Chapter 3

Demand estimation
Learning Objectives

 A) Identify the techniques used in

estimating demand relationship
 B) determine simple and multiple
regression using least squares method
 C) Interpret the regression analysis
result
Demand estimation
Estimating demand for the firm’s product is an essential and continuing process.
After all, decisions to enter new market, decisions concerning production, planning
production capacity, and investment in fixed assets inventory plans as well as pricing
and investment strategies are all depends on demand estimation.
The estimated demand function provides managers with an accurate way to predict
future demand for the firm’s product as well as set of elasticities that allow managers
to know in advance the consequences of planned changes in prices, competitors’
prices, variations in consumers’ income, or the expected changes in any of the other
factors affecting demand.
This chapter will provide you with a simplified version of the simple and multiple
regression analyses and techniques that belong to a field called “Econometrics”,
which focuses on the use of statistical techniques and economic theories in dealing
with economic problems.
Demand estimation

 Managers may not need to estimate demand by themselves,

especially in big firms. They may assign such technical tasks
to their research department or hire outsider consulting firms
(outsourcing) to do the job.
 However, a manager does need at least to have some basic
knowledge of econometrics, to be able to read and
understand reports.
Techniques of Demand Estimation

 1. Direct method- marketing research techniques examples:

 A) consumer survey(questioning a sample of consumers to
determine various factors such as willingness to pay, price
sensitivity and awareness of advertising campaigns.
 Consumer focus groups ( a market research technique
employing close relationship of discussion among target
consumers)
 Market experiments (examines the way consumers behave
in controlled purchase environments).
Techniques of Demand Estimation

 2. Indirect method- econometric technique

 The method integrates economic, mathematics and
econometric to measure relationship between
among variables . Examples:
 Qz= a+ b1Pz+b2Yd
Specification of demand function

 1. Identify variables/ parameters of

demand for a particular product.
 State the demand function in an
econometric form. Example:
Qz = a + b1PZ + b2Yd + b3Ps+b4Pc + b5Ad + e

 2.In general, demand function is

estimated through regression methods
Introduction to Regression
Analysis

 Regression analysis is used to:

 Predict the value of a dependent variable based
on the value of at least one independent variable
 Explain the impact of changes in an independent
variable on the dependent variable
Dependent variable: the variable we wish to
explain
Independent variable: the variable used to
explain the dependent variable
Selection of Demand Functional
Form(Regression Analysis)
 Regression analysis is a statistical technique for finding the best relationship
between dependent variable and selected independent variable(s).
 Dependent variable (Y): depends on the value of other variables. It is the
primary interest to researchers.
 Independent (explanatory) variable(X): used to explain the variation in the
dependent variable.
 Regression analysis is commonly used by economists to estimate demand for a
good or service.
 There are two types of statistical analysis:
a) Simple regression analysis/ Linear regression Analysis(1D, 1ID)
b) Multiple regression analysis (1D, many ID)
Selection of Demand Functional
Form

a. Simple Regression Model: one dependent

variable and one independent variable
Qx= a - b1Px +e
Where, Qx : quantity demanded for Good X (dependent
variable), amount to be determined
Px: Price of Good X (independent variable)
a: constant value; or y-intercept
b1: slope of demand function(regression coefficients), or
parameters to be estimated (it measures the impact of
independent variable)
e: random error
Simple Linear Regression Model

 Only one independent variable, x

 Relationship between x and y is
described by a linear function
 Changes in y are assumed to be
caused by changes in x
Regression analysis
b. Multiple Regression Analysis: One dependent variable
and many independent variable
Qx= a - b1Px + b2Py +b3Yd +b4Ad+ e
Where,
Qx= demand of Good X
Px= Price of Good X
Py= price of Good Y
Yd= personal income
Ad= advertising expenditure
e= error term
a=intercept
b1,b2…b4= coefficients
(k= number of independent variable in the regression model)
The well-known method of ordinary least squares (OLS) is used in our regression analysis.
Some of the assumptions of OLS include.
1.Independent (explanatory) variables are independent from the dependent variable and independent from each
other.
2.2. The error terms (µ or e) are independent and identically distributed normal random variables, with mean equal
to zero.
Choice of statistical technique

 Regression analysis is a statistical technique for

obtaining the line that best fits the data points
according to an objective statistical criterion.
 Least squares(LS) technique is used to estimate
the regression coefficient.
 Least squares minimizes the sum of squares of
the differences between the observed and
estimated values of the dependent variable over
the sample of observations.
Data collection
1. Researchers collect data based on the required
variables:
2. Two types of data:
a)Time series data= a sequence or a set of observations
taken at successive equally spaced points in time.
Example, years, daily or weekly stock prices.
b)Cross sectional data= a set of observations taken at
different subjects (such as individuals, firms, countries ,
or region) at a single point in time. Example weight of
high school students or consumption by the middle
income earners.
Pooled (Panel): Combinations of cross section and time series data
Empiricial process

