Chapter 5 - Basic Estimation Techniques

Managerial Economics
Managerial Economics Thomas

ninth edition Maurice
Chapter 4
Basic Estimation Techniques
McGraw-Hill/Irwin
Managerial Economics, 9e Copyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved.
Learning Outcomes
• Set up and interpret simple linear regression equations.
• Estimate intercept and slope parameters of a regression line

using the method of least-squares.
• Determine whether estimated parameters are statistically

significant using either t-tests or p-values associated with
parameter estimates.
4-2
Learning Outcomes
• Evaluate how well a regression equation “fits” the data by
examining the R 2 statistic and test for statistical significance of
the whole regression equation using an F-test.
• Set up and interpret multiple regression models that use more
than one explanatory variable.
• Use linear regression techniques to estimate the parameters
of two common nonlinear models: quadratic and log-linear
regression models.
4-3
Definition of Concepts
• Parameter Estimation
- the process of finding estimates of the numerical values of
the parameters of an equation is called parameter estimation.
• Regression Analysis
- a statistical technique for estimating the parameters of an
equation and testing for statistical significance
- a technique used to determine the mathematical relation
between a dependent variable and one or more explanatory
variables.
• Dependent variable
- the variable whose variation is to be explained.
4-4
• Explanatory variables
- the variables that are thought to cause the dependent variable to
take on different values.
• Intercept parameter
- the parameter that gives the value of Y at the point where the
regression line crosses the Y-axis.
• Slope parameter
- The slope of the regression line, b = dY/dX, or the change in Y
associated with a one-unit change in X.
4-5
• Time-series
- a data set in which the data for the dependent and explanatory
variables are collected over time for a specific firm.
• Cross-sectional
- a data set in which the data on the dependent and explanatory
variables are collected from many different firms or industries at a
given point in time.
• Scatter diagram
- a graph of the data points in a sample.
4-6
• Population regression line
- the equation or line representing the true (or actual) underlying
relation between the dependent variable and the explanatory
variable(s).
• Sample regression line
- the line that best fits the scatter of data points in the sample and
provides an estimate of the population regression line.
4-7
Simple Linear Regression

• Simple linear regression model relates
dependent variable Y to one independent (or
explanatory) variable X
Y  a  bX
• Intercept parameter (a) gives value of Y
where regression line crosses Y -axis (value
of Y when X is zero)
• Slope parameter (b) gives the change in Y
associated with a one-unit change in X,
b  Y / X
4-8
Method of Least Squares

• Parameter estimates are obtained by
choosing values of a & b that minimize
the sum of squared residuals
• The residual is the difference between the
actual & fitted values of Y , Yi  Yˆi
• The sample regression line is an estimate of the
true regression line
Yˆ  a ˆ
ˆ  bX
4-9
Fitting a Regression Line

• Problem:
The association wishes to determine the mathematical relation
between the dollar volume of sales of travel packages (S) and
the level of expenditures on newspaper advertising (A) for travel
agents located in the Tampa–St. Petersburg metropolitan area.
Suppose that the true (or actual) relation between sales and
advertising expenditures is
S = 10,000 + 5A
4-10
• Because of these random effects, the level of sales for a

firm cannot be exactly predicted. The regression equation
shows only the average or expected level of sales when a
firm spends a given amount on advertising.
• The exact level of sales for any particular travel agency
(such as the ith agency) can be expressed as
• Si = 10,000 + 5Ai + ei
4-11
Sales and Advertising Expenditures of

Travel Agencies
Firm Sales Advertising expenditure
A $15,000 $2,000
B 30,000 2,000
C 30,000 5,000
D 25,000 3,000
E 55,000 9,000
F 45,000 8,000
G 60,000 7,000
4-12
Fitting a Regression Line (Figure
4.2)
70,000 Si  60,000 Sample regression line

60,000
• Ŝi  11573
,  4.9719 A
Sales (dollars)
50,000
ei •
40,000
•
Ŝi  46,376
30,000
• •
20,000
•
10,00
•
0
A
0 2,00 4,00 6,00 8,000 10,00
0 0 0 0
Advertising expenditures
(dollars)
4-13
Firm Advertising expenditure Actual sales Expected sales Random effect
Tampa Travel Agency $3,000 $30,000 $25,000 $5,000
Buccaneer Travel Service 3,000 21,000 25,000 24,000
Happy Getaway Tours 3,000 25,000 25,000 0
4-14
Unbiased Estimators
• The estimates of â & b ˆ do not generally
equal the true values of a & b
ˆ are random variables computed using
• â & b
data from a random sample
• The distribution of values the estimates might take is

centered around the true value of the parameter
• An estimator is unbiased if its average value (or expected
value) is equal to the true value of the parameter
4-15
Relative Frequency Distribution* (Figure 4.3)
Relative frequency of b̂ Relative Frequency Distribution*

