Demand Estimation

“Deriving and Interpreting

Demand Equations”

The "Minivans" Case

1
 Zip Code Avg. Price Quantity Begin with
48104 18.78 55 only a small
43231 18.99 54 amount of
60202 20.87 23 information ...
70803 20.23 38 sales and
90048 18.99 28 price data
30064 18.46 47 broken down
95616 19.58 35
by zip code.
32611 20.91 37
94720 19.45 33
50311 19.77 35 The manufacturer
80231 20.45 30 has these data if
it tracks where its
20902 20.02 41 customers live,
93106 22.45 2 and what they paid.
45244 18.55 51
(Here average price is measured in thousands of $.)

2
A Few Simple Statistics ...
Average sales per zip code = 32.84.
Median sales = 33.
Average price per mini-van = 20.11 (or $20,110).
Median price = 20.04.

Already we can construct a primitive demand

curve, which is nothing more or less than a
description of the relationship between price
and quantity ...

3
 ANNUAL DEMAND FOR THE FIRM'S MINI-VANS

25

20
PRICE ($1000s)

15
Series1

10

0
0 10 20 30 40 50 60

SALES (WITHIN ZIP CODE)

Price = 22.74 - 0.08*Quantity 4

Of course, price is not the only
factor influencing sales ...
Income: Average household income in thousands of dollars.

Population: The population of the zip code in thousands.

% under 18: The percentage of the population under 18 years old.

Chrysler’s price: The average price (in $1000s) of the Chrysler mini-vans
sold in this zip code.

Advertising: The advertising expenditures (in $1000s) in each zip code

directed at mini-van purchasers.

5
 We can easily get more data ...
Location Zip Avg. Price Quantity Incom e Population % Under 18 Chrysler "Advertising"
Ann Arbor 48104 18.78 55 36.67 20.01 25.67 22.97 0.41
Westerville 43231 18.99 54 29.33 24.46 33.24 19.17 4.83
Evanston 60202 20.87 23 36.97 17.67 23.13 19.45 3.94
Baton Rouge 70803 20.23 38 30.97 17.94 29.33 20.36 2.56
Los Angeles 90048 18.99 28 32.65 25.88 17.97 18.76 0.21
Marietta 30064 18.46 47 27.85 20.77 30.76 20.01 3.67
Davis 95616 19.58 35 36.52 21.32 22.67 20.74 0.32
Gainesville 32611 20.91 37 34.24 21.76 28.36 19.88 0.53
Berkeley 94720 19.45 33 34.64 23.58 29.47 18.66 0.35
Des Moines 50311 19.77 35 27.36 21.46 28.93 18.87 5.23
Denver 80231 20.45 30 27.87 21.53 28.39 19.19 3.82
Wheaton 20902 20.02 41 28.76 22.87 29.82 19.01 4.91
Santa Barbara 93106 22.45 2 43.66 11.62 15.12 18.25 0.88
Cincinnati 45244 18.55 51 29.02 22.51 31.85 19.77 3.75

6
 Location Zip Avg. Price Quantity Incom e Population % Under 18 Chrysler "Advertising"
Ann Arbor 48104 18.78 55 36.67 20.01 25.67 22.97 0.41
Westerville 43231 18.99 54 29.33 24.46 33.24 19.17 4.83
Evanston 60202 20.87 23 36.97 17.67 23.13 19.45 3.94
Baton Rouge 70803 20.23 38 30.97 17.94 29.33 20.36 2.56
Los Angeles 90048 18.99 28 32.65 25.88 17.97 18.76 0.21
Marietta 30064 18.46 47 27.85 20.77 30.76 20.01 3.67
Davis 95616 19.58 35 36.52 21.32 22.67 20.74 0.32
Gainesville 32611 20.91 37 34.24 21.76 28.36 19.88 0.53
Berkeley 94720 19.45 33 34.64 23.58 29.47 18.66 0.35
Des Moines 50311 19.77 35 27.36 21.46 28.93 18.87 5.23
Denver 80231 20.45 30 27.87 21.53 28.39 19.19 3.82
Wheaton 20902 20.02 41 28.76 22.87 29.82 19.01 4.91
Santa Barbara 93106 22.45 2 43.66 11.62 15.12 18.25 0.88
Cincinnati 45244 18.55 51 29.02 22.51 31.85 19.77 3.75

We may want ... but we can not ignore the

to look at the influence other variables have
relationship on the number of mini-vans sold.
between price
and quantity .... 7
Just as we graphed the relationship between
price and quantity sold, we can graph ...

