PART B

1. Discuss the steps involved in demand forecasting. (APRIL 2012)

Steps in Demand Forecasting
1. Specifying the Objective: The objective for which the demand forecasting is to be
done must be clearly specified. The objective may be defined in terms of; long-term
or short-term demand. The objective of the demand must be determined before the
process of demand forecasting begins as it will give direction to the whole research.
2. Determining the Time Perspective: On the basis of the objective set, the demand
forecast can either be for a short-period, say for the next 2-3 year or a long period.
Thus, it is essential to define the time perspective, i.e., the time duration for which the
demand is to be forecasted.
3. Making a Choice of Method for Demand Forecasting: There are several methods
of demand forecasting falling under two categories; survey methods and statistical
methods. The Survey method includes consumer survey and opinion poll methods,
and the statistical methods include trend projection, barometric and econometric
methods.
4. Collection of Data and Data Adjustment: The primary data are the first-hand data
which has never been collected before. While the secondary data are the data already
available. Often, data required is not available and hence the data are to be adjusted,
even manipulated, if necessary with a purpose to build a data consistent with the data
required.
5. Estimation and Interpretation of Results: The estimates appear in the form of
equations, and the result is interpreted and presented in the easy and usable form.
Thus, the objective of demand forecasting can only be achieved only if these steps are
followed systematically.
2. Explain the difference between ‘change in demand’ and ‘Amount demanded’.
(APRIL 2013) (APRIL 2016)
In economics the terms change in quantity demanded and change in demand are two
different concepts. Change in quantity demanded refers to change in the quantity purchased
due to increase or decrease in the price of a product. In such a case, it is incorrect to say
increase or decrease in demand rather it is increase or decrease in the quantity demanded. On
the other hand, change in demand refers to increase or decrease in demand of a product due to
various determinants of demand, while keeping price at constant.
Changes in quantity demanded can be measured by the movement of demand curve,
while changes in demand are measured by shifts in demand curve. The terms, change in
quantity demanded refers to expansion or contraction of demand, while change in demand
means increase or decrease in demand.
3. Explain the different types of demand forecasting. (APRIL 2013)or Explain the
various methods of forecasting. (NOV 2012)
Forecasts can be broadly classified into:
(i) Passive Forecast and
(ii) Active Forecast.
Under passive forecast prediction about future is based on the assumption that the
firm does not change the course of its action. Under active forecast, prediction is done under
the condition of likely future changes in the actions by the firms.
From the view point of ‘time span’, forecasting may be classified into two, viz.,:
(i) Short term demand forecasting and (ii) long term demand forecasting. In a short
run forecast, seasonal patterns are of much importance. It may cover a period of three
months, six months or one year. It is one which provides information for tactical decisions.
Which period is chosen depends upon the nature of business. Such a forecast helps in
preparing suitable sales policy. Long term forecasts are helpful in suitable capital planning. It
is one which provides information for major strategic decisions. It helps in saving the
wastages in material, man hours, machine time and capacity. Planning of a new unit must
start with an analysis of the long term demand potential of the products of the firm.
There are basically two types of forecast, viz.,:
(i) External or national group of forecast, and
(ii) Internal or company group forecast.
External forecast deals with trends in general business. It is usually prepared by a
company’s research wing or by outside consultants. Internal forecast includes all those that
are related to the operation of a particular enterprise such as sales group, production group,
and financial group. The structure of internal forecast includes forecast of annual sales,
forecast of products cost, forecast of operating profit, forecast of taxable income, forecast of
cash resources, forecast of the number of employees, etc.
Forecast may be classified into (i) general and (ii) specific. The general forecast may
generally be useful to the firm. Many firms require separate forecasts for specific products
and specific areas, for this general forecast is broken down into specific forecasts.

