As mentioned in Section *Relationship between Variables*, the covariance and correlation statistics provide a measure
of the strength of the linear relationship between two variables.

Regression analysis is a technique which further examines the relationship between variables. It models the relationship between one or more independent variables (predictors or explanatory variables) and a dependent variable (response variable) and explains or predicts the outcome of the dependent variable, as a function of the independent variables.

The two basic types of regression are simple linear regression and multiple linear regression. Simple linear regression models the relationship as a linear function of one independent variable, whereas multiple regression uses two or more independent variables.

Simple linear regression (Exhibit 33.24) takes the following functional form: $$ y = b_0 + b_1x + e $$

Multiple linear regression takes the form:

$$ y = b_0 + b_1x_1 + b_2x_2 + b_3x_3 + ... + b_t x_t + e $$y: is the dependent or response variable.

x, x_{i}: independent variables (predictors or explanatory variables).

b_{0}: intercept.

b_{i}: regression coefficient is the slope of the regression line.

e: error term

Once the relationship has been determined, the regression equation can be used to visualize, explain, and predict how the dependent variable responds to changes in the independent variables.

For instance, if you are studying the impact of consumer promotions, regression will explain how price discounts for an item and its competitors affect the sales of the item. It provides a measure for the discount price elasticity of demand and the cross-discount-price elasticity of demand, as well as the impact of displays and other in-store influences.

Based on this understanding, you can construct a “due to” analysis to explain the
outcome of past marketing initiatives or develop a “what-if” analysis to predict or simulate the impact
of proposed initiatives. These analyses are covered in Section
*Sales Decomposition and Due-To Analysis*
and Section *What-if Analysis* of Chapter *Promotion*.

The approach to estimating the parameters for a regression equation is outlined in Exhibit 33.25. The intercept and coefficient estimates are based on the Least Squares Error (LSE) method where the criterion is to minimize the sum of the squared error (SSE) (actual – predicted): $$ min\sum(y_i-\hat y_i)^2 $$

y_{i}: observed value.

ŷ_{i}: estimated value.

In the case of simple linear regression:

$$ SSE = \sum_{i=1}^n (y_i - \hat y_i )^2 = \sum_{i=1}^n [y_i - (b_0 + b_1 x_i)]^2 $$Via differentiation we can obtain the estimate for the *regression coefficient*:

And, b_{0}, the intercept:

As with simple regression, estimates for multiple linear regression are based on the
LSE method. The parameters *b _{1}, b_{2}, b_{3}* etc. are called

*Note: The partial contribution of each x-variable (as measured by its b-coefficient)
may not agree in relative magnitude (or even sign) with the bivariate correlation between the
x-variable and y (the dependent variable).*

Regression coefficients vary with measurement scales. If we standardize (i.e., subtract
the mean and divide by the standard deviation) y as well as x_{1}, x_{2}, x_{3},
the resulting equation is scale-invariant:

While constructing a regression model, bear in mind that like any other market model,
it should have a *theoretical foundation*, a conceptual framework. The selection of variables and
their relationship should be based on concepts and theoretical principles.

The *regression equation* depicts the relationship between dependent and predictor
variables, in terms of importance or magnitude, as well as direction.

The *regression coefficients* denote the relative importance of their respective
predictor variables, in driving the response variable. The coefficient *b _{1}* for instance,
represents the amount the dependent variable

The linear model is theoretically unsound for predicting sales (and most other marketing
variables) because it suggests that sales can increase indefinitely. However, from a practical standpoint,
a linear model can provide a good approximation of the true relationship over a *small operating
range*, e.g., a __+__ 15% change in a predictor such as price.

*Nonlinear structural models* can be transformed into estimation models that are
linear in parameters by applying transformation functions. The advantage of doing this is that the
parameters of the original nonlinear model can be estimated using linear-regression techniques.

For instance, consider the multiplicative form, which is widely used in marketing mix models such as NielsenIQ’s Scan*Pro:

$$ y=e^α x_1^{β_1} x_2^{β_2} x_3^{β_3}\,…$$This nonlinear structural model can be transformed into an estimation model that is
*linear in parameters* by taking logarithms on both sides.

