Regression Analysis

11-2
Introduction
Regression analysis is a very valuable tool
for a manager
Regression can be used to
Understand the relationship between
variables
Predict the value of one variable based on
another variable
Examples
Studying the effectiveness of advertising
dollars in increasing sales volume

11-3
Introduction
The variable to be predicted is called the
dependent variable
Sometimes called the response variable
The value of this variable depends on the
value of the independent variable
Sometimes called the explanatory or predictor
variable
Independent
variable
Dependent
variable
Independent
variable
= +
11-4
Triple A Construction
Triple A Construction renovates old homes
They have found that the dollar volume of
renovation work is dependent on the area payroll
TRIPLE AS SALES
($100,000s)
LOCAL PAYROLL
($100,000,000s)
6 3
8 4
9 6
5 4
4.5 2
9.5 5
Table 4.1
11-5
Triple A Construction
Figure 4.1
12
10
8
6
4
2
0
S
a
l
e
s

(
$
1
0
0
,
0
0
0
)

Payroll ($100 million)
| | | | | | | |
0 1 2 3 4 5 6 7 8
11-6
Simple Linear Regression
where
Y = dependent variable (response)
X = independent variable (predictor or explanatory)
|
1
= intercept (value of Y when X = 0)
|
2
= slope of the regression line
c = random error

Regression models are used to test if there is a
relationship between variables (predict sales
based on payroll)
There is some random error that cannot be
predicted
c | | + + = X Y
2 1
11-7
Simple Linear Regression
True values for the slope and intercept are not
known so they are estimated using sample data
X Y
2 1

| | + =
where
Y = dependent variable (response)
X = independent variable (predictor or explanatory)

= intercept (value of Y when X = 0)

= slope of the regression line
^
1

|
2

|
11-8
Triple A Construction
Triple A Construction is trying to predict sales
based on area payroll
Y = Sales
X = Area payroll
The line chosen in Figure 4.1 is the one that
minimizes the errors
Error = (Actual value) (Predicted value)
Y Y e

=
11-9
Simple Linear Regression
Since is an estimate of Y, it will be very lucky
on our part to have a equal to Y, otherwise
they will be different. The difference between an
estimated value and the observed value of Y is
denoted by e, which is usually termed as
residual, deviation or error term.
Y
.
Y
.
X Y e
Y e Y
2 1
| |
. .
.
=
=
11-10
Least Squares Regression
Errors can be positive or negative so the average error could
be zero even though individual errors could be large.
Least squares regression minimizes the sum of the squared
errors.
Payroll Line Fit Plot
0
2
4
6
8
10
0 2 4 6 8
Payroll ($100.000,000's)
S
a
l
e
s

(
$
1
0
0
,
0
0
0
)
11-11
Least Square Technique
Thus, those values of should be
chosen which minimizes the sum of squared
residuals.
2 1
| |
. .
and


. .
.
=
=
2 2
2 2
)
2 1
(
) (
X Y e
Y e Y
| |
11-12
Least Square Technique
To minimize it, the first order condition for
minimization is that its first partial
derivative should be zero.
( )

=
|
|
.
|

\
|
=
c
c
. .
.
0 1
2 1
2
1
2
X Y
e
| |
|
1 .... ..........
2 1
0
2 1
0
2 1
0
2 1

. .
. .
. .
. .
+ =
=
=
=
|
|
.
|

\
|

X n Y
X n Y
X Y
X Y
| |
| |
| |
| |
11-13
Least Square Technique
Partial derivative w.r.t
2
|
.
( )

=
|
|
.
|

\
|
=
c
c
. .
.
0
2 1
2
2
2
X X Y
e
| |
|
2 ........ ..........
2 1
0
2 1
2
2


. .
. .
+ =
=
X X Y X
X X Y X
| |
| |
The two equations 1 and 2 are called the normal equations.
We can also derive the estimators from our normal
equations as follows
2 1
| |
. .
and
11-14
Least Square Technique
n
X
n
n
n
Y

.
.
+ =
2
1
|
|
Divide both sides of equation 1 by n and re-arrange
X Y OR
X Y
2 1
2 1
| |
| |
. .
. .
=
+ =
11-15
Least Square Technique
Substituting in equation 2
1
|
.

