Demand Estimation

Involves four steps :

1. Development of a theoretical model

2. Data collection

3. Choice of functional form

4. Estimation and interpretation of results

1. Development of a Theoretical Model :

The analyst must form a theoretical model.

This model should be based on sound economic theory and be expressed in mathematical terms. Fundamentally the model building process involves determining which variable should be included in analysis.

For example, in case of estimating a demand equation:

Q = f (P, I, PO, T)

where P, I, PO & T is price, income, price of some other goods & tastes and preferences of consumers.

Economic theory can also be used to analyze the expected relationship between the independent relationship and the dependent relationship. If there is any inconsistency between the economic theory and regression analysis, then the process should be re-examined.
A co-efficient with an unexpected result / sign, should be carefully re-examined.

2. Data Collection :
To estimate demand, data for each of the variables that influence demand first must be obtained.
The data may be collected from surveys, market experiments, or existing sources such as historical records of the firm or government publications.

 In general either time-series or cross section data may be used.

Time-series data consist of period-by-period observations in a specific market for each of the variables that affect demand. Cross-section data are based on a number of markets at a single point in time.

3. Choice of Functional Form :

Estimation using regression analysis requires the choice of a specific functional form for the equation.

Q = f (P, I, PO, T)

A linear equation is the simplest possible form as shown :

Q = B + apP + aI I + ao Po + aT T
The linear form has several advantage : - easy to operate. - no transformation of data is necessary - each coefficient represents the change in quantity per unit change in associated variable. - it is also possible to calculate elasticities based on the estimated coefficients. Thus, the formula for calculating point elasticity of demand is :

EP = dQ . P dP Q
But dQ / dP = aP. Thus by selecting the value of P and using the estimated equation, value of elasticity can be calculated.

 Other functional form can also be used for regression analysis. Other than linear form the most common form is multiplicative functional form. For estimating demand, the multiplicative equation is :

Q = B Pap Iai Poao TaT

But to make the calculation simple, we take the log of this equation

log Q = log (B) + aP log P + aI log I + ao log Po + aT log T

In this equation, the coefficients have an important interpretation.

They represent the respective elasticities :

dQ = (aP) B Pa Ia Poa Ta dP
P-1 I o

Multiplying both sides of the equation by P / Q

E = dQ . P = (aP) B Pa Ia Poa Ta dP Q Q
P I o

E = aP
Normally if the relationship is linear, then linear functional form should be used; and if it is non-linear, multiplicative functional form should be used.

4. Estimation and Interpretation of Results :

The result should be interpreted carefully with the value as well as the sign. Both have their own importance.
Result should be interpreted individually for each coefficient, as well as it should also be checked that how far the independent variable affects the value of dependent variable, with the help of analyzing the coefficient of determination and t-value. After interpreting these results carefully, we should come to any conclusion.