4. Explain the factors influencing demand forecast. (APRIL 2014)

1. Prevailing business conditions: While preparing demand forecast it becomes
necessary to study the general economic conditions very carefully. These include the price
level changes, change in national income, per-capita income, consumption pattern, savings
and investment habits, employment etc.
2. Conditions within the industry: Every business enterprise is only a unit of a
particular industry. Sales of that business enterprise are only a part of the total sales of that
industry.
3. Conditions within the firm: Internal factors of the firm also affect the demand
forecast. These factors include plant capacity of the firm, quality of the product, price of the
product, advertising and distribution policies, production policies, financial policies etc.
4. Factors affecting export trade: If a firm is engaged in export trade also it should
consider the factors affecting the export trade. These factors include import and export
control, terms and conditions of export, exim policy, export conditions, export finance etc.
5. Market behavior : While preparing demand forecast, it is required to consider the
market behavior which brings about changes in demand.
6. Sociological conditions: Sociological factors have their own impact on demand
forecast of the company. These conditions relate to size of population, density, change in age
groups, size of family, family life cycle, level of education, family income, social awareness
etc.
7. Psychological conditions: While estimating the demand for the product, it
becomes necessary to take into consideration such factors as changes in consumer tastes,
habits, fashions, likes and dislikes, attitudes, perception, life styles, cultural and religious
bents etc.
8. Competitive conditions: The competitive conditions within the industry may
change. Competitors may enter into market or go out of market. A demand forecast prepared
without considering the activities of competitors may not be correct.
5. Describe the factors influencing elasticity of demand. (APRIL 2015)
1. Nature of commodity:
Elasticity of demand of a commodity is influenced by its nature. A commodity for a
person may be a necessity, a comfort or a luxury.
i. When a commodity is a necessity like food grains, vegetables, medicines, etc., its demand
is generally inelastic as it is required for human survival and its demand does not fluctuate
much with change in price.
ii. When a commodity is a comfort like fan, refrigerator, etc., its demand is generally elastic
as consumer can postpone its consumption
iii. When a commodity is a luxury like AC, DVD player, etc., its demand is generally more
elastic as compared to demand for comforts.
iv. The term ‘luxury’ is a relative term as any item (like AC), may be a luxury for a poor
person but a necessity for a rich person.
2. Availability of substitutes:
Demand for a commodity with large number of substitutes will be more elastic. The
reason is that even a small rise in its prices will induce the buyers to go for its substitutes. For
example, a rise in the price of Pepsi encourages buyers to buy Coke and vice-versa.
Thus, availability of close substitutes makes the demand sensitive to change in the prices. On
the other hand, commodities with few or no substitutes like wheat and salt have less price
elasticity of demand.
3. Income Level:
Elasticity of demand for any commodity is generally less for higher income level groups in
comparison to people with low incomes. It happens because rich people are not influenced
much by changes in the price of goods. But, poor people are highly affected by increase or
decrease in the price of goods. As a result, demand for lower income group is highly elastic.
4. Level of price:
Level of price also affects the price elasticity of demand. Costly goods like laptop, Plasma
TV, etc. have highly elastic demand as their demand is very sensitive to changes in their
prices. However, demand for inexpensive goods like needle, match box, etc. is inelastic as
change in prices of such goods do not change their demand by a considerable amount.
5. Postponement of Consumption:
Commodities like biscuits, soft drinks, etc. whose demand is not urgent, have highly elastic
demand as their consumption can be postponed in case of an increase in their prices.
However, commodities with urgent demand like life saving drugs, have inelastic demand
because of their immediate requirement.
6. Number of Uses:
If the commodity under consideration has several uses, then its demand will be elastic. When
price of such a commodity increases, then it is generally put to only more urgent uses and, as
a result, its demand falls. When the prices fall, then it is used for satisfying even less urgent
needs and demand rises.
For example, electricity is a multiple-use commodity. Fall in its price will result in substantial
increase in its demand, particularly in those uses (like AC, Heat convector, etc.), where it was
not employed formerly due to its high price. On the other hand, a commodity with no or few
alternative uses has less elastic demand.
7. Share in Total Expenditure:
Proportion of consumer’s income that is spent on a particular commodity also influences the
elasticity of demand for it. Greater the proportion of income spent on the commodity, more is
the elasticity of demand for it and vice-versa. Demand for goods like salt, needle, soap, match
box, etc. tends to be inelastic as consumers spend a small proportion of their income on such
goods. When prices of such goods change, consumers continue to purchase almost the same
quantity of these goods. However, if the proportion of income spent on a commodity is large,
then demand for such a commodity will be elastic.
8. Time Period:
Price elasticity of demand is always related to a period of time. It can be a day, a week, a
month, a year or a period of several years. Elasticity of demand varies directly with the time
period. Demand is generally inelastic in the short period. It happens because consumers find
it difficult to change their habits, in the short period, in order to respond to a change in the
price of the given commodity. However, demand is more elastic in long rim as it is
comparatively easier to shift to other substitutes, if the price of the given commodity rises.
9. Habits:
Commodities, which have become habitual necessities for the consumers, have less elastic
demand. It happens because such a commodity becomes a necessity for the consumer and he
continues to purchase it even if its price rises. Alcohol, tobacco, cigarettes, etc. are some
examples of habit forming commodities. Finally it can be concluded that elasticity of demand
for a commodity is affected by number of factors. However, it is difficult to say, which
particular factor or combination of factors determines the elasticity. It all depends upon
circumstances of each case.
6. Describe the elasticity of demand and revenue relationship. (APRIL 2015)
Price elasticity of demand measures the responsiveness of quantity demanded to a
change in price. The law of demand says that when price falls (rises), quantity demanded
increases (decreases).
1. When the quantity increase (or decrease) is greater than fall (rise) in price, elasticity
of demand is greater than 1. Hence, high responsiveness of demand to change in price.
2. When the quantity increase (decrease) is equal to fall (rise) in price, elasticity of
demand is equal to 1. Hence, responsiveness of demand is moderate to change in price.
3. When the quantity increase (decrease) is less than fall (rise) in price, elasticity of
demand is less than 1. Hence, responiseveness of demand is low to change in price.
We know, Revenue = Price (P) * Quantity (Q). Now for a producer the most
favourable situation is the last one when the consumers (demanders) have no option but to
decrease the quantity consumed by not much when price is increased.
To give an example, say right now the Revenue is ₹100 where P =10; Q= 10. Now ,
say the producer is aware of the fact that the price elasticity of demand is less than 1 and
therefore he decides to increase the price to ₹12 (20% increase in price). According to law of
demand, there will be a fall in quantity. But as elasticity of demand is less than 1, quantity of
demand will fall by less than 20% , say to 9 (fall of 10%).
New revenue effective after price increase will be 12*9 = ₹108.
Here, the producer has gained ₹8 in spite of a price increase. The point is, the
producer realised that the responsiveness of quantity demanded to increase in price is low, so
consumers don't have much of an option but to not let the total quantity demanded to fall by
too much. This is why such products are said to have a relatively inelastic demand. Examples
are: salt, cigarettes, alcohol.
In case of elastic demand (case 1), revenue will fall for an increase (or decrease) in price. In
case of unit elastic demand (case 2), revenue will remain unchanged for an increase (or
decrease) in price.
7. Explain the objectives and purposes of forecasting. (APRIL 2016) (NOV 2012)
Demand forecasting constitutes an important part in making crucial business decisions.
The objectives of demand forecasting are divided into short and long-term objectives.
i. Short-term Objectives:
a. Formulating production policy:
It helps in covering the gap between the demand and supply of the product. The demand
forecasting helps in estimating the requirement of raw material in future, so that the regular
supply of raw material can be maintained. It further helps in maximum utilization of
resources as operations are planned according to forecasts. Similarly, human resource
requirements are easily met with the help of demand forecasting.
b. Formulating price policy:
It refers to one of the most important objectives of demand forecasting. An organization sets
prices of its products according to their demand. For example, if an economy enters into
depression or recession phase, the demand for products falls. In such a case, the organization
sets low prices of its products.
c. Controlling sales:
It helps in setting sales targets, which act as a basis for evaluating sales performance. An
organization makes demand forecasts for different regions and fixes sales targets for each
region accordingly.
d. Arranging finance:
Implies that the financial requirements of the enterprise are estimated with the help of