The size of the sample determines the reliability, the extent that the regression analysis result is error free. It determines the statistical power of the significance testing, as well as the generalizability, i.e., the ability to apply the result to the larger population.

As a thumb rule, 15 to 20 observations are required for each independent variable. If the sample is constrained, a bare minimum of 5 observations are required for each independent variable, provided there are at least 20 observations for simple regression, and 50 for multiple regression.

Small samples can detect only the stronger relationships. Moreover, if the ratio of observations to parameters is below norm, you run the risk of “overfitting” – making the results too specific to the sample, thus lacking generalizability. Increasing the degrees of freedom improves generalizability and reliability of the result.

The choice of variables is crucial to the validity and utility of a regression model.

The *omission of relevant independent variable* can *severely distort* the
findings, particularly when the variable relates to a distinct influence, yet coincides (correlates)
with some other independent variable.

For example, in Singapore, consumer promotions of some soft drink brands occur mainly during the Hungry Ghost festival. If the festive seasonality is not incorporated into the regression model, the discount price elasticity of these brands is greatly exaggerated as they soak up the impact of the festive season.

The *inclusion of irrelevant variables* is also a concern. It reduces the model’s
parsimony and may also mask or replace the effects of more useful variables.

A separate issue pertains to errors in the measurement of variables, missing data points for instance. Where it is necessary to include the data, analyst make use of a variety of techniques to clean data and incorporate missing information.

There are a number of underlying assumptions about the dependent and independent variables, and their relationship, which affect the statistical procedures such as LSE and significance tests used for linear regression. These assumptions, listed here, need to be tested at the different stages of the regression process.

*Normality:* Variables and their combination are assumed to follow the normal
distribution.

*Linearity* is assumed, as is evident from the name (*linear*
regression).

*Homoscedasticity:* Variance of dependent variable should not vary across range of
predictor variables.

*Residuals* (errors, i.e., predicted minus observed values) are assumed to be
independent. The prediction errors should be uncorrelated, otherwise it suggests some unexplained,
systematic relationship in the dependent variable.

The dependent and independent variables are assumed to follow normal distribution. Furthermore, in the case of multiple regression, this assumption is also applicable to the combination of variables.

If their distributions vary substantially from the normal distribution, the *F
test*, which assesses the overall regression, and the *t-test*, which assesses statistical
significance of the coefficients, may no longer remain valid. These tests assume that the residuals
are distributed normally.

Univariate normality can be visually examined through the histogram and the stem & leaf plot (Exhibit 33.26), though this may be problematic for smaller samples. The normal probability plot, Exhibit 33.27, is a more reliable check. This compares the cumulative distribution of the data with that for a normal distribution. If data is normal, it is scattered close to the diagonal which represents the theoretical normal distribution.

Additionally, the *Kurtosis* statistic tests for “peakedness” or “flatness” of the
data, and the *skewness* statistic is a measure for skewness.

Simple and multiple linear regression are linear by definition. Moreover, the correlation measures that these techniques are based on, represent only the linear association between variables.

Linearity may be visually examined via scatterplots such as the one shown in Exhibit 33.29. Alternatively, for a more accurate assessment, you could run a simple regression analysis and examine the pattern of residuals.

Nonlinear relationship can be made linear in parameters by transforming one or more of the variables.

Common approaches include,for relatively flat distributions, the inverse
transformation *1/x* or *1/y*, and for positively skewed distributions distribution, square
root transformation:
$$x_{new}=\sqrt{x_{old}},$$

And log, for negatively skewed distribution:

$$x_{new}= log(x_{old}).$$New variables may be created to represent the nonlinear portion of the relationship.
Polynomials (x^{2} or x^{3}) for instance, are power transformations of an
independent variable that add a non-linear component:

- x
^{1}(power = 1): linear. - x
^{2}(power = 2): quadratic. Single inflection point. - x
^{3}(power = 3): cubic. Two inflection points.

If the relationship is known to be nonlinear with inflection points, a common practice
is to start with the linear component, and then sequentially add higher-order polynomials till there
is no significant additional improvement in the fit (*R ^{2}*). The t-test would confirm whether
or not the additional terms are significant.

