Demand Estimation and Forecasting

Sharmistha Sikdar Managerial Economics, 1st Semester, Sep 2012 Ramaiah Institute of Management Studies

Agenda

Estimation vs. Forecasting Types of Data

Cross Sectional Data Time Series Data

Demand Estimation
Objective and Need Methods of Demand Estimation: Qualitative vs. Quantitative Qualitative Research Techniques and their Drawbacks Statistical/Quantitative Approach Types of Demand Function OLS Method of Demand Estimation

Advantages and Disadvantages of Statistical Approach

Forecasting Techniques
Types of Forecasting Objective & Need Methods of Forecasting: Qualitative vs. Quantitative Qualitative Research Techniques and their drawbacks Quantitative Methods

Estimation Vs. Forecasting

Estimation
It is a process of establishing a mathematical relationship between the level of demand for a product and the estimator variables which determine it Example: If D = F(P, I, A) is a demand function Demand estimation will help predict its functional form.

Forecasting
It is a technique to predict the level of demand/sales for a product at some future date. Example : If D1, D2, D3, D4, D5, D6 are the actual sales of a product from Jan-June 2012, forecasting techniques will help predict the sales for the time period July-Dec 2012

Dependent or Estimated Variable : Demand Estimator variables include: Price of the product (P) Price of complements/substitutes (Pc/Ps) Income of the consumer (I) Advertising outlays (A) Competitor Advertising (Ac) Other Macroeconomic factors such as: Interest rates (i) Consumer Price Index (CPI)

Predicted Variable : Demand/Sales at time point t Predictor Variables include: Time itself as in case of Trend Analysis The past values of the demand/sales: as in Moving Averages method

Estimation Vs. Forecasting

Estimation
Estimation Techniques can be used to forecast the future value of demand/sales

Forecasting
Forecasting techniques cannot be used to derive estimates of the parameters of demand/sales function

Demand estimation answers questions Forecasting answers questions such as : such as: What is the monthly demand expected What will be the volume of sales in for Kelloggs Oats 500 gm. packet Diwali 2012 for LG washing machines? launched at a price, say Rs 100 from a given income segment Rs 25000-Rs 50000 ? How will the demand change if a tax is imposed on a certain product?

Data Types Cross Sectional Data

o A type of One Dimensional Data o Data is collected on attributes such as income, prices, etc. across individuals, firms , regions at the same point of time. o Example*:
August 2012 Consumer Survey Data on Demand for XYZ's Oats in Region ABC Consumer_I Monthly # Family Breakfast D Income # 500 gm Units Bought/month Members Preferences 1 2 3 4 5 Rs 30000 Rs 35000 Rs 40000 Rs 25000 Rs 40000 2 2 1 1 4 3 3 4 4 5 Western Western Indian Indian Western

* Fictitious Data created for illustration purposes only

Data Types Time Series Data o A sequence of data points measured typically at successive time
instants spaced at uniform time intervals

o The observations are ordered by time and a time series trend is

defined for a specific variable measured across time points. o Examples*: Income trend of an individual Or Sales trend of a firm
Monthly Income Trend for an Individual Month Jan-12 Feb-12 Mar-12 Apr-12 May-12 Jun-12 Income (in Rs) 30000 32000 32000 33000 33500 34000
Month Jan-12 Feb-12 Mar-12 Apr-12 May-12 Jun-12 Jul-12 Aug-12 Sales & Advertising Trend for a Firm Advertising Exp (in Rs Sales (in Rs '000) '000) 5000 2000 2500 3000 3200 2700 2600 3800 10 6 6 8 8 6 6 9

Jul-12
Aug-12

32000
32000

* Fictitious Data created for illustration purposes only

DEMAND ESTIMATION

Objective and Need

Objective
o o

Identify the factors that determine the demand curve for a product Quantify the impact of changes in these factors on the demand for the product How sensitive the demand for their products are to changes in own price or price of related goods How consumers respond to changes in their own income levels How demand for the product gets impacted with changes in promotional strategies

Firms need to know

o o o

How macroeconomic factors such as changes in interest rate, growth in GDP etc impact the demand for their products

Methods of Demand Estimation

Demand Estimation Techniques

Qualitative Research Techniques

Quantitative/ Statistical Techniques

Consumer Surveys Market Experiments Consumer Clinics

Regression Analysis Linear Logistic

Qualitative Research Techniques

A) Consumer Surveys
o o

Questionnaire based information is gathered from a sample of consumers The questions are designed to get responses on sensitivity of consumer to price changes, quantities demanded at various price levels, awareness levels about the product and its substitutes, effectiveness of advertising and other related aspects Information thus collected is analyzed and the results are projected onto the population The questions are designed around hypothetical situations and hence consumer responses may not be honest or realistic Reliability of the responses could be a challenge The sample interviewed may not be representative of the population

