C HAPTER 13 Valuing Impacts from Observed Behavior: Direct Estimation of Demand Curves

C HAPTER 13 E STIMATING D EMAND Think of the chapter title… “Valuing behavior … by observing it…” How does observation occur?

C HAPTER 13 E STIMATING D EMAND Chapter objectives… Determine a demand function. Learn how to estimate demand. Understand statistical measures.

C HAPTER 13 E STIMATING D EMAND Interpret the results of statistical estimation of demand. Depict a demand curve. Determine social surplus.

C HAPTER 13 E STIMATING D EMAND “Measurement of changes in social surplus is relatively straightforward when we know the shapes (functional forms) and positions of supply and demand curves in the relevant market.”

C HAPTER 13 E STIMATING D EMAND Or, as Boardman, et al have stated, “to understand how a policy change will affect social surplus, we must know the shape and position of the supply and demand curves.” “In practice… these curves are not usually known.”

C HAPTER 13 E STIMATING D EMAND Or, as Boardman, et al have stated, “to understand how a policy change will affect ___________, we must know the shape and position of the supply and demand curves.” “In practice… these curves are not usually known.”

C HAPTER 13 E STIMATING D EMAND Or, as Boardman, et al have stated, “to understand how a policy change will affect _ social surplus_, we must know the shape and position of the supply and demand curves.” “In practice… these curves are not usually known.”

C HAPTER 13 E STIMATING D EMAND To begin to understand the measurement of demand, economists use the tools of regression analysis.

C HAPTER 13 E STIMATING D EMAND “Regression analysis is a technique used to determine the mathematical relations between a dependent variable and one or more explanatory variables.” Christopher Thomas and Charles Maurice, Managerial Economics, 10 th Edition, McGraw-Hill, p. 121.

C HAPTER 13 E STIMATING D EMAND “Regression analysis is a technique used to determine the mathematical relations between a dependent variable and one or more ____________ variables.” Christopher Thomas and Charles Maurice, Managerial Economics, 10 th Edition, McGraw-Hill, p. 121.

C HAPTER 13 E STIMATING D EMAND “Regression analysis is a technique used to determine the mathematical relations between a dependent variable and one or more __explanatory_ variables.” Christopher Thomas and Charles Maurice, Managerial Economics, 10 th Edition, McGraw-Hill, p. 121.

C HAPTER 13 E STIMATING D EMAND “Explanatory variables are the economic variables that analysts believe affect the value of the dependent variable.” Christopher Thomas and Charles Maurice, Managerial Economics, 10 th Edition, McGraw-Hill, p. 121.

C HAPTER 13 E STIMATING D EMAND Identify four or five explanatory variables: 1) “own price,” or “price” 2) 3) 4) 5)

C HAPTER 13 E STIMATING D EMAND Identify four or five explanatory variables: 1) “own price,” or “price,” 2) income, 3) 4)

C HAPTER 13 E STIMATING D EMAND Identify four or five explanatory variables: 1) “own price,” or “price,” 2) income, 3) population 4)

C HAPTER 13 E STIMATING D EMAND Identify four or five explanatory variables in Problem 2, p. 338: 1) price, 2) income, 3) population This problem has just three in all.

C HAPTER 13 E STIMATING D EMAND The analyst’s task… Collect enough information to estimate demand – and consumer surplus – using econometric techniques.

C HAPTER 13 E STIMATING D EMAND Reminder… Boardman et al … “we focus on estimating demand curves because, in practice, analysts are interested in estimating changes in social surplus …” Boardman, Greenberg, Vining and Weimer, Cost- Benefit Analysis, Prentice-Hall, 4 th edition, p. 320.

C HAPTER 13 E STIMATING D EMAND Boardman, et al state that “the task in this chapter is to estimate changes in social surplus where there is limited information.” Boardman, Greenberg, Vining and Weimer, Cost- Benefit Analysis, Prentice-Hall, 4 th edition, p. 320.

C HAPTER 13 E STIMATING D EMAND Think… social surplus demand information

C HAPTER 13 E STIMATING D EMAND In beginning the process of measuring demand, the analyst often faces three common situations… The analyst has only one observation … while some previous experience has led to an understanding of the demand curve’s slope or elasticity.

C HAPTER 13 E STIMATING D EMAND The analyst has several observations of price and quantity.

C HAPTER 13 E STIMATING D EMAND The analyst has many observations.

C HAPTER 13 E STIMATING D EMAND With many observations, the analyst may use econometric techniques to estimate the demand curve… and consumer surplus. And once consumer surplus is known, the analyst can observe how changes in the independent variables may affect this surplus.

C HAPTER 13 E STIMATING D EMAND Assignment… Prepare an econometric analysis of the demand for a publicly-funded swimming pool in Dryville, Texas. Determine demand. Measure consumer surplus. Define NSB of the project.

C HAPTER 13 E STIMATING D EMAND Information… Dryville has a population of 70,200 people and a median household income of $31,500. The analyst identified 24 towns in the region that already had public swimming pools.

