Demand Estimation and Forecasting

Demand Estimation and Forecasting
Shivraj Singh Negi (HS07H022)

Demand Estimation and
Ajai Kurian Mathew (NA07B002)
Harshawardhan R (CE06B054)
Forecasting Prem Ranjan(HS07B019)
Economics of Industrial Organizations

In this paper we attempt to review the models, process, qualitative and
quantitative methods of forecasting. We also review the needs and reasons
for forecasting and what methods and approaches are employed for
forecasting, requirements for forecasting, what are the shortcomings and
business implications of forecasting.
Economics Of Industrial Organizations Page 1


Contents
Demand Estimation....................................................................................................4
Methods of Demand Estimation..................................................................................5
Qualitative Methods................................................................................................5
Consumer surveys:..............................................................................................5
Market experiments:............................................................................................5
Quantitative Methods..............................................................................................6
Statistical methods..............................................................................................6
Model specification...............................................................................................6
Mathematical models:..........................................................................................6
Statistical models.................................................................................................8
Data collection........................................................................................................8
Types of data.......................................................................................................8
Sources of data....................................................................................................9
Presentation of data...........................................................................................10
OLS (Ordinary Least Squares) Method for Regression...........................................11
Goodness of fit...................................................................................................11
Correlation.........................................................................................................11
The coefficient of determination........................................................................12
Power Regression..................................................................................................13
Case Study: The Pizza Dillemna............................................................................13
Demand Forecasting................................................................................................14
Need for Forecasting.............................................................................................14
Type of Demand Forecasting.................................................................................14
Approaches to Forecasting....................................................................................15
The Requirements for Demand Forecasting..........................................................15
Factors affecting Method Selection.......................................................................16
Techniques of Forecasting........................................................................................16
Qualitative Techniques..........................................................................................17
Survey Method...................................................................................................17

Expert’s Opinion Method....................................................................................17

Consumer’s Interview Method............................................................................17
Historical Analogy Method..................................................................................18
Test Marketing...................................................................................................18
Quantitative Techniques.......................................................................................18
Trend Method.....................................................................................................19
Controlling the Forecast........................................................................................24
REFERENCES/SOURCES:...........................................................................................25
REFERENCES/SOURCES:

Demand Estimation
In the present century, Globalisation has completely overhauled the way businesses
are performed. At present, managers have to deal with an increasingly uncertain and
varying business environment due to the fast changing economic scenario. The
decision-making task has become difficult and extremely important. Needless to
mention that the uncertainty in business environment is due to the complex behavior
of market related variables like demand, market share, people’s perception and factors
affecting demand in the present day as a result of recent policy changes and market
forces. The need of the hour for a manager is to know the behavior of the market
related variables, their interrelationship and future movement. One of the most
important aspects for a manager in the present day is to know the process of
estimation of demand and forecasting of demand. Both of these terms are different:
Demand estimation attempts to quantify the links between the level of demand for a
product and the variables which determines it whereas demand forecasting simply
attempts to predict the level of sales at some particular future date .Demand
estimation involves a number of stages. Some of these stages may be omitted in the
simpler methods of estimation, like the first two steps (for simpler estimates).
However, with a statistical study, or econometric analysis there are essentially seven
stages:
1. Statement of a theory or hypothesis. This usually comes from a mixture of

economic theory and previous empirical studies. An example of such a theory
might be that the quantity people buy of a particular product might depend
more on the past price than on the current price. This obviously has implications
regarding perfect knowledge, information costs, habit formation and irrational
behavior.
2. Model specification. This means determining what variables should be
included in the demand model and what mathematical form or forms such a
relationship should take. These issues are again determined on the basis of
economic theory and prior empirical studies. Various alternative models may be
specified at this stage, since economic theory is often not robust enough to be
definitive regarding the details of the form of model.
3. Data collection. This stage can only be performed after the demand model has
been specified, otherwise it is not known for which variables we have to collect
data. However, there may be some interaction between the two stages,
particularly as far as the mathematical form is concerned; as stated above,
economic theory alone may be unable to specify this. Therefore the presentation
of data will also be considered in this stage. We have to discuss both the type of
data to be collected and the sources of data.

4. Estimation of parameters. This means computing the values of the

coefficients of the variables in the model, which as we have seen in the previous
chapter correspond to the effects of an independent variable on the dependent
variable. These effects can be measured in different ways, for example in terms
of the marginal effects and elasticities.
5. Checking goodness of fit. Once a model, or maybe several alternative
models, have been estimated, it is necessary to examine how well the models fit
the data and to determine which model fits best. If the fit is not good it may be
necessary to return to step 2 and re-specify the model before moving on to the
next stage.
6. Hypothesis testing. Having determined the best model, we want to test the
hypothesis stated in the first step; in the example quoted we want to test
whether current price or past price has a greater effect on sales.
7. Forecasting. This is the ultimate focus of most econometric analysis. In this
context we are trying to forecast sales, and maybe producing many forecasts in
the light of various possible scenarios. It should be clear from the above process
that, as far as managerial decision making is concerned, the last two stages are
the most important. However, it is not possible to test hypotheses or make
forecasts reliably without a good understanding of the prior stages.
Methods of Demand Estimation

