Demand Estimation

Chapter 5

Regression Analysis

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

1
 Regression: Outline
• Least Squares Methods
• Estimation: Least Squares
• Interpretation of estimators
• Properties of OLS estimators
• Variance of Y, b, and a
• Hypothesis Test of b and a
• ANOVA table
• Goodness-of-Fit and R2
2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
 Linear regression model
Y = 2 +.5X
5
4
3
y

.5
2

1
1

-1 0 1 2 3 4 5
x

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

 Terminology
• Dependent variable (DV) = response
variable = left-hand side (LHS) variable
• Independent variables (IV) = explanatory
variables = right-hand side (RHS) variables
= regressor (excluding a)
• a is an estimator of parameter α
• B is an estimator of parameter β
• a and b are the intercept and slope
2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
 Ordinary Least Square Method
• How to draw such a line based on data points
observed?
• Suppose an imaginary line of y= a + bx
• Imagine a vertical distance (or error) between the
line and a data point. e=Y-E(Y)
• This error (or gap) is the deviation of the data
point from the imaginary line, regression line
• What is the best values of a and b?
• a and b that minimizes the sum of such errors
(deviations of individual data points from the
line)
2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
 Ordinary least squares (OLS)
4 Least Squares Method

x3
e3
3

E(Y)=a + bX
2
y

x1

e2
e1
1

x2
0

0 1 2 3 4 5
x

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

 Ordinary least squares (OLS)
• Deviation does not have good properties for
computation
• Why do we use squares of deviation? (e.g.,
variance)
• Let us get a and b that can minimize the sum
of squared deviations rather than the sum of
deviations.
• This method is called least squares
2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
 Ordinary least squares (OLS)
Least squares method minimizes the sum of
squares of errors (deviations of individual data
points form the regression line)
Such a and b are called least squares
estimators (estimators of parameters α and β).
The process of getting parameter estimators
(e.g., a and b) is called estimation
“Regress Y on X”
Least squares method is the estimation
method of ordinary least squares (OLS)

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

 Ordinary least squares (OLS)
Ordinary least squares (OLS) =
Linear regression model =
Classical linear regression model
Linear relationship between Y and Xs
Constant slopes (coefficients of Xs)
Least squares method
Xs are fixed; Y is conditional on Xs
Error is not related to Xs
Constant variance of errors

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

 Least Squares Method 1
Y    X  
E (Y )  Yˆ  a  bX
  Y  Yˆ  Y  (a  bX )  Y  a  bX
 2  (Y  Yˆ ) 2  (Y  a  bX ) 2
(Y  a  bX ) 2  Y 2  a 2  b 2 X 2  2aY  2bXY  2abX
 
 2
 (Y  Yˆ ) 2
  (Y  a  bX ) 2

Min  2  Min (Y  a  bX ) 2

How to get a and b that can minimize the sum

of squares of errors?
2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
 Least Squares Method 2
• Linear algebraic solution
• Compute a and b so that partial derivatives
with respect to a and b are equal to zero

  2

 
  (Y  a  bX ) 2 
 2na  2 Y  2b X  0
a a
na   Y  b X  0

a  Y
b  X
 Y  bX
n n

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

 Least Squares Method 3
Take a partial derivative with respect to b and
plug in a you got, a=Ybar –b*Xbar

  2

 
  (Y  a  bX ) 2 
 2b X 2  2 XY  2a  X  0
b b
b X 2   XY  a  X  0 b X 2   XY  Y  bX  X  0
 Y  X 
b X   XY  
2
 b  X  0

 n n 
b X 2   XY   X Y
b
 X
2

0
n n
 n X 2   X 2   XY   X  Y
b 
 n  n
 
2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
 Least Squares Method 4
Least squares method is an algebraic solution
that minimizes the sum of squares of errors
(variance component of error)
n XY   X  Y  ( X  X )(Y  Y ) SP
b   xy

n X 2   X  (X  X )
2 2
SS x

a Y  b  X  Y  bX
n n

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

 OLS: Example 10-5 (1)
No x y x-xbar y-ybar (x-xb)(y-yb) (x-xbar)^2
1 43 128 -14.5 -8.5 123.25 210.25
2 48 120 -9.5 -16.5 156.75 90.25
3 56 135 -1.5 -1.5 2.25 2.25
4 61 143 3.5 6.5 22.75 12.25
5 67 141 9.5 4.5 42.75 90.25
6 70 152 12.5 15.5 193.75 156.25

Mean 57.5 136.5

Sum 345 819 541.5 561.5

b  ( X  X )(Y  Y ) SP
 xy

541.5
 .9644
(X  X ) SS 2
x 561.5

a  Y  bX  136.5  .9644  57.5  81.0481

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
 OLS: Example 10-5 (3)
Y hat = 81.048 + .964X
150
140
130
120

40 50 60 70
x

Fitted values y

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

 What Are a and b ?
• a is an estimator of its parameter α
• a is the intercept, a point of y where the
regression line meets the y axis
• b is an estimator of its parameter β
• b is the slope of the regression line
• b is constant regardless of values of Xs
• b is more important than a since that is
what researchers want to know.
2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
 How to interpret b?

• For unit increase in x, the expected

change in y is b, holding other things
(variables) constant.

• For unit increase in x, we expect that y

increases by .964, holding other
variables constant.

