Sharmistha Sikdar Managerial Economics, 1st Semester, Sep 2012 Ramaiah Institute of Management Studies
Agenda
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
Forecasting Techniques
Types of Forecasting Objective & Need Methods of Forecasting: Qualitative vs. Quantitative Qualitative Research Techniques and their drawbacks Quantitative Methods
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
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 Time Series Data o A sequence of data points measured typically at successive time
instants spaced at uniform time intervals
Jul-12
Aug-12
32000
32000
DEMAND ESTIMATION
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
How macroeconomic factors such as changes in interest rate, growth in GDP etc impact the demand for their products
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
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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
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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
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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
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*In India some of these publications are provided by the Centre for Monitoring Indian Economy, the Confederation of Indian industries etc.
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
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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
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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
e2
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)
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b0 = Dav - b1 Xav
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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
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Types of Forecasting
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Methods of Forecasting
Forecasting Methods
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
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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
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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
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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
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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.
The forecasts are generated from first hand information and hence tend to be unbiased
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
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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:
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
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Quantitative Techniques
B) Moving Averages Method
o o o o o
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
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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,
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
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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
Given this demand function future values of demand can be forecasted basis the forecasts of the independent variables P, Pc, Ps, I, A
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APPENDIX
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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
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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
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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
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