C HAPTER 13 E STIMATING D EMAND Information… The analyst conducted a telephone interview with the recreation department in each town to find out what fee each charged per visit (FEE) and how many visits it had during the most recent summer season (VISITS).

C HAPTER 13 E STIMATING D EMAND In addition, the analyst was able to find each town’s population (POP) and median household income (INCOME) in the most recent census.

C HAPTER 13 E STIMATING D EMAND The assignment… Observe how changes in the independent variables may affect this surplus. This is an effort to observe demand.

C HAPTER 13 E STIMATING D EMAND The assignment… Observe how changes in the independent variables may affect this surplus. This is an effort to observe demand.

C HAPTER 13 … D ATA …

C HAPTER 13 E STIMATING D EMAND Question… How can the analyst use the foregoing data – information – to learn the dimensions of demand and the amount of well-being that constructing a pool will have for Dryville?

C HAPTER 13 E STIMATING D EMAND Response… Follow a few basic steps to complete the analysis of this problem. Then, present results…

C HAPTER 13 E STIMATING DEMAND As stated above, the analyst can use econometrics to estimate demand curves with many data observations. The starting point is to determine the independent variables, or the “determinants of demand”. The next step is to determine functional form.

C HAPTER 13 E STIMATING DEMAND Variable specification is used to isolate the independent effects of the variables of interest. q= f (p, I, T) Ordinary Least Squares regression is a useful estimation function for econometrics.

C HAPTER 13 E STIMATING DEMAND Cross-Sectional Data v. Time Series Data Cross-Section Data involves observations on a number of comparable units at the same point in time…

C HAPTER 13 E STIMATING DEMAND Cross-Sectional Data v. Time Series Data … Cross-sectional may be subject to heteroscedasticity problems.

C HAPTER 13 E STIMATING DEMAND Time Series Data… … involves making repeated observations on the same unit at several points in time. Time series data are prone to problems of autocorrelation.

C HAPTER 13 E STIMATING DEMAND Finally, the analyst subjects the data to statistical estimation… Discussion…

S TATISTICAL O UTPUT

DEMAND CURVE ESTIMATION VISITS s = 140,547 – 14,638*FEE – *INCOME *POP (demand for any neighborhood) Inserting Income = 31,500 and POP= 70,200, we get demand curve estimation for Dryville : VISITS dv = 182,849 – 14,638*FEE

D EMAND C URVE FOR D RYVILLE 182,849 $ FEE Visits

D ETERMINING D EMAND To estimate social benefits of Dryville pool based on the previous demand curve, we must find the area under the demand curve from VISTIS dv = 0 to VISITS dv = 182,849. Numerical Solution:.5*12.49*182,849 = $1,141,892 Graphical Solution: Social Benefit 0 Fee Visits 182,849

Fee visits $1 $12.49 VISITS dv = – 14638*FEE VISITS dv = *(12.49) = 0 VISITS dv = *(0) = If Fee= 1 VISITS dv = *(1) = Government Revenue Consumer Surplus (.5)(168211)( ) = = (168211)(1) The gross benefit = = Additional benefit in the form of reduced excess burden of taxation = (0.25 * ) = Total gross benefit = = Consumer surplus

C ONCLUSIONS What are reasonable data sources? Prior research One must consider validity problems: 1.Internal Validity How valid is the estimate? How was it measured and computed? 2.External Validity Can the data be used in this instance? How similar is the case in question to the research case?

C ONCLUSIONS What factors are important in estimating a demand curve? Observations: more is better Which variables you put into the model Quality data sets Interpretation and understanding of data Econometric analysis is very common and used to predict responses to changes in healthcare policy, infrastructure, and consumer prices.

C ONCLUSIONS What factors are important in estimating a demand curve? Observations: more is better Which variables you put into the model Quality data sets Interpretation and understanding of data Econometric analysis is very common and used to predict responses to changes in healthcare policy, infrastructure, and consumer prices.

C HAPTER 13 E STIMATING D EMAND Questions for Test 2 ……. 1. What are several basic “starting points” (some knowledge of demand is known) in the estimation of demand for a good or service? Describe these starting points and how you would proceed in the estimation of consumer surplus. 2. Identify at least three determinants of demand. 3. After these three, identify additional determinants in special circumstances (i.e. the demand function for residential electricity use most likely has a determinant that you would not have in the demand function for oranges). 4. What is the difference between a movement along a demand curve and a shift in the curve?

C HAPTER 13 E STIMATING D EMAND Questions for the Final Exam ……. 5. What is meant by specifying a demand relationship? 6. Discuss how you would go about collecting data for an estimation. 7. Discuss how you would estimate demand once you have collected the data that you believe that must be in the model. a. Include a discussion of the signs on the coefficients of the independent variables. 8. What is meant by the “standard error” on the coefficients of the independent variables in the model? 9. What is meant by price elasticity of demand, and how would you use the coefficient of price in an estimated model to identify the value of price elasticity?

C HAPTER 13 E STIMATING D EMAND Questions for the Final Exam ……. 10. What is the expected sign on the coefficient of price elasticity in the model? 11. What is the expected sign on the coefficient of income (for a normal good)? 12. What does the “R-square” tell the economist? End of Questions