demand forecasting. This helps in ensuring proper liquidity within the organization.
ii. Long-term Objectives:
a. Deciding the production capacity:
Implies that with the help of demand forecasting, an organization can determine the size of
the plant required for production. The size of the plant should conform to the sales
requirement of the organization.
b. Planning long-term activities:
Implies that demand forecasting helps in planning for long term. For example, if the
forecasted demand for the organization’s products is high, then it may plan to invest in
various expansion and development projects in the long term.
PURPOSE of FORECASTING:
Forecasting is an approach to determine what the future holds. It is an estimate of
what the future will look like that every function within an organization needs in order to
build their current plans. Today, all organizations operate in an atmosphere of uncertainty.
Decisions that are made by organizations today will affect future outcomes. Here are a few
examples:
The eventualities and contingencies of general economic business cycles. An
expansion following enlargement and growth in business involves the use of additional
machinery, personnel, and a re-allocation of facilities, Changes in management philosophies
and leadership styles, The use of mechanical technology. Dynamic changes in the quantity or
quality of products and/or services require a change in the organization structure.
6. Explain the theory of consumer behaviour. (APRIL 2017) or Explain the different
theories of consumer behaviour. (NOV 16)
1. Rationality:
The consumer is assumed to be rational he aims at the maximization of his utility,
given his income and market prices. It is assumed he has full knowledge (certainty) of all
relevant information.
Utility is ordinal:
It is taken as axiomatically true that the consumer can rank his preferences (order the
various ‘baskets of goods’) according to the satisfaction of each basket. He need not know
precisely the amount of satisfaction. It suffices that he expresses his preference for the
various bundles of commodities. It is not necessary to assume that utility is cardinally
measurable. Only ordinal measurement is required.
Diminishing marginal rate of substitution:
Preferences are ranked in terms of indifference curves, which are assumed to be
convex to the origin. This implies that the slope of the indifference curves increases. The
slope of the indifference curve is called the marginal rate of substitution of the commodities.
The indifference-curve theory is based, thus, on the axiom of diminishing marginal rate of
substitution.
Consistency and transitivity of choice:
It is assumed that the consumer is consistent in his choice, that is, if in one period he
chooses bundle A over B, he will not choose B over A in another period if both bundles are
available to him.
Equilibrium of the consumer:
To define the equilibrium of the consumer (that is, his choice of the bundle that
maximizes his utility) we must introduce the concept of indifference curves and of their slope
(the marginal rate of substitution), and the concept of the budget line. These are the basic
tools of the indifference curves approach.
Indifference curves:
An indifference curve is the locus of points – particular combinations or bundles of
goods-which yield the same utility (level of satisfaction) to the consumer, so that he is
indifferent as to the particular combination he consumes. An indifference map shows all the
indifference curves which rank the preferences of the consumer. Combinations of goods
situated on an indifference curve yield the same utility. Combinations of goods lying on a
higher indifference curve yield higher level of satisfaction and are preferred. Combinations of
goods on a lower indifference curve yield a lower utility.
Properties of the indifference curves:
An indifference curve has a negative slope, which denotes that if the quantity of one
commodity (y) decreases, the quantity of the other (x) must increase, if the consumer is to
stay on the same level of satisfaction. The further away from the origin an indifference curve
lies, the higher the level of utility it denotes bundles of goods on a higher indifference curve
are preferred by the rational consumer. Indifference curves do not intersect. If they did, the
point of their intersection would imply two different levels of satisfaction, which is
impossible.
Proof:
The slope of a curve at any one point is measured by the slope of the tangent at that
point. The equation-of a tangent is given by the total derivative or total differential, which
shows the total change of the function as all its determinants change.
The total utility function in the case of two commodities x and y is
 It shows the total change in utility as the quantities of both commodities change. The
total change in U caused by changes in y and x is (approximately) equal to the change in y
multiplied by its marginal utility, plus the change in x multiplied by its marginal utility.
Along any particular indifference curve the total differential is by definition equal to zero.
Thus for any indifference curve

