1

Demand Estimation and Forecasting

Types of data
Research Approaches to Demand
Estimation & Forecasting
Survey Methods
Consumer surveys
Complete Enumeration Method
Sample Method
Expert Surveys (Delphi Method)
Statistical Methods
Trend Projection
Graphical Method
Trend Fitting using Least Squares Method
Box-Jenkins Method
Econometric Methods
Regression Method
Simple Regression
Multiple Regression
Simultaneous Equations
Complete Enumeration Method
Potential users are contacted and asked about their
future plan of purchasing the product.
If n out f m households in a city report the quantity
(d) they are willing to purchase of a commodity,
then total probable demand (Dp) will be

Dp = d1+d2+d3+.+dn


Sample Method
Dp = (HR/HS)( H.AD)
Dp = Probable Demand
HR = No. of households reporting demand
for the product.
HS = No. of households surveyed.
AD = Average expected consumption by the
reporting households.
H = Census no. of the households from the
relevant market.
H
HS
HR
Delphi Method
Delphi method uses expert opinion about future
developments. It was developed for long-range economical
predictions by scientists of the Rand Corporation (1950s). It is
an iterative process to collect and refine the anonymous
judgments of experts using a series of data collection and
analysis techniques interspersed with feedback.

The Delphi method is well suited as a research instrument
when there is incomplete knowledge about a problem or
phenomenon. Feedback of results follows each step of
questioning. The process continues until no further
convergence of the experts' opinion is to be expected.
Trend Projection: Graphical Method
Trend Fitting using Least Squares Method

Y
t
= a + b t


Sales =f (time)
S
t
= a + b t


Box-Jenkins Method
Moving Average Forecasts

Exponential Smoothing Forecasts
Moving Average Forecasts
Forecast is the average of data from w
periods prior to the forecast data point.
1
w
t i
t
i
A
F
w

=
=

Accuracy of a Forecasting Method

2
( )
t t
A F
RMSE
n

=

Root Mean Square Error (RMSE):
(Measures the accuracy of a forecasting Method)
Three-quarter and Five-quarter Moving Average Forecast
?
Exponential Smoothing
Forecasts
1
(1 )
t t t
F wA w F
+
= +
Forecast is the weighted average of the forecast
and the actual value from the prior period.
0 1 w s s
Root Mean Square Error
2
( )
t t
A F
RMSE
n

=

To measure the accuracy of the forecast
Regression Analysis
Regression Analysis
Regression Line: Line of Best Fit

Ordinary Least Squares (OLS) Method

Regression Line: Minimizes the sum of
the squared vertical deviations (e
t
) of
each point from the regression line.
Scatter Diagram
Regression Analysis
Year X Y
1 10 44
2 9 40
3 11 42
4 12 46
5 11 48
6 12 52
7 13 54
8 13 58
9 14 56
10 15 60
Ordinary Least Squares (OLS)
Model:
t t t
Y a bX e = + +


t t
Y a bX = +

t t t
e Y Y =
Properties:

(i) = 0

(ii) is minimum.
Ordinary Least Squares (OLS)
Objective: Determine the slope and intercept
that minimize the sum of the squared errors.
2 2 2
1 1 1


( ) ( )
n n n
t t t t t
t t t
e Y Y Y a bX
= = =
= =

Method used for this: Maxima Minima
Ordinary Least Squares (OLS)
Estimation Procedure
1
2
1
( )( )