Drawback of this approach

o o o

10

Qualitative Research Techniques

B) Market Experiments
o o o

Real experiments conducted by the seller of the product wherein the product is tested out in a representative market Seller introduces variations in the product features such as pricing, packaging and gathers information on the consumer reaction The results of these experiments are then analyzed and projected onto the population It is a high cost technique as the seller has to actually launch a sample of the varied product It is also risky for the seller as the situation cannot be fully controlled The seller is also at a risk of damaging its brand image if the product variant is not accepted by the consumers

Drawback of this approach

o o o

11

Qualitative Research Techniques

C) Consumer Clinics
o o o

An experimental set up similar to Market Experiments wherein the consumers are asked to act in a simulated situation The sample consumers are given some amount of money and indulged to buy Their buying behavior is studied and results thus analyzed is projected onto the population It is a high cost technique as actual money is given to consumers to study their buying pattern The method suffers the same drawback of the possibility of unrealistic responses, however this is more effective than consumer surveys

Drawback of this approach

o o

12

Quantitative Techniques
o

o
o

A hypothesis is formulated on the basis of consumer behavior theory and a list of possible variables that can impact demand is identified Example of a Hypothesis: Demand for a product is negatively related to its price The data on demand and other identified variables are collected from actual historical data. Data for this method is made available through various publications* and bureaus A mathematical relationship of the demand with other variables is specified: D = F( P, Pc, Ps, I, A) Example: D = 0 + 1P + 2Pc + 3Ps + 4I + 5A + error Econometric methods are applied to estimate the parameters of the demand function, i.e., 0 , 1 , 2 , 3 , 4 , 5 as given in the example Using this mathematical equation demand is then estimated for the population
13

*In India some of these publications are provided by the Centre for Monitoring Indian Economy, the Confederation of Indian industries etc.

Types of Demand Function

o

General Form of the Demand Function D = F( P, Pc, Ps, I, A)

A specific functional form needs to be chosen in order to estimate the parameters

The Simple Linear Form

D = 0 + 1P + 2Pc + 3Ps + 4I + 5A + error

o

The Exponential Form D = Pa Pc b Psc Id AeEf , where E = error Taking logarithmic transformation of the exponential form this changes to the Log-Linear Form log D= a log P + b log Pc + c log Ps + d log I + e log A + f log E
14

OLS* Method of Estimation

Scope - Two Variable Linear Regression Analysis Dependent Variable : Demand Independent Variable : Price or income or Advertising outlays etc. o Form of the 2 variable Linear Model D = 0 + 1X + where D = quantity demanded of the product (dependent) X = Independent variable (price, income etc.) 0 and 1 are the parameters of the model is the error in estimation
o
o

Interpretation of the parameters and the error term o 0 is the intercept of the demand function, i.e., the quantity demanded of the product when the independent variable is set to 0 o 1 is the coefficient that estimates the change in quantity demanded associated with a 1-unit change in the independent variable o The error term is included to account for the fact that the predicted (theoretical) value of demand may not be the same as the actual (observed) value
*NOTE: OLS implies Ordinary Least Squares, it is also called Least Squares

15

OLS Method of Estimation

o o o o o

Assume a sample data taken on price and quantity demanded Independent variable is the price Dependent Variable is the quantity demanded of a product The scatter plot of the data is shown in the graph below The estimated linear model is given by the line graph
Price-Quantity Demanded Scatter Plot
105 100 Price (Pi) (Rs per unit) 95 90 85 80 75 70 0 1 2 3 4 Quantity (Qi) (# units per week) 5 6

e1

Error in Estimation for a given price point

e2

OLS Estimates are such that this error is minimized

NOTE: The graphical convention in many textbooks is to plot the independent variable , e.g. price , on X-axis and dependent variable, i.e., demand on Y-axis. Here we have used standard Economics convention of plotting price on Y-axis and demand on quantity on Xaxis (Marshalls graphical convention)

16

OLS Method of Estimation

Objective:
Estimate values of 0 and 1 such that error in estimation is minimized Let b0 and b1 be the estimated values of 0 and 1 Then, Estimated Demand for ith data point (di) = b0 + b1.Xi Error in Estimation for ith data point (i) = Actual Demand Estimated Demand = Di (b0 + b1.Xi) Therefore, Parameters should be estimated so as to Minimize i2 = {Di (b0 + b1.Xi)}2 , where i = 1 to n (Sample size = n)