There are a variety of ways that can be used to estimate demand, each of which
has certain advantages and disadvantages. They are divided into Qualitative and
Quantitative Methods.
Qualitative Methods
Consumer surveys: Firms can obtain information regarding their demand
functions by using interviews and questionnaires, asking questions about buying
habits, motives and intentions. These can be quick on-the-street interviews, or in-
depth ones. They might ask, for example, how much more petrol respondents would
buy if its price were reduced by 15 pence per litre, or which brand of several
possibilities they prefer.
These methods have certain drawbacks:
a) Validity: Consumers often find it difficult to answer hypothetical questions,

and sometimes they will deliberately mislead the interviewer to give the
answer they think the interviewer wants.
b) Reliability: It is difficult to collect precise quantitative data by such means.
c) Sample bias: Those responding to questions may not be typical consumers.
In spite of these problems, there are advantages of surveys:

a) They give up-to-date information reflecting the current business

environment.
b) Much useful information can be obtained that would be difficult to
uncovering other ways; for example, if consumers are ignorant of the
relative prices of different brands, it may be concluded that they are not
sensitive to price changes. Firms can also establish product characteristics
that are important to the buyer, and priorities. Methods such as
multidimensional scaling can be used to give rating scores on product
characteristics.
Market experiments: As with consumer surveys these can be performed in many
ways. Laboratory experiments or consumer clinics seek to test consumer reactions
to changes invariables in the demand function in a controlled environment.
Consumers are normally given small amounts of money and allowed to choose how
to spend this on different goods at prices that are varied by the investigator.
However, such experiments have to be set up very carefully to obtain valid and
reliable results; the knowledge of being in an artificial environment can affect
consumer behavior.
Other types of market study involve using real markets in different geographic
locations and varying the controllable factors affecting demand. This kind of test
marketing has the advantage that direct observation of consumers’ actual
spending behavior is possible rather than just recording answers to hypothetical
questions regarding such behavior. There are still number of problems with this
method, however:
a) There is less control in this case, and greater cost; furthermore, some
customers who are lost at this stage may be difficult to recover.
b) The number of variations in the variables is limited because of the limited
number of market segments available. Thus only a small number of sample
observations are possible.
c) Experiments may have to be long-lasting in order to reveal reliable
indications of consumer behavior. We have seen in the previous chapter that
price elasticity, for example, can be very different in the long run from in the
short run because it takes time for consumers to change their habits
Quantitative Methods
Statistical methods
While the above methods are useful, they often do not provide management with
the kind of detailed information necessary to estimate a useful demand function,
and thereby test the relevant hypotheses and make forecasts. Statistical
techniques, especially regression analysis, provide the most powerful means of
estimating demand functions. Regression techniques do have various limitations:
1) They require a lot of data in order to be performed.

2) They necessitate a large amount of computation.
3) They suffer from a number of technical problems.
In spite of these limitations, regression techniques have become the most popular
method of demand estimation, since the widespread availability of powerful desktop
PCs and software packages have made at least the first two problems easy to
overcome.
Model specification
There are two major aspects of this stage. In order to understand this we must first
distinguish a statistical relationship from a deterministic relationship. The latter are
relationships known with certainty, for example the relationship among revenue,
price and quantity:
R=P*Q; if P and Q are known R can be determined exactly.
Statistical relationships are much more common in economics and involve an

element of uncertainty. The deterministic relationship is considered first.
Mathematical models: It is assumed to begin with that the relationship is

deterministic. With a simple demand curve the relationship would therefore be:
Q=f (P)
If we are also interested in how sales are affected by the past price, the model
might in general become:
Qt=f (Pt, Pt-1)
where Qt represents sales in one month, Pt represents price in the same month and
Pt-1 represents price in the previous month. This last variable, involving graph
values in a previous time period, is known as a lagged variable. Other variables
could also be included on the right hand side if economic theory or previous
empirical studies indicated that they might be important. The decision regarding
which variables to include is a difficult one. Theory often tells us that certain
variables, like price, promotion and income, should affect sales, but before we
collect the data and analyze the results we do not know for certain which variables
are relevant; in fact, even after analyzing the data we do not know for certain which
variables are important because we are estimating a relationship from sample data,
and therefore we can only make conclusions in probabilistic terms. Therefore there
is always a grey area if a priori economic theory conflicts

Figure 1
with a posteriori empirical results. Subjective judgment cannot be avoided in this

case. As mentioned in the introduction, economic theory is often not robust enough,
meaning sufficiently specific, to be able to do this. We therefore often use scatter
graphs, explained in the next section, to help us to specify the mathematical form.
These are particularly useful for bi-variate, or two-variable, relationships, although
several graphs can be used for multivariate relationships, which involve many
variables. For example, in the situation above we might draw graphs of both sales
as a function of current price and sales as a function of previous month’s price.
From these graphs it might be possible to determine whether a linear or power

relationship is the more appropriate mathematical form. As seen in the previous
chapter, the linear and power forms of sales as a function of current price can be
shown as follows:
Linear: Q=a+bP
Power: Q=aP^b
Frequently it is not possible to determine the mathematical form from the graphs
either.
Statistical models
In practice we can very rarely specify an economic relationship exactly. Models by
their nature involve simplifications; in the demand situation we cannot hope to

include all the relevant variables on the right hand side of the equation, for a
number of reasons:
1. We may not know from a theoretical viewpoint what variables are relevant in
affecting the demand for a particular product.
2. The information may not be available, or impossible to obtain. An example might

be the marketing expenditures of rival firms.
3. It may be too costly to obtain the relevant information. For example, it might be
possible to obtain information relating to the income of customers, but it would take
too much time (and may not be reliable).
If we simplify the relationship to just two variables the scatter graph given shows
that the relationship is far from perfect; in a perfect relationship the points would
exactly fit a straight line, or some other regular curve. We therefore have to specify
the relationship in statistical terms, using a residual term to allow for the influence
of omitted variables. This is shown for the linear form as follows:
Qi=a +bPi +di
where di represents a residual term. Thus, even if P is known, we cannot predict Q

with complete accuracy because we do not know for any observation what the size
or direction of the residual will be.
Data collection
Statistical methods place a big demand on data; therefore, the collection of data is
crucial in practice. This stage is often ignored in the kinds of problems with which
students are frequently faced, where they are already presented with data in a
usable form; this stage of the analysis is also usually discussed in more detail in
market research courses. Three aspects are discussed here: types of data, sources
of data and presentation of data.
Types of data
There are two main types of data that firms can collect.
a.Time series Data

