Managerial Economics

SEEG5013
Chapter 5
Datuk Prof. Mohd Yusof Kasim

Business and Economic Forecasting

Chapter 5
Demand Forecasting is a critical
managerial activity which comes in two
forms:

l Quantitative Forecasting +2.1047%

Gives the precise amount
or percentage

l Qualitative Forecasting
Gives the expected direction
Up, down, or about the same
2005 South-Western Publishing

What Went Wrong With

SUVs at Ford Motor Co?
Chrysler introduced the Minivan
in the 1980s

Ford expanded its capacity to produce the Explorer,

its popular SUV
Explorers price was raised substantially in 1995 at
same time competitors expanded their offerings of
SUVs.
Must consider response of rivals in pricing
decisions

Significance of Forecasting
Both public and private enterprises operate under
conditions of uncertainty.
Management wishes to limit this uncertainty by
predicting changes in cost, price, sales, and interest
rates.
Accurate forecasting can help develop strategies to
promote profitable trends and to avoid unprofitable
ones.
A forecast is a prediction concerning the future.
Good forecasting will reduce, but not eliminate, the
uncertainty that all managers feel.

Hierarchy of Forecasts
The selection of forecasting techniques depends in part
on the level of economic aggregation involved.
The hierarchy of forecasting is:
National Economy (GDP, interest rates,
inflation, etc.)

sectors of the economy (durable goods)

industry forecasts (all automobile manufacturers)
firm forecasts (Ford Motor Company)
Product forecasts (The Ford Focus)

Forecasting Criteria

1.
2.
3.
4.
5.

The choice of a particular forecasting method

depends on several criteria:
costs of the forecasting method compared with its
gains
complexity of the relationships among variables
time period involved
accuracy needed in forecast
lead time between receiving information and the
decision to be made

Accuracy of Forecasting
The accuracy of a forecasting model is measured by
how close the actual variable, Y, ends up to the
forecasting variable, Y. ^
Forecast error is the difference. (Y - Y) ^
Models differ in accuracy, which is often based on the
square root of the average squared forecast error over
a series of N forecasts and actual figures
Called a root mean square error, RMSE.

RMSE = { (Y - Y)2 / N }
^

Quantitative Forecasting
Deterministic Time
Series
Looks For Patterns
Ordered by Time
No Underlying Structure

Like technical
security analysis

Econometric Models
Explains relationships
Supply & Demand
Regression Models

Like fundamental
security analysis

Time Series
Examine Patterns in the Past
Dependent Variable
Secular Trend

Cyclical Variation

X
X

Forecasted Amounts
To

TIME

The data may offer secular trends, cyclical variations, seasonal

variations, and random fluctuations.

Elementary Time Series Models

for Economic Forecasting
NO Trend

1. Naive Forecast
^

Yt+1 = Yt

Method best when

there is no trend,
only random error
Graphs of sales over
time with and
without trends
When trending down,
the Nave predicts
too high

time

Trend

time

2. Nave forecast with adjustments for

secular trends
Yt+1
=
Y
+
(Y
Y
)
t
t
t-1
^
This equation begins with last periods
forecast, Yt.
Plus an adjustment for the change in the
amount between periods Yt and Yt-1.
When the forecast is trending up, this
adjustment works better than the pure
nave forecast method #1.

3. Linear & 4. Constant rate of growth

Linear Trend Growth

Used when trend has

a constant AMOUNT
of change
Yt = a + bT, where
Yt are the actual
observations and
T is a numerical time
variable

Uses a Semi-log Regression

Used when trend is a

constant PERCENTAGE
rate
Log Yt = a + bT,
where b is the
continuously
compounded growth
rate

More on Constant Rate of Growth Model

a proof
Suppose: Yt^ = Y0( 1 + G) t where g is the
annual growth rate
Take the natural log of both sides:
Ln Yt = Ln Y0 + t Ln (1 + G)
^ ( 1 + G ) g, the equivalent continuously
but Ln
compounded growth rate
SO:
Ln Yt = Ln Y0 + t g