( )
n
t t
t
n
t
t
X X Y Y
b
X X
=
=

=

a Y bX =
Data on sales and Advertising expenditure for 10
years for a firm.
Year Ad. Expenses Sales
1 10 44
2 9 40
3 11 42
4 12 46
5 11 48
6 12 52
7 13 54
8 13 58
9 14 56
10 15 60
Ordinary Least Squares (OLS)
Estimation Example
1 10 44 -2 -6 12
2 9 40 -3 -10 30
3 11 42 -1 -8 8
4 12 46 0 -4 0
5 11 48 -1 -2 2
6 12 52 0 2 0
7 13 54 1 4 4
8 13 58 1 8 8
9 14 56 2 6 12
10 15 60 3 10 30
120 500 106
4
9
1
0
1
0
1
1
4
9
30
Time t
X
t
Y
t
X X
t
Y Y ( )( )
t t
X X Y Y
2
( )
t
X X
10 n =
1
120
12
10
n
t
t
X
X
n
=
= = =

1
500
50
10
n
t
t
Y
Y
n
=
= = =

1
120
n
t
t
X
=
=

1
500
n
t
t
Y
=
=

2
1
( ) 30
n
t
t
X X
=
=

1
( )( ) 106
n
t t
t
X X Y Y
=
=

Ordinary Least Squares (OLS)

Estimation Example
10 n =
1
120
12
10
n
t
t
X
X
n
=
= = =

1
500
50
10
n
t
t
Y
Y
n
=
= = =

1
120
n
t
t
X
=
=

1
500
n
t
t
Y
=
=

2
1
( ) 30
n
t
t
X X
=
=

1
( )( ) 106
n
t t
t
X X Y Y
=
=

106

3.533
30
b = =
50 (3.533)(12) 7.60 a = =
Y = 7.60+3.533 X
Y = 7.60+3.533 X
Tests of significance?
Tests of Significance in
Regression
Testing the significance of Regression
Coefficients
Testing the significance of R2
Coefficient of Determination (Measure
of association between dependent
variable and independent variable(s))


Test for Significance



Under the validity of H0, t statistic will be used,
where


SE
b
denotes the standard deviation of b and
is called the standard error.

H
0
: |
1
= 0
H
1
: |
1
= 0
t =
b
SE
b
= 0.05
With d.f. = n-2
Standard Error of the Slope Estimate (b)
2 2

2 2

( )
( ) ( ) ( ) ( )
t t
b
t t
Y Y e
s
n k X X n k X X

= =



(k-1) (k-1)
Tests of Significance
2 2
1 1

( ) 65.4830
n n
t t t
t t
e Y Y
= =
= =

2
1
( ) 30
n
t
t
X X
=
=

( )
65.4830
0.52
( ) ( ) (10 2)(30)
t
b
t
Y Y
s
n k X X

= = =

1 10 44 42.90
2 9 40 39.37
3 11 42 46.43
4 12 46 49.96
5 11 48 46.43
6 12 52 49.96
7 13 54 53.49
8 13 58 53.49
9 14 56 57.02
10 15 60 60.55
1.10 1.2100 4
0.63 0.3969 9
-4.43 19.6249 1
-3.96 15.6816 0
1.57 2.4649 1
2.04 4.1616 0
0.51 0.2601 1
4.51 20.3401 1
-1.02 1.0404 4
-0.55 0.3025 9
65.4830 30
Time t
X
t
Y
t
Y

t t t
e Y Y =
2 2

( )
t t t
e Y Y =
2
( )
t
X X
Tests of Significance
Example Calculation
2

( )
65.4830
0.52
( ) ( ) (10 2)(30)
t
b
t
Y Y
s
n k X X

= = =

2
1
( ) 30
n
t
t
X X
=
=

2 2
1 1

( ) 65.4830
n n
t t t
t t
e Y Y
= =
= =

(k-1)
Tests of Significance
Calculation of the t Statistic

3.53
6.79
0.52
b
b
t
s
= = =
Degrees of Freedom = (n-k) = (10-2) = 8
Critical Value at 5% level =2.306
Since calculated t is higher than the critical
(tabulated) t, therefore, the Reg. coefficient is
significant.

Y = 7.60+3.533 X

Hence we can say that b is a significant
regression coefficient which infers that
X is a significant explanatory variable
for Y.

