Managerial Economics

Applications, Strategies and Tactics, 14e

James R. McGuigan
R. Charles Moyer
Frederick H. deB. Harris

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 PART II – DEMAND AND FORECASTING

Chapter 4 –
Estimating Demand

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 Chapter 4 – Estimating Demand
Overview
• STATISTICAL ESTIMATION OF THE DEMAND
FUNCTION
• A SIMPLE LINEAR REGRESSION MODEL
• USING THE REGRESSION EQUATION TO MAKE
PREDICTIONS
• MULTIPLE LINEAR REGRESSION MODEL

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 Ch 4 – Statistical Estimation of the Demand
Function Specification of the Model (1 of 5)
• The next step is to specify the firm of the equation
(regression relation) that indicates the relationship between
independent variables and dependent variables
• Linear Model – a linear demand model for Sherwin-Williams
paint would be specified as follows:

• Demand theory implies that price (P) would have a negative

effect on gallons of paint sold (Q)

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 Table 4.1 – Sherwin-Williams Company Data

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 Ch 4 – Statistical Estimation of the Demand
Function Specification of the Model (2 of 5)
• If we rearrange Equation 4.1 to solve for price (P), the
intercept of the resulting inverse demand function identifies
the maximum price that can be charged

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 Ch 4 – Statistical Estimation of the Demand
Function Specification of the Model (3 of 5)
• Multiplicative Exponential Model
• In the Sherwin-Williams example, this model would be:

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 Ch 4 – Statistical Estimation of the Demand
Function Specification of the Model (4 of 5)
• In this form, elasticities are constant over the range of data, and
equal to the estimated values of the respective parameters

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 Ch 4 – Statistical Estimation of the Demand
Function Specification of the Model (5 of 5)

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 Ch 4 – A Simple Linear Regression Model

• Here, analysis is limited to one independent and one dependent

variable, where the form of the relationship between the two
variables is linear:

• X represents the independent variable, and Y the dependent

variable

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 Figure 4.1 – Theoretical Regression Line

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 Ch 4 – A Simple Linear Regression Model
Assumptions Underlying the Simple Linear Regression Model (1 of 2)
• Assumption 1: the value of the dependent variable Y is postulated
to be a random variable, which is dependent on deterministic (i.e.,
nonrandom) values of the independent variable X
• Assumption 2: A theoretical straight-line relationship (Fig. 4.1)
exists between X and the expected value of Y for each of the
possible values of X; this theoretical regression line:

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 Ch 4 – A Simple Linear Regression Model
Assumptions Underlying the Simple Linear Regression Model (2 of 2)
• Assumption 3: Associated with each value of X is a probability
distribution, p(y|x), of the possible values of the random variable Y.
When X is set equal to some value x1, the value of Y will be drawn
from the p(y|x) probability distribution, and will not necessarily lie
on the theoretical regression line. See Figures 4.2, 4.3

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 Figure 4.2 – Conditional Probability
Distribution of Dependent Variable

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 Figure 4.3 – Deviation of the Actual Observations
about the Theoretical Regression Line

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 Ch 4 – Statistical Estimation of the Demand Function
Estimating the Population Regression Coefficients (1 of 3)

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 Figure 4.4 – Deviation of the observations
about the Sample Regression Line

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 Ch 4 – Statistical Estimation of the Demand Function
Estimating the Population Regression Coefficients (2 of 3)

• From Equation 4.15, the value of ei is given by:

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 Ch 4 – Statistical Estimation of the Demand Function
Estimating the Population Regression Coefficients (3 of 3)

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 Table 4.2 – Worksheet for Estimation of the Simple
Regression Equation: Sherwin-Williams Company

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 Figure 4.5 – Estimated Regression Line:
Sherwin-Williams Company

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 Ch 4 – Using the Regression Equation to Make
Predictions (1 of 3)
• To predict the value of Y, given any particular value of X. Substitute
Xp, into the sample regression equation (Equation 4.14):

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 Ch 4 – Using the Regression Equation to Make
Predictions (2 of 3)
• The standard error of the estimate is the standard deviation of the
error term in a regression model

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 Ch 4 – Using the Regression Equation to Make
Predictions (3 of 3)

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 Ch 4 – Using the Regression Equation to Make Predictions
Inferences about the Population Regression Coefficients (1 of 4)

• One of the purposes of regression analysis is testing whether the

slope parameter β is equal to some particular value β0
• To test hypotheses about the value of β, the sampling distribution
of the statistic b must be known; an estimate can be calculated:

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 Ch 4 – Using the Regression Equation to Make Predictions
Inferences about the Population Regression Coefficients (2 of 4)

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 Ch 4 – Using the Regression Equation to Make Predictions
Inferences about the Population Regression Coefficients (3 of 4)

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 Ch 4 – Using the Regression Equation to Make Predictions
Inferences about the Population Regression Coefficients (4 of 4)

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 Ch 4 – Using the Regression Equation to Make Predictions
Correlation Coefficient (1 of 1)

• A first measure of the degree of association between two variables

is called the correlation coefficient

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 Figure 4.6 – Correlation Coefficient

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 Ch 4 – Using the Regression Equation to Make Predictions
The Analysis of Variance (1 of 4)

• Another convenient measure of the overall “fit” of the regression

model to the sample of observations is the r-squared; see Fig 4.7

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 Ch 4 – Using the Regression Equation to Make Predictions
The Analysis of Variance (2 of 4)
• We can use this sum-of-squares analysis to measure the fit of the
regression line to the sample observations
• The sample coefficient of determination or (r2) is equal to the ratio of
the Expanded SS to the Total SS

• The coefficient of determination is a measure of the proportion of

total variation in the dependent variable that is explained by the
independent variable(s)
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 Figure 4.7 – Partitioning the Total Deviation

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 Table 4.3 – Calculation of the Explained, Unexplained
& Total SS for the Sherwin-Williams Co

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 Ch 4 – Using the Regression Equation to Make Predictions
The Analysis of Variance (3 of 4)

• Using Table 4.3 and Equation 4.28, the coefficient of determination

is

• The components of the r2 can be reconfigured into an F-ratio

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 Ch 4 – Using the Regression Equation to Make Predictions
The Analysis of Variance (4 of 4)

• Forming the F-ratio we obtain

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 Ch 4 – Multiple Linear Regression Model (1 of x)
• A linear relationship containing two or more independent variables
is known as a multiple linear regression model:

• Use of Computer Programs

• A variety of computer programs can be used to perform these procedures
• Estimating the Population Regression Coefficients

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 Ch 4 – Multiple Linear Regression Model (1 of 2)
• Using the Regression Model to Make Forecasts
• Point forecasts can be made by substituting the particular values of the
independent variables into the estimated regression equation
• See the Sherwin-Williams example

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 Figure 4.8 – Computer Output:
Sherwin-Williams Company

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 Ch 4 – Multiple Linear Regression Model (2 of 2)
• Inferences about the Population Regression Coefficients
• Most regression programs test whether each independent variable (Xs) is
statistically significant in explaining the dependent variable (Y)
• This tests the null hypothesis:

• See Figure 4.8

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 Ch 4 – Multiple Linear Regression Model (1 of 1)
• The Analysis of Variance
• Similar techniques are used to evaluate the overall explanatory power of
the multiple linear regression model
• In Figure 4.8, one is using the F-value to test the null hypothesis:

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