Chapter 4: Demand

Estimation
Managerial Economics
Instructor: Maharouf Oyolola
 Outline of the lecture
• -Introduction
• Statistical estimation of the demand
function
Model
OLS estimation technique
Interpretation of the results
Testing
• The preceding chapter developed the theory of
demand, including the concepts of price
elasticity, income elasticity, and cross-elasticity
of demand.
• A manager who is contemplating an increase in
the price of one of the firm’s products needs to
know the impact of this increase on:
• (1) quantity demanded
• (2) total revenue
• (3) profits
 What questions should the
manager answer?
• - Is the demand elastic, inelastic, or unit elastic
with respect to price over the range of
contemplated price increase?
• -What will happen to demand if consumer
incomes increase or decrease as a result of an
economic expansion or contraction.
• Managers face these types of problems
everyday whether in a profit-seeking enterprises,
not-for-profit organizations or governments.
 Example
• What will be the impact of cigarette taxes
on my quantity demanded of my product?
• What effect will a tuition increase have on
local state university revenues?

• These are the types of questions the

empirical investigation attempt to answer
 Statistical Estimation of the
Demand Function
• Econometrics is a collection of statistical
techniques available for testing economic
theories by empirically measuring relationships
among economic variables.
• The measurement of economic relationships is a
necessary step in using economic theories and
models to obtain estimates of the numerical
values of variables that are of interest to the
decision maker.
The estimation of a demand function using
econometric techniques involves the
following steps

• - Identification of the variables

• - Collection of the data
• - Formulation of the demand model
• -Estimation of the parameters
• - Development of forecasts (estimates)
based on the model
 Identification of the variables
• As discussed in the previous chapter, the
demand function may be viewed as the
relationship between the quantity demanded (the
dependent variable) and several independent
variables.
• The first task in developing a statistical demand
model is to identify the independent variables
that are likely to influence quantity demanded.
• These might include factors such as the price of
the good in question, price of competing or
substitute goods, population, per capita income,
and advertising and promotional expenditures.
 Collection of the data
• Once the variables have been identified,
the next step is to collect data on the
variables. Data can be obtained from a
number of different sources.
 Formulation of the model
• The next step is to specify the form of the
equation, that indicates the relationship
between the independent variables and
the dependent variable.
 Example
• The linear model, which is the most
common form of estimation equation:

Y = α + β 1 X1 + β 2 X 2 + β 3 X 3 + ε
 Linear Model
• α, β1, β2, β3, ε are the parameters of the
model and ε is the error term.
• The error term is included in the model to
reflect the fact that the relationship is not
an exact one, i.e., the observed demand
value may not always be equal to the
theoretical value.
 Interpretation of the value of β
• The value of each β coefficient provides
an estimate of the change in quantity
demanded associated with a one-unit
change in the given independent variable,
holding constant all other independent
variables.
Interpretation of the value of β
The β coefficients are equivalent to the partial derivatives of the
demand function:

∆Y
β1 =
∆X 1
∆Y
β2 =
∆X 2
∆Y
β3 =
∆X 3
Interpretation of the value of β

∆Y X 2
ED = .
∆X Y
X2
ED =β2 .
Y
 Simple Linear Regression Model
• The analysis in this section is limited to the
case of one independent and one
dependent variable (two-variable case),
where the form of the relationship between
the two variables is linear.
 Estimating the simple linear
regression coefficients
n − −
∑(X i −X )(Yi −Y)
b =i =
1
n −

∑(X
i=
1
i −X)2

n − −
∑X Y i i −n X Y
b =i =
1
n −

∑
2
X i −nX 2

i=
1
 Example 1
• Sherwin-Williams company is attempting to
develop a demand model for its line of exterior
house paints. The company’s chief economist
feels that the most important variables affecting
paint sales (Y) (measured in gallons) are:
• (1) promotional expenditures(X1) (measured in
dollars). These include expenditures on
advertising (radio, TV, and newspaper), in-store
displays and literature, and customer rebate
programs.
 Example1
• (2) Selling price (X2) (measured in dollars per
gallon).
• (3) Disposable income per household (X3)
(measured in dollars)
• The chief economist decides to collect data on
the variables in a sample of ten company sales
regions that are roughly equal in population.
Data on paint sales, promotional expenditures,
and selling prices were obtained from the
company’s marketing department. Data on
disposable income (per capita) was obtained
from the Bureau of Labor Statistics
 Answer
• Y= a + b.X
• Y= 120.75 + 0.434X

