Managerial Economics

PGDM : 2019 – 2021

Term 1 (June – September, 2019)
(Lecture 08)
Demand Estimation
Why is Demand Estimation Important for a Firm?

• Estimating Demand is important because

– It gives an idea about how much to produce to sell in the product
– It helps to make decisions on Pricing
– Helps to forecast revenue
– Helps to take a decision on Cost

• In general, we can say having a good idea about the demand for a product
helps to reduce uncertainty or risk associated with the business.
What are the Different Methods to Estimate Demand?

• Primarily Demand can be estimated using

• Survey or Descriptive Method

• Consumer Surveys: ask a sample of consumers to collect
information on their preferences and purchasing pattern and other
factors affecting their demand for a product.
• Consumer Focus Group: experimental groups try to emulate a
market
• Market Experiments in Test Stores: get demand information by
trying different prices

• Statistical Technique: Econometric Method

A general Overview of Econometric Estimation

• The very first step in econometric estimation is to specify the model

• An econometric model is developed on the basis of

• An established theoretical relationship or
• An intuition

• With the help of an econometric model either we validate or refute

(empirically) the theoretical/intuitive relationship

• An econometric model primarily consists of

• An Independent Variable
• A set of dependent Variables which together explains the
variation in the dependent variable
• An Unobserved term
A general Overview of Econometric Estimation

• Let’s take the following example

• It is reasonable to think that higher education leads to higher level of
earning. Most of the time we go for higher studies keeping this simple
logic in our minds.

• But the question is : Is it a valid logic?

• An econometric model developed on the basis of this intuition can verify it

with the help real data on schooling and Income.

• So, suppose the theoretical relationship between Income (Y) and years of
schooling (S) is the following: Y  f (S ) and assuming a linear relationship
between these two variables the exact form becomes
Y     S ................(1)
Specification of the Model

• However, when we are specifying the theoretical model we are having the
implicit assumption Ceteris paribus

• In reality there are many other factors which affect an individual’s income.
Even if two individuals have same level of education, these “many other
factors” may be different across these two individuals and in turn can affect
the income.

• Therefore, while developing an econometric (empirical) model we must

account for these “many other factors”.

• Therefore to verify the theoretical relationship (1) we consider the

following empirical model:
Y    S  X   ..............(2)
Specification of the Model

• In this particular example the many other factors may include

• Age
• Work Experience
• On-Job training
• School Quality
Measurable
• Family Background
• Health
• Gender
• Race (Think about the reservation policy of India)
• Motivation
• Talent
• Intelligence, and Difficult to be measured or remain
Unobserved in the model
• Others
Specification of the Model

• In equation (2), the variable X contains all those factors

• which affect Income (Y), other than years of schooling (S), and
• which can be measured

• The factor (random error) contains all those factors which are unobserved like
motivation, intelligence etc….

• It should be kept in mind that while specifying the empirical model, one must consider
all possible observed factors which affect income.

• To identify these “many other factors” is the “Identification Strategy” in an empirical

research.

• Also, to obtain a more precise estimate of the impact of schooling on income, it is the
researcher’s responsibility to find out suitable proxy variables for unobserved factors.
For example, SAT score has been used in research as a proxy (not a very good though)
for inherent ability or intelligence.
Estimation and Inference

• Once the model specification is done we estimate the model and run
statistical tests to confirm our estimated results.

• However, here we will not discuss the estimation technique at all rather
we will learn how to interpret estimated results and later will apply this
knowledge to demand estimation.

• So the estimated model is Yˆ  ˆ  ˆS  ˆX ..............(3)

• Note that,
• The estimated equation does not contain the error term any more.
• X is a set of “many other observed factors”, it is not a single variable
Interpretation of Estimated Coefficients

• So the estimated model is Yˆ  ˆ  ˆS  ˆX ..............(3)

• If our estimation is correct then ˆ will have positive sign

• ˆ measures, ceteris paribus, the increase in income for one additional year of
schooling, i.e., the marginal impact of schooling on income or return to
education.
ˆ Y

S
• Likewise different ̂ ' s for different other factors represent the marginal
impact of a particular factor on Income.
Demand Estimation

• Now following the Law of Demand, the theoretical relationship between Price (P)
and Quantity Demanded is Q d
 f (P )

• Now following this theoretical model when we specify the empirical model to
estimated demand from observed data the model becomes,
Qd    P  X   ................( 4)

• So as before, the X contains all those factors, other than the price of the
product, which affect demand either positively or negatively

• From our theoretical discussion we know these factors are primarily

• Income
• Number of Buyers
• Price of Related Goods
• Future Expectation
How you would include these factors in a
demand equation is the Identification
Strategy here…..
Demand Estimation: Model Specification

• Therefore, considering these factors our model to estimate demand

becomes
Q d    P  1 I  2 N  3 P C  4 P S  5 pref   ...........(5)

• In this model the most problematic variable is pref representing the

preference or taste of the consumer.

