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Demand Forecasting
Steps involved in demand forecasting
Objectives Deciding on Methodology
Survey sampling issues Experiment Historical data
Specification
Various types
Execution
Objectives
Long run Planning plant capacities, etc. Short run Planning production schedules, advertising campaigns, etc. Survey parameters and techniques will differ depending on the objectives
Methodology
Historical data
Situation may have changed considerably
Methodology
Designing of questionnaires
Required data to be collected Out-smarting the survey Defining the scales
Specification
Dependent variable Quantity demanded or any other D = a + bP + cY + dT + e Involves selecting the independent variable And specifying the functional relationships Requires understanding of the product and of basic economic relationships Specification issues
What is the nature of functional relationship between variables Identification problem Statistical issues having economic implications
Common Specifications
Distributed Lag Models Qx(t) = f (Px(t), Px(t-1), . . . Qx(t-1) . . . Y(t), Y(t-1), . . .) Models of this type recognize that current level of demand depends on Past demand patterns (habits) Stocks in possession Past incomes Past price movements, etc.
Common Specifications
Nerloves Stock-adjustment principle Consumers have a desired level of possessions which is a fn of current income Q*(t) = bY(t) However current increase in stock of possessions is only a fraction of the desired level Q(t) Q(t-1) = k[Q*(t) Q(t-1)] Substituting (1) in (2) Q(t) Q(t-1) = k[bY(t) Q(t-1)] Rearranging Q(t) = kbY(t) + (1-k)Q(t-1) This is especially used for studying demand for durables While analysing the demand for non-durables the stock adjustment (1-k) can be seen as an coefficient for habit formation
Common Specifications
Time series Forecasting future values based only on past data Qt = Q0 + (t) . . .
(t = time periods) Q0 = estimated value of Q in base period
Issues
Secular trend Seasonal & cyclical fluctuations Random influences
Common Specifications
Time Series Seasonal variations can be captured by Taking ratio of actual to trend and multiplying it to the predicted values Use of Dummy variables
Eg. for quarterly fluctuations The last quarter can be taken as base and other quarters defined as D1, D2, D3 respectively D1 takes value 1 for 1st quarter and 0 for all other quarters and so on for D2 and D3 Then
Execution
Geographical coverage Time schedules Precision v/s brevity Budgets
Statistical Issues
Test of significance of estimated parameters depends on the no. of variables estimated and sample size Multicollinearity 2 or more dependent variables correlated slope coefficients become statistically insignificant Auto-correlation errors show a high degree of correlation existence of trend or omission of an important explanatory variable Heteroscedasticity variance of error term not constant biased standard errors R2 /ANOVA - % of total variation in dependent variable explained by the dependent variable
Consumers Surplus
The consumer is willing to pay P1 for purchasing 1st unit Q1 and is willing to pay P2 for purchasing the 2nd unit Q2 However, the price is P and the consumer purchases Q units Thus he pays a lesser price (P) for Q1 and Q2, even though he was willing to pay more ABP is thus the consumers surplus
Price P1 P2
B P O
Q1
Q2
Q Quantity
Consumers Equilibrium
Law of Equi-Marginal Utility If the consumer has to spend his money income between a number of goods he will spend it in such a manner that ratio of Marginal Utility to price is equal. i.e. MUa/Pa = MUb/Pb If MUa/Pa > MUb/Pb The consumer will increase consumption of a MUa will reduce till such time that the two ratios are equal
Consumers Equilibrium
The consumer seeks to maximize his utility (U) by consuming a basket of products (x1, x2, x3, . . . xn) Max F(U) = (x1, x2, x3, . . . xn) S.t. Y = xiPi (i = 1, 2, 3, . . . n) Issues
What is the nature of functional relationship between xi and U Are xi s interdependent Is U dependent on any external factors i.e. factors not directly related to xi i.e. factors other than my own consumption Are F(U)s intercomparable Is Max(U) the same as Max Welfare
Consumers Equilibrium
Max F(U) = (x1, x2, x3, . . . xn) S.t. Y = xiPi (i = 1, 2, 3, . . . n) Y = x1P1 + x2P2 + x3P3 . . . + xnPn Y (x1P1 + x2P2 + x3P3 . . . + xnPn) = 0 Multiply by () the lagrangian multiplier [Y (x1P1 + x2P2 + x3P3 . . . + xnPn)] = 0 Subtract the above constraint from the Utility fn = U + {[Y (x1P1 + x2P2 + x3P3 . . . + xnPn)]} Necessary condition for maximization partial derivative for w.r.t. x1, x2, x3, . . . xn and = 0
Consumers Equilibrium
/x1 = U/dx1 P1 = 0 /x2 = U/dx2 P2 = 0 .... /xn = U/dxn Pn = 0 / = Y (x1P1 + x2P2 + x3P3 . . . + xnPn) = 0 U/dx1 = MU1 = P1 Thus solving for we get = MU1/P1 = MU2/P2 . . . MUn/Pn . . . Law of EquiMarginal Utility
Additional Readings
Microeconomics A. Koutsoyannis 2nd ed. Chapter 2