Two tail Hypothesis test with
rejection region in both tails
The rejection region is split equally between the two tails.
One-Tail Test
(left tail)
Two-Tail Test One-Tail Test
(right tail)
Two tail vs. one tail test
/2 /2
Test of Significance of R
2
Decomposition of Variation in Dependent
Variable
2 2 2

( ) ( ) ( )
t t t
Y Y Y Y Y Y = +

Total Variation = Explained Variation + Unexplained
Variation
n-1 = k-1 + n-k
Test of Significance
Coefficient of Determination
2
2
2

( )
( )
t
Y Y
ExplainedVariation
R
Total Variation Y Y

= =

2
373.84
0.85
440.00
R = =
Significance of Coefficient of Determination

H
0
: R
2
= 0

H
1
: R
2
> 0

Under the validity of H0, the appropriate test statistic is the F statistic:






which has an F distribution with 1 and n - 2 degrees of freedom.



F

=

S SR
/(k-1)
S SE / ( n -k )
05 . 0 = o

Source Sum of Squares D.F. Mean Square F

Regression SSR k-1

Error SSE n-k

Total SST n-1

If is accepted,

otherwise significant regression.

1
=
k
SSR
MSR
k n
SSE
MSE

=
MSE
MSR
F =
k n k
F F

<
, 1
ANOVA Table
Multiple Regression Analysis
Model:
Multiple Regression Analysis
Analysis of Variance and F Statistic
/( 1)
/( )
ExplainedVariation k
F
UnexplainedVariation n k

2
2
/( 1)
(1 ) /( )
R k
F
R n k

=

Significance Testing of Overall
Regression
H
0
: R
2
= 0

This is equivalent to the following null hypothesis:

H
0
: |
1
= |
2
=|
3
= . . . = |
k
=0

The overall test can be conducted by using an F statistic:






R
2
/ K-1
( 1 - R
2
) / ( n - k)
which has an F distribution with k-1 and (n - k ) degrees of freedom.
F =
Problems in Regression Analysis
Multicollinearity: Two or more
explanatory variables are highly
correlated.
Heteroscedasticity: Variance of error
term is not independent of the Y
variable.
Autocorrelation: Consecutive error
terms are correlated.
Multicollinearity (MC)
Multicollinearity inflates the variances of the
parameter estimates leading to insignificant t-
ratios even when R
2
is significant.
Measures to detect:
Bivariate Correlation Coefficients b/w the independent
variables.
VIF (Variance Inflation factor)

VIF more than 10 indicates high multicollinearity
Remedial Measures for MC
Increase the sample size and check.
Check with the specification of the model (linear vs. Non-
linear).
If single variable causing MC, can be dropped, if theoretically
permitted.
The specification of the individual variables can be changed
such as per capita Income rather than total income.
Centering of the variables Replacing the values by ( )
Principal Component Analysis

X X
Durbin-Watson Statistic
Test for Autocorrelation
2
1
2
2
1
( )
n
t t
t
n
t
t
e e
d
e

=
=

If d = 2, autocorrelation (AC) is absent.

If d= 0, perfect +ve AC.
If d= 4, perfect -ve AC.
0-2: High +ve AC.
2-4: High -ve AC.
H0: R= 0
H1: R> 0




If d > dU conclude H0 (R= 0)
if dL <= d <= dU the test is inconclusive
if d < dL conclude H1 (R > 0)
2
1
2
2
1
( )
n
t t
t
n
t
t
e e
d
e

=
=

The Durbin-Watson Test:

Interpreting the Results
D-W Statistic Table
No. of independent variables
Steps in Demand Estimation
Model Specification: Identify Variables
Collect Data
Specify Functional Form
Estimate Function
Test the Results
Functional Form Specifications
Linear Function:
Power Function:
1 2
( )( )
b b
X X Y
Q a P P =
Estimation Format:
1 2
ln ln ln ln
X X Y
Q a b P b P = + +