THE RELATIONSHIP BETWEEN SALES AND INCOME

45
40
IN COME ($1000s)

35
30
25 Series1
20
15
10
5
0
0 10 20 30 40 50 60

SALES

It appears that there is a slight NEGATIVE relationship. 8

 Just as we graphed the relationship
between price and sales, we can graph ...
THE RELATIONSHIP BETWEEN SALES AND POPULATION
ZIP CODE POPULATION (THOUSANDS)

30

25

20

Series1
15

10

0
0 10 20 30 40 50 60

SALES

It appears that there is a strong positive relationship. 9

Just as we graphed the relationship between
price and sales, we can graph ...
THE RELATION BETWEEN SALES AND CHILDREN
% OF POPULATION UNDER 18 YEARS OLD

35

30

25

20
Series1

15

10

0
0 10 20 30 40 50 60

SALES

It appears that there is a strong positive relationship. 10

Just as we graphed the relationship between
price and sales, we can graph ...
THE RELATIONSHIP BETWEEN SALES AND ADVERTISING

5
ADVERTISING ($1000s)

Series1
3

0
0 10 20 30 40 50 60

SALES

It appears that there is NO strong relationship. 11

Just as we graphed the relationship between
price and sales, we can graph ...
RELATIONSHIP BETWEEN SALES AND CHRYSLER'S PRICE

25
CHRYSLER'S PRICE ($1000s)

20

15
Series1

10

0
0 10 20 30 40 50 60

SALES

It appears that there is only a slight POSITIVE Relationship.

12
What we have done so far:
• Taken readily available price and sales quantity data on our
customers, gathered by zip code.
• Matched these data with cheap and readily available demographic
data on the residents of each zip code.
• Graphed the data two variables at a time, to form some initial
impressions.

What we have concluded so far (very tentative):

· This manufacturer faces intense price competition. Small price
changes lead to large changes in sales.
· This manufacturer’s product appears to be an “inferior” good: as
people become wealthier, they shun the product in favor of other
brands or goods.
· As expected, mini-van sales increase along with population and the
number of children.
· The company’s advertising program does not seem to have a strong
link with higher sales.

13
 Our objective:
Isolate the effect price has on sales,
holding all other variables constant.

But how?

14
 What happens if I divide my zip
codes up so that they have very
similar residents?
Location Category # Zip Avg. Price Q Income Population % < 18 Ad$ Chrysler
Evanston, IL Affluent 3 60202 20.87 23 36.97 17.67 23.13 3.94 19.45
Santa Barbara, CA Affluent 13 93106 22.45 2 43.66 11.62 15.12 0.88 18.25
Water Mill, NY Affluent 15 11976 23.01 7 41.35 10.11 19.36 3.44 20.23
Irvine, CA Affluent 17 92717 19.95 20 39.61 14.37 24.12 0.87 18.45
Park Ridge, IL Affluent 18 60068 20.76 24 37.89 14.39 28.45 4.62 19.18
San Francisco, CA Affluent 20 94102 20.34 12 39.88 16.63 17.52 1.32 18.15
Rutherford, NJ Affluent 26 7070 20.06 25 37.38 17.36 20.46 4.37 20.77
New Rochelle, NY Affluent 43 10801 21.22 21 40.85 16.93 19.47 3.88 19.48

For example, we could group all of the more affluent zip

codes together.

15
 We can create other
categories, too….

• College towns
• Urban/mixed
• Zip codes with many young families
• “Other”

16
 What happens if I divide my zip
codes up so that they have very
similar residents?
Category Income Price Sales Population % < 18 Chrysler Adve
Affluent 39.7 21.1 16.8 14.9 21 19.2 2
College Town 34.4 20.4 35.9 18.8 26 20.9 1
Urban/Mixed 30.6 20.5 28.1 22.6 27 19.1 0
Families 28.4 19 43.7 22.2 31 19.5 4

Notice that affluent zip codes share more than just high income.
They also tend to have lower populations and a smaller fraction of children.
This does not completely solve the problem, but it helps.
17
 INCOME AND SALES -- AFFLUENT ZIP CODES

