Estimating Demand

Chapter 4
• 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.
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 Is this curve demand

• Look at the relationship of price and
quantity over time or supply?
• Plot it
• Is it a demand curve or a supply curve? 2004
• The problem is this does not hold other 2007
things equal or constant.
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 + b•P + c•Y
• double log log Q = a + b•log P + c•log Y
• quadratic Q = a + b•P + c•Y+ d•P2
•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 + b•P + c•Y
•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) = b•P/Q
•Income elasticity is: EY = (Q/Y)(Y/Q)= c•Y/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 + b•Log P + c•Log 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
Y
• time subscripts & error term
• Find “best fitting” line
t = Yt - a - b Xt a

t2 = [Yt - a - b Xt] 2 . _

• min  t 2=  [Yt - a - b Xt] 2 . Y
Solution:
slope b = Cov(Y,X)/Var(X) and DY
DX
intercept a = mean(Y) - b•mean(X)
_
X
 Simple Linear Regression:
Assumptions & Solution Methods
• Spreadsheets - such as
1. The dependent variable is
• Excel, Lotus 1-2-3, Quatro Pro, or Joe
random. Spreadsheet
2. A straight line relationship • Statistical calculators
exists.
• Statistical programs such as
3. The error term has a mean • Minitab
of zero and a finite
• SAS
variance: the independent
• SPSS
variables are indeed
• For-Profit
independent.
• 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
Figure 4.5 Estimated Regression Line
Sherwin-Williams Case
 Sherwin-Williams Case

• In the simple linear • The estimated t is:

regression:
Y = 120.755 + .434 X t = (.434 – 0 )/.14763 = 2.939
• The standard error of the • The critical t for a sample of 10, has
slope coefficient is .14763. only 8 degrees of freedom
(This is usually available » D.F. = 10 – 1 independent variable – 1 for
from any regression the constant.
program used.) » Table B2 shows this to be 2.306 at the .05
significance level
• Test the hypothesis that the
slope is zero, b=0. •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).