3.

0 DEMAND ESTIMATION

OUTLINE
4.1 Introduction to demand Estimation
4.2 Technique of demand estimation
4.3 Demand estimation by Multiple Regression
-Least square method
4.4 Interpretation of regression results
A)
Standard error of coefficients or tstatistics
B)
Coefficient of Determination
C)
Standard error of estimation (see)

DEMAND ESTIMATION
Demand function :Qx = f(Px, Py, I ,A)
Objective: Estimate the quantity demanded for
the product if certain variable changes
Qx
--- dependent variable
Px,Py,I,A --- independent variable
Ex.

Qx = a + bPx + cPy + dI + eA
a,b,c,d,e ------ coefficient
If 1% or 1 unit of the independent variables
changes, what will happen to the Qx.
Technique of demand estimation
e.g Manager wants to determine the relationship
between firm's advertising expenditures and
its sales revenue
To test hypothesis, that increase in Advertising
Will increase sales and estimate the
strength of the relationship.
e.g $ Increase in Advertising--------increase in Sales
Sales (y-axis)
--- dependent variable
Advertising expenditures (x-axis)---- independent
variable
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Data for past 10 years

Yr
Advertising
Sales
1
$1500
$60,000
2
1650
74,000
3
4
.
.
.
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Scatter Diagram

Sales

.
.
..

Advertising
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Linear relationship between sales and

advertising expenditures
Standard form of linear equation Y = a + bX
a=intercept
b=slope
Regression analysis
Statistical technique for obtaining the line that
best fits the data points according to an objective
statistical criteria
It describes relations among dependent and
independent variables.
The regression line is the line obtained by
minimizing the sum of the squared vertical
derivations of each point from the regression
line---Least square method

y=a + bx

MULTIPLE REGRESSION
Estimation of the parameter of equation with more
than one independent variable
e.g demand ----price, income , price of other
product
Qd = f(P,I,Po)
Qd = a +bP+cI+dPo
Regression analysis- 4 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
-formulate model of economic relationship and
expressed in mathematical form
-specify the variable to be included in regression
equation that are expected to influence demand

Prior knowledge- based on economic theory

can be used to assess empirical results of
regression analysis
P & Qd---inverse relationship
I & Qd-positive relationship (normal goods)
Po & Qd-positive relationship (substitute goods)
- negative relationship (complementary
goods)
Data Collection
-obtaining data on the variables
-collect data-survey,market
experiments,existing sources/publication
-Time series data-period by period
observations for each of the variable that
affect demand
-Cross section data-based on the markets
at a single point in time

3.

Choice of Functional form

-to reflect the true relationship between
variables in the system
-specify the form of equation
a) Linear equation
Qd=a + bP +cPo +dI +eA
-simplest form
b) Power functions
-multiplicative form
Q=aPbPocIdAe

4.

Estimation and Interpretation of Results

a) Estimated Coefficient
Values of coefficient gives us an estimate of
a change in dependent variable associated
with 1 unit change in independent variable
e.g b= -1.2
RM 1 increases in price will decrease
quantity demanded by 1.2 units
-Sign of coefficient- does it justify the
theory?
Independent and dependent variable has
positive or negative relationship
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b) Standard error of Coefficients

-it measure the accuracy of the calculated
value, the smaller the error the better the
coefficient
t-test
-to determine if there is a significant
relationship between the dependent and each
independent variable
t-value= estimated coefficient= b
std error of coefficient sb
If the calculated t-value > table value, of t for nk-1 d.f; b coefficient is significant
( statistically significant relationship exist
between dependent and the appropriate
independent variable)
n-k-1 = number of degrees of freedom
n=number of observations
k=number of independent variables in the
equation

c)

Coefficient of Determination (R 2)
-proportion of total variation in the dependent
variable explained by changes by
independent variable
-indicates how well the entire regression
model explains changes in the value of
dependent variable
R 2 =0.68
68% of total variation in dependent variable
(Qd) is explained by the independent
variables (e.g price,income, price of other
good,etc)
0< R 2<1 values of R 2
0-no explanation of variation in dependent
variable
1-all variation has been explained by
independent variable
High R 2-Good fit-actual data fit near the r
egression line
Low R 2- Poor fit-actual data are scattered

d) Standard error of Estimation

(see)
-measure the dispersion of the data
points from the line of best fit
-determine the range within which
we can predict the dependent
variable with different degrees of
statistical confidence
e.g 95% Confidence Interval
estimate
= Q 1.96 (Std error of estimate)
99% Confidence Interval
= Q + 2.576 (Std error of estimate)

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e) F-test
-provides evidence on whether or not a
statistically significant proportion of the total
variation in the dependent variable has been
explained.
F= R2/ (k-1)
(1-R2 )/(n-k)
-to test whether a significant proportion of the
total variation in the dependent variable has
been explained by the estimated regression
equation
If value of F-statistics =0, regression
equation provides no explanation of the
variation in the dependent variable
If F-value> 0 (large number), assume
that at least some of the variation in the
regression model are significant factors in
explaining the variation in the dependent
variable

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RULE:
F-statistics for regression > Critical value of Fdistribution table
Reject hypothesis of independent between
dependent variable and independent variable in
the regression.
Regression equation as a whole, does
significantly explain the variation in the
dependent variable
Critical value of F-distribution table
=F f1 f2
f1= degree of freedom for numerator = k-1
(k=number of estimated coefficient)
f2= degree of freedom for denominator = n-k

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