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

Slide 1
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 2
The Identification
Problem
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The demand curve for a commodity
is generally estimated from market
data on the quantity purchased of the
commodity at various prices over
time (i.e. using time-series data) or
for various consuming units or
markets at one point in time (i.e.
using cross-sectional data).

Simply joining the price-quantity
observations on a graph does not
generate the demand curve for the
commodity.
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The reason is that each price-
quantity observation is given by the
intersection of a different (but
unobserved) demand and supply
curve of the commodity.

Over time or across different
individuals or markets, the demand
for the commodity shifts or differs
because of changes or differences in
tastes, incomes, price of related
commodities, and so on.
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Over time or across different sellers
or markets, the supply cure shifts or
is different because of changes or
differences in technology, factor
prices, and weather conditions (for
agricultural commodities).

The intersection (equilibrium) of the
different but unknown demand and
supply curves generates the different
price-quantity points observed.
Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 6
By simply joining the different price-
quantity observations, we do not
generate the demand curve for the
commodity.
This is referred to as the identification
problem.
Suppose that the following price and
quantity information has been collected
from a particular market. These data
result from the interaction of supply and
demand in the market. Specifically, they
are the equilibrium prices and
quantities observed for each year.

Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 7
Year Price Quantity
1 10 100
2 8 120
3 6 140
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Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 9
The data have bee plotted and a line
fitted through the three points. Note
that this line has a negative slope. If
other factors that affect demand did
not change over the three-year
period and the supply curve shifted
to the right from S1 to S2 to S3 as
shown in Figure 4.3a, then DD can be
legitimately identified as a demand
curve.
Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 10
Alternatively, suppose that income,
prices of other goods, or changes in
tastes and preferences caused the
demand curve to shift over time.

In this case, the three points
represent equilibrium prices and
quantities determined by the
intersection of different demand and
supply curves, as shown in Figure
4.3b.
Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 11
Without more information, it is
impossible to choose between the
two possibilities; the separate
demand curves cannot be identified.

That is both the quantity demanded
and the quantity supplied is affected
by a change in the price of the good.
Thus, the effects of price on quantity
demanded and quantity supplied
cannot be separately determined.
Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 12
The key to identifying the true
supply-and-demand relationships is
to add one or more additional
variables to each equation that are
not included in the other equation.

Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 13
By including among the independent
or explanatory variables the most
important determinants of demand,
regression analysis allows the
researcher to disentangle the
independent effects of the various
determinants of demand, so as to
isolate the effect of the price of the
commodity on the quantity
demanded of the commodity.
Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 14
Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 15
Demand Estimation:
Marketing Research Approaches
Consumer Surveys
Observational Research
Consumer Clinics
Market Experiments
Virtual Shopping
Virtual Management
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Scatter Diagram
Regression Analysis
Year X Y
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
Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 17
Regression Analysis
Regression Line: Line of Best Fit

Regression Line: Minimizes the sum of
the squared vertical deviations (e
t
) of
each point from the regression line.

Ordinary Least Squares (OLS) Method
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Regression Analysis
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Ordinary Least Squares (OLS)
Model:
t t t
Y a bX e


t t
Y a bX

t t t
e Y Y
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Ordinary Least Squares (OLS)
Objective: Determine the slope and
intercept that minimize the sum of
the squared errors.
2 2 2
1 1 1


( ) ( )
n n n
t t t t t
t t t
e Y Y Y a bX



Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 21
Ordinary Least Squares (OLS)
Estimation Procedure
1
2
1
( )( )

( )
n
t t
t
n
t
t
X X Y Y
b
X X

a Y bX
Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 22
Ordinary Least Squares (OLS)
Estimation Example
1 10 44 -2 -6 12
2 9 40 -3 -10 30
3 11 42 -1 -8 8
4 12 46 0 -4 0
5 11 48 -1 -2 2
6 12 52 0 2 0
7 13 54 1 4 4
8 13 58 1 8 8
9 14 56 2 6 12
10 15 60 3 10 30
120 500 106
4
9
1
0
1
0
1
1
4
9
30
Time t
X
t
Y
t
X X
t
Y Y ( )( )
t t
X X Y Y
2
( )
t
X X
10 n
1
120
12
10
n
t
t
X
X
n

1
500
50
10
n
t
t
Y
Y
n

1
120
n
t
t
X

1
500
n
t
t
Y

2
1
( ) 30
n
t
t
X X

1
( )( ) 106
n
t t
t
X X Y Y

106

3.533
30
b
50 (3.533)(12) 7.60 a
Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 23
Ordinary Least Squares (OLS)
Estimation Example
10 n
1
120
12
10
n
t
t
X
X
n

