing the sum of the squared deviations. The value of b is given by
b

Ordinary Least Squares (OLS)

Estimation Example

(X
t 1 n t 1

Time

Xt
10 9 11 12 11 12 13 13 14 15 120

Yt
44 40 42 46 48 52 54 58 56 60 500

Xt X
-2 -3 -1 0 -1 0 1 1 2 3
n

Yt Y
-6 -10 -8 -4 -2 2 4 8 6 10

( X t X )(Yt Y )
12 30 8 0 2 0 4 8 12 30 106

( X t X )2
4 9 1 0 1 0 1 1 4 9 30

X )(Yt Y )
t

(X

Y bX a

X)

1 2 3 4 5 6 7 8 9 10
n

n 10
n

X
t 1

120
n

Y 500
t 1 t

(X
t 1 n

X ) 2 30 X )(Yt Y ) 106

106 3.533 b 30

X 120 X t 12 10 t 1 n
43

Y 500 Y t 50 10 t 1 n

(X
t 1

50 (3.533)(12) 7.60 a

Ordinary Least Squares (OLS)

Estimation Example

Ordinary Least Squares (OLS)

Caution when using the regression line to estimate sales revenue of the firm for advertising expenditure very different from those used in the estimation of the regression line itself. Regression line should be used only to estimate the sales revenue of a firm resulting from advertising expenditures that were within the range or that at least near the advertising values that are used in the estimation of the regression line.
46

n 10

X
t 1 n

X t 120 12 n 10

X
t 1
n t 1 n

120

Y 500
t 1 t

Y
t 1

Yt 500 50 n 10

(X
(X
t 1

X ) 2 30 X )(Yt Y ) 106

106 3.533 b 30

50 (3.533)(12) 7.60 a

Ordinary Least Squares (OLS)

Regression analysis is based on a number of assumptions: The error term
is normally distributed, has zero expected value or mean, has constant variance in each time period and for all values of X, its value in one time period is unrelated to its value in any other period.

Tests of significance of parameter estimates

Estimate of slope coefficient from different sample of adverts sales data would obtain different result/estimate of slope coefficient. The greater is the dispersion of the estimated value of b, the smaller is the confidence that we have in our single estimated value of the b coefficient.

These assumptions are required so as to obtain unbiased estimates of the slope coefficient and to be able to utilize probability theory to test for the reliability of estimates.
47

48

20-Jul-10

Tests of significance of parameter estimates

To test the hypothesis that b is statistically significant (adverts positively affects sales), we need to calculate the standard error (deviation) of b. This can be done with regression analysis using computer programs.

Tests of Significance
Standard Error of the Slope Estimate

sb

(Y Y ) ( n k ) ( X X )
2 t t

e (n k ) ( X
2 t

X )2

49

Tests of Significance
Example Calculation
Time
1 2 3 4 5 6 7 8 9 10

Tests of Significance
Example Calculation
( X t X )2
4 9 1 0 1 0 1 1 4 9 30

Xt
10 9 11 12 11 12 13 13 14 15

Yt
44 40 42 46 48 52 54 58 56 60

Y t
42.90 39.37 46.43 49.96 46.43 49.96 53.49 53.49 57.02 60.55

et Yt Y t
1.10 0.63 -4.43 -3.96 1.57 2.04 0.51 4.51 -1.02 -0.55

)2 et2 (Yt Y t
1.2100 0.3969 19.6249 15.6816 2.4649 4.1616 0.2601 20.3401 1.0404 0.3025 65.4830

e (Y Y )
t 1 2 t t 1 t t

65.4830

(X
t 1

X ) 2 30
65.4830 0.52 (10 2)(30)

e (Y Y )
t 1 2 t t 1 t t

65.4830

(X
t 1

X ) 30
2

sb

(Y Y ) ( n k ) ( X X )
2 t t

sb

65.4830 0.52 (10 2)(30)

(Y Y ) ( n k ) ( X X )
2 t t

Tests of Significance
Calculation of the t Statistic

Tests of goodness of fit and correlation

Besides testing for statistical significance of particular estimated parameter, we can also test for the overall explanatory power of the entire regression. This is accomplished by calculating the coefficient of determination, denoted by R2 the coefficient of determination. Coefficient of determination is defined as the proportion of the total variation or dispersion in the dependent variable, that is explained by the variation in the independent or explanatory variable in the regression.
54

3.53 b 6.79 sb 0.52

Degrees of Freedom = (n-k) = (10-2) = 8 Critical Value at 5% level =2.306

20-Jul-10

Tests of goodness of fit and correlation

R2 measures how much of the variation in the firms sales is explained by the variation in its advertising expenditures. The closer the observed data points fall to the regression line, the greater is the proportion of the variation in the firms sales explained by the variation in its adverts expenditures, and the larger is the value of the coefficient of determination, R2.
55

Questions or comments?

Reference: Salvatore (2008), Ch. 4

10