This refers to data on a single entity at different periods of time. These data can be
collected annually, quarterly, monthly or at any regular interval. Thus sales of firm A
in the period 1994–99 would involve time series data. Such data may be quantitative,
meaning that they are measured numerically on an ordinal or cardinal; examples are
sales, prices and income. Alternatively, data may be qualitative, meaning that they
are nominal, or expressed in categories; examples are male/female,
married/single/widowed/divorced, east/west. The treatment of such variables, often
called dummy variables, is considered, under extensions of the model.

b. Cross-section data
This refers to data on different entities at a single period of time. In managerial
economics these entities are normally firms, thus sales of firms A-F in 1999 would
involve cross-section data. Sometimes the entities are individuals, industries or
areas. The different types of data have certain advantages and disadvantages to
the investigator .In practice the investigator may have little choice, because only
one type of data may be available or feasible to use. Sometimes the two types of
data can be pooled, that is combined together. For example, a study of six firms
over six time periods would yield thirty-six observations; such data allow more
observations, which is an advantage in analysis. However, pooling data has to be
done with care to avoid problems of interpretation.
Sources of data
In practice we should try to collect data relating to all the variables that we think
might affect sales, on either a time-series or cross-section basis, according to how
we have specified the model. Later, after the statistical analysis, some of these
variables may be omitted. There are many sources of data available, but in general
the following are the most important in demand estimation, and indeed in most of
managerial economics.
1) Records of firms. Sales, marketing and accounting departments keep records

of many of the key variables of interest. Such data are normally up to date.
2) Commercial and private agencies. These include consulting firms, market

research firms and banks. In addition, a firm may want to commission one of these
agencies to carry out a particular study, but it would have to consider the cost
involved compared with using freely available data.
3) Official sources. These include government departments and agencies, and

international agencies like the EU, OECD, WTO and the various UN agencies. Such
data tend to be more macroeconomic in nature, although there are also many
industry studies. The data may also be somewhat out of date, since it takes time to
collect, collate and publish it, sometimes as long as a couple of years. Much of the
above data is now available on the Internet, particularly those from the third source
and some of those from the second.
It is important to appreciate that the use of any of the above sources, whether
published on the Internet or not, involves abstraction. This means using data that
have been collected by someone else; such data are frequently referred to as
secondary data. Although it is obviously easier and cheaper to use such data, there
are limitations of which the investigator has to be aware. The data have been
collected for a different purpose from that of the current investigation and the
investigator does not know the conditions under which the data were collected. The
definitions used may be different from those now desired. For example, the price
variable measured and recorded in a firm’s records may be the quoted price, not

the actual price allowing for any discounts. Clearly it is the second measure that is
important in demand estimation, but the investigator may not be aware of the
original definition used.
Presentation of data
a) Tables: The most basic method of presenting demand data is in the form of a
table. To begin with, we will take a two-variable study, involving just quantity (sales)
and current price, to simplify the analysis. In reality this is only justified if either:
1) No other variables affect sales (highly unlikely), or
2) Other variables do affect sales but remain constant (still fairly unlikely).
The main advantage of limiting the study to two variables is that such relationships
can easily be shown graphically. Consider the example in Table 2, relating to a cross-
section study of seven firms. The reason for recording the price variable in the last
column, after graph column show regular increments of one unit; although one is
unlikely to find such regularity in practice; it simplifies the numerical analysis and
allows easier insights as far as statistical inference is concerned.
Table 2
b) Graphs: In order to examine the relationship more closely the next step is to
draw a graph. There are two main principles involved here:
 Sales (Q) should be measured on the vertical axis as the dependent
variable; this is contrary to most price–quantity graphs, but the
rationale for this was explained in the previous chapter.
 Scales should be selected so as to have the data spread over the
whole graph; this involves looking at both the highest and lowest
values in the data. Scales should not therefore automatically start at
zero.
The result is a scatter graph, as shown in Figure 1; no attempt is made to join the
points together in any way. We can see several things from this graph:
 There is generally an inverse relationship between the variables.
 The relationship is not a perfect one; the points do not lie exactly on a
straight line or hyperbola. This is because of the omission of other

variables affecting sales, meaning that the assumption made earlier

regarding these variables (that they did not affect sales or remained
constant) was not completely justified.
 The relationship is approximately linear, although a hyperbola may
also fit well.
For simplicity we will assume, to begin with, that the relationship is linear. If we
want to describe the relationship using an equation, we need to draw a line of best
fit. There are three basic criteria for the method of doing this. It should be:
• Objective
• Mathematically sound
• Easy to compute.
Although the second and third criteria are somewhat vague, they provide a simple
justification for using the method of OLS (ordinary least squares)regression, which
satisfies all the above criteria. In addition, and ultimately more important, OLS is
justified on two, more technical criteria: the Gauss–Markov theorem and maximum
likelihood estimation (MLE).
OLS (Ordinary Least Squares) Method for Regression

The method of least squares means finding the line that minimizes the sum of the
squares of the differences between the observed values of the dependent variable
and the fitted values from the line. To put it mathematically, we need to find an
equation Ŷ=aX+b which minimizes the sum of squared deviations ∑(Y-Ŷ)2, where Ŷ
is the estimated value of the dependent variable as per the fitted curve. The
technique for solving for the values of a and b is to use partial differentiation with
respect to both a and b, set both expressions equal to zero to minimize them, and
solve them simultaneously. The resulting solutions are as follows:
Goodness of fit
Whereas regression analysis examines the type of relationship between variables,
correlation analysis examines the strength of the relationship, or goodness of fit.
This refers to how closely the points fit the line, taking into consideration the units
of measurement. Some idea of this can be obtained from a visual inspection of the
graph, but it is better to use a quantitative measure.

