DEMAND FORECASTING METHODS

There is no particular method that enables organizations to anticipate risks and uncertainties in future.
Generally, there are two approaches to demand forecasting.

The first approach involves forecasting demand by collecting information regarding the buying behavior
of consumers from experts or through conducting surveys. On the other hand, the second method is to
forecast demand by using the past data through statistical techniques.

Thus, we can say that the techniques of demand forecasting are divided into survey methods and
statistical methods. The survey method is generally for short-term forecasting, whereas statistical methods
are used to forecast demand in the long run.

Survey Method:
Survey method is one of the most common and direct methods of forecasting demand in the short term.
This method encompasses the future purchase plans of consumers and their intentions. In this method, an
organization conducts surveys with consumers to determine the demand for their existing products and
services and anticipate the future demand accordingly.

i. Experts’ Opinion Poll:

Refers to a method in which experts are requested to provide their opinion about the product. Generally,
in an organization, sales representatives act as experts who can assess the demand for the product in
different areas, regions, or cities.

Sales representatives are in close touch with consumers; therefore, they are well aware of the consumers’
future purchase plans, their reactions to market change, and their perceptions for other competing
products. They provide an approximate estimate of the demand for the organization’s products. This
method is quite simple and less expensive.

ii. Delphi Method:

It refers to a group decision-making technique of forecasting demand. In this method, questions are
individually asked from a group of experts to obtain their opinions on demand for products in future.
These questions are repeatedly asked until a consensus is obtained.

In addition, in this method, each expert is provided information regarding the estimates made by other
experts in the group, so that he/she can revise his/her estimates with respect to others’ estimates. In this
way, the forecasts are cross checked among experts to reach more accurate decision making.

Ever expert is allowed to react or provide suggestions on others’ estimates. However, the names of
experts are kept anonymous while exchanging estimates among experts to facilitate fair judgment and
reduce halo effect.

The main advantage of this method is that it is time and cost effective as a number of experts are
approached in a short time without spending on other resources. However, this method may lead to
subjective decision making.

iii. Market Experiment Method:

It involves collecting necessary information regarding the current and future demand for a product. This
method carries out the studies and experiments on consumer behavior under actual market conditions. In
this method, some areas of markets are selected with similar features, such as population, income levels,
cultural background, and tastes of consumers.

The market experiments are carried out with the help of changing prices and expenditure, so that the
resultant changes in the demand are recorded. These results help in forecasting future demand.

There are various limitations of this method, which are as follows:

a. Refers to an expensive method; therefore, it may not be affordable by small-scale organizations

b. Affects the results of experiments due to various social-economic conditions, such as strikes, political
instability, natural calamities

Statistical Methods:
Statistical methods are complex set of methods of demand forecasting. These methods are used to
forecast demand in the long term. In this method, demand is forecasted on the basis of historical data and
cross-sectional data.

Historical data refers to the past data obtained from various sources, such as previous years’ balance
sheets and market survey reports. On the other hand, cross-sectional data is collected by conducting
interviews with individuals and performing market surveys. Unlike survey methods, statistical methods
are cost effective and reliable as the element of subjectivity is minimum in these methods.

Trend Projection Method:

Trend projection or least square method is the classical method of business forecasting. In this method, a
large amount of reliable data is required for forecasting demand. In addition, this method assumes that the
factors, such as sales and demand, responsible for past trends would remain the same in future.

In this method, sales forecasts are made through analysis of past data taken from previous year’s books of
accounts. In case of new organizations, sales data is taken from organizations already existing in the same
industry. This method uses time-series data on sales for forecasting the demand of a product.

iii. Box-Jenkins Method:

It refers to a method that is used only for short-term predictions. This method forecasts demand only with
stationary time-series data that does not reveal the long-term trend. It is used in those situations where
time series data depicts monthly or seasonal variations with some degrees of regularity. For instance, this
method can be used for estimating the sales forecasts of woolen clothes during the winter season.