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

 Sample Data: The Demand for Pizza
College Qslices Pslices Tuition Psoftdrink Urban Residential
1 9.89 97.3 17.92 98.8 1 1
2 12.07 101.2 26.36 95.2 1 0
3 13.08 91 14.57 110.8 1 0
4 13.9 95 7.7 91.9 1 0
5 8.93 109.6 14.56 100 0 1
6 8.05 126.4 9 100.8 0 0
7 3.98 126.4 17.48 122.9 1 1
8 3.18 149.4 20.46 149.1 0 0
9 15.07 78.8 29.26 102.4 1 0
10 11.86 75.7 13.96 87.8 1 1
11 13.1 91.9 12.17 80.2 1 0
12 13.87 103.4 3.76 75.2 1 0
13 12.02 101.6 18.72 99.6 1 0
14 10.19 113 20.69 123.5 0 0
15 9.88 121.7 17.63 131.2 0 0
16 11.94 112.6 20.71 79.2 1 0
17 10.93 150.1 21.91 88.5 0 0
18 11.99 100.3 17.97 94.1 1 0
19 10 151.4 18 101.6 0 0
20 8.12 145.3 18.71 90 0 0
21 9.18 150.5 25.01 94.3 0 0
22 9.86 129.7 18.44 98.4 1 0
23 11 123 24.15 95 1 0
24 11.91 104.5 22.87 99.8 0 0
25 13.12 82 18.75 100.9 1 0
26 10.02 100.3 18.63 112.1 1 0
27 8.91 109.4 6.35 124.3 0 0
28 7.96 128.1 13.99 90.2 0 1
29 7.89 155.1 8.83 80.5 0 0
30 4.96 148.7 13.83 97.1 0 1

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

 Model specfication

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

 Anticipated Relationship
Between X’s an Y

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

 Excel’s Regression Output
SUMMARY OUTPUT

Regression Statistics
Multiple R 0.940502
R Square 0.884543
Adjusted R Square
0.86049
Standard Error
1.06418
Observations 30

ANOVA
df SS MS F Significance F
Regression 5 208.229 41.64581 36.77399 1.72E-10
Residual 24 27.17952 1.13248
Total 29 235.4085

Coeffi cients
Standard Error t Stat P-value Lower 95%Upper 95%Lower 95.0%
Upper 95.0%
Intercept 29.16132 2.200962 13.24935 1.57E-12 24.61876 33.70388 24.61876 33.70388
Pslices -0.09257 0.011827 -7.82718 4.64E-08 -0.11698 -0.06816 -0.11698 -0.06816
Tuition 0.059756 0.034522 1.730945 0.0963 -0.01149 0.131006 -0.01149 0.131006
Psoftdrink -0.08185 0.012899 -6.3455 1.47E-06 -0.10847 -0.05523 -0.10847 -0.05523
Urban -0.74684 0.575019 -1.29881 0.206348 -1.93363 0.439938 -1.93363 0.439938
Residential -3.04912 0.492581 -6.19008 2.14E-06 -4.06576 -2.03248 -4.06576 -2.03248

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

 Multiple Regression Example
A paint company is
Region Sales Prom Expen Price Disp Income
attempting to develop a
1 160 150 15 19
2 220 160 13.5 17.5
demand model for its
3 140 50 16.5 14 exterior house paints. The
4 190 190 14.5 21 company believes most
5 130 90 17 15.5 important variables are:
6 160 60 16 14.5
7 200 140 13 21.5
-Promotional
8 150 110 18 18 Expenditures measured in
9 210 200 12 18.5 1000 dollars
10 190 100 15.5 20 -Price measured in dollars
per gallon
-Disposable Income per
household measured in
1000 dollars
-Data were obtained from
10 company sales regions

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

 Excel Regression Results
SUMMARY OUTPUT
Sales = 310.24 + 0.008 Prom Expen -12.20 Price
Regression Statistics
Multiple R 0.888583 + 2.677 Disp Income
R Square 0.78958
Adjusted R Square
0.68437
Standard Error
17.41711
Observations 10

ANOVA
df SS MS F Significance F
Regression 3 6829.866 2276.622 7.504796 0.018698
Residual 6 1820.134 303.3556
Total 9 8650

Coeffi cients
Standard Error t Stat P-value Lower 95%Upper 95%Lower 95.0%
Upper 95.0%
Intercept 310.2448 95.07486 3.263163 0.017181 77.60497 542.8846 77.60497 542.8846
Prom Expen0.007717 0.204064 0.037816 0.971061 -0.49161 0.507044 -0.49161 0.507044
Price -12.2025 4.58207 -2.6631 0.037369 -23.4144 -0.99057 -23.4144 -0.99057
Disp Income2.676784 3.160072 0.847064 0.429446 -5.05563 10.4092 -5.05563 10.4092

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

 Coefficients Interpretations
B0= 310.24 This is the intercept, the value of y when all
the variables take the value zero.
B1=0.008 For one unit increase ($1000) in promotional
expenditure, sales increase by 0.008 *1000 = 8 gallons
(assuming the other variables are held constant).

B2= -12.2 For each additional a $1.0 increase in price,

sales decrease by -12.202*1000 = 12202 gallons
B3= 2.677 For additional one unit ($1000) in disposable
income, sales increase by 2.677*1000 =2677 gallons.

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

 Point and Interval Forecasts
Use the model to estimate point forecast (or interval).
Suppose company is interested to estimate sales in
region where promotional expenditures are $185000,
price is $15 per gallon, and disposable income per
house hold is $19500.

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young