=
=
+ =
+ =
+ =
+
|
|
.
|

\
|
=
.
. .
. .
. .
. .
. .
2 2
2 2
2 2
2
2
2
2
) (
2 2
2
) (
2
2 2
2 2
2 2
X n X
Y X n XY
X n X Y X n XY
X X n Y X n
X
n
X
X n
n
X
Y n XY
X X X X Y XY
X X X Y XY
|
| |
| |
| |
| |
| |
11-16
Triple A Construction
For the simple linear regression model, the values
of the intercept and slope can be calculated using
the formulas below
X Y
2 1

| | + =
values of (mean) average X
n
X
X = =

values of (mean) average Y

n
Y
Y = =

=
2
2
) (
) )( (

X X
Y Y X X
|
X Y
2 1

| | =
11-17
Triple A Construction
Y X (X X)
2
(X X)(Y Y)
6 3
8 4
9 6
5 4
4.5 2
9.5 5
Table 4.2
Regression calculations
11-18
Triple A Construction
Y X (X X)
2
(X X)(Y Y)
6 3 (3 4)
2
= 1 (3 4)(6 7) = 1
8 4 (4 4)
2
= 0 (4 4)(8 7) = 0
9 6 (6 4)
2
= 4 (6 4)(9 7) = 4
5 4 (4 4)
2
= 0 (4 4)(5 7) = 0
4.5 2 (2 4)
2
= 4 (2 4)(4.5 7) = 5
9.5 5 (5 4)
2
= 1 (5 4)(9.5 7) = 2.5
Y = 42
Y = 42/6 = 7
X = 24
X = 24/6 = 4
(X X)
2
= 10 (X X)(Y Y) = 12.5
Table 4.2
Regression calculations
11-19
Triple A Construction
4
6
24
6
= = =

X
X
7
6
42
6
= = =

Y
Y
25 . 1
10
5 . 12
) (
) )( (

2
2
= =

X X
Y Y X X
|
2 ) 4 )( 25 . 1 ( 7

2 1
= = = X Y | |
Regression calculations
X Y 25 1 2 .

+ = Therefore
11-20
Triple A Construction
Regression calculations
sales = 2 + 1.25(payroll)
If the payroll next
year is $600 million
000 950 $ or 5 9 6 25 1 2 , . ) ( .

= + = Y
11-21
Estimation of Demand Function
Y X XY
50 30
55 27
60 24
61 21
63 18
65 15
70 12
2
X
Suppose Y is quantity demanded (in Kg) and
X is price (in Rs.). Estimate the demand function.
11-22
Estimation of Demand Function
Y X XY
50 30 900 1500
55 27 729 1485
60 24 576 1440
61 21 441 1281
63 18 324 1134
65 15 225 975
70 12 144 840
424 147 3339 8655
2
X
Suppose Y is quantity demanded (in Kg) and
X is price (in Rs.). Estimate the demand function.
11-23
Estimation of Demand Function
571 . 60
7
424
21
7
147
= = =
= = =

n
Y
Y
n
X
X
( )( )
( )
9878 . 0
252
937 . 248
3087 3339
937 . 8903 8655
21 7 3339
571 . 60 21 7 8655
2
2
2 2
=

.
X n X
Y X n XY
|
( )( )
X
X
X Y
Y
Y
9878 . 0 35 . 81
2 1
3148 . 81
7438 . 20 571 . 60
21 9878 . 0 571 . 60
2 1
=
+ =
=
+ =
=
=
.
. .
.
. .
| |
| |
11-24
Regression Coefficient and Elasticity
Q
P
P
Q
E
P
Q
E
P Q
d
P Q
.
%
%
.
.
A
A
=
A
A
=
X of Mean X ice X
Y of Mean Y demand Quantity Y
= =
= =
Pr
2
.
.
|
.
=
Y
X
E
P Q
Y = Quantity demanded of tea in thousand pounds
X= Price in Rs. /pound

Y: 38 36 35 32 30
X: 8 8.5 9 9.5 10
=
= =
= =
. .
P Q
E
Y X
.
1 2
| |
11-25
Regression Coefficient and Elasticity
Q
P
P
Q
E
P
Q
E
P Q
d
P Q
.
%
%
.
.
A
A
=
A
A
=
X of Mean X ice X
Y of Mean Y demand Quantity Y
= =
= =
Pr
2
.
.
|
.
=
Y
X
E
P Q
Y = Quantity demanded of tea in thousand pounds
X = Price in Rs. /pound

Y: 38 36 35 32 30
X: 8 8.5 9 9.5 10
( )
Demand Elastic E
demand of elasticity ice E
Y X
P Q
P Q
05 . 1
Pr 05 . 1 4 .
2 . 34
9
2 . 70
1
4
5 . 12
50
2
2 . 34 9
.
.
=
= =
= =

=
= =
. .
| |