OLS estimates* are computed as :

b1 = n X iDi - X i D i n X i 2 ( X i )2
where Dav and Xav are the arithmetic means of D and X, and summation is over i = 1 to n
Estimates are computed using differential calculus with first order derivative set to 0 for a minimization problem Tests for Model accuracy in the Appendix

b0 = Dav - b1 Xav

17

Pros & Cons of Statistical Approach Advantages

o Eliminates subjectivity of the qualitative research techniques o Bases the calculation of parameters on actual historical data

Disadvantages
o Multicollinearity Problem If too many independent variables that are related to each other are introduced in the model the OLS method may assign coefficients arbitrarily. This makes it difficult to segregate the effect of two closely-related variables. The t-test of significance of the independent variables helps identify this problem and the correlated variables can be eliminated and model parameters re-estimated. o Identification Problem In case of Time Series or Pooled data all variables are allowed to vary causing shifts in demand and supply curve (Ceteris Paribus assumption violated) Impact of an independent variable on demand maybe overestimated or underestimated o Autocorrelation Problem This problem also occurs in case of TS data where the errors are not independent over time, i.e., high error in estimation in a given period leads to a high error in the following period. Existence of this problem signifies that a crucial variable has been missed out in the estimation and the error term gets amplified in magnitude in each successive time18 period

DEMAND FORECASTING

19

Types of Forecasting

Short Term Forecasting

o Forecasting done for short periods typically 1 year o It is done by firms to formulate policies on sales, purchase, price and finances o Sales forecasting helps firms determine production o Price forecasting for raw materials helps reduce costs of operation by enabling businesses to buy these in advance if a price rise is expected o Sales and demand forecasting enables the firms to procure funds on reasonable terms

Long Term Forecasting

o Forecasting typically done for longer time periods , greater than 1 year o Enables firms to predict the long term demand for their product which can impact decisions such as need to buy a new plant or expansion of existing units o For multiproduct firms, long term forecasting helps decide which products to expand into and which ones to reduce production o The risk of error is higher in case of long run forecasting

20

Methods of Forecasting
Forecasting Methods

Qualitative Research Techniques

Quantitative/ Statistical Techniques

Opinion Survey Expert Opinion Delphi Method Consumers Interview Method Complete Enumeration Sample Survey End-use Method

Time Series Trend Analysis Moving Averages Exponential Smoothing Barometric Technique Regression Analysis
21

Qualitative Research Techniques

A) Opinion Survey Method
o o o

This method is also called the Sales-Force-Composite Method or Collective Opinion Method The salesmen of the company are asked to submit estimates of future sales in their respective territories. The top executives of the company then consolidate, review and adjust the estimates to eliminate biases of the sales-force. Simple and straightforward method and requires minimum technical skill This is less expensive than consumer interview method Based on the salesmens first hand and personal knowledge and thus more realistic Useful in forecasting sales of new products Vulnerable to subjective biases of the salesmen Only useful for short term forecasting such as that for 1 year

Advantages of this approach

o o o o

Drawback of this approach

o o

22

Qualitative Research Techniques

B) Expert Opinion
o

In many industries, sales estimates are given by experts who have a thorough industry knowledge and are aware of the fluctuations in the macroeconomic environment Various public and private agencies sell periodic forecasts of businesses

Advantages of this approach

o
o

Forecasting through this method is relatively quick and inexpensive

In case of data unavailability for elaborate statistical methods, this is a good alternative

Drawback of this approach

o
o

Vulnerable to subjective biases of the experts

Good and bad estimates are given equal weights

23

Qualitative Research Techniques

C) Delphi Method
o o o o o o o

A variant of the survey method wherein a panel of experts is selected for a given business problem Both internal and external experts of the firm can be part of the panel This method involves multiple rounds of question-answer sessions In each round, the panel members are given a questionnaire and asked to express their opinion in an anonymous manner A coordinator mediates and presides over this survey. He collects the results and prepares a summary report at the end of each round In the next iteration, the panelists recalibrate their forecasts basis review from previous round At the end of the final round the panel members reach a consensus on the forecasts Forecasts through this approach are more reliable than expert opinion survey method as the consensus is reached over multiple rounds In case of data unavailability for elaborate statistical methods, this is a good alternative Has proved to be more successful in forecasting of non-economic rather than economic variables

Advantages of this approach

o o

Drawback of this approach

o

24

Qualitative Research Techniques

D) Consumers Interview Method
o

Consumers are contacted personally and interviewed on their preferences and plans to purchase the product in question The potential buyers of the product are then asked to reveal the quantity of the product that they plan to purchase. The demand forecast for the product is then made This survey can be done in 3 wayso Complete Enumeration Method: All the consumers of the product are interviewed based on which forecast is made. The forecast is free of any bias as it contains first hand information of actual buyers of the product. o Sample Survey Method: In this method a sample of consumers is selected for interview. Random or stratified sampling methods can be used to generate the sample. o End-use Method: The demand for the product is found out from different sectors such as industries, consumers, exportimport. Basis this data, forecasts are made on future demand.

