Lecture Note

Managerial Economics (UM20MB503)

Unit 3
Topic: Demand Forecasting

Hello Everyone!

In our last session, we have discussed the mechanism in a free market for the
price to change until the quantity supplied and the quantity demanded are equal.
We have also discussed the scenario where the surplus and shortage exists in the
market. Finally, discussed a case study to understand the effect of the September
11, 2001, terrorist attack on the World Trade Centre, on the supply and demand
for New York City office space.

In this session, we will start UNIT III on demand forecasting.

Demand Forecasting:1

We understand that the firm needs to plan for the right volume of output,
appropriate price for its products, and also the future expansion of its business;
and all this in the backdrop of uncertainty. Forecasting is a method which helps in
reducing the uncertainty factor by planning the future systematically and
diligently. The ability to forecast demand accurately helps a firm to determine
optimum level of output, which in turn will determine the future cost and
production functions and successfully control its inventory. Moreover, such
knowledge acts as a vital tool in the hands of the finance managers and the
marketing team of a firm to decide on how much to invest in existing line of
products, which markets of goods or services to enter in the future etc.

We begin this unit by exploring the concepts of demand forecasting; thereafter

we would discuss an entire range of approaches of demand forecasting, including
survey methods, statistical tools and move advanced econometric techniques,
citing their merits and demerits.

Meaning of Demand Forecasting

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Extracted from Geetika et al (2018).

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Forecasting is essential in operations research techniques of planning and
decision making; it refers to making prediction of any future event. We can thus
define demand forecasting as the scientific and analytical estimation of demand
for a product (good or service) for a particular period of time. It is the process of
determining how much of which product is needed when and where. It involves
estimation of the level of demand; extent and magnitude of demand;
responsiveness of demand (elasticity) to a proposed change in price, income of
consumer, price of other goods (complements or substitutes) and other
determinants.

Categorization of Demand Forecasting

Demand forecasting can be categorized on basis of: i) the level of forecasting, i.e.,
firm, industry, economy; ii) time period, i.e., short run and long run; iii) nature of
goods, i.e., capital and consumer goods.

Categorization by level of forecasting

Firm (Micro) level: This refers to the forecasting of demand for its product by an
individual firm. It is the most important category of forecasting from the
manager’s viewpoint to take various important decisions related to production
and marketing.

Industry level: This is forecasting of demand for a product in an industry as a

whole. It provides insight into the growth pattern of the industry and is also
helpful in identifying the life cycle stage of the product. Industry level forecasting
provides an insight into the relative contribution of the industry in national
income.

Economy (Macro) level: This refers to forecasting of aggregate demand (output) in

the economy as a whole. This helps in various policy formulations at government
level.

Categorization by Time Period

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Short-term forecasting: This refers to demand forecasting for a period not
exceeding a year. In the short run, the manager has to select different levels of
variable input to combine with the fixed input, in order to optimize the level of
production. The main focus of such forecasting is on the short-term production
decisions of any firm to avoid over production or under production. It helps in
taking decision regarding inventory, cost on variable factors, sales target and
appropriate pricing.

Long-term forecasting: This refers to long-term decisions such as capacity

expansion (reduction), new plant, new product, wider product range etc. It may
have a time horizon of 5 to 7 years and may extend up to 10 to 20 years. Long-
term forecasting helps in manpower planning, long-term capital requirement, and
investment decisions. At a macro level, in determines interdependence of
industries.

Categorization by Nature of Goods

Consumer Goods: Demand forecasting is indispensable for consumer goods. For

durable consumer goods, demand forecasting can be for new demand or
replacement demand, for which long term demand forecasting may be more
useful. For non-durable goods, demand would vary with income level, social
status, gender, age, education and occupation of the consumers, and price of
product.

Capital Goods: This refers to the demand for further production thus, they have
derived demand. This in turn implies that demand for such goods depends upon
demand for consumer goods which they can produce. This category of demand
forecasting is highly complex but very important for long-term growth.

Techniques of Demand Forecasting

There is a wide variety of techniques of forecast demand and it is very important

that the most suitable technique is selected. Therefore, an understanding of all
the popular techniques is necessary. For the sake of convenience, we have
categorized various techniques under two broad heads: i) subjective, and ii)
quantitative.

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Subjective methods of demand forecasting

Consumer’s opinion survey: In consumer opinion survey, buyers are asked about
their future buying intentions of products.

Salesforce composite method: Salespersons are in direct contact with the

customers and hence, are in a better position to forecast demand for any
product.

Experts opinion method: This method of forecasting demand is essentially based

on the opinion of experts, either internal or external to the firm.

Market simulation: It is like laboratory testing of consumer behavior. Firms may

create an “artificial market”, in which the consumers are instructed to shop with
some money.

Test marketing: In test marketing the product is actually sold in certain segments
of the market, regarded as “test market”.

Quantitative methods of demand forecasting

The basic limitation of subjective methods is the element of bias, time and cost of
collecting information and uncertainty of accuracy. Therefore, these methods
should be used only when past data is not available, as in the case of new
products, new price, and new market. However, when past data is available it is
advisable that firms use statistical tools, as they are more scientific and cost
effective.

Trend projection: Trend is a general pattern of change in the long run.

Smoothing techniques: Most of the series do not show a continuous trend, some
increase and decreases in values can be seen in any time series. To take care of
these seasonal or random variations efforts are made to smooth the series.

Barometric techniques: The barometric technique of forecasting indicates or

alerts businesses to change in the overall economic conditions, rather than for a
specific industry or firm. Although such series are available only for macro

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indicators yet on the basis of such alerts, a firm can modify forecasts for the
demand for its commodity.

Econometric methods: An econometric model consists of a system of

simultaneous equations or may be a single equation estimated from past data,
that is used to forecast economic and business variables. Econometric models are
considered to be more reliable in forecasting demand than many other methods
discussed so far. As such econometric tools like multiple regression techniques
and multiple equation models are being increasingly used by firms in demand
forecasting.

Choice of a Specific Forecasting Techniques

Choice of a forecasting technique depends on objectives, costs, time, nature of

data, and complexity of the technique.

1) Imminent objective of forecast, whether it is for a new product, or to gauge

impact of a new advertisement, etc.
2) Cost involved, i.e., cost of forecasting should not be more than its benefit,
here opportunity cost of resources will also be important.
3) Time perspective, i.e., whether the forecast is meant for the short run or
the long run.
4) Complexity of the technique, vis-à-vis availability of expertise; this would
determine whether the firm would look for experts “in house” or outsource
it.
5) Nature and quality of available data, i.e., does the time series show a clear
trend or is it highly unstable.

To summarize, we have understood the concept of demand forecasting,

particularly the meaning of demand forecasting, different categories of demand
forecasting by level of forecasting, time period, and nature goods. Thereafter, we
have discussed variety of subjective and quantitative techniques available for
demand forecasting. Subjective techniques like – consumer opinion survey,
salesforce composite method, expert’s opinion method, market simulation, test
marketing etc. and the quantitative techniques like - trend projection, smoothing
techniques, barometric techniques, econometric methods etc. Finally, we have
discussed the factors related with the choice of forecasting technique.

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If you have any queries regarding the concepts discussed in today’s session,
please raise your question on PESU Forum. You can also drop me a mail to the
email id [email protected].

A small assignment and five multiple-choice questions related to today's’

discussion have been uploaded on the PESU platform. You are requested to
practice that before the next session.

Keep learning keep practicing.

Thank you.