MM/EBM 2143 – Managerial Economics
03.
(Part II)
Demand Estimation & Forecasting
Ms. Sanduni Dilanka
1
Basic Estimation Techniques
Simple Linear Regression
• Simple linear regression model relates
dependent variable Y to one independent
(or explanatory) variable X
Y a bX
•
• Slope parameter (b) gives the change in Y
associated with a one-unit change in X,
Sample Regression Line
70,000 Si 60,000 Sam ple regression line
Ŝi 11, 573 4.9719 A
60,000 •
ei •
Sales (dollars)
50,000
40,000
•
Ŝi 46,376
30,000
• •
20,000
•
10,000
•
A
0 2,000 4,000 6,000 8,000 10,000
Advertising expenditures (dollars)
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
Estimation & Forecasting
Direct Methods of Demand Estimation
• Consumer interviews
• Range from stopping shoppers to speak with them
to administering detailed questionnaires
• Potential problems
• Selection of a representative sample, which is a sample
(usually random) having characteristics that accurately
reflect the population as a whole
• Response bias, which is the difference between responses
given by an individual to a hypothetical question and the
action the individual takes when the situation actually
occurs
• Inability of the respondent to answer accurately
Direct Methods of Demand Estimation
• Market studies & experiments
• Market studies attempt to hold everything constant
during the study except the price of the good
• Lab experiments use volunteers to simulate actual
buying conditions
• Field experiments observe actual behavior of
consumers
Empirical Demand Functions
• Demand equations derived from actual
market data
• Useful in making pricing & production
decisions
• In linear form, an empirical demand function
can be specified as
Empirical Demand Functions
Q a bP cM dPR
• In linear form
• b = Q/P
• c = Q/M
• d = Q/PR
• Expected signs of coefficients
• b is expected to be negative
• c is positive for normal goods; negative for inferior goods
• d is positive for substitutes; negative for complements
Empirical Demand Functions
Q a bP cM dPR
• Estimated elasticities of demand are
computed as
Nonlinear Empirical Demand Specification
• When demand is specified in log-linear form,
the demand function can be written as
Demand for a Price-Setter
• To estimate demand function for a price-setting firm:
• Step 1: Specify price-setting firm’s demand function
• Step 2: Collect data for the variables in the firm’s demand
function
• Step 3: Estimate firm’s demand using ordinary least-squares
regression (OLS)
Time-Series Forecasts
• A time-series model shows how a time-
ordered sequence of observations on a
variable is generated
• Simplest form is linear trend forecasting
• Sales in each time period (Qt ) are assumed to be linearly related
to time (t)
Linear Trend Forecasting
Use regression analysis to estimate
values of a and b
• If b > 0, sales are increasing over time
• If b < 0, sales are decreasing over time
• If b = 0, sales are constant over time
A Linear Trend Forecast
Q
Estimated trend line
Q̂ 2009
12
Q̂ 20047
Sales
t
2006
2004
2005
2007
1997
1999
2000
1998
2001
2002
2003
2012
Time
Forecasting Sales for Terminator Pest Control
Seasonal (or Cyclical) Variation
• Can bias the estimation of parameters in linear
trend forecasting
• To account for such variation, dummy variables
are added to the trend equation
• Shift trend line up or down depending on the
particular seasonal pattern
• Significance of seasonal behavior determined by
using t-test or p-value for the estimated coefficient on
the dummy variable
Sales with Seasonal Variation
2004 2005 2006 2007
Dummy Variables
• To account for N seasonal time periods
• N – 1 dummy variables are added
• Each dummy variable accounts for one seasonal time
period
• Takes value of 1 for observations that occur during the season
assigned to that dummy variable
• Takes value of 0 otherwise
Effect of Seasonal Variation
Qt
Qt = a’ + bt
Qt = a + bt
Sales
c
a’
a
t
Time
Some Final Warnings
• The further into the future a forecast is made, the
wider is the confidence interval or region of
uncertainty
• Model misspecification, either by excluding an
important variable or by using an inappropriate
functional form, reduces reliability of the forecast
• Forecasts are incapable of predicting sharp changes
that occur because of structural changes in the
market
Thank you…!!!
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