Chapter 5

Demand Estimation
and Forecasting

1
Overview
Regression analysis
Hazards with use of regression
analysis
Subjects of forecasts
Prerequisites of a good forecast
Forecasting techniques

2
Learning objectives

understand importance of forecasting in

business

describe six different forecasting

techniques

know how to specify and interpret a

regression

3
Learning objectives

recognize limitations of consumer data

use seasonal and smoothing methods

4
Data collection
Data for studies pertaining to countries,
regions, or industries are readily available

Data for analysis of specific product

categories may be more difficult to obtain
buy from data providers (e.g.
ACNielsen, IRI)
perform a consumer survey
focus groups
technology: point-of-sale, bar codes
5
Regression analysis
Regression analysis: a procedure
commonly used by economists to estimate
consumer demand with available data

Two types of regression:

cross-sectional: analyze several
variables for a single period of time
time series data: analyze a single
variable over multiple periods of time
6
Regression analysis
Regression equation: linear, additive

eg: Y = a + b1X1 + b2X2 + b3X3 + b4X4

Y: dependent variable
a: constant value, y-intercept
Xn: independent variables, used to explain Y
bn: regression coefficients (measure impact of
independent variables)

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Regression analysis
Interpreting the regression results:

coefficients:
negative coefficient shows that as the
independent variable (Xn) changes, the variable
(Y) changes in the opposite direction
positive coefficient shows that as the
independent variable (Xn) changes, the
dependent variable (Y) changes in the same
direction
magnitude of regression coefficients is a
measure of elasticity of each variable
8
Regression analysis
Statistical evaluation of regression results:

t-test: test of statistical significance of

each estimated coefficient
b
t
SE b

b = estimated coefficient
SEb = standard error of estimated coefficient

9
Regression analysis
Statistical evaluation of regression results:

rule of 2: if absolute value of t is

greater than 2, estimated coefficient is
significant at the 5% level

if coefficient passes t-test, the

variable has a true impact on demand

10
Regression analysis
Statistical evaluation of regression results

R2 (coefficient of determination):
percentage of variation in the variable
(Y) accounted for by variation in all
explanatory variables (Xn)
R2 value ranges from 0.0 to 1.0
the closer to 1.0, the greater the
explanatory power of the regression
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Regression analysis
Statistical evaluation of regression results

F-test: measures statistical significance

of the entire regression as a whole (not
each coefficient)

12
Regression results

Steps for analyzing regression results

check coefficient signs and magnitudes

compute implied elasticities

determine statistical significance

13
Regression results

Example: estimating demand for pizza

demand for pizza affected by

1. price of pizza
2. price of complement (soda)
managers can expect price decreases to
lead to lower revenue
tuition and location are not significant

14
Regression problems
Identification problem: the estimation
of demand may produce biased results
due to simultaneous shifting of supply and
demand curves

solution: use advanced correction

techniques, such as two-stage least
squares and indirect least squares

15
Regression problems
Multicollinearity problem: two or more
independent variables are highly
correlated, thus it is difficult to separate
the effect each has on the dependent
variable

solution: a standard remedy is to drop

one of the closely related independent
variables from the regression

16
Regression problems
Autocorrelation problem: also known as
serial correlation, occurs when the
dependent variable relates to the Y
variable according to a certain pattern
Note: possible causes include omitted
variables, or non-linearity; Durbin-Watson
statistic is used to identify autocorrelation

solution: to correct autocorrelation

consider transforming the data into a
different order of magnitude or introducing
leading or lagging data
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Forecasting
Examples: common subjects of business
forecasts:
Gross domestic product (GDP)
Components of GDP
consumption expenditure, producer
durable equipment expenditure,
residential construction
Industry forecasts
Sales of products across an industry
sales of a specific product
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Forecasting

A good forecast should:

be consistent with other parts of the business

be based on knowledge of the relevant past
consider the economic and political
environment as well as changes
be timely

19
Forecasting techniques

Factors in choosing the right forecasting

technique:

item to be forecast
interaction of the situation with the forecasting
methodology
amount of historical data available
time allowed to prepare forecast

20
Forecasting techniques
Approaches to forecasting

Qualitative forecasting is based on

judgments expressed by individuals or
group

Quantitative forecasting utilizes

significant amounts of data and
equations

21
Forecasting techniques
Approaches to forecasting

Nave forecasting projects past data

without explaining future trends

Causal (or explanatory) forecasting

attempts to explain the functional
relationships between the dependent
variable and the independent variables

22
Forecasting techniques
Six forecasting techniques

expert opinion
opinion polls and market research
surveys of spending plans
economic indicators
projections
econometric models

23
Forecasting techniques
Expert opinion techniques

Jury of executive opinion: forecasts

generated by a group of corporate
executives assembled together
Drawback: persons with strong
personalities may exercise
disproportionate influence

24
Forecasting techniques
Expert opinion techniques

The Delphi method: a form of expert

opinion forecasting that uses a series of
questions and answers to obtain a
consensus forecast, where experts do
not meet

