CHAPTER 5

ESTIMATION OF THE DEMAND FUNCTION

Bayu, Anora, Annisa
 Executive Summary
This chapter examines methods that are used to obtain demand data for the solution of
business decision problems. Given the prior expectation that the value of the information will
exceed the search costs of obtaining that information, the decision maker can generate demand
data using a variety of techniques from market research and statistical analysis.
Demand estimation means the process of finding current values for the coefficients in
the demand function for a particular product, while demand forecasting means the process of
finding values for demand in future time periods. Current values are necessary to evaluate the
optimality of current pricing and promotional policies and to make day-to-day decisions in these
strategy areas. Future values are necessary for planning production, inventories, new-product
development, investment, and other situations where the decision to be made has impacts over
a prolonged period of time. This chapter is confined to the issue of demand estimation.
We consider direct methods of demand estimation, such as interviews, surveys, and
market experiments, in which the potential buyer is asked questions about his or her reactions
to hypothetical changes in price and other variables, or, alternatively, is observed reacting to
changes in such variables. Indirect methods of demand estimation involve the statistical
analysis of data to ascertain the impact of changes in determining variables on the quantity
demanded. We introduce and discuss the use of regression analysis as a tool to quantify the
dependence of quantity demanded on each of the determining variables in the demand
function. Special attention is given to the interpretation of the regression results and the
avoidance of the six major pitfalls of regression analysis.
Direct Vs Indirect Methods of Demand Estimation

• Direct methods directly involve the consumer and include interviews and
surveys, simulated market situations, and controlled market experiments.

• Indirectdemand estimation uses data that have been collected and

attempts to find statistical correlations between the dependent and the
independent variables.
 The Difficulties of Interviews and Surveys Approaches

• The randomness of the sample

• Interviewer bias
• Best of intention problem
• Confusing, misinterpreted, or unknowable (if it involves things beyond the
realm of the respondent’s knowledge or imagination)
 Experiments Approaches

• Simulated Market Situations

• Direct Market Experiments
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 Regression Analysis of Consumer Demand

• Regression analysis is a statistical technique used to discover the apparent

dependence of one variable on one or more other variables.
• Time-series analysis uses observations that have been recorded over time in a
particular situation.
• Cross-section analysis uses observations taken from different firms or situations at the
same point or period of time.
 The Linearity of the Regression Equation
• Regression analysis requires that the dependence be expressed in the linear
form
Y = α + β1X1 + β2X2 + … + βnXn + e
• The most commonly used nonlinear form is the power function, such as
Y = αX1β1X2β2e
where this curvilinear relationship can be expressed as a rectilinear
relationship by logarithmic transformation as
log Y = log α + β1 log X1 + β2 log X2 + log e
• A quadratic function can be expressed linearly as
Y = α + β1X + β2X2 + e
• If the appropriate functional form is thought to be a cubic function, we can
postulate the relationship to be
Y = α + β1X + β2X2 + β3X3 + e
Estimating the Regression Parameters

where,
Y = the arithmetic mean of the Y values
X = the arithmetic mean of the X values
n = the number of observations or data points
 The Coefficient of Determination

• The coefficient of determination (R2) is a statistic that indicates the

proportion of the variation in the dependent variable which is explained by
the variation in the independent variable(s). In effect, the R2 value tells us
how well the regression equation fits the data.
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 The Standard Error of Estimate
• The standard error of estimate is a measure of the dispersion
of the data points from the line of best fit.
 The Predictive Power of the Regression Equation

• If the confidence interval is relatively narrow because of a relatively small

value of the standard error estimate, we say that the regression equation
has greater predictive power than it would if the value of Se were relatively
large and the confidence interval relatively broad.
 The Standard Error of the Coefficient

• The standard error of the coefficient (Sβ ) is a measure of the

accuracy of the calculated value of β, the coefficient
estimating the marginal relationship between the variables Y
and X.
 Problems in Regression Analysis:
Six Major Pitfalls

• Specification Errors
• Measurement Errors
• Simultaneous Equation Relationships
• Multicollinearity
• Heteroscedasticity
• Autocorrelation