Demand Estimation and Forecasting Dr. Nihal Hennayake

Demand Estimation and Forecasting Information about demand is essential for making pricing and production decisions A knowledge of future demand useful to managers when planning production schedules, inventory control, advertising campaigns, 3/05/2016Dr Nihal Hennayake2

An empirical demand function Empirical demand functions are demand equations derived from actual market data 3/05/2016Dr Nihal Hennayake3

DIRECT METHODS OF DEMAND ESTIMATION Regression analysis does not involve This method is quite simple and straightforward But far from truth due to many reasons 3/05/2016Dr Nihal Hennayake4

5 Consumer surveys: These surveys require the questioning of a firm’s customers in an attempt to estimate the relationship between the demand for its products and a variety of variables perceived to be for the marketing and profit planning functions. These surveys can be conducted by simply stopping and questioning people at shopping centre or by administering sophisticated questionnaires to a carefully constructed representative sample of consumers by trained interviewers. 3/05/2016Dr Nihal Hennayake

Major advantages: they may provide the only information available; they can be made as simple as possible; the researcher can ask exactly the questions they want Major disadvantages: consumers may be unable or unwilling to provide reliable answers; careful and extensive surveys can be very expensive. 3/05/2016Dr Nihal Hennayake6

Observational Research attempts by the firm to estimate the demand for the commodity by changing price and other determinants of the demand for the commodity in the actual market place. Major advantages: consumers are in a real market situation; they do not know that they being observed; they can be conducted on a large scale to ensure the validity of results. Major disadvantages: in order to keep cost down, the experiment may be too limited so the outcome can be questionable; competitors could try to sabotage the experiment by changing prices and other determinants of demand under their control; competitors can monitor the experiment to gain very useful information about the firm would prefer not to disclose. 3/05/2016Dr Nihal Hennayake7

Consumer Clinics: These are laboratory experiments in which the participants are given a sum of money and asked to spend it in a simulated store to see how they react to changes in the price, packing, displays, prices of related, and other factors Participants in the experiments can be selected so as to closely represent the socioeconomic characteristics of the market of interest. 3/05/2016Dr Nihal Hennayake8

Major advantages: More realistic than consumer surveys Avoid the drawbacks of actual market experiments Major disadvantages: The results are questionable because participants know that they are in an artificial situation They know also that they are being observed Sample of participants must necessarily be small because of high cost 3/05/2016Dr Nihal Hennayake9

Market Experiments Conducted in actual market place Select several markets with similar socioeconomic characteristics and change some determinants in one market and record the different responses Major advantages: Can be conducted in a large scale Higher validity Major disadvantages: To keep costs down experiments likely to be conducted in a limited scale and over a short period of time Strike. Unusual weather can affect (uncontrolled) Competitors can try to sabotage 3/05/2016Dr Nihal Hennayake10

EMPIRICAL DEMAND FUNCTION use the techniques of regression analysis to obtain estimates of the demand for the firms' products. It is necessary to use a specific functional form. linear Nonlinear In general demand relation, quantity demanded depends on the price of product, consumer income, the price of related goods, consumer tastes or preferences, expect price, number of buyers. 3/05/2016Dr Nihal Hennayake11

b=∆Q/∆P c=∆Q/∆M Normal/ inferior d=∆Q/∆PR Substitute/ complement e=∆Q/∆N Expected signs b – negative, c – negative or positive, d – negative or positive, e – positive 3/05/2016Dr Nihal Hennayake12

The parameters a, b, d, and e can be estimated using regression Then perform test of significance t-tests or p-values The elasticities of demand-with respect to P, M, and the PR -can be calculated from a linear demand function without much difficulty 3/05/2016Dr Nihal Hennayake13

A Procedure for the Hypothesis Testing Step-1: State the null and alternative hypotheses H 0 : b = 0 H 1 : b >0  one-sided test with rejection region in right tail. H 0 : b = 0 H 1 : b ≠ 0  two-sided test with rejection region in both tails. Step-2: Select the level of significance. Determine the chance of error you can accept. e.g.  =.05 3/05/2016Dr Nihal Hennayake14

Step-3: Choose the statistics Depending on the characteristics of your sample. Step-4: Formulate the decision rule Obtain the critical value based on the significance level you chose. Step-5: Make a decision compare critical value and statistics you computed. Reject or do not reject your null hypothesis. 3/05/2016Dr Nihal Hennayake15

A Nonlinear Empirical Demand Specification A log-linear demand function (constant elasticity) Parameter b measures the price elasticity of demand c - income elasticity d - cross price elasticity of demand This log-linear demand function can convert it to natural logarithms and then it can be estimated is linear in the logarithms: In Q = In a + bIn P + c In M + dIn P R + e In N 3/05/2016Dr Nihal Hennayake16

Estimate demand for a price-setting firm 3/05/2016Dr Nihal Hennayake17 Demand function for pizza Data on the last 24 months of pizza sales, prices charged by competitor, average household income from the region, price of a Big Mac for the last 24 months Then adjusts price and income data for the effects of inflation the number of residents in the region ( but not included,why?)

Demand function for pizza Linear Non-linear Non linear specification can covert into log-linear specification 3/05/2016Dr Nihal Hennayake18

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calculate estimated demand elasticities at values of P, M, PR, and P BMac that she consider the values P = 9.05, M = 26,614, PR = 10.12, and P BMac = The estimated demand is Q = 1, (9.05) (26,614) (10.12) (1.15) = 2, /05/2016Dr Nihal Hennayake20

E = b(P /Q) = (9.05/2,784.4) = Inelastic= if P increased by 10% Quantity come down by 7% EM = c(M/Q) = (26,614/2,784.4) = Normal good = 10% increase in income will cause sales to rise by 8% EXR = d(P R/Q) = (10.12/2,784.4) = Substitute= 10% increase rivals’ price will cause to increase sales of this one by 3.68 % E XBMac = e(PBMac/Q) = (1.15/2,784.4) = % decrease in the price of a Big Mac will decrease sales of pizzas only by about 0.30 % 3/05/2016Dr Nihal Hennayake21

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