Correlation
More specifically the correlation coefficient (r) measures the degree of linear
association between variables. It should be noted that correlation says nothing
about causation. The causation between the variables could be reversed in
direction, or it could act in both directions in a circular manner. For example, high
sales could lead to economies of scale in production, enabling firms to reduce their
price. An alternative explanation of correlation between variables is that there may
be no causation at all between two variables; they may both be influenced by a
third variable.
A notorious example is that empirical studies show that there is a strong
relationship between the number of teachers in a country and alcohol consumption.
This does not mean that teachers are heavy drinkers, or that people who are heavy
drinkers become teachers! It is more likely that both the number of teachers and
the level of alcohol consumption are influenced by the level of income in the
country. If one substitutes purchases of TV sets or mobile phones for alcohol the
same relationship would still hold good, since all these consumer goods are much
influenced by income.
It should also be stressed that correlation only applies directly to linear relationships,
meaning that weak correlation does not necessarily imply a weak relationship; there
might be a strong non-linear relationship. Thus drawing a graph of the data is
important, since this can give an insight into this possibility. The formula for
calculating the correlation coefficient can be expressed in a number of ways, but
probably the most common is:
The coefficient of determination

The problem with the correlation coefficient is that it does not have a precise
quantitative interpretation. A better measure of goodness of fit is the coefficient of
determination, which is given by the square of the correlation coefficient, and is
usually denoted as R2. This does have a precise quantitative interpretation and it
measures the proportion of the total variation in the dependent variable that is
explained by the relationship with the independent variable.
In order to understand this measure more fully it is necessary to examine the
statistical concept of variation and the components of explained and unexplained
variation. This is best done with the aid of a graph (see figure below).

In statistical terms, variation refers to the sum

of squared deviations. Thus the total variation in Y is the sum of squared deviations
from the mean of Y, or the total sum of squares (TSS). However, for each X, Total
Deviation or TD, can be partitioned into two components, explained deviation (ED)
and unexplained deviation (UD). The first component is explained by the regression
line, in other words the relationship with X. Thus:
TD = UD + ED
It can also be shown that: TD2 = ED2 + UD2, which can be rewritten as TSS = ESS
+ RSS,where RSS is the residual sum of squares and is unexplained by the
regression line. These relationships are frequently illustrated in an analysis of
variance, or ANOVA, table. The definition of the coefficient of determination
indicates that it is given by: R2 = ESS/TSS.
Power Regression
It was assumed in the above analysis that the relationship between the variables
was linear. Demand relationships are usually considered to be in linear or power
form. Rarely do we have a strong a priori belief regarding which mathematical form
is correct from the point of view of economic theory; therefore, we tend to see
which form fits the data best in practice and use that one.
The power form, Q=aPb, cannot be estimated directly using the OLS technique
because it is a linear method, meaning that the estimators a and b are linear
combinations of the values in the data. However, the power equation canbe
transformed into a linear one by taking the logarithms of both sides to obtain:
log(Q)=a+b log(P).
This ignores the error term for the sake of simplicity of expression. The relationship
is now linear in logarithms and therefore OLS can be applied.
Case Study: The Pizza Dillemna

During the presentation, we discussed the application of the OLS technique to real
demand estimation using the case of Pizza sales in and around universities. The
model was linear with 4 independent variables, and using supplied data, we had

calculated the values of the coefficients, the error terms and the significance of the
independent variables.
The aim is to estimate the demand for Pizza by college students. First we select
variables for the model that you believe are relevant and for which data can be
found.The variables assumed here are:
Average number of pizza slices consumed per month by students (Y),Average
Selling Price of a Pizza slice (X1),Annual Course Fee – proxy for student income
(X2),Average price of a soft drink – complementary product (X3),Location of the
campus – proxy for availability of substitutes (X4) -1 for city campus, 0 for outskirts.
The demand equation is : Y = a + b1X1 + b2X2 + b3X3 + b4X4
Results of linear regression based on actual data came out to be :
Y = 26.67 – 0.088 X1 + 0.138 X2 - 0.076 X3 - 0.0544 X4
(0.018) (0.087) (0.020) (0.884)
2 2
R = 0.717 Adjusted R = 0.67
Standard Error of the Y-estimate = 1.64.The standard errors of the coefficients are
listed in parenthesis.
Values of Elasticity such as Price Elasticity, Income Elasticity and Cross-price
Elasticity are found to be -0.807, 0.177 and -0.767 respectively. The R2 = 0.717
value shows the how close the data is to the regression equation approximation.

