Managerial Economics in a Global Economy, 5th Edition by Dominick Salvatore

Chapter 4 Demand Estimation

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 1

The Identification Problem

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 2

Demand Estimation: Marketing Research Approaches

Consumer Surveys Observational Research Consumer Clinics Market Experiments Virtual Shopping Virtual Management
Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 3

Prepared by Robert F. Brooker, Ph.D.

Regression Analysis
Year 1 2 3 4 5 6 7 8 9 10 X 10 9 11 12 11 12 13 13 14 15 Y 44 40 42 46 48 52 54 58 56 60
Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 4

Scatter Diagram

Prepared by Robert F. Brooker, Ph.D.

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
Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 5

Regression Analysis

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 6

Ordinary Least Squares (OLS)

Model:
Yt a bX t et

a Y bX t t et Yt Y t

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 7

Ordinary Least Squares (OLS)

Objective: Determine the slope and intercept that minimize the sum of the squared errors.
2 2 )2 e ( Y Y ) ( Y a bX t t t t t t 1 t 1 t 1 n n n

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 8

Ordinary Least Squares (OLS)

Estimation Procedure

(X
t 1 n t 1

X )(Yt Y )
t

(X

Y bX a

X)

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 9

Ordinary Least Squares (OLS)

Estimation Example
Time
1 2 3 4 5 6 7 8 9 10
n

Xt
10 9 11 12 11 12 13 13 14 15 120

Yt
44 40 42 46 48 52 54 58 56 60 500

Xt X
-2 -3 -1 0 -1 0 1 1 2 3
n

Yt Y
-6 -10 -8 -4 -2 2 4 8 6 10

( X t X )(Yt Y )
12 30 8 0 2 0 4 8 12 30 106

( X t X )2
4 9 1 0 1 0 1 1 4 9 30

n 10
X
t 1 n

X t 120
t 1

Yt 500
t 1

(X
t 1 n

X ) 2 30 X )(Yt Y ) 106

106 3.533 b 30
50 (3.533)(12) 7.60 a

X t 120 12 n 10

Yt 500 50 10 t 1 n

(X
t 1

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 10

Ordinary Least Squares (OLS)

Estimation Example
n 10
X
t 1 n n

X t 120 12 n 10

X
t 1

120
2

Y
t 1

500

Yt 500 50 10 t 1 n

(X
t 1 n

X ) 30 X )(Yt Y ) 106

106 b 3.533 30

(X
t 1

50 (3.533)(12) 7.60 a
Slide 11

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Tests of Significance
Standard Error of the Slope Estimate
2 ( Y Y ) t 2 e t

sb

(n k ) ( X t X )

(n k ) ( X t X ) 2

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 12

Tests of Significance
Example Calculation
Time
1 2 3 4 5 6 7 8 9 10

Xt
10 9 11 12 11 12 13 13 14 15

Yt
44 40 42 46 48 52 54 58 56 60

Y t
42.90 39.37 46.43 49.96 46.43 49.96 53.49 53.49 57.02 60.55

et Yt Y t
1.10 0.63 -4.43 -3.96 1.57 2.04 0.51 4.51 -1.02 -0.55

)2 et2 (Yt Y t
1.2100 0.3969 19.6249 15.6816 2.4649 4.1616 0.2601 20.3401 1.0404 0.3025 65.4830

( X t X )2
4 9 1 0 1 0 1 1 4 9 30

e (Yt Yt )2 65.4830
t 1 2 t t 1

(X
t 1

X ) 30
2

sb

(Y Y ) ( n k ) ( X X )
2 t t

65.4830 0.52 (10 2)(30)

Slide 13

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Tests of Significance
Example Calculation
2 2 e ( Y Y ) t t t 65.4830 t 1 t 1 n n

2 ( X X ) 30 t t 1

65.4830 sb 0.52 2 ( n k ) ( X t X ) (10 2)(30)

Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 14

2 (Yt Y )

Tests of Significance
Calculation of the t Statistic
3.53 b t 6.79 sb 0.52

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

Critical Value at 5% level =2.306

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 15

Tests of Significance
Decomposition of Sum of Squares
Total Variation = Explained Variation + Unexplained Variation

2 2 (Yt Y ) (Y Y ) (Yt Yt ) 2

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 16

Tests of Significance
Decomposition of Sum of Squares

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 17

Tests of Significance
Coefficient of Determination
R2 Explained Variation 2 TotalVariation ( Y Y ) t
2 ( Y Y )

373.84 R 0.85 440.00

2

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 18

Tests of Significance
Coefficient of Correlation
r R2 withthe signof b

1 r 1
r 0.85 0.92

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 19

Multiple Regression Analysis

Model:

Y a b1 X 1 b2 X 2

bk ' X k '

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 20

Multiple Regression Analysis

Adjusted Coefficient of Determination
(n 1) (n k )

R 2 1 (1 R 2 )

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 21

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 )

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 22

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.
Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 23

Durbin-Watson Statistic
Test for Autocorrelation
2 ( e e ) t t 1 t 2 2 e t t 1 n n

If d=2, autocorrelation is absent.

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 24

Steps in Demand Estimation

Model Specification: Identify Variables Collect Data Specify Functional Form Estimate Function Test the Results

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 25

Functional Form Specifications

Linear Function:
QX a0 a1 PX a2 I a3 N a4 PY e

Power Function:
b1 QX a ( PX )( PYb2 )

Estimation Format:
ln QX ln a b1 ln PX b2 ln P Y

Prepared by Robert F. Brooker, Ph.D.

Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved.

Slide 26