When an independent variable is nonmetric (e.g., seasonality), and has *k* (two
or more) categories, it can be represented by *k-1* dummy variables.

For example, the coding of in-store causal influences like display and co-op advertising can be captured with the use 3 dummy variables:

- Display only. (No co-op):
*D*._{1}=1, D_{2}=D_{3}=0 - Co-op, no display:
*D*._{2}=1, D_{1}=D_{3}=0 - Display + co-op:
*D*._{3}=1, D_{1}=D_{2}=0 - The 4th option, no display and no co-op, is represented by
*D*._{1}=D_{2}=D_{3}=0

The impact of dummy variables is reflected in the change of intercept (b_{0}).
For instance, consider the relationship between sales and discount price. The x-coefficient
(*b _{1} = discount price elasticity*) remains unchanged when there is a display. The impact of
an in-store display is reflected in an incremental lift in sales, referred to as

Intended to achieve common imperatives, the elements of the marketing mix often interact synergistically to produce an effect greater than the sum of their individual effects.

Take consumer promotions for instance. Discounts, displays and co-op ads, often have a synergistic impact lifting sales more than the sum of their individual impact on sales.

Similarly, theme advertising strengthen a brand’s equity, resulting in the lowering of consumers’ sensitivity to changes in price.

These interaction effects where one element of the marketing mix affects the sensitivity
of one or more other elements, can be captured in response functions by the inclusion of an additional
term, x_{1} × x_{2}, formed by the product of the two variables that interact.

In this example, the overall effect of x_{1} for any value of x_{2} is
equal to: b_{1-total} = b_{1} + b_{3} x_{2}.

To determine the presence of the moderator effect (b_{3}x_{1}x_{2}),
compare the unmoderated *R ^{2}* with the moderated

As mentioned, the choice of variables is a crucial decision. The omission of relevant, important variables can distort the findings. The inclusion of irrelevant variables on the other hand, reduces model parsimony, and may also mask or replace the effects of more useful variables.

Once an initial set of variables has been listed, some of them may turn out to be less important, not contribute significantly to the relationship.

For example, in the analysis of promotions, the sale of an item depends on the discounted price of that item (discount price elasticity) as well as the discounted price of competing items (discounted cross-price elasticity). It will turn out that some competitor items do compete strongly, and their prices are included as variables in the final model, whereas the prices of other items are not having a significant impact, and they are removed from the model.

There are a variety of approaches leading to the final selection of variables. Some of these are discussed here.

The *confirmatory* approach is one where the analyst specifies the variables.
Typically, one would use a variety of other methods, arrive at some conclusions, and then confirm the
variables that you want to deploy in the regression.

Another method commonly found in statistical packages is called *stepwise regression*.
It follows this sequence of steps:

- At the start, dependent variable (
*y*) is regressed with the most highly correlated predictor variable (*x*):_{1}
$$ y = b_0+b_1 x_1 $$
- Next, the predictor (
*x*) with highest_{2}*partial correlation*, is added to the model:
$$ y = b_0+b_1 x_1+b_2 x_2 $$
- After each additional variable is added, the algorithm examines the partial F value for
the previous variable(s) (
*x*). If the variable no longer makes a significant contribution, given the presence of the new variable, it is removed._{1} - Steps 2 and 3 are repeated with remaining independent variables, till all are examined, and a “final” model emerges.

Sometimes the coefficients of one or two variables in the final model may not be meaningful; the direction of the relationship may be nonsensical. Normally this occurs for variables that have relatively low contribution to the relationship, and they can be removed.

Another approach referred to as the *forward regression* is similar to the stepwise
method. It adds independent variables progressively as long as they make contributions greater than
some threshold level. However, unlike stepwise estimation, once selected, variables are not deleted at
any subsequent stage.

Yet another approach, *backward regression*, is essentially forward regression in
reverse. It starts with all possible independent variables in the model, and sequentially deletes those
which make contributions below some threshold value.

These diverse model selection procedures, which are automated in statistical packages like R, SAS and SPSS, are useful for variable screening.