Barometric Method:
In barometric method, demand is predicted on the basis of past events or key variables occurring in the
present. This method is also used to predict various economic indicators, such as saving, investment, and
income. This method was introduced by Harvard Economic Service in 1920 and further revised by
National Bureau of Economic Research (NBER) in 1930s.

This technique helps in determining the general trend of business activities. For example, suppose
government allots land to the XYZ society for constructing buildings. This indicates that there would be
high demand for cement, bricks, and steel.
The main advantage of this method is that it is applicable even in the absence of past data. However, this
method is not applicable in case of new products. In addition, it loses its applicability when there is no
time lag between economic indicator and demand.

Econometric Methods:
Econometric methods combine statistical tools with economic theories for forecasting. The forecasts
made by this method are very reliable than any other method. An econometric model consists of two
types of methods namely, regression model and simultaneous equations model.

These two types of methods are explained as follows:

Regression Methods:
Refer to the most popular method of demand forecasting. In regression method, the demand function for a
product is estimated where demand is dependent variable and variables that determine the demand are
independent variable.

Simultaneous Equations:
Involve several simultaneous equations.

There are two types of variables that are included in this model, which are as follows:
i. Endogenous Variables:
Refer to inputs that are determined within the model. These are controlled variables.

ii. Exogenous Variables:

Refer to inputs of the model. Examples are time, government spending, and weather conditions. These
variables are determined outside the model.

For developing a complete model, endogenous and exogenous variables are determined first. After that,
necessary data on both exogenous and endogenous variables are collected. Sometimes, data is not
available in required form, thus, it needs to be adjusted into the model.

After the development of necessary data, the model is estimated through some appropriate method.
Finally, the model is solved for each endogenous variable in terms of exogenous variable. The prediction
is finally made.

iii. Index Number:

Refers to the measures used to study the fluctuations in a variable or group of related variables with
respect to time period/base period. They are most commonly used in economics and financial research to
study various factors, such as price and quantity of a product. The factors that are responsible for the
problem are identified and calculated.

If only one variable affects the demand, then it is called single variable demand function. Thus, simple
regression techniques are used. If demand is affected by many variables, then it is called multi-variable
demand function. Therefore, in such a case, multiple regression is used.

INDIFFERENCE CURVE ANALYSIS

The concept of indifference curve analysis was first propounded by British economist Francis Ysidro
Edgeworth and was put into use by Italian economist Vilfredo Pareto during the early 20 th century

Indifference curve
An indifference curve is a locus of all combinations of two goods which yield the same level of
satisfaction (utility) to the consumers.

Since any combination of the two goods on an indifference curve gives equal level of satisfaction, the
consumer is indifferent to any combination he consumes. Thus, an indifference curve is also known as
‘equal satisfaction curve’ or ‘iso-utility curve’.

On a graph, an indifference curve is a link between the combinations of quantities which the consumer
regards to yield equal utility. Simply, an indifference curve is a graphical representation of indifference
schedule.

The table given below is an example of indifference schedule and the graph that follows is the
illustration of that schedule.

Table: Indifference schedule

Combination Mangoes Oranges

A 1 14

B 2 9

C 3 6

D 4 4

E 5 2.5

Figure: Graphical representation of indifference curve

Assumptions of indifference curve
The indifference curve theory is based on few assumptions. These assumptions are

Two commodities
It is assumed that the consumer has fixed amount of money, all of which is to be spent only on two goods.
It is also assumed that prices of both the commodities are constant.

Non satiety
Satiety means saturation. And, indifference curve theory assumes that the consumer has not reached the
point of satiety. It implies that the consumer still has the willingness to consume more of both the goods.
The consumer always tends to move to a higher indifference curve seeking for higher satisfaction.

Ordinal utility
According to this theory, utility is a psychological phenomenon and thus it is unquantifiable. However,
the theory assumes that a consumer can express utility in terms of rank. Consumer can rank his/her
preferences on the basis of satisfaction yielded from each combination of goods.

