Chapter 5:

Demand Estimation and

Forecasting

Demand Estimation
and Forecasting
Regression Analysis
Problems in Use of Regression
Analysis
Subjects of Forecasts
Prerequisites of a Good Forecast
Forecasting Techniques

Data Collection
Data for studies pertaining to
countries, regions, or industries are
readily available and reliable.
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,

Regression Analysis
Regression Analysis: A procedure
commonly used by economists to
estimate consumer demand with
available data.
Cross-Sectional Data: provide
information on variables for a given
period of time.
Time Series Data: give information
about variables over a number of
periods of time.

Regression Analysis
Regression equation: linear, additive
Y = a + b1X1 + b2X2 + b3X3 + b4X4
Y: dependent variable, amount to be
determined
a: constant value, y-intercept
Xn: independent, explanatory variables,
used to explain the variation in the
dependent variable
bn: regression coefficients (measure
impact of independent variables)

Regression Analysis
Regression Results
Negative coefficient shows that as the
independent variable (Xn) changes, the
quantity demanded changes in the
opposite direction.
Positive coefficient shows that as the
independent variable (Xn) changes, the
quantity demanded changes in the
same direction.
Magnitude of regression coefficients is
measured by elasticity of each variable.

Regression Analysis
Statistical evaluation of regression
results

t-test: test of statistical significance of

each estimated regression bcoefficient
t
SE b
b: estimated coefficient
SEb: standard error of the estimated
coefficient
Rule of 2: if absolute value of t is greater
than 2, estimated coefficient is
significant at the 5% level

Regression Analysis
Statistical evaluation of regression
results
Coefficient of determination (R2):
percentage of variation in the
dependent variable (Y) accounted for by
variation in all explanatory variables (Xn)
Value ranges from 0.0 to 1.0
Closer to 1.0, the greater the explanatory
power of the regression equation

F-test: measures statistical significance

of the entire regression as a whole (not

Regression Results
Steps for analyzing regression results
Check signs and magnitudes
Compute elasticity coefficients
Determine statistical significance

Subjects of Forecasts
Gross Domestic Product (GDP)
Components of GDP
E.g. consumption expenditure, producer
durable equipment expenditure,
residential construction

Industry Forecasts
Sales of products across an industry

Sales of a specific product

Prerequisites of a Good
Forecast
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

Forecasting Techniques
Factors in choosing the right
forecasting technique:
Item to be forecast
Interaction of the situation with the
characteristics of available forecasting
methods
Amount of historical data available
Time allowed to prepare forecast

Forecasting Techniques

Expert opinion
Opinion polls and market research
Surveys of spending plans
Economic indicators
Projections
Econometric models

Forecasting Techniques
Qualitative forecasting is based on
judgments of individuals or groups.
Quantitative forecasting utilizes
significant amounts of prior data as a
basis for prediction.
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.

Forecasting Techniques
Expert opinion techniques
Jury of executive opinion: Forecasts
generated by a group of corporate executives
assembled together. The major drawback is
that persons with strong personalities may
exercise disproportionate influence.
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.

Forecasting Techniques
Opinion polls: Sample populations are
surveyed to determine consumption
trends.
choice of sample is important
questions must be simple and clear

Market research is closely related to

opinion polling.
Market research 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, and what characteristics the
consumer thinks are most important in the
purchasing decision.

Forecasting Techniques
Surveys of spending plans: seek
information about macro-type data
relating to the economy.
Consumer intentions
Survey of Consumers, Survey Research
Center, University of Michigan
Consumer Confidence Survey, The
Conference Board

Inventories and sales expectations

Forecasting Techniques
Economic Indicators: A barometric
method of forecasting designed to
alert business to changes in
economic conditions.
Leading, coincident, and lagging
indicators
One indicator may not be very reliable,
but a composite of leading indicators
may be used for prediction.

Forecasting Techniques
Leading Indicators predict changes in 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
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

Forecasting Techniques
Coincident Indicators identify peaks and troughs
in economic activity

Employees on nonagricultural payrolls

Personal income less transfer payments
Industrial production
Manufacturing and trade sales

Lagging Indicators confirm upturns and

downturns in economic activity

Average duration of unemployment, weeks

Ratio, manufacturing and trade inventories to sales
Change in labor cost per unit of output, manufacturing
(%)
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

Forecasting Techniques
General rule of thumb: if, after a
period of increases, the leading
indicator index sustains three
consecutive declines, a recession (or
a slowing) will follow.
Economic indicators have predicted
each recession since 1948.

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.

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

Forecasting Techniques
Compound growth rate:
Forecasting by projecting the
average growth rate of the past into
the future.
Calculate the constant growth rate using
available data, then project this
constant growth rate into the future.
Provides a relatively simple and timely
forecast
Appropriate when the variable to be
predicted increases at a constant

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

Forecasting Techniques
Visual Time Series Projections:
plotting observations on a graph and
viewing the shape of the data and
any trends.

Forecasting Techniques
Time series analysis: A nave method
of forecasting from past data by
using least squares statistical
methods.
Data collected of a number of
periods usually exhibit certain
characteristics:
Trends
Cyclical fluctuations
Seasonal fluctuations
Irregular movements

Forecasting Techniques

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
Additive form: Yt = Tt + Ct + St + Rt
Multiplicative form: Yt = (Tt)(Ct)(St)
(Rt)

Forecasting Techniques
Must decompose the time series into
its four components
Remove seasonality
Compute trend
Isolate cycle
Cannot do anything with random
component

Forecasting Techniques
Seasonality: need to identify and
remove seasonal factors, using
moving averages to isolate those
factors.
Remove seasonality by dividing data
by seasonal factor

Forecasting Techniques
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

Forecasting Techniques
Cycle and Random Elements
Random factors cannot be predicted and
should be ignored
Isolate cycle by smoothing with a
moving average

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

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

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

Forecasting Techniques
Econometric Models: causal or
explanatory models of forecasting
Regression analysis
Multiple equation systems
Endogenous variables: comparable to
dependent variables of single-equation
model, but may influence other endogenous
variables
Exogenous variables: from outside the
system, truly independent variables