Regression Techniques and Demand

Estimation
From Theory to Practice

D: Qx = f(px ,Y, pr , pe, Τ , N)

 What is the true quantitative relationship

between demand and the factors that affect
it?

 How can demand functions be estimated?

 How can managers interpret and use these

estimations?
Most common methods used are:

a) consumer interviews or surveys

 to estimate the demand for new products
 to test customers reactions to changes in the
price or advertising
 to test commitment for established products
b) market studies and experiments
 to test new or improved products in controlled
settings
c) regression analysis
 uses historical data to estimate demand
functions
Consumer Interviews (Surveys)

 Ask potential buyers how much of the

commodity they would buy at different prices
(or with alternative values for the non-price
determinants of demand)
 face to face approach
 telephone interviews
Consumer Interviews

Problems:
1. Selection of a representative sample
 what is a good sample!

2. Response bias
 how truthful can they be?

3. Inability or unwillingness of the

respondent to answer accurately
Market Studies and Experiments

 More expensive and difficult technique for

estimating demand and demand elasticity is
the controlled market study or experiment

 Displaying the products in several different

stores, generally in areas with different
characteristics, over a period of time

 for instance, changing the price, holding

everything else constant
Market Studies and Experiments

 Experiments in laboratory or field

• a compromise between market studies
and surveys
• volunteers are paid to stimulate buying
conditions
Market Studies and Experiments

 Problems in conducting market studies and

experiments:
a) expensive
b) availability of subjects
c) do subjects relate to the problem, do they take
them seriously

BUT: today information on market behavior

also collected by membership and award
cards of stores
Regression Analysis and Demand
Estimation
 A frequently used statistical technique in
demand estimation
 Estimates the quantitative relationship
between the dependent variable and
independent variable(s)
 quantity demanded being the dependent variable
 if only one independent variable (predictor) used:
simple regression
 if several independent variables used: multiple
regression
A Linear Regression Model

 In practice the dependence of one variable on

another might take any number of forms, but an
assumption of linear dependency will often
provide an adequate approximation to the true
relationship
General Form of Demand Function

Qi = α + β 1Y - β 2 pi + β 3ps - β 4pc + β 5Z + e
where
Qi = quantity demanded of good i
Y = income
pi = price of good i
ps = price of the substitute(s)
pc = price of the complement(s)
Z = other relevant determinant(s) of demand
e = error term

Values of α and β i ?
Types of Data

 Data used in regression analysis

 cross-sectional data provide
information on variables for a given
period of time

 time series data give information about

variables over a number of periods of
time
Simple Linear Regression
Model
In the simplest case, the dependent variable Y
is assumed to have the following relationship
with the independent variable X:
Y = a + bX + u
where
Y = dependent variable
X = independent variable
a = intercept
b = slope
u = random factor
 Regression Analysis
Year X Y
Scatter Diagram
1 10 44
2 9 40
3 11 42
4 12 46
5 11 48
6 12 52
7 13 54
8 13 58
9 14 56
10 15 60
Regression Analysis

 Regression Line: Line of Best Fit

 Regression Line: Minimizes the sum of the

squared vertical deviations (et) of each point
from the regression line.

 Ordinary Least Squares (OLS) Method

Regression Analysis
Ordinary Least Squares (OLS)

Model: Yt = a + bX t + et

Yˆ = a
ˆ + ˆ
bX
t t

et = Yt − Yˆ
t
Ordinary Least Squares (OLS)

Objective: Determine the slope and

intercept that minimize the sum of
the squared errors.

n n n

∑t ∑ t t ∑ t
e 2

t =1
= (Y −
t =1
Yˆ) 2
= (Y
t =1
− a
ˆ − ˆ )2
bX t
Ordinary Least Squares (OLS)

Estimation Procedure
n

∑(X t − X )(Yt − Y )
bˆ= t =1 ˆ
aˆ= Y − bX
n

∑(X
t =1
t − X) 2
Ordinary Least Squares (OLS)

Estimation Example
T im e Xt Yt Xt − X Yt − Y ( X t − X )(Yt −Y ) ( X t − X2 )
1 10 44 -2 -6 12 4
2 9 40 -3 -1 0 30 9
3 11 42 -1 -8 8 1
4 12 46 0 -4 0 0
5 11 48 -1 -2 2 1
6 12 52 0 2 0 0
7 13 54 1 4 4 1
8 13 58 1 8 8 1
9 14 56 2 6 12 4
10 15 60 3 10 30 9
n
120 n
500 n
106 30
106
n = 10 ∑X
t =1
t = 120 ∑Y
t =1
t = 500 ∑(X
t =1
t − X ) 2 = 30 bˆ=
30
= 3.533

n n n
X 120 Y 500
X =∑ t = = 12 Y =∑ t = = 50 ∑(X t − X )(Yt − Y ) = 106 aˆ= 50 − (3.533)(12) = 7.60
t =1 n 10 t =1 n 10 t =1
Ordinary Least Squares (OLS)