• This is hard to measure, but you must find a suitable proxy for this variable;
otherwise it will be included in the error term and you will end up with a
wrong estimate of demand for your product.
Demand Estimation: Estimated Model and
Interpretation

• The estimated demand equation in

Qˆ d  ˆ  ˆP  ˆ1 I  ˆ2 N  ˆ3 P C  ˆ4 P S  ˆ5 pref ........(6)

• we have an elaborate discussion on the “ interpretation of estimated

results”

• Also, I expect that you are able to find out different types of elasticity from
this estimated demand equation. So, do it yourself……………
 The Demand for Sweet Potatoes (SP) in the United
States
• Estimates the demand for Sweet Potatoes in the United States for the period of 1949-
1972

• The demand equation to be estimated is

Qsd     Ps  N  I   Pw  t  
Error Term
Quantity of SPs sold per Two year moving
year per 1000 hundred average of US
Real dollar price of
weight (cwt) population
Real per capita White potatoes per
Real-dollar price of SPs per personal cwt
cwt received by the farmers disposable income,
in thousands of
dollars

Time Trend ( t = 1 for 1949, t = 2 for 1950,………., t = 24 for 1972

The Demand for Sweet Potatoes in the United States

• The Estimated demand equation is

d
Qs  7609  1606 Ps  59 N  947 I  479 Pw  271t
• The estimated demand function indicates that the quantity demanded of SPs
per year in 1000 cwt (i.e., in 100,000 lbs) units in the United States
The Demand for Sweet Potatoes in the United States

• The Estimated demand equation is

d
Qs  7609  1606 Ps  59 N  947 I  479 Pw  271t

• The estimated demand function indicates that the quantity demanded of

SPs per year in 1000 cwt (i.e., in 100,000 lbs) units in the United States
– declines by 1606 for each $1 increase in its price
– Increases by 59 for each 1 million increase in population
– Increases by 947 for each $1000 increase in real income
– Increases by 479 for each $1 increase in the real price of white potatoes
– Decreases by 271 every year (coefficient of t the time trend variable)
The Demand for Sweet Potatoes in the United States
• Putting the actual value of all other variables, the estimated demand for
Sweet Potatoes in the year 1949,
d
Qs ,1949  7609  1606 Ps  59 (150.73)  947(1.76)  479( 2.94)  271(1)
d
Qs ,1949  19306  1606 Ps ..................(1)
• So,
– at a price of $7 of SP, quantity demanded is 8064 ,
– at price $ 5.6 (actual real price of SP in 1949) quantity demanded is 10,
312
– at price $ 4 quantity demanded is 12882

• Similarly the estimated demand in the year 1972 is,

d
Qs ,1972  7609 1606 Ps  59 ( 208.78)  947(3.19)  479( 2.41)  271(24)
d
Qs ,1972  17598 1606 Ps ......................(2)
Exercise

• From the estimated demand equation of Sweet Potatoes, calculate the

following
– Own Price elasticity of Sweet Potatoes
– Income Elasticity of Sweet Potatoes , and
– Cross Price Elasticity of Sweet Potatoes
– Given that,
• The real price of Sweet Potato in 1949 = $5.6
• The real Price of White Potato in 1949 = $2.94
• Real income in 1949 = 1.76
• Do the same exercise for the year 1972.
– Suppose, the real price of Sweet Potato in 1972 = $5.2
– Find out income and price of white potatoes in 1972 from equation (2).

• Finally compare the elasticities across the years 1949 and 1972 and comment.
Estimation of the Demand for Air Travel between
India and Singapore

• Let the theoretical relation between Air Travel demand and its fare and other
factors is the following:
Q d  A( P )  ( I ) e

• This is not our familiar demand relation. Here the relation is non-linear. Taking
Log (natural log) on both sides we get,
ln(Q d )     ln( P )   ln(GNP )  
Where,   ln ( A)
Estimation of the Demand for Air Travel between
India and Singapore

• Therefore the demand equation to be estimated is

ln(Qtd )     ln( Pt )   ln(GNPt )  

Number of passengers per Indian GNP in

year travelling between each year, adjusted
India and Singapore from for Inflation
1994 to 2000
Average yearly airfare
between Delhi and
Singapore (weighted by the
seasonal distribution of
traffic and adjusted for
inflation)
Estimation of the Demand Travel for Air Travel
between India and Singapore

• The Estimated demand equation is

ln(Qtd )  3.342  1.452 ln( Pt )  1.92 ln(GNPt )

• Interpretation of the results:

– A 10% increase in airfare causes the quantity demanded _____________
– A 10% increase in GNP ___________________________

• What can be said about the nature of the service “Air Travel”?
– ________________________________;

– __________________________________________.
The Demand for Automobile

• Gregory Chow (1960) estimated the demand for Automobiles in the United States

• The demand equation to be estimated is

QAd     PAt  I et  
Error Term
The per capita stock of
automobiles at the end of Expected Per
period t An automobile Capita Income
Price Index
The Demand for Automobile

• The Estimated demand equation is

d
QA   0.72  0.05PAt  0.02 I et
• For the year 1960,
– The price elasticity was (-) 0.06, and
– Income elasticity was 1.5

• These results suggest that ___________________________.

• The generally low price elasticities may explain automakers’ past

reluctance to reduce list prices, even though they have been known to offer
sizable rebates when caught with large inventories in periods of declining
expected real consumer income.
Problem
The demand curves for steak, eggs, and hot dogs are given in the table below. The
current price of steak is $5. The price of eggs is $2.50, and the price of hot dogs is
$0.75. Fill in the remaining columns of the table using this information. Indicate
which goods are substitutes and which goods are complements.

Steak Price Egg Price Hotdog Price

Good Demand Equation Elasticity of Elasticity of Elasticity of
Demand Demand Demand

Steak DS = 500 - 2PS – (1/10) PE + PH      

Egg DE = 75 - 3PE - PS + (1/10) PH      

DH = 300 - (1/10) PH + PS + (1/10)

Hotdog      
PE
Statistical Demand Functions for Automobiles and
Their Use for Forecasting in an Energy Crisis

• Rodney Carlson and M. Michael Umble (1980) estimated the demand for Automobiles in
the United States for the period 1967 - 1978

• The demand equation estimated is

United Auto Worker’s Strike

Estimated Results