Demand Forecasting
We will now shift the focus to the process of Demand forecasting. It is a very
important aspect of demand analysis. Some companies may actually produce on
order, but large numbers of firms produce for a future anticipated demand.
Accurate demand forecasting is necessary in order to produce right quantities at
the right time and arrange well in advance for the various factors of production like
raw materials, equipment, machine accessories, labor and building. These
forecasting based decisions will influence current level of production, which is
dependent upon anticipated future demand. This is necessary to avoid an
unmanageable inventory build up or a glut in market.
Demand forecasting reduces the uncertainties associated with business. A forecast

is a prediction or estimation of a future event. Accuracy of a forecast is determined
by its nearness to the actual value in future. A passive forecast assumes business
conditions and factors influencing the demand to stay stable and same, while an
active forecast assumes a change in the business conditions and demand
influencing factors in future.
Need for Forecasting

1. Long Range Strategic Planning for corporate objectives such as profit, market
share, Return on Capital Employed (ROCE), strategic acquisitions, international
expansion, etc.
2. Annual Budgeting for operating plans such as annual sales, revenues, profits
3. Annual Sales Plans for regional and product specific targets.
4. Resource Needs Planning for HRM, Production, Financing, Marketing, etc
Type of Demand Forecasting

Based upon the time period for which demand forecasting is being done, it can
either be short term or long term. Both are associated with the kind of business
decisions that are required to be taken in order to meet the short term and long
term changes in demand. A third type called medium term demand forecast can be
done between the two. Short term demand forecast is usually done for periods of
less than one year.
A short term demand forecast is done for production schedules of less than one
year. It is done to deal with annual variations in sales. This takes care of an
optimum use of current production capacity to meet the demand for the current
financial year. Long term demand forecast are related to the need for capacity
expansion or reduction depending upon the demand. It also takes care of changes
in labor force needed and financial mechanism required to fund the expansion. This
capacity expansion is usually not possible in the short run. If the firm anticipates

major changes in demand then it will change the production capacity accordingly.
For making a forecast a firm usually takes into account facts like population,
competition in the market, technology, and government policies. The longer the
time horizon of the forecast lesser is the accuracy of the forecast as the number of
factors which can influence the demand becomes too high and their precise
measurement is not possible. A medium term forecast is usually done to bridge the
gap between the short term and long term forecast. It deals with business cycles
that usually last for periods from two to five years.
The choice for the kind of forecast is also influenced by nature of the business.
Where the output is diversified and it is easier to shift between different production
mixes, short term forecast is preferred. In businesses with complex technology, like
aircraft manufacturing, steel, motors where the shift in production mix is not easy
and takes long time, long term forecast are done. The results of short term and the
long term demand forecast may not be necessarily in agreement. The demand may
be different for short term forecast and may show entirely different behavior for the
long term forecast.
Approaches to Forecasting
Judgmental Approaches: the forecast is based upon the judgment and expertise
of experts.
Experimental Approaches: A demand experiment is conducted among a small

group of consumers who are adequately representative of characteristics of general
population. This type of approach is adopted when the product being introduced is
new, and there is no pre-existing data available.
Relational Causal Approaches: Interviews and other methods are used to

determine the reasons why consumers purchase a particular product. Once these
reasons are clear, the forecast can be done.
Time Series Approaches: Sales and other data for different markets, for different
periods of time is analyzed to get a general trend or pattern in sales.
The Requirements for Demand Forecasting

For making a demand forecast of market firms have to do a market research in
order to understand the probable future conditions of the markets thoroughly. Some
of the elements of the market research are:
Consumer Related Elements: Total number of consumers, distribution of

consumers/ products, total purchasing power and per capita household income,
income elasticities, consumer tastes, social customs etc, consumer purchasing
details, effect of design, color etc on consumer preferences.

Supplier Related Elements: Current level of sales, Current level of goods, Trends
in sales and stocks, market share, patterns of seasonal fluctuations, Research and
Development trends, company strength and weaknesses, product life cycle (age)
and new product possibilities.
Market Related Elements: The effect of prices and price elasticities, product
characteristics, identification of competitive and complementary products, number
and nature of competitors, forms of market competition (price, advertisement,
brand policy etc), general price levels, and prices of similar goods.
Other Elements: Economic environment of the country which includes levels of

economic activities, employment, trends in income, national income, population,
education etc, government policies, taxation and international economic climate.
The quantitative information related to these elements is collected and their effect
on demand analyzed carefully. Then the firm may proceed to assess general
economic and national situation in future (like population, income, price levels,
technology, productivity, and international trade and government policies). Then
the future total market demand for the commodity or product is estimated, based
on the previously estimated general economic and national factors. In the last step
the firm will estimate its share in the total market.
Factors affecting Method Selection
1. Time Factor: The lead time required for making decisions dependent on results
of the model is crucial. Based on the time required for actually changing the
output, in nature and level, it can be a short, medium or long term forecast.
2. Level of Forecasting: Demand forecasting may also be classified based upon

whether it is done by an individual firm for its own product (micro), by an
industrial or trade organization for the products of a particular industry
(Industrial level) and if it is done for total industrial output based on national
income or aggregate expenditure of that country.
3. General or Specific Forecasting: It can be general or total (if a firm has done
a general forecast) or a specific forecast (if a firm has done area wise,
commodity wise or industry wise forecast).
4. Problems and Methods of Forecasting: The methods and problems of

forecasting demand for a new product (which has never been tested and there is
no market data for it) are different from techniques used in forecasting for old
product or commodity (for which market data and past behavior is available).
5. Classification of Goods: Demand forecast may depend upon the nature of

goods like consumer and capital goods, durable and non-durables etc.

