DEMAND ESTIMATION:

THE WONDER OF ECONOMETRIC ANALYSIS

Why do we have to estimate demand?
…because demand dictates the music.
What is Econometric Analysis?
• Econometrics means “economic measurement”.
• “Consists of the application of mathematical statistics to
economic data to lend empirical support to the models
constructed by mathematical economics and to obtain
numerical results” (Gerhard 1968).
• “Econometrics may be defined as the social science in
which the tools of economic theory, mathematics, and
statistical inference are applied to the analysis of economic
phenomena…” (Goldberger 1964).
• “Econometrics is concerned with the empirical
determination of economic laws” (Theil 1971).
Why is it a separate discipline?
• Economic theory makes statements or hypotheses that are
mostly qualitative in nature (e.g. the law of demand). The law
does not provide any numerical measure of the relationship.
• The main concern of mathematical economics is to express
economic theory in mathematical form without regard to
measurability or empirical verification of the theory.
• Economic statistics is mainly concerned with collecting,
processing, and presenting economic data in the form of charts
and tables. It does not go any further. The one who does that is
the econometrician.
METHODS OF ESTIMATING DEMAND
• Consumer surveys (e.g. interviews, surveys)
• Pros: up-to-date information, generally easy to conduct
• Cons: validity, reliability and sample bias
• Market experiments (e.g. lab and field experiments)
• Pros: direct observation
• Cons: lack of control, lesser sample, length of time needed
• Statistical methods (e.g. econometric analysis)
• Pros: more accurate and reliable
• Cons: require big data, complex computations
SEVEN STAGES OF ECONOMETRIC ANALYSIS
1. Statement of theory and hypotheses
2. Model specification
3. Data collection
4. Estimation of variables
5. Checking goodness of fit
6. Hypothesis testing
7. Forecasting
1. STATEMENT OF THEORY AND HYPOTHESIS

• Hypothesis - a supposition or proposed explanation

made on the basis of limited evidence as a starting
point for further investigation.
• Theory - a supposition or a system of ideas
intended to explain something, especially one
based on general principles independent of the
thing to be explained.
1. STATEMENT OF THEORY AND HYPOTHESIS
Example of a theory:
JM Keynes states that on average, consumers increase their
consumption as their income increases, but not as much as the
increase in their income (i.e. marginal propensity to consume)
In mathematical terms:

Where MPC is the marginal propensity to consume

2. MODEL SPECIFICATION
Deterministic vs. Statistical
• Deterministic relationship – relationships are
known with certainty
(e.g. Revenue = Price x Quantity sold, or R = PQ)
• Statistical relationship – involves an element
of uncertainty
(e.g. Quantity = function of Price, or Q = f(P))
2. MODEL SPECIFICATION
• Example:
• Single-equation model for consumption:
Y = β1 + β2X 0<β <1 2

Y = consumption expenditure (dependent variable)

X = income (independent, or explanatory variable)
β1 = the intercept
β2 = the slope coefficient

The slope coefficient β2 measures the MPC.

Graphically…
2. MODEL SPECIFICATION
Note: The relationships between economic
variables are generally inexact. In addition to
income, other variables affect consumption
expenditure. For example, size of family, ages of
the members in the family, family religion, etc., are
likely to exert some influence on consumption.
2. MODEL SPECIFICATION
• To allow for the inexact relationships between
economic variables, (I.3.1) is modified as follows:
Y = β1 + β2X + u

where u, known as the disturbance, or error, term, is a random variable

that has well-defined probabilistic properties. The disturbance term u
may well represent all those factors that affect consumption but are not
taken into account explicitly.
Graphically…
3. DATA COLLECTION
• TYPES OF DATA
• Time-series data – single entity at different
periods
• Cross-section data – different entities at single
period of time
• SOURCES OF DATA
• Records of firms
• Commercial and private agencies
• Official sources (i.e. public agencies)
3. DATA COLLECTION

• Y = consumption
expenditure

• X = gross domestic
product (which in
economics is a
good measure of
national income)
4. ESTIMATION OF THE ECONOMETRIC MODEL
• Regression analysis (e.g. least squares method) is
the main tool used to obtain the estimates. Using this
technique and the data given in Table I.1, we obtain the
following estimates of β1 and β2, namely, −184.08 and
0.7064. Thus, the estimated consumption function is:

Y = −184.08 + 0.7064X
5. CHECKING GOODNESS OF FIT
5. CHECKING GOODNESS OF FIT
• (Continuation of example) The regression line
fits the data quite well*. The slope coefficient
(i.e., the MPC) was about 0.70, an increase in
real income of 1 dollar led, on average, to an
increase of about 70 cents in real consumption.
*this may be validated through the use of a statistical
technique known as the coefficient of determination
(commonly known as R squared)
6. HYPOTHESIS TESTING
• Keynes expected the MPC to be positive but less than 1.
In our example we found the MPC to be about 0.70. But
before we accept this finding as confirmation of the
theory, we must first ask, is 0.70 statistically less than 1?
If it is, it may support Keynes’ theory.
• Such confirmation or refutation of economic theories on
the basis of sample evidence is based on a branch of
statistical theory known as statistical inference
(hypothesis testing).
7. FORECASTING
To illustrate, suppose we want to predict the mean consumption
expenditure for 1997. The GDP value for 1997 was 7269.8 billion.
Using the model, dollars consumption would be:

Yˆ1997 = −184.0779 + 0.7064 (7269.8) = 4951.3

The actual value of the consumption expenditure reported in 1997

was 4913.5 billion dollars. The estimated model thus over-predicted
the actual consumption expenditure by about 37.82 billion dollars. We
could say the forecast error is about 37.8 billion dollars, which is about
0.76 percent of the actual GDP value for 1997 (not bad, right?).
8. USING THE MODEL TO PROPOSE ECONOMIC POLICIES
Suppose we have the estimated consumption function given in
Suppose further the government believes that consumer expenditure of
about 4900 will keep the unemployment rate at its current level of
about 4.2%. What level of income will guarantee the target amount of
consumption expenditure? If the regression results given in seem
reasonable, simple arithmetic will show that:
4900 = −184.0779 + 0.7064X

which gives X = 7197, approximately. That is, an income level of

about 7197 (billion) dollars.
CONCLUSION

Economic concepts and theories, when

combined with data collection, statistics and
predictive analytics, is undoubtedly a game-
changer both in the macro- and micro-
levels.