44 Here is the
42
cause of the
IN COME

40 Series1

38
negative
36 relationship!
0 5 10 15 20 25

SALES

INCOME AND SALES -- COLLEGE TOWN ZIP CODES

40
IN COME

30
20 Series1
10
0
0 10 20 30 40 50 60

SALES
18
 INCOME AND SALES -- URBAN/MIXED ZIP CODES

40
30
IN COME

20 Series1

10
0
0 5 10 15 20 25 30 35

SALES

Income and Sales--Young Families

32

31

30
Income

29 Series1
28

27

26
0 10 20 30 40 50 60

Sales

19
Must we limit ourselves to
looking at just two
variables at a time, or is
there some way to
express a relationship
between all of the
variables?

20
 Expressing an “over-arching”
mathematical relationship:
Estimated Quantity = - 32.5

- 4.22*(Price)

+ 0.31*(Income)

+ 0.92*(Population)

+ 1.13*(% of Population < 18 Years)

+ 0.94*(Advertising)

+ 4.52*(Chrysler’s Price)

21
 Application #1:
forecasting demand in new markets
Estimated Quantity = - 32.5

- 4.23*(Price)
Suppose the manufacturer
enters a new region of + 0.32*(Income) 34.40
the country. Among the
new zip codes where it
+ 0.92*(Population) 18.8
expects sales is one with 26.0
the characteristics here.
+ 1.13*(% of Population < 18 Years)

+ 0.94*(Advertising) 1.10

+ 4.52*(Chrysler’s Price) 20.90

22
 Application #1:
forecasting demand in new markets
Estimated Quantity = - 32.5

If we substitute all of this
information into the
demand relationship, we
can express sales as a
function of price alone ...
- 4.23*(Price)
+ 0.32*(Income) 34.40
+ 0.92*(Population) 18.8
26.0
+ 1.13*(% of Population < 18 Years)

+ 0.94*(Advertising) 1.10

+ 4.52*(Chrysler’s Price) 20.90

Estimated Quantity = 121.5 - 4.23*(Price) 23

If we solve this for price on the left-hand side, we get

Price = 28.8 - 0.24*Quantity

Price
($1000s)

28.8

slope = -0.24 = D(price)/D(sales)

Sales in
121.52 this zip code
24
 Application #2: forecasting
demand in existing markets
Estimated Quantity = - 32.5

- 4.23*(Price)
Suppose the manufacturer
wants to know the relation- + 0.32*(Income) 29.33
ship between price and
sales in Westerville, Ohio,
+ 0.92*(Population) 24.46
a market it already serves. 33.24
Then ...
+ 1.13*(% of Population < 18 Years)

+ 0.94*(Advertising) 4.83

+ 4.56*(Chrysler’s Price) 19.17

Estimated Quantity = 128.7 - 4.23*(Price) 25

 Application #2: forecasting
demand in existing markets
Estimated Quantity= - 32.5

But this reflects demand in
Westerville, Ohio LAST
YEAR. Suppose that this
year Westerville looks the
same, except that it has
2000 more people. Then ...
- 4.23*(Price)
+2.0
+ 0.32*(Income) 29.33
+ 0.92*(Population) 24.46
33.24
+ 1.13*(% of Population < 18 Years)

+ 0.94*(Advertising) 4.83

+ 4.52*(Chrysler’s Price) 19.17

130
Estimated Quantity = 128.7 - 4.23*(Price) 26
 Price
At every price, the firm can
($1000s) expect to sell more mini-vans.
30.7

30.4 slope = -0.24 = D(price)/D(quantity)

Q sold in
Q1 Q2 128.7 130 this zip code
27
 Application #3: Assessing the
impact of a change in a rival’s price
Estimated Quantity = - 32.5

Now ... suppose that in
addition to the 2000 new
people, Chrysler lowers its
price by $1800 on average.
Then ...
- 4.23*(Price)
+2.0
+ 0.32*(Income) 29.33
+ 0.92*(Population) 24.46
33.24
+ 1.13*(% of Population < 18 Years)

+ 0.94*(Advertising) 4.83 -1.8

+ 4.52*(Chrysler’s Price) 19.17

121.8 130
Estimated Quantity = 128.7 - 4.23*(Price) 28
 Price
A decrease in Chrysler’s price
($1000s) causes demand to shift back in.
30.7