1 for bˆ when b  5
0 1 2 3 4 5 6 7 8 9 10
ˆ
Least-squares estimate of b (b)
*Also called a probability density function (pdf) 4-16

Statistical Significance
• Must determine if there is sufficient statistical evidence
to indicate that Y is truly related to X (i.e., b  0)
• Even ifb = 0 it is possible that the

sample will produce an estimate b̂
that is different from zero
• Test for statistical significance using t-tests

or p-values
4-17
Performing a t-Test
• First determine the level of significance
• Probability of finding a parameter estimate to be
statistically different from zero when, in fact, it is zero
• Probability of a Type I Error
• 1 – level of significance = level of confidence
4-18
Performing a t-Test
b̂
• t -ratio is computed as t 
Sb̂
where Sb̂ is the standard error of the estimate bˆ
• Use t-table to choose critical t-value with n – k

degrees of freedom for the chosen level of
significance
• n = number of observations
• k = number of parameters estimated
4-19
Performing a t-Test
• If absolute value of t-ratio is greater than the
critical t, the parameter estimate is
statistically significant
4-20
Using p-Values
• Treat as statistically significant only those parameter
estimates with p-values smaller than the maximum
acceptable significance level
• p-value gives exact level of significance

• Also the probability of finding significance when none
exists
4-21
Coefficient of Determination
• R2 measures the percentage of total variation in the dependent
variable that is explained by the regression equation
• Ranges from 0 to 1
• High R2 indicates Y and X are highly correlated
4-22
F-Test
• Used to test for significance of overall regression
equation
• Compare F-statistic to critical F-value from F-table
• Two degrees of freedom, n – k & k – 1

• Level of significance
• If F-statistic exceeds the critical F, the regression

equation overall is statistically significant
4-23
Multiple Regression
• Uses more than one explanatory variable
• Coefficient for each explanatory variable measures the

change in the dependent variable associated with a one-
unit change in that explanatory variable
4-24
Quadratic Regression Models

• Use when curve fitting scatter plot
U
is U-shaped or -shaped
• Y  a  bX  cX 2
• For linear transformation compute

new variable Z  X 2
• Estimate Y  a  bX  cZ
4-25
Log-Linear Regression Models

• Use when relation takes the form: Y  aX b Z c
Percentage change in Y
• b 
Percentage change in X
Percentage change in Y
• c 
Percentage change in Z
• Transform by taking natural logarithms:
lnY  ln a  b ln X  c ln Z
• b and c are elasticities
4-26

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Managerial Economics

Managerial Economics Thomas

• Set up and interpret simple linear regression equations.

• Estimate intercept and slope parameters of a regression line

• Determine whether estimated parameters are statistically

Simple Linear Regression

Method of Least Squares

Fitting a Regression Line

• Because of these random effects, the level of sales for a

Sales and Advertising Expenditures of

70,000 Si  60,000 Sample regression line

Firm Advertising expenditure Actual sales Expected sales Random effect

Tampa Travel Agency $3,000 $30,000 $25,000 $5,000

Buccaneer Travel Service 3,000 21,000 25,000 24,000

Happy Getaway Tours 3,000 25,000 25,000 0

• The distribution of values the estimates might take is

Relative Frequency Distribution* (Figure 4.3)

Relative frequency of b̂ Relative Frequency Distribution*

*Also called a probability density function (pdf) 4-16

• Even ifb = 0 it is possible that the

• Test for statistical significance using t-tests

• Probability of a Type I Error

• 1 – level of significance = level of confidence

• Use t-table to choose critical t-value with n – k

• p-value gives exact level of significance

• Two degrees of freedom, n – k & k – 1

• If F-statistic exceeds the critical F, the regression

• Coefficient for each explanatory variable measures the

Quadratic Regression Models

• For linear transformation compute

Log-Linear Regression Models

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