Ln Yt = a + b t

where b is the growth rate

Numerical Examples: 6 observations

MTB > Print c1-c3.
Sales Time Ln-sales
100.0
109.8
121.6
133.7
146.2
164.3

1
2
3
4
5
6

4.60517
4.69866
4.80074
4.89560
4.98498
5.10169

Using this sales

data, estimate
sales in period 7
using a linear and
a semi-log
functional
form

The regression equation is

Sales = 85.0 + 12.7 Time
Predictor Coef
Constant
84.987
Time
12.6514
s = 2.596

Stdev
2.417
0.6207

R-sq = 99.0%

t-ratio p
35.16 0.000
20.38 0.000
R-sq(adj) = 98.8%

The regression equation is

Ln-sales = 4.50 + 0.0982 Time

Predictor Coef
Stdev
Constant 4.50416 0.00642
Time
0.098183 0.001649
s = 0.006899

R-sq = 99.9%

t-ratio
p
701.35 0.000
59.54 0.000
R-sq(adj) = 99.9%

Forecasted Sales @ Time = 7

Linear Model
Sales = 85.0 + 12.7 Time
Sales = 85.0 + 12.7 ( 7)
Sales = 173.9

Semi-Log Model
Ln-sales = 4.50 + 0.0982
Time

Ln-sales = 4.50 + 0.0982

(7)
Ln-sales = 5.1874
To anti-log:
e5.1874 = 179.0

linear

Sales Time Ln-sales

100.0
109.8
121.6
133.7
146.2
164.3
179.0 7
173.9 7

1 4.60517
2 4.69866
3 4.80074
4 4.89560
5 4.98498
6 5.10169
semi-log
linear

Semi-log is
exponential

Which prediction
do you prefer?

5. Declining Rate of Growth Trend

A number of marketing penetration models
use a slight modification of the constant
rate of growth model
In this form, the inverse of time is used

Ln Yt = b1 b2 ( 1/t )

This form is good for patterns

like the one to the right
It grows, but at continuously
declining rate

a
time

6. Seasonal Adjustments: The Ratio to Trend Method

Take ratios of the actual to
12 quarters of data
the forecasted values for past
years.

Find the average ratio. This is

the seasonal adjustment

Adjust by this percentage by

multiply your forecast by the

seasonal adjustment
I II III IV I II III IV I II III IV

If average ratio is 1.02, adjust

forecast upward 2%

Quarters designated with roman numerals.

7. Seasonal Adjustments: Dummy Variables

Let D = 1, if 4th quarter and 0 otherwise
Run a new regression:

Yt = a + bT + cD

the c coefficient gives the amount of the adjustment for the fourth
quarter. It is an Intercept Shifter.
With 4 quarters, there can be as many as three dummy variables; with
12 months, there can be as many as 11 dummy variables

EXAMPLE: Sales = 300 + 10T + 18D

12 Observations from the first quarter of 2002 to 2004-IV.
Forecast all of 2005.

Sales(2005-I) = 430; Sales(2005-II) = 440; Sales(2005-III) = 450;

Sales(2005-IV) = 478

Soothing Techniques
8. Moving Averages
A smoothing forecast
method for data that
jumps around
Best when there is no
trend
3-Period Moving Ave.
Yt+1 = [Yt + Yt-1 + Yt-2]/3

Dependent Variable

*
*

Forecast
Line

TIME

Smoothing Techniques

9. First-Order Exponential Smoothing

A hybrid of the Naive Each forecast is a function
of all past observations
and Moving Average
methods
Can show that forecast is
^
^
based on geometrically
Yt+1 = wYt +(1-w)Yt
declining weights.
A weighted average of
past actual and past
forecast.

^Y = w .Y +(1-w)wY +
t+1
t
t-1
^ t-1 +
(1-w)2wY

Find lowest RMSE to pick

the best alpha.

