The demand for lamb

A real-world demand function

The diagram shows what happened to the consumption of lamb in the UK over the period 19742004. How can we explain this dramatic fall in consumption? One way of exploring this issue is to make use of a regression model, which should help us to see which variables are relevant and how they are likely to affect demand.

The following is an initial model fitted (using the Microfit statistical software package) to annual data for the years 19742004. QL = 170.2 0.197PL 0.069PB + 0.280PP 0.0094Y (1) where: QL is the quantity of lamb sold in grams per person per week; PL is the real price of lamb (in pence per kg, 1985 prices); PB is the real price of beef (in pence per kg, 1985 prices); PP is the real price of pork (in pence per kg, 1985 prices); Y is households real disposable income per head ( per year, 2002 prices).

This model makes it possible to predict what would happen to the demand for lamb if any one of the four explanatory variables changed, assuming that the other variables remained constant.

Question
Using equation (1), calculate what would happen ceteris paribus to the demand for lamb if: (a) the real price of lamb went up by 10p per kg; (b) the real price of beef went up by 10p per kg; (c) the real price of pork fell by 10p per kg; (d) real disposable income per head rose by 100 per annum. Are the results as you would expect?

There is a serious problem with estimated demand functions like these: they assume that other determinants of demand (i.e. those not included in the model) have not changed. In the case of this demand-for-lamb function, one of the other determinants did change. This was tastes during the 1980s and 1990s there was a shift in demand away from lamb and other meats, partly for health reasons, and partly because of an expansion in the availability of and demand for vegetarian and low-meat alternatives.

On the assumption that this shift in taste took place steadily over time, a new demand equation was estimated for the same years: QL = 148.7 0.278PL 0.030PB + 0.116PP + 0.0062Y 3.787TIME (2)

where TIME = 1 in 1974, 2 in 1975, 3 in 1976, etc.

Questions

How does the introduction of the variable TIME affect the relationship between the demand for lamb and (a) its real price; (b) real disposable income per head?

2 3

Does lamb now appear to be a normal good or an inferior good? What does the negative coefficient of PB indicate? Model (2) is a better model than model (1) in two major respects. The first point is

that it has a better goodness of fit. This can be shown by the R-squared. R = 1 represents a perfect fit, whereas R = 0 shows that the model has no explanatory power whatsoever. In model (2), R = 0.925 compared with 0.908 for model (1). This means that model (2) can explain 92.5 per cent of the variation in the consumption of lamb during the period 1974 to 2004, whereas model (1) can explain only 90.8 per cent.
2 2

Secondly, the coefficient of Y is now positive, suggesting that lamb is a normal good, which seems sensible. By omitting a measure of consumers tastes from model (1), we mis-specified that model and introduced a bias into the estimated coefficient of Y. In effect, the income variable was picking up the effects of changing tastes and its coefficient ended up being negative rather than positive. By including TIME, we eliminated that bias.

Whilst model (2) is clearly an improvement on model (1), it is by no means perfect. One problem is that its R2 is still somewhat below 1. Another problem is that PB should have a positive coefficient, since beef is surely a substitute for lamb. More importantly, the model takes no account of the fact that consumers purchases of lamb this year are likely to be strongly influenced by what they were consuming last year. Finally, whilst the model includes the real prices of two substitutes for lamb, it does not include the real prices of any complements.

To take the above points into account, the following third model was estimated, using data for 1975 to 2004.

QL = 2.657 0.237PL + 0.071PB + 0.145PP

+ 0.0113Y 3.298TIME + 0.572LQL 0.084PC (3)

