Demand

Estimation

BY:
JUDELYN P. OSORIO
REY L. SABAS JR.
Objectives
• To explain the meaning of demand estimation. • To describe forecasting methods.
• To examine different methods of demand • To explain the multiple regression model
estimation. and its advantages compared to simple
• To explain the nature of empirical studies. regression.
• To illustrate the principles in drawing graphs
of empirical data.
• To explain the OLS regression model.
• To explain and interpret measures of
goodness of fit.
• To explain different mathematical forms of the
regression model.
Introduction
Introduction In the previous chapter it was generally assumed that the demand function for a
firm or market was known; in practice it has to be estimated from empirical data, and that is the
subject of this chapter. When we speak of estimation there are a number of stages involved in
this process. Some of these stages may be omitted in the simpler methods of estimation, like
the first two described in the next section. However, with a statistical study, or econometric
analysis as it is often called, there are essentially the following seven stages:
1. Statement of a theory or hypothesis 5. Checking goodness of fit
2. Model specification 6. Hypothesis testing
3. Data collection
4. Estimation of parameters
Statement of a theory or hypothesis
This usually comes from a mixture of economic theory and previous empirical studies. An example of such
a theory might be that the quantity people buy of a particular product might depend more on the past price than on
the current price. This obviously has implications regarding perfect knowledge, information costs, habit formation
and ‘irrational’ behavior.

Model Specification
This means determining what variables should be included in the demand model and what mathematical
form or forms such a relationship should take. These issues are again determined on the basis of economic theory
and prior empirical studies. Various alternative models may be specified at this stage, since economic theory is often
not robust enough to be definitive regarding the details of the form of model
Data Collection
This stage can only be performed after the demand model has been specified, otherwise it is not known
for which variables we have to collect data. However, there may be some interaction between the two stages,
particularly as far as the mathematical form is concerned; as stated above, economic theory alone may be unable to
specify this and we may have to refer to graphs of the data or even statistical calculations in order to do this.
Therefore the presentation of data will also be considered in this stage. We have to discuss both the type of data to
be collected and the sources of data.

Estimation of Parameters
This means computing the values of the coefficients of the variables in the model, which as we have seen
in the previous chapter correspond to the effects of an independent variable on the dependent variable. These
effects can be measured in different ways, for example in terms of the marginal effects and elasticities already
discussed. We have to have a technique to estimate these values, and the method of ordinary least squares (OLS)
regression will be used in this context.
Checking Goodness of Fit
Once a model, or maybe several alternative models, have been estimated, it is necessary to examine how
well the models fit the data and to determine which model fits best. If the fit is not good it may be necessary to
return to step 2 and re-specify the model before moving on to the next stage.

Hypothesis Testing
Having determined the best model, we want to test the hypothesis stated in the first step; in the example
quoted we want to test whether current price or past price has a greater effect on sales. This stage involves
inferential statistics of a more advanced nature than the rest of the topic.

Forecasting
This is the ultimate focus of most econometric analysis. In this context we are trying to forecast sales, and
maybe producing many forecasts in the light of various possible scenarios. Some aspects of this can be considered
without covering the previous stage. It should be clear from the above process that, as far as managerial decision
making is concerned, the last two stages are the most important. However, it is not possible to test hypotheses or
make forecasts reliably without a good understanding of the prior stages
Methods
There are variety of ways that can be used to estimate demand, which has certain advantages
and disadvantages. For this topic we’ll going to discuss 3 ways to estimate demand, namely:

1. Consumer Survey
2. Market Experiments
3. Statistical Methods
 Consumer Survey
Firms can obtain information regarding their demand functions by using interviews and questionnaires,
asking questions about buying habits, motives and intentions. These can be quick on-the-street interviews, or in-
depth ones. They might ask, for example, how much more petrol respondents would buy if its price were
reduced by 15 pence per litre, or which brand of several possibilities they prefer. These methods have certain
drawbacks:

1. Validity. Consumers often find it difficult to answer hypothetical questions, and sometimes they will
deliberately mislead the interviewer to give the answer they think the interviewer wants.
2. Reliability. It is difficult to collect precise quantitative data by such means.
3. Sample bias. Those responding to questions may not be typical consumers.
In spite of these problems, there are advantages of surveys:
1. They give up-to-date information reflecting the current business environment.
2. Much useful information can be obtained that would be difficult to uncover in other ways; for example, if
consumers are ignorant of the relative prices of different brands, it may be concluded that they are not
sensitive to price changes. Firms can also establish product characteristics that are important to the
buyer, and priorities. Methods such as multidimensional scaling can be used to give rating scores on
product characteristics.
 Market Experiments
Market experiments or consumer clinics test consumer reactions to changes in variables in
the demand function in a controlled environment. However, such experiments have to be set up very
carefully to obtain valid and reliable results; the knowledge of being in an artificial environment can
affect consumer behaviour. This kind of test marketing has the advantage that direct observation of
consumers’ actual spending behaviour is possible rather than just recording answers to hypothetical
questions regarding such behaviour. There are still a number of problems with this method, however:

1. There is less control in this case, and greater cost; furthermore, some customers who are lost at
this stage may be difficult to recover.
2. The number of variations in the variables is limited because of the limited number of market
segments available. Thus only a small number of sample observations is possible.
3. Experiments may have to be long-lasting in order to reveal reliable indications of consumer
behaviour. We have seen in the previous chapter that price elasticity, for example, can be very
different in the long run from in the short run because it takes time for consumers to change
their habits.
 Statistical Method
While the above methods are useful, they often do not provide management with the kind
of detailed information necessary to estimate a useful demand function, and thereby test the relevant
hypotheses and make forecasts. Statistical techniques, especially regression analysis, provide the
most powerful means of estimating demand functions. Regression techniques do have various
limitations:

1 They require a lot of data in order to be performed.

In spite of these limitations, regression techniques have become the most popular method of
demand estimation, since the widespread availability of powerful desktop PCs and software packages
have made at least the first two problems easy to overcome. They are therefore the main subject of
this topic.
Model Specification
As stated in the introduction, there are two aspects to this stage. In order
to understand this we must first distinguish a statistical relationship from a
deterministic relationship.
Deterministic relationships - are relationships known with certainty, for
example the relationship among revenue, price and quantity: R ¼ P Q ; if P and
Q are known R can be determined exactly.
Statistical relationships - are much more common in economics and
involve an element of uncertainty.
The deterministic relationship is considered first.
 Mathematical Model
Deterministic Relationship
Mathematical models are generally exact and given by equations. Mathematical
models are kind of static model that represent a natural/real phenomenon in
mathematical form; the models once formulated does not necessitate to change the
form after they are formed. It describes the interdependence of variables (or factors)
involved.
𝑄𝑡 = 𝑃1 + 𝑃1−𝑡
The decision regarding which variables to include is a difficult one. Theory often
tells us that certain variables, like price, promotion and income, should affect sales, but
before we collect the data and analyse the results we do not know for certain which
variables are relevant; in fact, even after analysing the data we do not know for certain
which variables are important because we are estimating a relationship from sample
data, and therefore we can only make conclusions in probabilistic terms. Subjective
judgement cannot be avoided in this case.
 Statistical Model
Statistical or data based models are enough flexible to change as per
arrival of new data as they can incorporate new and emerging patterns and
trends; this is where pattern recognition/machine learning come into focus.
We therefore have to specify the relationship in statistical terms, using a residual
term to allow for the influence of omitted variables. This is shown for the linear
form as follows:
𝑄𝑖 = 𝑎 + 𝑏𝑃𝑖 + 𝑑𝑖
where di represents a residual term. Thus, even if P is known, we cannot predict
Q with complete accuracy because we do not know for any observation what
the size or direction of the residual will be.
Data Collection
• Types of Data • Presentation of Data
o Time-series data o Tables
o Cross-section data o Graphs
• Sources of Data
o Records of firm
o Commercial and private
agencies
o Official Sources
Simple Regression
The Ordinary Least Squares (OLS) method
 Simple regression means two-variable regression. The method of least squares means
finding the line that minimizes the sum of the squares of the differences between the
observed values of the dependent variable and the fitted values from the line
Application of OLS
 The OLS procedure is normally performed on a computer using a software package
like SPSS, SAS or Minitab. In the case of simple regression many calculators are
programmed to do the necessary calculations; the data are entered, the relevant
commands are given and the values of a and b are then displayed.
Goodness to Fit
Whereas regression analysis examines the type of relationship between variables, correlation
analysis examines the strength of the relationship, or goodness of fit. This refers to how closely the
points fit the line, taking into consideration the units of measurement. Some idea of this can be
obtained from a visual inspection of the graph, but it is better to use a quantitative measure.
 Correlation
o specifically the correlation coefficient (r) measures the degree of linear association
between variables. It should be noted that correlation says nothing about causation
 The coefficient of determination
o The problem with the correlation coefficient is that it does not have a precise
quantitative interpretation. A better measure of goodness of fit is the coefficient of
determination, which is given by the square of the correlation coefficient, and is usually
denoted as R2 . This does have a precise quantitative interpretation and it measures the
proportion of the total variation in the dependent variable that is explained by the
relationship with the independent variable.
Power Regression
Nature of the model
• The power form,𝑄 = 𝑎𝑃𝑏 , cannot be estimated directly using the OLS technique because
it is a linear method, meaning that the estimators a and b are linear combinations of the
values in the data. However, the power equation can be transformed into a linear one by
taking the logarithms of both sides to obtain:
log 𝑄 = log 𝑎 + 𝑏 log(𝑃)
This ignores the error term for the sake of simplicity of expression.
Application of the model
• Many calculators now will perform regression analysis on many different mathematical
forms, as long as they involve linear transformations.
Forecasting
Nature
o Forecasting means estimating a specific value of a variable, as opposed to estimating a
whole relationship. Again there are various methods involved, both qualitative and
quantitative, but generally the most reliable, based on the discussion in this chapter, is
regression analysis. In this case a value (or values) of the independent variable(s) is
given, or estimated in turn, and these values are substituted into the appropriate
demand equation.
Application
o The appropriate demand equation (demand function)
o Assumptions
Multiple Regression
Nature of the model
o It has already been stated that if a simple regression model produces a low R2 this is an
indication that other factors should be explicitly included in the analysis, thereby involving a
multiple regression model. Applications and calculators are available in performing MR.
Advantages of Multiple Regression
o The effects of several explanatory variables on a dependent variable can be estimated.
o Even if we are only interested in the effect of a single variable it is still better to use multiple
regression to avoid a biased estimation of the regression coefficient.
o Because of the better fit to the data, shown in the higher R2 , standard errors of coefficients
are reduced, thus producing more reliable estimates of coefficients and forecasts; confidence
intervals for these are reduced.
 Dummy Variables
o It is frequently desired to use qualitative rather than quantitative data in regression analysis
 Interpretation of model results
Reference
Wilkinson, N. (2005). Demand Estimation. In Managerial economics: A problem-solving approach.
Cambridge: Cambridge Univ. Press.
Case Study
“Crashing U.S. Auto Sales: Can the Industry Recover”
(June 15, 2020, Wharton Business Daily)
https://knowledge.wharton.upenn.edu/article/crashi
ng-auto-sales-can-the-industry-recover/
NEWS ARTICLES
“Auto industry sales up 37% in September”
(October 13, 2020, Bernie C. Maglikat)
https://mb.com.ph/2020/10/13/us-gives-ph-213-m-new-grant/

“SMC completes P70-B Skyway 3”