The indifference curves are convex to the origin. This implies that the slope of an
indifference curve decreases (in absolute terms) as we move along the curve from the left
downwards to the right: the marginal rate of substitution of the commodities is diminishing.
This axiom is derived from introspection, like the ‘law of diminishing marginal utility’ of the
cardinalist school.
The axiom of decreasing marginal rate of substitution expresses the observed
behavioural rule that the number of units of x the consumer is willing to sacrifice in order to
obtain an additional unit of y increases as the quantity of y decreases. It becomes increasingly
difficult to substitute x for y as we move along the indifference curve. In figure 2.9 the fifth
unit of y can be substituted for x by the consumer giving up x 1x2 of x; but to substitute the
second unit of y and still retain the same satisfaction the consumer must give up a much
greater quantity of x, namely x3 x4.
The budget constraint of the consumer:
The consumer has a given income which sets limits to his maximizing behaviour.
Income acts as a constraint in the attempt for maximizing utility.
Critique of the indifference-curves approach:
The indifference-curves analysis has been a major advance in the field of consumer’s
demand. The assumptions of this theory are less stringent than for the cardinal utility
approach. Only ordinarily of preferences is required, and the assumption of constant utility of
money has been dropped.
The methodology of indifference curves has provided a framework for the measure-
ment of the ‘consumer’s surplus’, which is important in welfare economics and in designing
government policy.
8. What are the various determinants of demand? (APRIL 2017)
Determinants of Demand
1. Income: A rise in a person’s income will lead to an increase in demand (shift demand
curve to the right), a fall will lead to a decrease in demand for normal goods. Goods whose
demand varies inversely with income are called inferior goods (e.g. Hamburger Helper).
2. Consumer Preferences: Favourable change leads to an increase in demand, unfavorable
change lead to a decrease.
3. Number of Buyers: the more buyers lead to an increase in demand; fewer buyers lead to
decrease.
4. Price of related goods:
a. Substitute goods (those that can be used to replace each other): price of substitute and
demand for the other good are directly related. Example: If the price of coffee rises, the
demand for tea should increase.
b. Complement goods (those that can be used together): price of complement and demand
for the other good are inversely related. Example: if the price of ice cream rises, the demand
for ice-cream toppings will decrease.
5. Expectation of future:
a. Future price: consumers’ current demand will increase if they expect higher future prices;
their demand will decrease if they expect lower future prices.
b. Future income: consumers’ current demand will increase if they expect higher future
income; their demand will decrease if they expect lower future income.
9. Describe the importance of Indifference curve with diagram. (NOV 2012)
1. In the theory of production:
The basic aim of a producer is to attain a low cost combination. Indifference curves are useful
in the realization of this objective. When we use these curves in the theory of production,
they are called iso-product curves. Producer’s equilibrium i.e. low cost combination is
obtained at the point where producer’s budget line becomes tangent to one of the iso-product
curves on the map.
2. In the theory of Exchange:
Prof. Edge worth used the technique of indifference curves to show the mutual gains from the
exchange of two goods between two consumers. Exchange makes it possible for both the
consumers to reach a higher level of satisfaction. The process of shifting to the higher level of
satisfaction is explained with the help of ‘contract curves.’
3. In the field of Rationing:
This technique can also be made use of in the field of rationing. Ordinarily two commodities
are rationed out to different individuals, irrespective of their preferences. But if their
respective preferences are considered and the amounts of the two commodities be distributed
among consumers in accordance with their scale of preferences, each of them shall be in a
position to search a higher indifference curve and satisfaction.
4. In the measurement of consumer’s surplus:
Indifference curve technique has rehabilitated the old Marshallian concept of consumer’s
surplus that has lain buried almost for decades under the weight of unrealistic and illusory
assumptions. Consumer’s surplus can be measured with the help of this technique without
any need for making unrealistic assumptions.
5. In the field of taxation:
The technique is also applied to test preference between a direct and indirect tax. With the
help of indifference curves it can be shown that a direct tax is preferable to an indirect tax as
regards its effects on consumption and satisfaction of the tax payer. In view of the above
application of the technique, it may be asserted that it forms an integral part of the modern
welfare economics. However, there are certain writers who also assert that the indifference
curves technique is merely ‘the old wine in a new bottle’ for example, Prof. Robertson is of
the view that this analysis has substituted new concepts and equations in place of the old
ones.