where LQL is the lagged consumption of lamb (i.e. consumption in the previous year) and PC is the real price of a complement (potatoes). R = 0.954.
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Questions
4 5 To what extent is model (3) an improvement on model (2)? Use the three equations and also the data given in the table below to estimate the demand for lamb in 1996 and 2004. (First you will need to fill in the missing figures in the TIME column.) Which model works the best in each case? Why? Explain why the models are all subject to error in their predictions. Note: 1996 was unusual in the sense that there was the BSE scare, which caused an abrupt shift in demand from beef to lamb. Can you discern this BSE effect in the graph? 6 Use model (3) and the data given in the table to explain why the demand for lamb fell so dramatically between 1975 and 2004. 7 The formula for the elasticity of demand (price elasticity, income elasticity or cross elasticity) can be written as dQ/dX Q/X, where dQ/dX represents the coefficient for a given variable, X. For example, in equation (3), 0.071 gives the value of the term dQL/dPB when working out the cross-price elasticity of demand for lamb with respect to changes in the price of beef. Using equation (3) and the table (on page 142) work out the following for 2004: (a) the price elasticity of demand for lamb; (b) the income elasticity of demand for lamb; (c) the cross-price elasticity of demand for lamb with respect to (i) beef, (ii) pork, (iii) potatoes. QL 1975 1996 2004 119 65 50 LQL 113 54 51 PL 274.0 295.0 318.3 PB 348.2 325.3 324.6 PP 310.1 280.5 274.3 Y 5 873 10 203 12 491 TIME 2 PC 27.3 25.9 37.1

Sources: Nominal food prices were calculated by dividing expenditure by consumption. These nominal prices in pence per kg were then adjusted to real prices by dividing by the RPI (retail price index) for total food (1985 = 100) and multiplying by 100. http://stat istics.defra.gov.uk/esg/publications/efs/datasets/efsexpd.xls (expenditure) http://statistics.defra.gov.uk/esg/publications/efs/datasets/efscons.xls (consumption) http://www.statistics.gov.uk/downloads/theme_economy/ETSupp2005.pdf (income & RPI food) Economic Trends Annual Supplement 2005, Tables 1.5 & 2.1.

Source: Sloman J and Hinde K (2007) Economics for Business. Pearson.

Using equation (1), calculate what would happen  ceteris paribus  to the demand for lamb if: (a) the real price of lamb went up by 10p per kg; (b) the real price of beef went up by 10p per kg; (c) the real price of pork fell by 10p per kg; (d) real disposable income per head rose by 100 per annum. Are the results as you would expect?
(a) The demand would go down by 1.97 grams per person per week (i.e. 10 v 0.197). (b) The demand would go down by 0.69 grams per person per week (i.e. 10 v 0.069). (c) The demand would go down by 2.8 grams per person per week (i.e. 10 v 0.280). (d) The demand would go down by 0.94 grams per person per week (i.e. 100 v

0.0094).

1. How does the introduction of the variable TIME affect the relationship between the demand for lamb and (a) its real price; (b) real disposable income per head?
(a) The demand for lamb is more sensitive to a change in its price than in the first equation (the coefficient has changed from 0.197 to 0.278. (b) The demand for lamb is slightly less sensitive to a change in real personal disposable income per head than in the first equation (the coefficient has changed from 0.0094 to 0.0062).

2. Does lamb now appear to be a normal good or an inferior good?

An inferior good in the first equation and a normal good in the second. In the first equation, as personal disposable income r ises so the demand for lamb falls. In the second equation as personal disposable income rises so the demand for lamb rises. The reason is that, by introducing the TIME term, we are now allowing for the fall in demand for lamb over time as a result of a shi ft in tastes away from meat. In other

words, the second equation allows us to take this factor out of account when looking at the effect of a change in the price of lamb on the demand for lamb.

3. What does the negative coefficient of P B indicate?

It implies that lamb and beef are complementary goods, which is clearly not the case. It would be expected that they are substitutes (with the price of beef having a positive coefficient), such that as the price of beef rises the demand for lamb would go up as consumers switch from beef to lamb. The text in the box following on from this question explains why the coefficient was negative rather than positive.

1. To what extent is model (3) an improvement on model (2)?

It includes a lagged consumption of lamb variable (consumption in the previous year) and a variable for a major complement (potatoes). The signs on these two additional variables (positive and negative respectively) are as you would expect. Also the R has risen from 0.925 to 0.954.
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2. Use the three equations and also the data given in the table below to estimate the demand for lamb in 1996 and 2004. (First you will need to fill in the missing figures in the TIME column.) Which model works the best in each case? Why? Explain why the models are all subject to error in their predictions. Note: 1996 was unusual in the sense that there was the BSE scare, which caused an abrupt shift in demand from beef to lamb. Can you discern this BSE effect in the graph?
Equation 1: 1996:

QL = 170.2 (0.197 295.0) (0.069 325.3) + (0.280 280.5)

(0.0094 10,203) = 170.2 58.12 22.45 + 78.54 95.91 = 72.26 (grams per person per week) 2004:

QL = 170.2 (0.197 318.3) (0.069 324.6) + (0.280 274.3)

(0.0094 12,491) = 170.2 62.71 22.40 + 76.80 117.42 = 44.47 (grams per person per week) Equation 2: 1996:

QL = 148.7 (0.278 295.0) (0.030 325.3) + (0.116 280.5) +

(0.0062 10,203) (3.787 23) = 148.7 82.01 9.76 + 32.54 + 63.26 87.10 = 65.63 (grams per person per week)

2004:

QL = 148.7 (0.278 v 318.3) (0.030 v 324.6) + (0.116 v 274.3) +

(0.0062 v 12,491) (3.787 31) = 148.7 88.49 9.74 + 31.82 + 77.44 117.40 = 42.33 (grams per person per week)

Equation 3: 1996:

QL = 2.66 (0.237 295.0) + (0.071 325.3) + (0.145 280.5) +

(0.0113 10,203) (3.298 23) + (0.572 54) (0.084 25.9) = 2.66 69.92 + 23.10 + 40.67 + 115.29 75.85 + 30.89 2.18 = 59.34 (grams per person per week)

2004:

QL = 2.66 (0.237 v 318.3) + (0.071 v 324.6) + (0.145 v 274.3) +

(0.0113 v 12,491) (3.298 31) + (0.572 51) (0.084 37.1) = 2.66 75.44 + 23.01 + 39.77 + 141.15 102.24 + 29.17 3.12 = 49.64 (grams per person per week)

Taking the two yea rs together, equation 3 predicts better than equation 2, which in turn predicts better than equation 1. Equation 3 predicts better than equation 1 in both years. Equation 2, however, predicts the 1996 figure more accurately than equation 3, but the reason why a generally less well specified equation (such as equation 2) can sometimes predict better than a better specified equation (such as equation 3) is if some random shock outside both models affects the outcome. Hence in 1996, the BSE scare about beef caused a surge in demand for lamb (which you can see by the spike that year in the graph), which made equation 2, by chance, predict better. All models are subject to error in their predictions as they cannot take account of all determining factors. Even th e ones that are included will change in their effects over time

3. Use model (3) and the data given in the table to explain why the demand for lamb fell so dramatically between 1975 and 2004.
There was a general shift away from the consumption of lamb, as shown by the negative co-efficient on the TIME term; the real price of lamb rose over the period and PL has a relatively large negative coefficient; the real price of potatoes rose and

PC also has a negative coefficient; the real price of both beef and pork, however, fell
and the PB and PP terms have positive coefficients.

4. The formula for the elasticity of demand (price elasticity, income elasticity or cross elasticity) can be written as xQ/xX Q/X, where xQ/xX represents the coefficient for a given variable, X. For example, in equation (3), 0.071 gives the value of the term xQL/xPB when working out the cross price elasticity of demand for lamb with respect to changes in the price of beef. Using equation (3) and the table work out the following for 2004: (a) the price elasticity of demand for lamb;

(b) the income elasticity of demand for lamb; (c) the cross-price elasticity of demand for lamb with respect to (i) beef, (ii) pork, (iii) potatoes. Are the values for elasticity much as you would expect? Explain.
(a)
xQL/xPL QL/PL = 0.237 50/318.3

= 1.51 (b)
xQL/xY QL/Y = +0.0113 50/12,491

= +2.82 (c) (i) xQL/xPB QL/PB = +0.071 50/324.6 = +0.46 (c) (ii) xQL/xP P QL/PP = +0.145 50/274.3 = +0.80 (c) (ii) xQL/xPC QL/PC = 0.084 50/37.1 = 0.062 All the values are much as would be expected. In terms of the signs, there is a positive income elasticity of demand (b), indicating a normal good, and a positive cross-price elasticity of demand for substitutes (c)(i) and (c)(ii); there is a negative price elasticity of demand (a) and a negative cross -price elasticity of demand for a complement (c)(iii). Also as expected, there is a relatively high income elasticit y of demand, indicating a product that is nowadays regarded as a not very necessary good; also the price elasticity of demand is relatively high, indicating peoples willingness to substitute between lamb and other food products. The cross -price elasticities are all inelastic, indicating that people do not regard them as very close substitutes or complements. Changes in the price of potatoes, especially, have only a relatively minor effect on the demand for lamb. Pork would seem to be regarded as a closer substitute than beef.