25
Forecasting techniques

Opinion polls: sample populations are

surveyed to determine consumption trends

may identify changes in trends

choice of sample is important
questions must be simple and clear

26
Forecasting techniques
Market research: is closely related to
opinion polling and will indicate not only
why the consumer is (or is not) buying,
but also

who the consumer is

how he or she is using the product
characteristics the consumer thinks are
most important in the purchasing
decision
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Forecasting techniques
Surveys of spending plans: yields
information about macro-type data
relating to the economy, especially:

consumer intentions
Examples: Survey of Consumers (University of
Michigan); Consumer Confidence Survey
(Conference Board)

inventories and sales expectations

28
Forecasting techniques
Economic indicators: a barometric
method of forecasting designed to alert
business to changes in conditions

leading, coincident, and lagging indicators

composite index: one indicator alone may

not be very reliable, but a mix of leading
indicators may be effective

29
Forecasting techniques
Leading indicators predict future economic
activity

average hours, manufacturing

initial claims for unemployment insurance
manufacturers new orders for consumer
goods and materials
vendor performance, slower deliveries
diffusion index
manufacturers new orders, nondefense
capital goods
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Forecasting techniques
Leading indicators predict future economic
activity

building permits, new private housing

units
stock prices, 500 common stocks
money supply, M2
interest rate spread, 10-year Treasury
bonds minus federal funds
index of consumer expectations

31
Forecasting techniques
Coincident indicators identify trends in
current economic activity

employees on nonagricultural payrolls

personal income less transfer payments
industrial production
manufacturing and trade sales

32
Forecasting techniques
Lagging indicators confirm swings in past
economic activity

average duration of unemployment,

weeks
ratio, manufacturing and trade
inventories to sales
change in labor cost per unit of output,
manufacturing (%)

33
Forecasting techniques
Lagging indicators confirm swings in past
economic activity

average prime rate charged by banks

commercial and industrial loans
outstanding
ratio, consumer installment credit
outstanding to personal income
change in consumer price index for
services
34
Forecasting techniques
Economic indicators: drawbacks

leading indicator index has forecast a

recession when none ensued
a change in the index does not indicate
the precise size of the decline or
increase
the data are subject to revision in the
ensuing months
35
Forecasting techniques

Trend projections: a form of nave

forecasting that projects trends from past
data without taking into consideration
reasons for the change

compound growth rate

visual time series projections
least squares time series projection

36
Forecasting techniques
Compound growth rate: forecasting by
projecting the average growth rate of the
past into the future

provides a relatively simple and timely

forecast

appropriate when the variable to be

predicted increases at a constant %
37
Forecasting techniques
General compound growth rate formula:

E = B(1+i)n

E = final value
n = years in the series
B = beginning value
i = constant growth rate

38
Forecasting techniques

Visual time series projections: plotting

observations on a graph and viewing the
shape of the data and any trends

39
Forecasting techniques

Time series analysis: a nave method of

forecasting from past data by using least
squares statistical methods to identify
trends, cycles, seasonality and irregular
movements

40
Forecasting techniques
Time series analysis:

Advantages:
easy to calculate
does not require much judgment or
analytical skill
describes the best possible fit for past
data
usually reasonably reliable in the short
run
41
Forecasting techniques
Time series data can be represented as:

Yt = f(Tt, Ct, St, Rt)

Yt = actual value of the data at time t

Tt = trend component at t
Ct = cyclical component at t
St = seasonal component at t
Rt = random component at t
42
Forecasting techniques
Time series components: seasonality

need to identify and remove seasonal

factors, using moving averages to isolate
those factors

remove seasonality by dividing data by

seasonal factor

43
Forecasting techniques
Time series components: trend

to remove trend line, use least squares

method
possible best-fit line styles:
straight Line: Y = a + b(t)
exponential Line: Y = abt
quadratic Line: Y = a + b(t) + c(t)2
choose one with best R2
44
Forecasting techniques

Time series components: cycle, noise

isolate cycle by smoothing with a

moving average

random factors cannot be predicted and

should be ignored

45
Forecasting techniques
Smoothing techniques

moving average
exponential smoothing

work best when:

no strong trend in series
infrequent changes in direction of series
fluctuations are random rather than
seasonal or cyclical

46
Forecasting techniques
Moving average: average of actual past
results used to forecast one period ahead

Et+1 = (Xt + Xt-1 + + Xt-N+1)/N

Et+1 = forecast for next period

Xt, Xt-1 = actual values at their respective
times
N = number of observations included in
average
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Forecasting techniques
Exponential smoothing: allows for
decreasing importance of information in
the more distant past, through geometric
progression

Et+1 = wXt + (1-w) Et

w = weight assigned to an actual

observation at period t
48
Forecasting techniques
Econometric models: causal or
explanatory models of forecasting
regression analysis
multiple equation systems
endogenous variables: dependent
variables that may influence other
dependent variables
exogenous variables: from outside the
system, truly independent variables

49
Forecasting techniques
Example: econometric model
Suits (1958) forecast demand for new
automobiles
R = a0 + a1 Y + a2 P/M + a3 S + a4 X
R = retail sales
Y = real disposable income
P = real retail price of cars
M = average credit terms
S = existing stock
X= dummy variable
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Global application

Example: forecasting exchange rates

GDP
interest rates
inflation rates
balance of payments

51