10. Explain the time impact on elasticity. (NOV 2013)

The time period allowed following a price change – demand is more price elastic, the
longer that consumers have to respond to a price change. They have more time to search for
cheaper substitutes and switch their spending.
Price elasticity of demand is always related to a period of time. It can be a day, a week, a
month, a year or a period of several years. Elasticity of demand varies directly with the time
period. Demand is generally inelastic in the short period.

It happens because consumers find it difficult to change their habits, in the short period, in
order to respond to a change in the price of the given commodity. However, demand is more
elastic in long rim as it is comparatively easier to shift to other substitutes, if the price of the
given commodity rises.

11. How do you relate income elasticity of demand and business decisions? .(NOV
2013)
To know about stage of trade cycle
We have already known that demand of normal goods is directly proportional to the income
of consumers while demand of inferior goods is inversely proportional to the income of
consumers.
Demand for normal goods increases during prosperity and decreases during regression.
Conversely, demand for inferior goods increases during regression and decreases during
prosperity. However, demands for goods that are necessary in our day to day lives are not
much affected during prosperity as well as during regression.
Figure: Trade cycle

For forecasting demand

Income elasticity of demand can be used for predicting future demand of any goods and
services in case when manufacturers have knowledge of probable future income of the
consumers.
To determine price
Having knowledge of income elasticity of any product is essential in order to correctly price
them. Demand of income elastic goods or goods with positive income elasticity tends to fall
with fall in income of the demanding consumers. Thus, a reduction in price of the commodity
may help in increasing the demand and compensate the for the reduction in price by
generating more sales and revenue.
12. Bring out the features of a good forecasting method. (NOV 2014)
1. Plausibility
The management should have good understanding of the technique chose and they should
have confidence in the technique adopted. Then only proper interpretation will be made.
According to Joel Dean, the plausibility requirements can often increase the accuracy of the
result. Accuracy entails the executives to accept the results. Experienced executives will have
a market feel and they can contribute effectively.
2. Simplicity
The method chosen should be of simple nature or ease of comprehension by the executives.
Elaborate mathematical and econometric procedures are less desirable, if the management
does not really understand what the forecaster is doing.
3. Economy
Cost is a primary consideration which should be weighed against the importance of the
forecasts to the business operation. There is no point in adopting very high levels of accuracy
at great expense, if the forecast has little importance in the business.
4. Availability
Immediate availability of data is a vital requirement in forecasting method. The technique
should yield quick and meaningful result. Delay in result will adversely affect the managerial
decision. To conclude, the ideal forecasting method is the one which yields good returns and
costs in accuracy meets new circumstances with flexibility.
13. Write a note on : (NOV 15)
(a) Derived demand
Derived demand is demand that comes from (is derived) from the demand for
something else. Thus, the demand for machinery is derived from the demand for consumer
goods that the machinery can make. If there is low demand for consumer goods, there is low
demand for the machinery that can make them. Demand for bricks is derived from spending
on new construction projects.
The demand for a good that arises because of the demand for some other good is
called derived demand. For instance, demand for land, fertilizer and agricultural tools and
implements are derived demand, since the demand of goods, depends on the demand of food.
Similarly, demand for steel, bricks, cement etc., is a derived demand because it is derived
from the demand for houses and other kind of buildings.
(b) Autonomous demand.
An Autonomous demand for a product is one that arises independently of the demand
for any other good whereas a derived demand is one, which is derived from demand of some
other good. To look more closely at the distinction between the two kinds of demand,
consider the demand for commodities, which arise directly from the biological or physical
needs of the human beings, such as demand for food, clothes and shelter. The demand for
these goods is autonomous demand. Autonomous demand also arises as a’ result of
demonstration effect, rise in income, and increase in population and advertisement of new
products.
13. Write a note on demand estimation. (NOV 15)
The basic techniques of estimating demand functions and forecasting future sales and
prices. Estimation of demand functions is most often accomplished using the technique of
regression analysis. Two specifications for demand, linear and log-linear. When demand is
specified to be linear in form, the coefficients on each of the explanatory variables measure
the rate of change in quantity demanded as that explanatory variable changes, holding all
other explanatory variables constant. In linear form, the empirical demand specification is
Q = a + bP + cM + dPR
where Q is the quantity demanded, P is the price of the good or service, M is consumer
income, and PR is the price of some related good R. The estimated demand elasticities are
computed as
As in any regression analysis, the statistical significance of the parameter estimates can be
assessed by performing t-tests or examining p-values.
When demand is specified as log-linear, the demand function is written as
Q = aPbMcPdR
In order to estimate the log-linear demand function, it is converted to natural logarithms:
ln Q = ln a + b ln P + c ln M + d ln PR
In log-linear form, the elasticities of demand are constant, and the estimated elasticities are

The method of estimating the parameters of an empirical demand function depends on