Advantages of this approach

o

The forecasts are generated from first hand information and hence tend to be unbiased

Drawback of this approach

o
o

The consumers may be hesitant to reveal their purchase plans for privacy
As the consumers are numerous, this may turn out to be costly. However, the cost implications may vary across sample survey , complete enumeration and end-use methods. The consumers often may be unable to predict the exact amounts they plan to purchase due to multiple alternatives available, anticipation of shortages, general irregularity in buying plans. This may reduce the accuracy of the data collected and hence affect forecasts
25

Quantitative Techniques
A) Trend Analysis
o o

The historical data for demand/sales for a given product is collected A trend line is fitted onto the data by developing an equation given as:

Dt = a + bT, where a = intercept and b = impact of time on demand, T = Time

Using OLS Method of parameter estimation,

b = n TtDt - Tt Dt n Tt2 ( Tt)2

a = Dav - b1 Tav

Where t = 1, 2, .n refer to n time periods, Dav = average demand across n time points, Tav = average time point

Actual Sales Vs Forecasted Trend

650 600 in Rs '000 550 500 450 400 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Actual Sales Trend line

26

Quantitative Techniques
B) Moving Averages Method
o o o o o

The historical data for demand/sales for a given product is collected

The future values are forecasted as the simple averages of the past data
When the demand is stable, this is a good method of forecasting E.g.: In the 3- point moving average method, the average of values collected for timepoints t-2, t-1 and t is used as the forecast for the time point t + 1 In general, this technique can be written as Dt+1 = xt + xt-1 + xt-2 + xt-3 +. + xt-n+1
n

Where n = number of time-points taken to compute the moving average Dt+1 = The demand forecast for time point t+1 xt , xt-1, xt-2.. , xt-n+1 are the actual demand values in the previous n time points

27

Quantitative Techniques
C) Exponential Smoothing Method
o o

This is an improvement over the Moving Averages Method In the Moving Averages method, the values across different time points are given equal weights in determining the forecasted value. The underlying logic of Exponential Smoothing is to give higher weightage to more recent values This is achieved as follows, Let Dt be the forecast for time period t,

where Dt = xt-1 + xt-2 + xt-3 +. + xt-n+1

n

n = number of time points for which the average is computed The forecast for time period t+1 is then computed as Dt+1 = ( xt/n ) + ( 1 1/n) Dt

28

Quantitative Techniques
D) Regression and Correlation Technique
o

This technique uses the demand estimation OLS method to arrive at a functional relationship between demand/sales and other independent variables such as price, income, advertising outlay. The data is collected across time points for all the independent and dependent variables The demand function is estimated as

o o

D = 0 + 1P + 2Pc + 3Ps + 4I + 5A + error

o

Given this demand function future values of demand can be forecasted basis the forecasts of the independent variables P, Pc, Ps, I, A

29

APPENDIX

30

Tests to Measure Accuracy of OLS Estimates

o

Testing Overall Explanatory Power of the Model

o This test uses the coefficient of determination (R2) which is given as: R2 = Total Explained Variation Total Variation Where, = (di Dav)2 Di is the actual demand 2 di is the estimated demand (Di - Dav)
Dav is the sample mean demand

o Higher the explained component of the variation implies the estimated demand is close to the actual demand and lower is the error in estimation. That is, higher the value of R2 better is the model fit o The value of R2 ranges from 0 to 1 o If R2 = 0, there is no relationship between Demand and the independent variable, hence b1 = 0, b0 = Dav and di = Dav

31

Tests to Measure Accuracy of OLS Estimates

o

Evaluating Explanatory Power of Individual Independent Variable

o This is achieved through the t-test that enables determine whether there is a significant relationship between the dependent and the independent variable o The t-test statistic is computed as t = b1/ SE(b1) where SE(b1) is the standard deviation or standard error of the estimated b1

o The estimated value of the parameter 1 varies with samples. If demand is indeed explained by the independent variable X, then the variation in the parameter estimate (b1) across different samples should be small. That is, SE(b1) should be small. In that case, the t-statistic should have a high value. o This implies higher the value of the t-statistic better is the explanatory power of the independent variable and the coefficient b1 is said to be statistically significant

32

References

Managerial Economics Cauvery, Sudhanayak, Girija, Meenakshi Managerial Economics Suma Damodaran

Consumer Behavior and Estimating and Forecasting Demand Howard Davies (Slideshare)
http://www.egyankosh.ac.in/bitstream/123456789/35386/1/Unit-6.pdf

33