 1. Use a suitable computer software

package programme such as SPSS,
EVIEWS and MINITAB.
 Run the regression equation.
 Here we use “EXCEL”
Regression Analysis

 Interpreting the regression results:

 Coefficients:
- Negative coefficient shows that as the independent variable (Xn)
changes, the variable (Y) changes in opposite direction.
- Positive coefficient shows that as the independent variable (Xn)
changes, the dependent variable (Y) changes in the same direction.
- The regression coefficient are used to compute the elasticity for each
variable.
Properties of empirical model

 1. In general, the estimated demand function report the

following properties.
a) coefficients: Demand equation with estimated values of
coefficients such ad b1,b2..etc.
b) Regression or coeficient of determination (R2):
 It is statistical measure of how close the data are to the fitted
regression line.
 R2 of 1 indicates that the regression line perfectly fits the data.
 E:g R2=0.75 or 75% of the variation in dependent variable is
explained by independent variables.
f) F-test (F-test):
It is used to test the hypothesis that all the independent
variables in the regression equation jointly explain a significant
proportion of the variation in the dependent variable.
F= R2/(k-1) divided by (1-R2)/ (n-k)
n is number of observations
k is number of independent variables.
If F greater than F significance , Alternative hypothesis accepted means more confident the
research would be.
H0(Null Hypothesis): There is no significant relationship between dependent and independent
variables.
H1 (Alternative Hypothesis): There is a significant relationship between dependent and
independent variables. Or independent variable has a true impact on the independent variable
Example of Demand Regression
Model
The manager of Valerie woman handbags wishes to estimate the
demand function for its Valerie woman handbags monthly. A regression
was conducted and the result are shown below:
R2= 0.78 SEE= 400
Variables Coefficients Standard error

C 150 50
Px -350 155
Py 180 60
Pz 120 50
Y 60 40
 The dependent variable is Valerie woman handbangs (Qx) and the
details of the demand estimation is prrsented as follow:
 Px= RM60, Py= RM55, Pz=65, Y= RM4000
 Where Qx= quantity demanded for Valerie woman handbags
 Px= price of Valerie woman handbags
 Py= price of Tylor woman handbags
 Pz= price of Cutie woman handbags
 Y= per capita disposable income
Q1: Determine the estimation regression

Qx= 150- 350Px + 180Py +120Pz+60Y

Dependent Qx= a - b1px+b2py+b3pz+b4Y
Q2 Identify the independent variables that are statistically significant at
5% significance level, given the critical t value at 95% is 2.
Answer: Note: if T statistics is greater than 2 then the independent
variable is significant to influence the dependent variable

Variables T-statistics= Significance

Coefficient/
standard error

Px 350/155= 3 Significant

Py 180/60= 3 Significant

Pz 120/50= 2.4 Significant

Y 60/40=1.5 Not significant

Q3 Interpret the coefficient of variables that are significant
Answer: If the price of Px increases by RM1, the quantity demanded for Valerie
handbags decreases by 350 units , ceteris paribus
If the price of Py increases by RM1, the demand for Valerie handbangs
increases by 180 units, ceteris paribus
If the price of Pz increases by RM1, the demad for Valerie handbags increases
by 120 units, ceteris paribus
Q4 Interpret the coefficient of determination(R 2)
Answer R2= 0.78
78% of the variation in dependent variable is explained by independent variables.
Q5: Determine the monthly quantity demanded for Valerie woman handbags
Answer: Qx= 150-350Px+180Py+120Pz+60Y
= 150- 350(60)+180(55)+120(65)+60(4000)= 236850 unit
Q6 Is the quantity demanded for Valerie woman handbags (Qx) sensitive to its
own price?
Answer:
Edx = dQx/ dPx multiply by Px/Qx
Where dQx/dPx= bi coefficient (bi=350)
= 350 X 60/236850 = 0.088

The demand for Valerie woman handbags is inelastic. Therefore, consumers are
not sensitive to changes in its price.

Q7 Is Valerie woman handbags a luxury or necessity

Einc= dQx/dY X Y/Qx
Where dQx/dY= coefficient 60
= 60 (4000/236850)
= 1.013 income elasticity is greater than 1 and a positive number.
therefore, Valerie woman handbags is a luxury
 Regression Analysis as a Method for
Forecasting
Regression analysis takes advantage
of the relationship between two
variables. Demand is then
forecasted based on the
knowledge of this relationship and
for the given value of the related
variable.