whether the price of the product is market-determined or manager-determined.
When estimating industry demand for price-taking firms, complications arise because
of the problem of simultaneity. The simultaneity problem refers to the fact that the observed
variation in equilibrium output and price is the result of changes in the determinants of both
demand and supply. Because output and price are determined jointly by the forces of supply
and demand, two econometric problems arise when a researcher tries to estimate the
coefficients of industry demand: the identification problem and the simultaneous equations
bias problem.
The identification problem involves determining whether it is possible to trace out the
true demand curve from the sample data. Industry demand is identified when supply includes
at least one exogenous variable that is not also in the demand equation. The problem of
simultaneous equations bias arises when price is an endogenous variable, as it is when price
is market-determined for price-taking firms. In order for the standard or ordinary least-
squares (OLS) regression procedure to yield unbiased parameter estimates, all explanatory
variables must be uncorrelated with the random error term in the demand equation. An
endogenous variable is always correlated with the error term in both the demand and supply
equations. (This can be verified by examining the reduced form equation for Q, which shows
how Q is related to all the exogenous variables and error terms in the system.) Because price
is an explanatory variable in the demand equation, and an endogenous variable in the case of
price-taking firms, a simultaneous equations bias will result when the OLS procedure is used
to estimate demand. The simultaneous equations bias is eliminated by estimating the
parameters of the industry demand equation using 2SLS.
When estimating the demand curve facing a price-setting firm—a firm that can
control or set the price of its product by varying its own level of production—the problem of
simultaneity does not arise. The demand curve for price-setting firms is estimated using the
ordinary least-squares (OLS) method of estimation.
Statistical forecasting models can be subdivided into two categories: time-series
models and econometric models. Time-series forecasts use the time-ordered sequence of
historical observations on a variable to develop a model for predicting future values of that
variable. Time-series models specify a mathematical model representing the generating
process, then use statistical techniques to fit the historical data to the mathematical model.
The simplest time-series forecast is a linear trend forecast where the generating process is
assumed to be the linear model Qt = a + bt. Using time-series data on Q, regression analysis
is used to estimate the trend line that best fits the data. If b is greater (less) than 0, sales are
increasing (decreasing) over time. If b equals 0, sales are constant over time.
When data exhibit cyclical variation, such as seasonal patterns, dummy variables can
be added to the time-series model to account for the seasonality. If there are N seasonal time
periods to be accounted for, N − 1 dummy variables are added to the demand equation. Each
dummy variable accounts for one of the seasonal time periods. The dummy variable takes a
value of 1 for those observations that occur during the season assigned to that dummy
variable and a value of 0 otherwise. This type of dummy variable allows the intercept of the
demand equation to take on different values for each season—the demand curve can shift up
and down from season to season.
In contrast to time-series models, econometric models use an explicit structural model
to explain the underlying economic relations. Econometric forecasting can be employed to
forecast future industry price and sales or to forecast future demand for price-setting firms.
The three steps for forecasting industry price and sales are
1. Estimate the industry demand and supply equations.
2. Locate industry demand and supply in the forecast period.
3. Calculate the intersection of future demand and supply.
Process by forecasting future copper price and consumption. The three steps for forecasting
the future demand for a price-setting firm are
1. Estimate the firm's demand function.
2. Forecast the future values of the demand-shifting variables.
3. Calculate the location of future demand.
Process by forecasting the future demand facing a pizza restaurant.
14. Discuss the importance of indifference curve with diagram. (NOV 16)

1. In the theory of production:

The basic aim of a producer is to attain a low cost combination. Indifference curves are useful
in the realization of this objective.
When we use these curves in the theory of production, they are called iso-product curves.
Producer’s equilibrium i.e. low cost combination is obtained at the point where producer’s
budget line becomes tangent to one of the iso-product curves on the map.
2. In the theory of Exchange:
Prof. Edge worth used the technique of indifference curves to show the mutual gains from the
exchange of two goods between two consumers.
Exchange makes it possible for both the consumers to reach a higher level of satisfaction. The
process of shifting to the higher level of satisfaction is explained with the help of ‘contract
curves.’
3. In the field of Rationing:
This technique can also be made use of in the field of rationing Ordinarily two commodities
are rationed out to different individuals, irrespective of their preferences.
But if their respective preferences are considered and the amounts of the two commodities be
distributed among consumers in accordance with their scale of preferences, each of them
shall be in a position to search a higher indifference curve and satisfaction.
4. In the measurement of consumer’s surplus:
Indifference curve technique has rehabilitated the old Marshallian concept of consumer’s
surplus that has lain buried almost for decades under the weight of unrealistic and illusory
assumptions.
Consumer’s surplus can be measured with the help of this technique without any need for
making unralistic assumptions.
4. In the field of taxation:
The technique is also applied to test preference between a direct and indirect tax. With the
help of indifference curves it can be shown that a direct tax is preferable to an indirect tax as
regards its effects on consumption and satisfaction of the tax payer.
In view of the above application of the technique, it may be asserted that it forms an integral
part of the modern welfare economics.
However, there are certain writers who also assert that the indifference curves technique is
merely ‘the old wine in a new bottle’ for example, Prof. Robertson is of the view that this
analysis has substituted new concepts and equations in place of the old ones.