30.4 slope = -0.23 = D(price)/D(quantity)

28.8

Q Sold in
121.8 this zip code
29
 Application #4: assessing the
performance of individual dealers
Estimated Quantity = - 32.5

- 4.23*(Price)
The key word here
is “estimated.” We + 0.32*(Income)
can not forecast
sales perfectly. + 0.92*(Population)

+ 1.13*(% of Population < 18 Years)

+ 0.94*(Advertising)

+ 4.52*(Chrysler’s Price)

30
 Let’s look at the table again ...
Location Income Price Population % < 18 Chrysler Ad $ Quantity Estimate Difference
Evanston, IL 36.97 20.87 17.67 23.13 19.45 3.94 23 25 -2
Santa Barbara 43.66 22.45 11.62 15.12 18.25 0.88 2 -3 5
Water Mill, NY 41.35 23.01 10.11 19.36 20.23 3.44 7 9 -2
Irvine, CA 39.61 19.95 14.37 24.12 18.45 0.87 20 20 0
Ann Arbor, MI 36.67 18.78 20.01 25.67 22.97 0.41 55 51 4
BatonRouge, LA 30.97 20.23 17.94 29.33 20.36 2.56 38 36 2
Ithaca, NY 37.83 22.01 16.94 21.45 21.23 0.26 28 22 6
Philadelphia, PA 27.45 21.57 22.07 30.11 21.69 0.63 25 38 -13
Boston, MA 27.45 22.03 21.87 24.64 19.01 0.57 14 18 -4
Atlanta, GA 31.17 21.04 23.18 30.11 18.85 0.93 35 29 6
Westerville, OH 29.33 18.99 24.46 33.24 19.17 4.83 54 47 7
Marietta, GA 27.85 18.46 20.77 30.76 18.85 3.67 47 41 6
Des Moines, IA 27.36 19.77 21.46 28.93 20.43 5.23 35 42 -7
Cincinnati, OH 29.02 18.55 22.51 31.85 18.87 3.75 51 43 8
Nashville, TN 33.57 20.01 24.22 27.56 20.21 0.25 26 38 -12
Holland, MI 29.47 18.95 24.16 29.34 18.78 0.67 45 37 8

There are two additional columns at the end

31
 The first of these columns takes
information from each row ...
Location Income Price Population % < 18 Chrysler Ad $ Quantity Estimate Difference
Evanston, IL 36.97 20.87 17.67 23.13 19.45 3.94 23 25 -2
Santa Barbara 43.66 22.45 11.62 15.12 18.25 0.88 2 -3 5
Water Mill, NY 41.35 23.01 10.11 19.36 20.23 3.44 7 9 -2
Irvine, CA 39.61 19.95 14.37 24.12 18.45 0.87 20 20 0
Ann Arbor, MI 36.67 18.78 20.01 25.67 22.97 0.41 55 51 4
BatonRouge, LA 30.97 20.23 17.94 29.33 20.36 2.56 38 36 2
Ithaca, NY 37.83 22.01 16.94 21.45 21.23 0.26 28 22 6
Philadelphia, PA 27.45 21.57 22.07 30.11 21.69 0.63 25 38 -13
Boston, MA 27.45 22.03 21.87 24.64 19.01 0.57 14 18 -4
Atlanta, GA 31.17 21.04 23.18 30.11 18.85 0.93 35 29 6
Westerville, OH 29.33 18.99 24.46 33.24 19.17 4.83 54 47 7
Marietta, GA 27.85 18.46 20.77 30.76 18.85 3.67 47 41 6
Des Moines, IA 27.36 19.77 21.46 28.93 20.43 5.23 35 42 -7
Cincinnati, OH 29.02 18.55 22.51 31.85 18.87 3.75 51 43 8
Nashville, TN 33.57 20.01 24.22 27.56 20.21 0.25 26 38 -12
Holland, MI 29.47 18.95 24.16 29.34 18.78 0.67 45 37 8