First-Order Exponential
Smoothing Example for w = .50
1
2
3
4

Actual Sales
100
120
115
130

Forecast
100 initial seed required
.5(100) + .5(100) = 100

First-Order Exponential
Smoothing Example for w = .50

1
2
3
4

Actual Sales
100
120
115
130

Forecast
100 initial seed required
.5(100) + .5(100) = 100
.5(120) + .5(100) = 110

First-Order Exponential
Smoothing Example for w = .50

1
2
3
4

Actual Sales
100
120
115
130

Forecast
100 initial seed required
.5(100) + .5(100) = 100
.5(120) + .5(100) = 110
.5(115) + .5(110) = 112.50
.5(130) + .5(112.50) = 121.25

MSE = {(120-100)2 + (110-115)2 + (130-112.5)2}/3 = 243.75

RMSE = 243.75 = 15.61

Period 5
Forecast

Qualitative Forecasting

10. Barometric Techniques

Direction of sales can be indicated by other variables.
PEAK

Motor Control Sales

peak
Index of Capital Goods

TIME
4 Months

Example: Index of Capital Goods is a leading indicator

There are also lagging indicators and coincident indicators

Time given in months from change

LEADING INDICATORS*
COINCIDENT INDICATORS

M2 money supply (-12.4)

S&P 500 stock prices (-11.1)
Building permits (-14.4)
Initial unemployment claims
(-12.9)
Contracts and orders for
plant and equipment (-7.4)

Nonagricultural payrolls
(+.8)
Index of industrial
production (-1.1)
Personal income less
transfer payment (-.4)
LAGGING INDICATORS
Prime rate (+2.0)
Change in labor cost per unit
of output (+6.4)

*Survey of Current Business, 1994

See pages 206-207 in textbook

Handling Multiple Indicators

Diffusion Index: Wall Street With Louis
Ruykeyser has eleven analysts. If 4 are
negative about stocks and 7 are positive, the
Diffusion Index is 7/11, or 63.3%.
above 50% is a positive diffusion index
Composite Index: One indicator rises
4% and another rises 6%. Therefore, the
Composite Index is a 5% increase.
used for quantitative forecasting

Qualitative Forecasting
11. Surveys and Opinion Polling Techniques
Common Survey Problems
New Products have no
historical data -- Surveys
can assess interest in new
ideas.

Sample bias- telephone, magazine

Biased questions- advocacy surveys

Survey Research Center

of U. of Mich. does repeat
surveys of households on
Big Ticket items (Autos)

Ambiguous questions
Respondents may lie on
questionnaires

Qualitative Forecasting
12. Expert Opinion
The average forecast from several experts
is a Consensus Forecast.
Mean
Median
Mode
Truncated Mean
Proportion positive or negative

EXAMPLES:
IBES, First Call, and Zacks Investment -earnings forecasts of stock analysts of companies
Conference Board macroeconomic predictions
Livingston Surveys--macroeconomic forecasts
of 50-60 economists

Individual economists tend to be less

accurate over time than the consensus
forecast.

13. Econometric Models

Specify the variables in the model
Estimate the parameters
single equation or perhaps several stage methods

Qd = a + bP + cI + dPs + ePc
But forecasts require estimates for future
prices, future income, etc.
Often combine econometric models with time series
estimates of the independent variable.

Garbage in

Garbage out

example
Qd = 400 - .5P + 2Y + .2Ps
anticipate pricing the good at P = $20
Income (Y) is growing over time, the estimate
is: Ln Yt = 2.4 + .03T, and next period is T =
17.
Y = e2.910 = 18.357

The prices of substitutes are likely to be

P = $18.
Find Qd by substituting in predictions for P, Y,
and Ps
Hence Qd = 430.31

14. Stochastic Time Series

A little more advanced methods incorporate into time
series the fact that economic data tends to drift

yt = a + byt-1 + et
In this series, if a is zero and b is 1, this is essentially
the nave model. When a is zero, the pattern is called
a random walk.
When a is positive, the data drift. The Durbin-Watson
statistic will generally show the presence of
autocorrelation, or AR(1), integrated of order one.
One solution to variables that drift, is to use first
differences.

Cointegrated Time Series

Some econometric work includes several stochastic
variable, each which exhibits random walk with drift
Suppose price data (P) has positive drift
Suppose GDP data (Y) has positive drift
Suppose the sales is a function of P & Y
Salest = a + bPt + cYt
It is likely that P and Y are cointegrated in that they
exhibit comovement with one another. They are not
independent.
The simplest solution is to change the form into first
differences as in: DSalest = a + bDPt + cDYt