In applications such as data mining, where the association between variables is often unknown and needs to be explored, these techniques help unearth promising relationships.

Issues pertaining to variables need to be addressed to ensure the outcome is a model that is statistically significant and theoretically sound.

Regression can ascertain relationships, but not the underlying causal mechanism. So, first and foremost, models must remain true to their theoretical foundation. We must ensure that the coefficients are meaningful; that their expected sign and magnitude are conceptually correct.

A subtle problem can arise due to the stepwise estimation process. Since it takes one
variable at a time, if a pair *(x _{i}, x_{j}) collectively* explain a significant
proportion of the variance, they will not be selected by the stepwise method, if by themselves, neither
is significant.

Another issue, *multicollinearity* or the correlation among independent variables
may make some variables redundant. This needs to be assessed, since in the selection process, it is
likely that after one is included, the others will *not* be included.

While multicollinearity masks relationships that are not needed for predictive purposes, it does not reflect on their relationship with the dependent variable. This is discussed in the next section.

The inclusion of variables with low multicollinearity with the other independent variables, and high correlation with the dependent variable, increases the overall predictive power of a model.

*Collinearity* is the correlation between two independent variables, and
*multicollinearity* is the correlation between three or more independent variables. The terms,
however, are often used interchangeably.

*Multicollinearity* reduces the predictive power of an independent variable by
the extent to which it is associated with other independent variables. As the correlation increases,
the proportion of the variance explained by each independent variable decreases, while their shared
contribution increases.

An extreme example of multicollinearity would be duplicate variables, for instance advertising spend in dollars and in ‘000 dollars. These two variables are essentially identical, and one should be removed.

On the other hand, if one of the variables is GRP and the other is spend in dollars, in that case the analyst should pick the one that has the greater predictive power. (In theory, that ought to be GRP, if the dependent variable is advertising awareness or sales).

Finally, consider *Brand Equity* research. Of the large number of attributes that
relate to brand equity, many are correlated. For instance, value for money, low price, attractive
promotions and house brands.

The approach in this case is to club variables together to form factors, or composite variables. The dependent variable is then regressed with the factors; the regression coefficients reveal the importance of each factor, and the factor loading reveals the importance of each attribute or independent variable.

To sum up, sometimes *factor analysis* and other means of combining variables
into summated scales, can effectively address multicollinearity. In other instances, one or more of
the variables may be redundant.

An *outlier* is an observation that is distant from other observations. It may
result from measurement error; in which case it should be discarded. Or it may be indicative of a
heavy-tailed population distribution, which then violates the assumption of normality.

Box and whisker plots such as the one shown in Exhibit 33.30, reveal outliers in a univariate assessment. For pairs of variables, outliers appear as isolated points on the outskirts of scatterplots. For more than 2 variables, statistical techniques such as Mahalanobis D2 may be used for detecting outliers.

Influential observations are any observations, outliers included, that have a disproportionate effect on the regression results. These need to be carefully examined and should be removed, unless there is a rationale for retaining them.

Coefficient of Determination (R2) represents the proportion of the variance of a dependent variable that is explained by the predictor(s).

The sum of squared deviations,
∑(y_{i} − ȳ)^{2} (SS_{tot}), is an unscaled, or unadjusted measure
of dispersion or variability. When scaled for the number of degrees of freedom, it becomes the variance.

Partitioning of the sum of squared deviations, allows the overall variability in the
data to be ascribed to that explained by the regression (SS_{reg}), and that not explained by
the regression, i.e., the residual sum of squares, (SS_{res}).

SS_{tot}: Total sum of squared deviations.

SS_{reg}: Explained sum of squared deviation.

SS_{res}: Residual (error) sum of squares.

*Coefficient of Determination* (*R ^{2}*) is the proportion of the variance in the
dependent variable that is predictable from the independent variables:

This is a commonly used statistic to evaluate model fit; it is an indicator of how
well the model explains the movement in the data. For instance, an *R ^{2}* of 0.8 means that
the regression model explains 80% of the variability in the data.

*R ^{2}* always increases when explanatory variables are added to a model. As
such it can create the illusion of a better fit as more terms are added.

