July 14, 2012

DEMAND ESTIMATION AND FORECASTING

Managerial Economics Sat. 11:00 14:00 DEMAND ESTIMATION AND FORECASTING Facilitators : Mr. John Michael G. Favila Mr. Jose Miguel G. Catan Learning Objectives Identify a wide range of Demand Estimation and Forecast Methods. Understand the nature of Demand Function Understand that the Demand Estimation and Forecasting is all about minimizing risk. Demand Estimation and Demand Forecasting; distinguished. it is necessary to determine how well the model fits the data and to determine whicg model fits best. 6. Hypothesis Testing : Having determined the best model, we want to test the hypothesis stated in the first step. 7. Forecasting : This is the ultimate focus of economic analysis. In this context, we are trying to forecast sales, and may be producing many forecast in light of possible scenario.

Demand Estimation attempts to quantify the link between the level of for a product and the variables which determines it whereas the Demand Forecasting Methods of Demand Estimation simply attempts to predict the level of sales at some particular future date. A. Qualitative Methods a. Consumer Survey : Firms can obtain information 7 stages of Demand Estimation regarding their demand fucntions by using interviews and questionnaires, asking questions 1. Statement of a Theory or Hypothesis : This usually about buying habits, motive and intention. comes from a mixture of economic Theory and previous empherical studies. b. Market Experiment : As with consumer surveys, this can be performed in many ways, one of which 2. Model Specification : This means determining what is Laboratory or Clinic Experiment that seeks to variables should be included in the demand model and test consumer reactions to chnages invariable in what mathematical form or forms such a relationship the demand function in the controlled should take. environment. 3. Data Collection : Gathering necessary information. c. Virtual Shopping : Shop on a virtual store simulated a. Cross-sectional data : Provide information on a on a computer screen. group opf entities at a given time. b. Time-serie data: Provide information on the entityB. Qualitative Methods over time. a. Statistics Method : statistical techniques i. Quantitative: Data that are expressed in especially Regression Analysis provides the most nominal in either ordinal or cardinal. powerful means of estimating demand function. ii. Qualitative: Expressed in categories. b. Model Specification : there are two major aspects of this stage, in order to understand this, we must 4. Estimation of Parameters : This means computing the first distinguish a statistical relationship from a value of the coefficient of the variables in the model. deterministic relationship, the latter also known with certainty while statistical relationship 5. Checking goodness of fit : Once a model or may be involves an element of uncertainty. several alternatives models have been estimated,

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DEMAND ESTIMATION AND FORECASTING

c. Mathematical Models : This is assumed to beginD. Presentation of Data with that the relationship is deteministic. With a simple demand curve, the relationship would a. Tabular Form : This is the most basic and common therefore be; method in presentation. Q= f ( P ) If we are also interested in how sales are affected by the past price, the odel might in general become: Qt = f (Pt, Pt-1) d. Statistical Model : C. Data Collection Statistic Methods place a big demand on data; therefore the collection of data is crucial in practice. Types of data : there are two main types of data that a firm can collect. a. Time-series Data : This refer to data on a single entity at different period of time. This data can be collected annualy, quarterly, monthly or any regular interval. b. Cross-section Data : This refers on data on different entities at a single period of time. In Managerial economics, theses entities are normaly firms, but sometimes the entities are individuals, industries or areas. Sources of Data : in practice, we should try to collect all data relating to all the variables that we think might affect sales on either a time series or cross-sectional basis, according to how we have specify the models. a. Record of firms : Sales, Marketing and Accounting departments keep records of many of the key variables of interest. Such a data are normally up to date. b. Commercial and Private Agencies : In includes consulting firms, market firms and banks. c. Official Sources : this includes government departments and agencies, and international agencies. 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 b. Graphs : In order to examine the relationship more closely the next step is to draw a graph.

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 =aX+b which minimizes the sum of squared deviations (Y-)2, where 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:

July 14, 2012

DEMAND ESTIMATION AND FORECASTING

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. 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:

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.

FORECASTING
What is Forecasting? Process of predicting a future event Seven Steps in Forecasting Determine the use of the forecast Select the items to be forecasted Determine the time horizon of the forecast Select the forecasting model(s) Gather the data Make the forecast Validate and implement results Types of Demand Forecasting Short-range forecast Up to 1 year (usually less than 3 months) Job scheduling, worker assignments Medium-range forecast 3 months to 3 years Sales & production planning, budgeting Long-range forecast 3 years, or more New product planning, facility location Approaches of Forecasting Judgmental Approaches Experimental Approaches Relational Causal Approaches Time Series Approaches

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

July 14, 2012

DEMAND ESTIMATION AND FORECASTING

Requirements for Demand Forecasting Consumer Related Elements Total number of consumers, consumer taste Supplier Related Elements Current level of sales, current level of goods Market Related Elements The effect of prices and price elasticities Other Elements Trends in income, population

Technique of Demand Forecasting Qualitative Methods Used when situation is vague & little data exist New products New technology Involves intuition, experience e.g., forecasting sales on Internet Quantitative Methods Used when situation is stable & historical data exist Existing products Current technology Involves mathematical techniques e.g., forecasting sales of color televisions

Trend Component Persistent, overall upward or downward pattern Due to population, technology etc. Several years duration Seasonal Component Regular pattern of up & down fluctuations Due to weather, customs, etc. Occurs within 1 year Cyclical Component Repeating up & down movements Due to interactions of factors influencing economy Can be anywhere between 2-30+ years duration Random Component Erratic, unsystematic, residual fluctuations Due to random variation or unforeseen events Union strike Tornado Short duration & non-repeating Realities of Forecasting Forecasts are seldom perfect Most forecasting methods assume that there is some underlying stability in the system Both product family and aggregated product forecasts are more accurate than individual product forecasts

Qualitative Methods Survey Method Experts Opinion Method Consumers Interview Method Historical Analogy Method Quantitative Approaches Trend Cyclical Seasonal Random My interest is in the future because I am going to spend the rest of my life there. Charles F. Kettering