Ex: Sale of Tires (Y), Sale of Autos (X)

are obviously related

If we analyze the past data of these

two variables and establish a
relationship between them, we may
use that relationship to forecast the
sales of tires given the sales of
automobiles.

The simplest form of the relationship

is, of course, linear, hence it is Sales of Autos (100,000)
referred to as a regression line.
SOLUTION

b
 XY  n X Y
Sales $ Adv.$ XY X2 Y2 2
(Y) (X)  X  nX 2

1 130 48 6240 2304 16,900 30282  451.25147.25

b  3.58
2 151 52 7852 2704 22,801 10533  451.25
2

3 150 50 7500 2500 22,500 a  Y  b X  147.25  3.5851.25

4 158 55 8690 3025 24964 a  -36.20
5 153.85 53 Y  a  bX  -36.20  3.58x
Y5  -36.20  3.5853  153.54
Tot 589 205 30282 10533 87165
Avg 147.25 51.25
How Good is the Fit?

 Correlation coefficient (r) measures the direction and strength of the linear
relationship between two variables. The closer the r value is to 1.0 the better
the regression line fits the data points.

n  XY   X  Y 
r
 X   X   Y   Y 
2 2
2 2
n * n
(4)30,282  (205)589
r 2
 .888
4(10,533) - (205) * 487,165  589
2

r 2  .982  .788
2

 Coefficient of determination ( r 2) measures the amount of variation in the

dependent variable about its mean that is explained by the regression line.
2
Values of ( r ) close to 1.0 are desirable.
Linear Regression
 Identify dependent (y) and
independent (x) variables
b
 XY  X  Y   Solve for the slope of the
 X 2  X  X 
line
b
 XY  n XY
2
 X  nX
2

 Solve for the y intercept

a  Y  bX
 Develop your equation for
the trend line
Y=a + bX
 Formulas
y = a + b x

where,


x

xy  n x y
y
b 2
 x  nx 2

x
y
a  y  bx
Linear regression using Least
Square Method

 Write a linear equation that “best fits”

the data in the table shown below:

X(independent ) Y(dependent )
1 1.5
2 3.8
3 6.7
4 9.0
5 11.2
6 13.6
7 16
Chap 13-31
These values help us to calculate slope (b) and a
intercept of linear eqauation

X Y XY X2
1 1.5 1.5 1
2 3.8 7.6 4
3 6.7 20.1 9
4 9 36 16
5 11.2 56 25
6 13.6 81.6 36
7 16 112 49
28 61.8 314.8 140
b=314.8-7(4)(8.83)/ 140- 7(4)2
=314.8 – 247.24/ 140-112= 67.56/28=2.412
a=8.83-2.412(4)= 8.83-9.648 = -0.813
y=a +bx = -0.813 + 2.412x
Problem

 A maker of Samsung mobile has been

tracking the relationship between sales
and advertising dollars. Use linear
regression to find out what sales might
be if the company invested $7,000 in
advertising next month(july).
Regression – Example
y = a+ b X b
 xy  n x y
2
a  y  bx
 x  nx
2

MonthAdvertising Sales X 2 XY
January 3 1 9.00 3.00
February 4 2 16.00 8.00
March 2 1 4.00 2.00
April 5 3 25.00 15.00
May 4 2 16.00 8.00
June 2 1 4.00 2.00
July 7 49.00 0.00

TOTAL 20 10 74 38
SOLUTION

38  63.31.67 
b  0.57
74  63.3
2

a  Y  b X  1.67  0.573.3
a  -0.21
Y  a  bX  -0.21  0.57x
Y5  -0.21  0.577   3.78
Example

Month sales Advertising

jan 1 3
feb 2 4
march 1 2
april 3 5
may 2 4
june 1 2
SUMMARY OUTPUT

Regression Statistics

Multiple R 0.943879807

R Square 0.890909091

Adjusted R Square 0.863636364

Standard Error 0.301511345

Observations 6

ANOVA

  df SS MS F Significance F

Regression 1 2.96969697 2.96969697 32.66666667 0.004635839

Residual 4 0.363636364 0.090909091

Total 5 3.333333333      

  Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%

Intercept -0.454545455 0.391014785 -1.162476387 0.309670996 -1.54017654 0.631085631 -1.54017654 0.631085631

Advertising 0.636363636 0.111340443 5.715476066 0.004635839 0.327233009 0.945494264 0.327233009 0.945494264