Estimation Example
n
X t 120
n = 10 X =∑ = = 12
t =1 n 10
n
n n Yt 500
∑X = 120 ∑Y = 500 Y =∑ = = 50
t =1 n 10
t t
t =1 t =1

n
106
∑(X
t =1
t − X ) = 30
2 ˆ
b=
30
= 3.533

∑(X
t =1
t − X )(Yt − Y ) = 106 aˆ= 50 − (3.533)(12) = 7.60
Tests of Significance

Example Calculation
n n

∑ e = ∑ (Yt − Yt ) = 65.4830
t =1
2
t
ˆ 2

t =1
n

∑ t
( X
t =1
− X ) 2
= 30

sbˆ =
∑ t
(Y − Yˆ) 2

=
65.4830
= 0.52
( n − k )∑ ( X t − X ) 2
(10 − 2)(30)
Tests of Significance

Calculation of the t Statistic

bˆ 3.53
t= = = 6.79
sbˆ 0.52

Degrees of Freedom = (n-k) = (10-2) = 8

Critical Value at 5% level =2.306
t-test: test of statistical significance of each
estimated regression coefficient

b̂
t=
SE b̂
 b: estimated coefficient
 SEb: standard error of the estimated coefficient
 Rule of 2: if absolute value of t is greater than
2, estimated coefficient is significant at the 5%
level
 If coefficient passes t-test, the variable has a
true impact on demand
Tests of Significance
Tests of Significance

Decomposition of Sum of Squares

Total Variation = Explained Variation + Unexplained Variation

∑ (Yt − Y ) = ∑ (Y − Y ) + ∑ (Yt − Yt )
2 ˆ 2 ˆ 2
Sum of Squares

TSS = Σ (Yi - Y)2

(total variability of the dependent variable about its
mean) where Y = mean of Y
RSS = Σ (Ŷi - Y)2
(variability in Y explained by the sample regression)
ESS = Σ (Yi - Ŷi)2
(variability in Y unexplained by the dependent variable x)

This regression line gives the minimum ESS

among all possible straight lines.
The Coefficient of Determination

 Coefficient of determination R2 measures how

well the line fits the scatter plot (Goodness of
Fit)

2 RSS ESS
R = = 1−
TSS TSS
 R2 is always between 0 and 1
 If it’s near 1 it means that the regression line
is a good fit to the data
 Another interpretation: the percentage of
variance ”accounted for”
Tests of Significance

Coefficient of Determination

R =
2 Explained Variation
=
∑ (Yˆ− Y ) 2

Total Variation ∑ t
(Y − Y ) 2

373.84
R =
2
= 0.85
440.00
Multiple Regression Analysis

Model: Y = a + b1 X 1 + b2 X 2 + L + bk ' X k '

Multiple Regression Analysis

Adjusted Coefficient of Determination

(n − 1)
R = 1 − (1 − R )
2 2

(n − k )
Multiple Regression Analysis

Analysis of Variance and F Statistic

Explained Variation /(k − 1)

F=
Unexplained Variation /(n − k )

R 2 /(k − 1)
F=
(1 − R 2 ) /(n − k )
Problems in Regression Analysis

 Multicollinearity:
Two or more explanatory
variables are highly correlated.
 Heteroskedasticity: Variance of error term is not
independent of the Y variable.
 Autocorrelation: Consecutive error terms are
correlated.
Durbin-Watson Statistic

Test for Autocorrelation

n

∑ t t −1
( e − e ) 2

d= t =2
n

∑t
e 2

t =1

If d=2, autocorrelation is absent.

Steps in Demand Estimation

 Model Specification: Identify Variables

 Collect Data
 Specify Functional Form
 Estimate Function
 Test the Results
Functional Form Specifications

Linear Function:
QX = a0 + a1PX + a2 I + a3 N + a4 PY + L + e

Power Estimation Format:

Function:
QX = a ( PXb1 )( PYb2 ) ln QX = ln a + b1 ln PX + b2 ln PY