1
500
50
10
n
t
t
Y
Y
n

1
120
n
t
t
X

1
500
n
t
t
Y

2
1
( ) 30
n
t
t
X X

1
( )( ) 106
n
t t
t
X X Y Y

106

3.533
30
b
50 (3.533)(12) 7.60 a
Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 24
Tests of Significance
Standard Error of the Slope Estimate
2 2

2 2

( )
( ) ( ) ( ) ( )
t t
b
t t
Y Y e
s
n k X X n k X X

Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 25
Tests of Significance
Example Calculation
2 2
1 1

( ) 65.4830
n n
t t t
t t
e Y Y



2
1
( ) 30
n
t
t
X X

( )
65.4830
0.52
( ) ( ) (10 2)(30)
t
b
t
Y Y
s
n k X X

1 10 44 42.90
2 9 40 39.37
3 11 42 46.43
4 12 46 49.96
5 11 48 46.43
6 12 52 49.96
7 13 54 53.49
8 13 58 53.49
9 14 56 57.02
10 15 60 60.55
1.10 1.2100 4
0.63 0.3969 9
-4.43 19.6249 1
-3.96 15.6816 0
1.57 2.4649 1
2.04 4.1616 0
0.51 0.2601 1
4.51 20.3401 1
-1.02 1.0404 4
-0.55 0.3025 9
65.4830 30
Time t
X
t
Y
t
Y

t t t
e Y Y
2 2

( )
t t t
e Y Y
2
( )
t
X X
Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 26
Tests of Significance
Example Calculation
2

( )
65.4830
0.52
( ) ( ) (10 2)(30)
t
b
t
Y Y
s
n k X X

2
1
( ) 30
n
t
t
X X

2 2
1 1

( ) 65.4830
n n
t t t
t t
e Y Y



Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 27
Tests of Significance
Calculation of the t Statistic

3.53
6.79
0.52
b
b
t
s

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 28
Tests of Significance
Decomposition of Sum of Squares
2 2 2

( ) ( ) ( )
t t t
Y Y Y Y Y Y

Total Variation = Explained Variation + Unexplained Variation
Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 29
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 30
Tests of Significance
Coefficient of Determination
2
2
2

( )
( )
t
Y Y
ExplainedVariation
R
Total Variation Y Y

2
373.84
0.85
440.00
R
Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 31
Tests of Significance
Coefficient of Correlation
2

r R withthesignof b
0.85 0.92 r
1 1 r
Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 32
Multiple Regression Analysis
Model:
1 1 2 2 ' ' k k
Y a b X b X b X
Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 33
Multiple Regression Analysis
Adjusted Coefficient of Determination
2 2
( 1)
1 (1 )
( )
n
R R
n k

Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 34
Multiple Regression Analysis
Analysis of Variance and F Statistic
/( 1)
/( )
ExplainedVariation k
F
UnexplainedVariation n k

2
2
/( 1)
(1 ) /( )
R k
F
R n k

Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 35
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 36
Durbin-Watson Statistic
Test for Autocorrelation
2
1
2
2
1
( )
n
t t
t
n
t
t
e e
d
e

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 37
Steps in Demand Estimation
Model Specification: Identify Variables
Collect Data
Specify Functional Form
Estimate Function
Test the Results
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Functional Form Specifications
Linear Function:
Power Function:
0 1 2 3 4 X X Y
Q a a P a I a N a P e
1 2
( )( )
b b
X X Y
Q a P P
Estimation Format:
1 2
ln ln ln ln
X X Y
Q a b P b P
Prepared by Robert F. Brooker, Ph.D. Copyright 2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 39

PROBLEMS IN REGRESSION


ANALYSIS

Problem Conditions under which this occurs Impact How to overcome
1. Multicollinearity Two or more explanatory variables in
Regression are highly correlated.
Ex-aggregated
SEs resulting in lowt values for
regression coefficient.

The regression coefficients shall be
insignificant (despite high R
2
) while
these indeed may be significant.
1. Extending the sample size.
2. Using prior information.
3. Transforming the functional
relationship.
4. Dropping one of highly collinear
variable.
2. Hetroscedasticity The assumption of constant term for all
independent variables is violated.
Biased SEs, incorrect statistical tests
and C.Is for parameter estimate.
1. Using log of explanatory variable
that lead to hetroscedastic
disturbances.
2. Running a weighted least
sequences regression.
3. Auto-correlation
(Serial correlation)
Consecutive errors or residuals are
correlated (-ve or +ve).
Estimated coefficients are not
biased.

SEs are biased downwards. t
though insignificant shall become
significant can be detected by using
D.W. test

d
c
< d
L
Auto-correlation exists.

d
L
< d
c
< d
u
iconclusive
d
c
> d
u
No auto correlation
- including of time as an additional
variable.
- Inclusion of an important
missing variable into regression.
- Restimation of regression in non-
linear form. f