6. Knowledge of Different Market Conditions: Based upon the market

structure and conditions (monopoly market, oligopolistic or competitive market)
the forecast will be different.
7. Benefit Factors: The firms also have to do a cost-benefit analysis of the

forecast method used. The expense and the effort invested should be justified by
the potential benefits. The level of complexity and amount of accuracy required
for forecast also effects the method selection.
8. Other Factors: Other special factors that need to be taken into account are
political factors, sociological factors, psychology of consumers, and patterns of
income distribution.
Techniques of Forecasting
The methods used may be divided broadly into two categories, qualitative and
quantitative. Demand forecasting is full of uncertainties due to changing conditions.
Consumer behavior is unpredictable as it is motivated and influenced by a
multiplicity of forces. Every method developed for forecasting has its advantages
and disadvantages and selection of the right method is crucial to make as accurate
as possible forecast. A right combination of quantitative and qualitative methods is
to be used.
Qualitative Techniques
Qualitative techniques are generally used when there is insufficient data available
for quantitative analysis. They are also known as subjective methods as they are
dependent upon intuition based on experience, intelligence, and judgment. They
are also preferred for giving a quick estimate and cost savings.
Some of these techniques are as follows
Survey Method
The information about future demand of goods is obtained directly through a survey
method. They are important for short term forecasts. Firms generally use them
while introducing a new product into the market. It involves conducting consumer
interviews, mailing questionnaires to consumers in order to judge their intentions
about their demand for goods. Sometimes the employees, distributors and partners
involved in the sales are interviewed. This is known as sales force composite
method or collective opinion method. The salespersons are asked to report their
estimates of expectations of sales in their territories. A similar exercise is done with
the retailers and the wholesalers of the company. The average values thus
obtained, from sales executives, marketing managers, business and managerial
economists and other members of the trade, reflect the estimate of forecast.

Survey methods are dogged by numerous problems that are normally associated
with surveys. There is always a risk of subjectivity, bias and over estimation or
optimism about future (or a tendency to over report the expected sales), which may
lead to a wrong forecast. The consumers picked for survey may not take the survey
seriously or may not be a representative population sample.
Expert’s Opinion Method
This method is also known as the Delphi Method. Under this method a group of
experts are repeatedly questioned for their opinion/comments on some issues and
their agreements and disagreements are clearly identified. This involves a number
of rounds involving their ‘interrogation, response and feedback’. In the first round
they are asked for information necessary for forecast. The subsequent rounds
involve questioning until a complete consensus is reached. The experts belong to a
heterogeneous group with diverse background. This technique is used in
technological forecasting, defense strategies, education and manpower planning,
business demand forecasting etc.
This method has problems associated with selection of an appropriate expert panel,
their timing schedules, time taken between different rounds and also the fact that
the final result is not quantitative in nature. It is only a reasonable guess.
Consumer’s Interview Method
The consumers are contacted personally to know about their plans and preferences
regarding the consumption of the product. All the potential buyers are then drawn
and they are approached and asked how much they plan to buy the listed product
in future. This method gives first hand information for demand forecast. There are
three main methods for the interviews.
Complete Enumeration method: All the consumers of the product are

interviewed and their future plans for product is ascertained.
Sample Survey Method: A sample of consumers is interviewed.
End use Method: Information about the end use of the product is collected form
the industrial users to calculate the demand in industries, exports etc.
Historical Analogy Method
This method is used for forecasting demand for a new product or an existing
product when introduced in a new area. When it is an existing product, then its
sales data for a previous place (which has similar socio-economic conditions as the
place where the product is being introduced) is taken for studying and estimating
the future demand. In such cases one has to carefully account for sociological and
psychological differences. Generally, places which are as similar as possible are

taken for studying. If the product has not been used anywhere, then the past
consumption pattern of some other similar product is taken as basis for forecasting
the demand for the product.
The process is difficult as it is tough to find very similar locations, account for all the
differences or find a similar product.
Test Marketing
It involves selecting a test area which can be regarded as true sample of total
market. The product is launched in that area in the same manner in which it is
intended to be used when product is launched nationally. All marketing devices are
selected with this in mind. The sales data of the product tin the test area is then
used to forecast the demand for the product nationally.
This method is costly and time consuming. Considerable energy and effort goes as
all marketing devices are used for a small area. Selection of an appropriate test
area is also difficult. The test needs to be run for a long period of time, to be sure
about the sales data. Also differences in sociological and psychological
characteristics need to be taken into account for this data. The launch if product in
a test area gives competitors to prepare for the imitation of the product or prepare
their own strategies to deal with the product.
Quantitative Techniques
Quantitative techniques are used for long run forecasting. They are used to explain
time series and cross-section data for estimating long term demand. As they are
quantitative in nature and give precise numbers, they are considered to be superior
techniques of demand forecasting. Some of these methods are
Trend Method
The time series data of sales of a product may show some variation because of
systematic forces. It may show a trend which is due to the effect of certain basic
demand influencing factors like population, capital, technology etc. Cyclic variation
in sales may be indicator of business cycles. There could be some variation based
on seasonal variation also. Some other factors like strike, riots, theft, political
disturbances etc will contribute to ‘random variation’. Time series analysis in
statistics provides techniques by which all these variations and their effects on sales
are isolated and identified. Several Quantitative techniques are used for this.
Graphical Method
Annual Sales data is plotted on paper and line is drawn through the points. This
method is simple and less expensive.