• Interpretation: The coefficient of X (0.434)

indicates that for one-unit increase in X
($1,000 in additional promotional
expenditures), expected sales (Y) will
increase by 0.434 (X1,000)= 434 gallons
in a given sales region.
 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. This is
done by substituting the particular value of
X, namely Xp, into the sample regression
equation
 Example
• Suppose one is interested in estimating
Sherwin-William’s paint sales for a
metropolitan area with promotional
expenditures equal to $185,000 (i.e.,
Xp=185).
• Y=120.75 + 0.434(185)
• Y=201.045 gallons or 201,045 gallons
 Example
• Xp=300 or $300,000
• Remark: Xp falls outside of the series of
observations for which the regression line
was calculated.
• Thus, because of the above remark, we
cannot be certain that the prediction of
paint sales based on the regression model
would reasonable.
 Standard Error of the estimate
• The error term ei is defined as the
difference between the observed and
predicted value of the dependent variable.
• The standard deviation of the error terms
is calculated as:

n n

∑ei ∑ i
( y − a − bxi ) 2

Se = i =1
= i =1
n −2 n −2
• The standard error of the estimate (Se)
can be used to construct prediction
intervals for Y. An approximate 95 percent
prediction interval is equal to

Y ±2 S e
Returning to our previous example

Y ± 2S e = 201.045 ± 2(22.7)

155.447 to 246.643 (that is, from 155,447 gallons to 246,643 gallons).

 Testing
• H0: β=0 ( No relationship between X and
Y)
• Ha: β≠0 ( linear relationship between X
and Y)
 Testing
• There are two ways of doing the testing:

3) Calculate the t statistic and compare it to

the critical value
4) Use the p-value technique
 Correlation Coefficient

n − −
∑( x i − x)( y − y )
r= i =1
n − −
∑( x
i =1
i − x ) ( yi − y )
2 2
 Correlation Coefficient
• The correlation coefficient measures the degree
to which two variables tend to vary together.
• Correlation analysis is useful in explanatory
studies of the relationship among economic
variables. The information obtained in the
correlation analysis can then be used as a guide
in building descriptive models of economic
phenomena that can serve as a basis for
prediction and decision making.
 Correlation Coefficient
• The value of the correlation coefficient ®
ranges from +1 for the two variables with
perfect positive correlation to -1 for two
variables with perfect negative correlation.
The Coefficient of Determination

^ −
( y −y) 2
r 2
= −
( yi − y ) 2
The Coefficient of Determination
• It measures the proportion of the variation
in the dependent variable that is explained
by the regression line (the independent
variable).
• The coefficient of determination ranges
from 0 ( when none of the variation in Y is
explained by the regression) to 1( when all
the variation in Y is explained by the
regression.
 Example
• If r2=0.519 ( from the Sherwin-William’s
company example).
• Interpretation: the regression equation, with
promotional expenditures as the independent
variable, explains about 52 percent of the
variation in paint sales in the sample.
• Remark: In the two-variable linear regression
model, the coefficient of determination is equal
to the square of the correlation coefficient, i.e.,
r2=0.519=( r)2=(0.72059)2.
 F-ratio
• It is used to test whether the estimated
regression equation explains a significant
proportion of the variation in the dependent
variable.
• The decision is to reject the null hypothesis of no
relationship between X and Y ( that is, no
explanatory power) at the k level of significance
if the calculated F-ratio is greater than the Fk,1,n-2
value obtained from the F-distribution.
 Example
• If F=8.641
• The value of F0.05,1,8 from the F-distribution (from
the table) is 5.32.
• We reject, at the 0.05 level of significance, the
null hypothesis that there is no relationship
between promotional expenditures and paint
sales. In other words, we conclude that the
regression models does explain a significant
proportion of the variation in paint sales in the
sample.
 Association and Causation
• The presence of association (correlation)
does not necessarily imply causation.
 Multiple Linear Regression
• A functional relationship containing two or
more independent variables is known as a
multiple linear regression model.

Y = α + β1 X 1 + β 2 X 2 + ...... + β m X m + ε
Regression Techniques
 Regression techniques
• Consider a simple demand equation
Q= a + bP. The law of demand implies that
the coefficient b should be negative,
indicating that less of the product is
demanded at higher prices.
 Estimating Coefficients
• Consider a small restaurant chain specializing in
fresh lobster dinner. The business has collected
information on prices and the average number of
meals served per day for a random sample of
eight restaurants in the chain. These data are
shown below. Use regression analysis to
estimate the coefficients of the demand function
Qd= a +bP. Based on the estimated equation,
calculate the point price elasticity of demand at
the mean values of the variables.
The Least-Squares regression
estimation
−
−

b=
∑(X i −X )(Y −Y )
−

∑( X i −X ) 2
−
−
a=
Y −b X
 Estimating the demand for lobsters
dinners using the OLS
Qi Pi Qi-Q(bar) Pi-P(bar) (Pi-P(bar))2 (Pi-P(bar))(Qi-Q(bar))
100 15 0 -1 1 0
90 18 -10 2 4 -20
85 19 -15 3 9 -45
110 14 10 -2 4 -20
120 13 20 -3 9 -60
90 19 -10 3 9 -30
105 16 5 0 0 0
100 14 0 -2 4 0

40 -175

b -4.375

a 170
 Estimating the demand for lobster
dinners
• Using the ordinary Least Squares
regression, we find the estimates of the
demand for lobsters.
• We can now use our results to determine
the point elasticity of demand for lobsters.
 Written assignment
• Problem #6 page 180