Answer to Question #117093 in Microeconomics for STACEY MERVYN

Question

When estimating a demand function, explain why fitting a line of best fit through observed price and quantity combinations over time is not likely to yield good estimates. please show graphs

Answer 1

In every estimation process, we expect the plotted lines of best fits to have a zero error of the standard estimate. In majority of cases, the lines drawn do not achieve to zero error requirement. This becomes true when we consider scatter diagrams in fitting a regression line for the relationship between prices of goods P and the quantity Q demanded as shown in the diagram below.

From the illustration, one would realize that the line of best fit does not take into consideration some of the plotted points but cuts through selected pints with majority of the points. The extreme points of within the graph as marked by the arrows give a higher deviation and if not properly represented, the relationship between the product prices and the quantity demanded will not presents the accurate picture of the intended description. A higher standard error of the estimate would mean poor representation of the statistical information and if the gradient of the line is used as the regression coefficient, the values predicted become exaggerated. The analysis of the demand is therefore flawed and non-representative.