Fitting Trend Equation
To get a relationship between sales of product and time, we have to fit the trend
line by Least Square Method. The graph is plotted and trend line is plotted, which on
extrapolation gives the forecasts for sale. The short term fluctuations are removed
to get a more accurate forecast. This is ‘ironed out’ or ‘smoothened’ line. A three
year moving average is used to remove the short term fluctuations in a more
efficient manner. We may get the relationship in a form of an equation, each of
which will tell us something unique about the sales relationship with time. If it is a
Linear Trend Equation: Demand for the product is increasing over time at a
constant rate.
Quadratic Trend Equation: The marginal time increment of demand varies

linearly with time, which means that total sales increases (or decreases) first and
then decreases (or increases) thus showing a turning point on the sales-time graph.
Logarithmic Trend Equation: Time Elasticity of demand is constant.
Exponential Trend Equation: Rate of growth of demand is constant over time.
The advantage of this process is that it removes the short term fluctuations. Sales
curve of any commodity eventually turns out to be ‘S’ shaped. This is known as
product life cycle. The first stage is Research and Development, where product is
market tested. No sales occur but a lot of expenditure is incurred. In Introduction
stage product is launched and commercial exploitation and marketing begins. Sales
grow in the next two stages of ‘market development’ and ‘exploitation’. Intensive
advertising and sales promotion is done. At this optimum level of resource
utilization the firm gets maximum profit here. As similar products by competitors
flood the market, growth rate of sales decline in the ‘maturity’ stage. Price elasticity
is very high, and in the later ‘saturation’ stage the high cross elasticity between
different brands makes rate of sales growth zero. Marketing becomes ineffective,
but firms maintain quality, services etc to maintain market share. Eventually this
leads to the phase of decline the product life comes to an end. All these phases give
the exponential shape to the curve.

Product life cycle curve is

S shaped.
The knowledge of product life cycle helps in planning the marketing process and
budget.
The trend method assumes that the conditions which existed in past influencing the
sales of the product will continue to hold in future also. Thus it cannot predict any
sudden changes, and nothing can be done to correct this limitation.
Leading Indicators Method
If there are frequent turning points then trend method cannot explain the
relationship fully between time and sales as there is negative relationship
sometimes, while at other it is positive. Therefore some other indictor is used which
shows a similar variation as the commodity. It can be GNP, personal income, bank
rate, WPI, Industrial production, Employment Rate etc. There might be some time
lag or lead in case of these indictors affecting the demand of the product. After
identifying the product, one may use the regular least square approach to get the
sales forecast. This is also known as barometric method as indicator is used as a
barometer to forecast the demand.

Box Jenkins Method

Box Jenkins Method also known as ARIMA(‘Auto-Regressive Integrated Moving
Average’) models, this is an empirically driven method of systematically identifying,
estimating, analyzing and forecasting time series. This method is used only for short
term predictions since it is suitable only for demand with stationary time series
sales data, i.e. the one that does not reveal the long term trend.
The models are designated by the level of auto regression, integration and moving
averages (P,d,q) where P is the order of regression, d is the order of integration and
q is the order of moving average.
There are 3 components of the ARIMA process:
 AR(Autoregressive) process.
 MA(Moving Average) process.
 Integration process.
AR process: Of order ‘p’, generates current observations as a weighted average of

the past observations over p periods, together with a random disturbance in the
current period.
Yt=μ+a1Yt-1+a2Yt-2+….+apYt-p+et
MA process: Order q, each observation of Yt is generated by the weighted average

of random disturbances over the past q periods.
Yt= μ +et-c1et-1-c2et-2+….-cqet-q
Integrated Process: Ensures that the time series used in the analysis is
stationary. The previous 2 equations are combined to form:
Yt=a1Yt-1+a2Yt-2+...+apYt-p+μ+et-c1et-1-c2et-2+…-cqet-q
Input-output model
An input-output model uses a matrix representation of a nation's (or a region's)

economy to predict the effect of changes in one industry on others and by
consumers, government, and foreign suppliers on the economy.One who wishes to
do work with input-output systems must deal skillfully with industry classification,
data estimation, and inverting very large, ill-conditioned matrices.Wassily Leontief,
won the Nobel Memorial Prize in Economic Sciences for his development of this
model in 1973.

Consider 4 industries,
Industry 1: X1=X11+X12+X13+X14+C1
Xij = Output of the industry i which is purchased by industry j for the production of
its output.
Ci = Demand of the customers for products for final use.
Let Xij= aijXj, i=1 to 4,j=1 to 4
(or) Xij/Xj=aij
where aij is the output of ith industry required to produce unit output of jth industry.
Thus
X1=a11X1+a12X2+a13X3+a14X4+C1
X2=a21X1+a22X2+a23X3+a24X4+C2
X3=a31X1+a32X2+a33X3+a34X4+C3
X4=a41X1+a42X2+a43X3+a44X4+C4
I=Unit Matrix
A=Technology Coefficient Matrix
X=Output Vector
C=Final Demand Vector.

X=AX+C
[I-A]X=C
X=[I-A]-1C
If we know/get a forecast for X, total output, we can easily find labor, capital & other
requirements. This makes Input-Output method a powerful tool for planning.
To find the component D(represented as C before),Demand, one may use the

previously discussed methods or a simple projection method.
Dit=Di0(1+ ρi)t
Dit-Level of Final Demand
ρi = Growth rate of final Demand
Pt=P0(1+s)t

Pt-Population at time t
s = Rate of growth of Population
dit=di0(1+x)t
dit = Per-capita consumption in time t
x = rate of growth of per-capita consumption in time t.
eyi=(∆ dit/dit)/(∆ y/y)∆
eyi =Income elasticity of Demand
r= ∆ y/y= Rate of growth of per capita income.
Thus eyi=x/r;
x= eyi *r
Thus dit=di0(1+eyi*r)t
dit=Dit/Pt, di0=Di0/P0
We get,
Dit/Pt=Di0/P0*(1+eyi*r)t
Dit=Di0/P0*(1+eyi*r)t * P0*(1+s)t i.e
Dit=Di0*(1+eyi*r)t*(1+s)t
Comparing with the original eqn. for Demand,
ρi=[(1+eyi*r)(1+s)]-1.
This eqn. gives the growth rate of final demand for the ith commodity in terms of its
income elasticity of demand, target rate of growth of per capita income and
population growth.If these parameters are known exogenously then ρi can be
computed and final demand Dit can be predicted.
Advantages:
1. It gives sector wise breakdown of demand forecasts for commodities.
2. Helps the firm to formulate its marketing policies in a better way by taking into
account various market segment strengths for its products.
Disadvantages:

1. Input-output tables are not available every year. Sometimes there may be large gap
between the years for which input-output coefficients are available and the years
for which the forecasts are needed. Larger the time gap, less stable will be the
coefficients, thus reducing the forecasting accuracy.
2. Also changes in the production technology, tastes and preferences during the
period make the forecast less valid.
Controlling the Forecast

Control of forecasting is the process of comparison, evaluation, interpretation and
auditing the performances of the firm against objectives and standards forecasted.
We measure the inaccuracy in forecasting in terms of Percentage Forecasting
Inaccuracy (PFI).
PFI1=(|Yt-Yt’|*100)/Yt
PFI2=( *100)/
PFI1 stands for one period forecast and PFI2 stands for multi-period forecasts, t for
time, k for length of time.Based on these ratios we fix some acceptable limits for
them which depends on the commodity type, market nature, and forecasting
method.
REFERENCES/SOURCES:
Armstrong, J. S. (2001). Standards and Practices for Forecasting. In Principles of
Forecasting: A Handbook for Researchers and Practitioners (pp. 1-46). Kluwer
Academic Publishers.
Barthwal, R. R. (2010). Industrial Economics An Introductory Textbook. New Age

International Publishers.
J. Scott Armstrong, K. C. (2005). Demand Forecasting: Evidence-based Methods. In

L. M. Southern, Strategic Marketing M.anagement: A Business Process Approach.
Savvides, D. S. (n.d.). Demand Estimation & Forecasting. EC611--Managerial

Economics . Cyprus: European University Cyprus.
Webster, T. J. (2003). Managerial Economics Theory and Practice. San Diego:

Academic Press.

Wilkinson, N. (2005). Managerial Economics A Problem Solving Approach.

Cambridge: Cambridge University Press.
Mangerial Economics, Keat and Young

Demand Estimation and Forecasting

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Demand Estimation and Forecasting

Shivraj Singh Negi (HS07H022)

Forecasting Prem Ranjan(HS07B019)

Economics of Industrial Organizations

Economics Of Industrial Organizations Page 1

Economics Of Industrial Organizations Page 2

Economics Of Industrial Organizations Page 3

Expert’s Opinion Method....................................................................................17

Economics Of Industrial Organizations Page 4

1. Statement of a theory or hypothesis. This usually comes from a mixture of

Economics Of Industrial Organizations Page 5

4. Estimation of parameters. This means computing the values of the

Methods of Demand Estimation

a) Validity: Consumers often find it difficult to answer hypothetical questions,

Economics Of Industrial Organizations Page 6

a) They give up-to-date information reflecting the current business

1) They require a lot of data in order to be performed.

Economics Of Industrial Organizations Page 7

2) They necessitate a large amount of computation.

3) They suffer from a number of technical problems.

R=P*Q; if P and Q are known R can be determined exactly.

Statistical relationships are much more common in economics and involve an

Mathematical models: It is assumed to begin with that the relationship is

Qt=f (Pt, Pt-1)

Economics Of Industrial Organizations Page 8

with a posteriori empirical results. Subjective judgment cannot be avoided in this

From these graphs it might be possible to determine whether a linear or power

Economics Of Industrial Organizations Page 9

2. The information may not be available, or impossible to obtain. An example might

Qi=a +bPi +di

where di represents a residual term. Thus, even if P is known, we cannot predict Q

a.Time series Data

Economics Of Industrial Organizations Page 10

1) Records of firms. Sales, marketing and accounting departments keep records

2) Commercial and private agencies. These include consulting firms, market

3) Official sources. These include government departments and agencies, and

Economics Of Industrial Organizations Page 11

Economics Of Industrial Organizations Page 12

variables affecting sales, meaning that the assumption made earlier

OLS (Ordinary Least Squares) Method for Regression

Economics Of Industrial Organizations Page 13

The coefficient of determination

Economics Of Industrial Organizations Page 14

In statistical terms, variation refers to the sum

Case Study: The Pizza Dillemna

Economics Of Industrial Organizations Page 15

Economics Of Industrial Organizations Page 16

Demand forecasting reduces the uncertainties associated with business. A forecast

Need for Forecasting

Type of Demand Forecasting

Economics Of Industrial Organizations Page 17

Experimental Approaches: A demand experiment is conducted among a small

Relational Causal Approaches: Interviews and other methods are used to

The Requirements for Demand Forecasting

Consumer Related Elements: Total number of consumers, distribution of

Economics Of Industrial Organizations Page 18

Other Elements: Economic environment of the country which includes levels of

Factors affecting Method Selection

2. Level of Forecasting: Demand forecasting may also be classified based upon

4. Problems and Methods of Forecasting: The methods and problems of

5. Classification of Goods: Demand forecast may depend upon the nature of

Economics Of Industrial Organizations Page 19

6. Knowledge of Different Market Conditions: Based upon the market

7. Benefit Factors: The firms also have to do a cost-benefit analysis of the

Dit=Di0/P0(1+eyir)t * P0*(1+s)t i.e