... and forms an estimate of sales

based upon the demand equation. 32
 The last column lists the difference
between estimated sales and actual sales ...
Location Income Price Population % < 18 Chrysler Ad $ Quantity Estimate Difference
Evanston, IL 36.97 20.87 17.67 23.13 19.45 3.94 23 25 -2
Santa Barbara 43.66 22.45 11.62 15.12 18.25 0.88 2 -3 5
Water Mill, NY 41.35 23.01 10.11 19.36 20.23 3.44 7 9 -2
Irvine, CA 39.61 19.95 14.37 24.12 18.45 0.87 20 20 0
Ann Arbor, MI 36.67 18.78 20.01 25.67 22.97 0.41 55 51 4
BatonRouge, LA 30.97 20.23 17.94 29.33 20.36 2.56 38 36 2
Ithaca, NY 37.83 22.01 16.94 21.45 21.23 0.26 28 22 6
Philadelphia, PA 27.45 21.57 22.07 30.11 21.69 0.63 25 38 -13
Boston, MA 27.45 22.03 21.87 24.64 19.01 0.57 14 18 -4
Atlanta, GA 31.17 21.04 23.18 30.11 18.85 0.93 35 29 6
Westerville, OH 29.33 18.99 24.46 33.24 19.17 4.83 54 47 7
Marietta, GA 27.85 18.46 20.77 30.76 18.85 3.67 47 41 6
Des Moines, IA 27.36 19.77 21.46 28.93 20.43 5.23 35 42 -7
Cincinnati, OH 29.02 18.55 22.51 31.85 18.87 3.75 51 43 8
Nashville, TN 33.57 20.01 24.22 27.56 20.21 0.25 26 38 -12
Holland, MI 29.47 18.95 24.16 29.34 18.78 0.67 45 37 8

33
 We can then go to our dealers in
Philadelphia and Nashville ...
Location Income Price Population % < 18 Chrysler Ad $ Quantity Estimate Difference
Evanston, IL 36.97 20.87 17.67 23.13 19.45 3.94 23 25 -2
Santa Barbara 43.66 22.45 11.62 15.12 18.25 0.88 2 -3 5
Water Mill, NY 41.35 23.01 10.11 19.36 20.23 3.44 7 9 -2
Irvine, CA 39.61 19.95 14.37 24.12 18.45 0.87 20 20 0
Ann Arbor, MI 36.67 18.78 20.01 25.67 22.97 0.41 55 51 4
BatonRouge, LA 30.97 20.23 17.94 29.33 20.36 2.56 38 36 2
Ithaca, NY 37.83 22.01 16.94 21.45 21.23 0.26 28 22 6
Philadelphia, PA 27.45 21.57 22.07 30.11 21.69 0.63 25 38 -13
Boston, MA 27.45 22.03 21.87 24.64 19.01 0.57 14 18 -4
Atlanta, GA 31.17 21.04 23.18 30.11 18.85 0.93 35 29 6
Westerville, OH 29.33 18.99 24.46 33.24 19.17 4.83 54 47 7
Marietta, GA 27.85 18.46 20.77 30.76 18.85 3.67 47 41 6
Des Moines, IA 27.36 19.77 21.46 28.93 20.43 5.23 35 42 -7
Cincinnati, OH 29.02 18.55 22.51 31.85 18.87 3.75 51 43 8
Nashville, TN 33.57 20.01 24.22 27.56 20.21 0.25 26 38 -12
Holland, MI 29.47 18.95 24.16 29.34 18.78 0.67 45 37 8

34
Let’s revisit the relationship between sales
and advertising expenditures ...
THE RELATIONSHIP BETWEEN SALES AND ADVERTISING

5
ADVERTISING ($1000s)

Series1
3

0
0 10 20 30 40 50 60

SALES

It appeared that there was NO strong relationship. 35

 And yet, in this relationship ...

Estimated Quantity = - 32.5

- 4.23*(Price)

+ 0.32*(Income)

+ 0.92*(Population)

+ 1.13*(% of Population < 18 Years)

+ 0.94*(Advertising)

+ 4.52*(Chrysler’s Price)

What are the possible explanations? 36

 Possible explanations ...
• The relationship is positive but very “weak”.
– A line through the scatter gram might slope upward,
and yet the relationship may still be weak.
• The relationship is positive but not very positive.
– How do we interpret the coefficient 0.94?
• Other variables confound the simple 2-variable graph:
– Perhaps the manufacturer targets advertising dollars
on high-income zip codes.
– Perhaps the manufacturer targets advertising dollars
on zip codes where Chrysler charges a low price.
– In general, perhaps the manufacturer spends more
on advertising in “tough” zip codes.
37