*R _{adj}^{2}* adjusts for number of explanatory terms in a model relative
to the number of data points. Unlike

Where *k* is the number of explanatory variables, and *n* is sample size.

As explanatory variables are added to a regression in order of importance, the point
before *R _{adj}^{2}* starts to decrease, is where the stepwise selection of variables
should conclude.

The F-ratio, which follows the F-distribution, is the test statistic to assess the statistical significance of the overall model. It tests the hypothesis that the variation explained by regression model is more than the variation explained by the average value (ȳ).

$$ F =\frac{SS_{reg}/df_{reg}}{SS_{res}/df_{res}} $$ $$ = \frac{R^2/k}{(1-R^2)/(n-k-1)}$$Where:

*k* is the number of explanatory variables, and *n* is sample size.

SS_{reg}: Explained sum of squared deviation.

SS_{res}: Residual (error) sum of squares.

df_{reg}: Degrees of freedom (regression) = number of estimated coefficients
including intercept − 1 = number of explanatory variables (k).

df_{res}: Degrees of freedom (residual) = sample size (n) − (k+1).

*R ^{2}*: Coefficient of Determination (

Since the coefficients in the regression represent key parameters such as elasticities and cross-elasticities of demand, it is important that we test their statistical significance.

The t-test is used for this purpose. For each coefficient, it tests that the coefficient differs significantly from zero value.

Consider the regression model: $$ y = b_0+b_1 x_1+b_2 x_2+b_3 x_3 \,…$$

For the coefficient b_{1}, in the above equation:

Null hypothesis H0: b_{1} = 0

Alternative hypothesis HA: b_{1} <> 0

Relevant test statistic is t = b_{1} /σb_{1}, where σb_{1} is the
standard error of b_{1}.

Relevant distribution is the t-distribution, with degrees of freedom = n − (k + 1). Where k is the number of explanatory variables, and n is sample size.

Similar tests are run for b_{2}, b_{3} … to determine the individual
significance of X_{2} and X_{3} in the model.

In interpreting the quality of a regression model, the following aspects are taken into consideration.

*High adjusted R^{2}:*

*Significant F-statistic:* The null hypothesis that all coefficients (b_{1},
b_{2} …) are zero can be conclusively rejected

*Significant t-statistics:* The individual coefficients are statistically
significant.

*Residuals* are random, normally distributed, with mean 0, and their variance does
not vary significantly, over the values of the independent variables.

Validation, or more specifically, cross-validation is a method of assessing how well the regression can be generalized.

One approach it to retain a portion of the original data for validation purposes and use the rest to construct the model. Once the model is finalized, the estimated parameters are used to predict the out-of-sample data.

The model’s validity may be assessed by comparing the out-of-sample mean squared error (the mean squared prediction error), with the in-sample mean square error. If the out-of-sample mean squared error is substantially higher, that would imply deficiency in the model’s ability to predict.

To summarize, here is the sequence of steps to be followed in the development of a regression model.

*Research Objective*stems from the marketing objective. It determines which dependent variables or responses need to be predicted, and/or what needs to be explained.*Sample*: The sample size should be adequately large to ensure statistical power and generalizability of the regression.*Model design*: Choose the dependent and plausible explanatory variables. Check assumptions:*Normality**Linearity**Homoscedasticity**Independence of the error terms.*

*Transformations*, in case some assumptions are not met.*Dummy variables*to cater for nonmetric variables.*Polynomials*required if curvilinear relationships exist.*Interaction terms*required if there are moderator effects.

*Run the model*. Variable Selection is usually a combination of methods such as confirmatory, stepwise estimation, forward regression and backward regression.*Examine Results*: Output need to be thoroughly examined in the context of the following:*Issues*: Influential observations. Check for multicollinearity.*Practical Significance*: Is it theoretically sound? Are the signs and magnitude of coefficient meaningful?*Statistical Significance*:*R*: Adjusted coefficient of determination._{adj}^{2}*F-ratio*: Standard error of estimation.*t-test*: Statistical significance of regression coefficients.*Residuals*: Ensure that residuals meet required criteria.

*Validation*: Cross-validate the regression to assess how well the model can be generalized.

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