Quantitative Demand Analysis

Course outline
Managerial Microeconomics

Basic Model

Managerial perspective

Additional topics

application

Demand
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Question-PRS

According to an FTC Report by Michael Ward, AT&Ts own price elasticity of demand for long distance services is -8.64. AT&T needs to boost revenues in order to meet its marketing goals. To accomplish this goal, should AT&T raise or lower its price?
1.

2.
3.

Raise price, Lower price, Not enough information

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Lecture Outline
1.
1. 2. 3. 4.

Elasticity of Demand
Own-price elasticity of Demand Income elasticity of demand Cross-price elasticity of demand Advertising elasticity of demand

2. 3.

Estimating demand Creating demand

1.1 Elasticity of Demand

Measures responsiveness of demand (or supply) to changes in an underlying factor (e.g. price, income, other prices).

Own-Price elasticity of demand = % change in quantity demanded % change in price

1.2 Income Elasticity of Demand

Income elasticity of demand = % change in quantity demanded % change in income

Positive for a normal good Negative for an inferior good

1.3 Cross-Price elasticity of demand

Cross-price elasticity of demand = % change in quantity demanded % change in price of other commodity Positive if substitutes Negative if complements

Question-2

In July 1995 the Consumer Council of Hong Kong published a report on the gas industry in the territory. It contained annual estimates for the price elasticity of town gas: -1.384 in 1991, +0.706 in 1993. The report concluded: electricity and liquefied petroleum gas are not close substitutes for town gas with consumers having limited liability to switch in response to price changes.

1.3 Cross-Price Elasticity of Market Demand

Products
C onsum er pr oducts

Market

Cross price elasticity 0.1 1.2 0.1 0 0.25

clothing/food U.S. gaseline at competing stations Boston, MA

U tilities

electricity/gas (residential) electricity/oil (residential) bus/subway

Quebec Quebec London

1.3 Cross-Price Elasticity

Suppose a firm sells two related products, X and Y. The impact of a small percentage change in the price of product X (%Px= Px/Px) on the firms total revenue is:

R [R x (1 EQx , Px ) Ry EQy , Px ] %Px

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1.4 Advertising Elasticity of Demand

Advertising Elasticity of Demand =

% change in quantity demanded % change in advertising expenditure

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1.4 Advertising Elasticity of Market Demand

P r oduct Mar ket

beer wine cigarettes clothing recreation

U.S. U.S. U.S. U.S. U.S.

Advertising elasticity 0 0.08 0.04 0.01 0.08

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2. ESTIMATING DEMAND
1.

Demand functions
Linear Log-linear

2.

3.

Demand functions and elasticity Estimate demand function and understand regression results

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Question-3

A New York Times article contained a table summarizing the price paid per (airwaves) license in 10 different regions, the number of licenses sold, and the population of each region. The average price is $70.7 million for a single license. lnP=2.23-1.2lnQ+1.25lnPop A regional telephone company: region population 7% higher than average of the 10, the FCC plans to auction the average number of licenses. How to estimate the amount of money needed to buy a license?

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2.1 Demand functions

Mathematical representations of demand curves

Linear demand Qdx =a+b1Px +b2I+b3A+b4Py

Log-Linear Demand ln Qdx = +1lnPx +2 lnI+3 lnA+4 lnPy

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P
Elasticity differs along the demand curve

Constant Elasticity

Linear

Q Log-Linear
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2.2 Example of Linear Demand

Demand for car lube service D=63.48-0.48P+0.65N+0.03A+0.42C

Suppose at P=30, A=446, C=30, D=90 What is own price elasticity? -0.16 What is advertising elasticity? 0.15 What is cross price elasticity? 0.42

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2.2 Example of Log-linear demand

Demand for town gas in Hong Kong (Lam1996)

ln Q=-8.06-0.26lnP+1.53lnI -0.053 lnPCLP +..

What is own price elasticity of demand? -0.26 What is income elasticity, cross price elasticity?

1.53 ; -0.053

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2.2 Demand functions and elasticity

Linear demand Qdx =a+b1Px +b2I+b3A+b4Py own price elasticity: b1Px/Qdx income elasticity: b2I/Qdx advertising elasticity: b3A/Qdx cross price elasticity: b4Py/Qdx

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2.2 Demand functions and elasticity

Log-Linear Demand ln Qdx = +1lnPx +2 lnI+3 lnA+4 lnPy Own price elasticity: 1 Income elasticity: 2 Advertising elasticity: 3 Cross price elasticity: 4

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2.3 Understanding regression results

Regression analysis is concerned with the study of the dependence of one variable, the dependent variable, on one or more other variables, the explanatory variables. Used to estimate demand functions

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2.3 Understanding regression results

Important terminology

Least Squares Regression: Y=a+bX+e R-square or coefficient of Determination F-statistic t-statistic

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2.3 Specify the Model

Linear model: D=b0 + bP P + bA A +bI I +e bs are called coefficients. D is the unit demand for a particular product, P is the price charged, A represents advertising expenditures, I is per capita disposable income, e is the collective effect of other factors (random variable)

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2.3.1 Least Squares Method

,b ,b ,b ) (b Find best fit the data in the sense 0 P A I that it minimizes the sum of squared deviations.