Diminishing marginal rate of substitution

Marginal rate of substitution may be defined as the amount of a commodity that a consumer is willing to
trade off for another commodity, as long as the second commodity provides same level of utility as the
first one.

And, diminishing marginal rate of substitution states that the rate by which a person substitutes X for Y
diminishes more and more with each successive substitution of X for Y.

As indifference curve theory is based on the concept of diminishing marginal rate of substitution, an

indifference curve is convex to the origin.
Rational consumers
According to this theory, a consumer always behaves in a rational manner, i.e. a consumer always aims to
maximize his total satisfaction or total utility.

Properties of indifference curve

There are four basic properties of an indifference curve. These properties are

Indifference curve slope downwards to right

An indifference curve can neither be horizontal line nor an upward sloping curve. This is an important
feature of an indifference curve.

When a consumer wants to have more of a commodity, he/she will have to give up some of the other
commodity, given that the consumer remains on the same level of utility at constant income. As a result,
the indifference curve slopes downward from left to right.

In the above diagram, IC is an indifference curve, and A and B are two points which represent
combination of goods yielding same level of satisfaction.

We can see that when X1 amount of commodity X was consumed, Y1 amount of commodity Y was also
consumed. When the consumer increased the consumption of commodity X to X2, the amount of
commodity Y fell to Y2. And, thus the curve is sloping downward from left to right.

Indifference curve is convex to the origin

As mentioned previously, the concept of indifference curve is based on the properties of diminishing
marginal rate of substitution.
According to diminishing marginal rate of substitution, the rate of substitution of commodity X for Y
decreases more and more with each successive substitution of X for Y.

Also, two goods can never perfectly substitute each other. Therefore, the rate of decrease in a
commodity cannot be equal to the rate of increase in another commodity.

Table: Indifference schedule

Combination Cigarette Coffee

A 1 12

B 2 8

C 3 5

D 4 3

E 5 2

The above table represents various combination of coffee and cigarette that gives a man same level of
utility. When the man drinks 12 cup of coffee, he consumes 1 cigarette every day. When he started
consuming two cigarettes a day, his coffee consumption dropped to 8 cups a day. In the same way, we
can see other combinations as 3 cigarettes + 5 cup coffee, 4 cigarettes + 3 cup coffee and 5 cigarettes + 2
cup coffee.
We can clearly see that the rate of decrease in consumption of coffee is not the same as rate of increase in
consumption of cigarette. Similarly, rate of decrease in consumption of coffee has gradually decreased
even with constant increase in consumption of cigarette.

Thus, indifference curve is always convex (neither concave nor straight).

Indifference curve cannot intersect each other

Each indifference curve is a representation of particular level of satisfaction.

The level of satisfaction of consumer for any given combination of two commodities is same for a
consumer throughout the curve. Thus, indifference curves cannot intersect each other.

The following diagram will help you understand this property clearer.

In the above image, IC1 and IC2 are two indifference curves and C is the point where both the curves
intersect.

According to indifference curve theory, satisfaction at point C = satisfaction at point A

Also, satisfaction at point C = satisfaction at point B
But, satisfaction at point B ≠ satisfaction at point A.

Therefore, two indifference curves cannot intersect. Yet, two indifference curves need not be parallel to
each other.

Higher indifference curve represents higher level of satisfaction

Higher the indifference curves, higher will be the level of satisfaction. This means, any combination of
two goods on the higher curve give higher level of satisfaction to the consumer than the combination of
goods on the lower curve.
In the above figure, IC1 and IC2 are two indifference curves, and IC2 is higher than IC1. We can also see
that Q is a point on IC2 and S is a point on IC2.

Combination at point Q contains more of both the goods (X and Y) than that of the combination at point
S. We know that total utility of commodity tends to increase with increase in stock of the commodity.
Thus, utility at point Q is greater than utility at point S, i.e. satisfaction yielded from higher curve is
greater than satisfaction yielded from lower curve.