) Minimize ( D D
i 1 i i

i n

n is the number of observations (Di,Pi,Ai,Ii) is the ith observation and

b P b A b I b D i 0 P i A i I i

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2.3.2 Understand regression results

R-square (R2): called the coefficient of determination: measure of the goodness of fit for a multiple regression model;
Variation Explained by Regression

R2 =
Total Variation of Y
Percentage of variation explained by the variable (Between 0 and 1)

How large R-square is large enough.

Where Y is the dependent variable.

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2.3.2 Understand regression results

If the number of estimated coefficients equals or exceeds the number of observations, R2 is always 100%. Degrees of freedom of residue: the number of observations minus the number of coefficients to be estimated. (including constant.)

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2.3.2 Understand regression results

Corrected coefficient of determination (adjusted R2 ): Downward adjustment of R2 in the light of the number of data points and estimated coefficients. R2 = R2 ((k-1)/(n-k)) (1-R2) K is the number of coefficient to be estimated.
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2.3.3 Understand Regression Results

F statistic measures the overall significance of the independent variables. Fk-1, n-k = Explained Variation / (k-1)

Unexplained Variation/ (n-k)

n is the number of observations, k is the number of estimated coefficients. Fk-1, n-k = R2 / (k-1) (1-R2)/(n-k)

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2.3.3 F Statistic

F statistic ranges from 0 to infinity. The F statistic is calculated under the hypothesis that the coefficients (excluding the constant) are all 0. If the hypothesis is true, F statistic follows F distribution. If the F statistic is large enough (> 3 or 4 depending on n, k), then we can reject the hypothesis, which means the regression estimates are statistically significant.
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F4,30

90% 95% 99% 2.14 F statistic

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2.69

4.02

2.3.3 Understand regression results

Significance (P-Value) gives the probability of obtaining the value of F statistic this extreme (large) or even more extreme (larger) if the Null hypothesis is true, i.e., all coefficients (excluding constant) are 0. If this probability falls below a specific benchmark, then we say that the regression estimates are statistically significant. The conventional benchmark is 1% and 5%.

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2.3.4 Understand regression results

t stat of bp^

t statistic measures individual variable significance It ranges from negative infinity to positive infinity. tn-k = b^ / standard Deviation of b^ t statistic is calculated under the hypothesis that the coefficient is 0. If the hypothesis is true, t statistic follows t distribution.
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90% 2.576 -1.96 -1.645 t statistic

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95% 99% 0 1.96 1.645

2.576

2.3.4 t statistic

If the absolute value of the t statistic is large enough ( > 2.5 or 3), then we can reject the hypothesis, which means the estimated coefficient is statistically significant. The significance (P-Value) gives the probability of obtaining the value of t statistic or more extreme values if the coefficient is 0, i.e., the hypothesis is true.

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2.3.5 Interval EstimationRule of Thumb

Rule of Thumb for a 95 Percent Confidence Interval

2 , b 2 ] [b b b . where b is the standard error of b

(bp^-bp)/sd of bp^ ~ t n-k Prob{|(bp^-bp)/sd of bp^ | <=2} = 95% Prob{-2<= (bp^-bp)/sd of bp^ <=2} = 95% Prob{bp^-2sd of bp^<=bp<=bp^+2sd of bp^} = 95%

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2.3 Demand Estimation

Technical methods Consumer interviews, survey, and market experiments

New coke: In April 1985, Coca-Cola announced its plan to change to an improved formula.190,000 taste tests conducted by the company. Three months later, apologized, and Coke Classic.

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3. Creating demand

Through providing complements:

What (goods or services) else can my customers buy so that they will value my product (service) more?
Real estate Supermarkets

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3. Thinking Complements

What are the complements to cars?

Paved roads Easy financing: General Motors Acceptance Corporation

1919, Ford Motor Credit 1959

Auto insurance Auto repairs: parts and service. Alfa Romeo and Fiat
had trouble selling their cars in the U.S., because people knew that theyd have trouble finding spare parts and qualified mechanics.

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3. More on creating demand

Advertise! Advertise! Advertise! Become your own customer!

Boeing bid for U.S. Post Office to deliver airmail Automakers own car rental agencies:

Chrysler owns part of Avis GM owns part of Avis and owned National Mitsubishi owns part of Value Rent-a-car

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Topic Intended Learning Outcomes

3.1 Calculate and interpret own price elasticity. 3.2 Distinguish elastic, inelastic, and unitary elastic demand; and explain the relationship between own price elasticity and changes in revenue. 3.3 Calculate and interpret cross price elasticity, income elasticity, and advertising elasticity. 3.4 Interpret mathematical representations of demand curves. 3.5 Use Excel to run simple regression with given demand function specification. 3.6 Explain Least Square Method, R square, Adjusted R-square, Fstatistic, t-statistic, and interpret regression results. 3.7 Derive demand function from regression result and calculate/ interpret elasticity and apply it to business decision. 3.8 Propose measures to boost demand.

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