UNIT I

DEMAND ANALYSIS
Meaning of Demand
• Demand for commodity implies ;
• Desire to acquire it
• Willingness to pay for it
• Ability to pay for it

Demand = Desire + Ability to Pay + Willingness to Pay

• Demand for a particular commodity refers to the commodity which an

individual consumer or household is willing to purchase per unit of time
at a particular price.
Types of Demand

Individual and Market demand

• The quantity of a commodity an individual is willing and able to purchase at a
particular price, during a specific time period, given his/her money income,
his/her taste, and prices of other commodities, such as substitutes and
complements, is referred to as the individual demand for the commodity.

• The total quantity which all the consumers of the commodity are willing and
able to purchase at a given price per time unit, given their money incomes,
their tastes, and prices of other commodities, is referred to as the market
demand for the commodity.
Demand for firm’s and industry product

• The quantity of a firm’s product that can be sold at a given price over
time is known as the demand for the firm’s product.
• The sum of demand for the products of all firms in the industry is
referred to as the market demand or industry demand for the
product.
Autonomous and Derived demand

• An autonomous demand or direct demand for a commodity is one

that arises on its own out of a natural desire to consume or possess a
commodity. This type of demand is independent of the demand for
other commodities.

• The demand for a commodity which arises from the demand for other
commodities, called ‘parent products’ is called derived demand.
Demand for land, fertilizers and agricultural tools, is a derived demand
because these commodities are demanded due to demand for food.
Demand for durable and non-durable goods

• Durable goods are those goods for which the total utility or usefulness
is not exhaustible in the short-run use. Such goods can be used
repeatedly over a period of time.

• The demand for non-durable goods depends largely on their current

prices, consumers’ income, and fashion. It is also subject to frequent
changes.
Short-term and long-term demand

• Short-term demand refers to the demand for goods over a short

period.

• The long-term demand refers to the demand which exists over a long
period of time
Law of Demand

• Law of demand expresses the relationship between the Quantity demanded and
the Price of the commodity.
• The law of demands states that, “Ceteris Paribus, (other things remaining
constant) the lower the price of a commodity the larger the quantity demanded of
it and vice versa.”
• In simple terms other things remain constant, if the price of the commodity
increases, the demand will decrease and if the price of the commodity decreases,
the demand will increase.
• The quantity of a good that consumers are willing and able to buy per period
relates inversely, or negatively, to the price, other things constant.
Law of Demand
Part 1. As PRICE increases, DEMAND decreases

Demand goes down

Price goes up
THEN

Part 2. As PRICE decreases, DEMAND increases

Price goes down

Demand goes up
THEN
Demand Analysis
Demand Schedule
• A demand schedule is a numerical tabulation that shows the quantity
demanded of a commodity at different prices.
• The demand schedule may be of 2 types :
• Individual demand Schedule
• Market demand Schedule.
 Catherine’s Demand Schedule and Demand Curve: Example
Price of QD Price of
Ice-cream Cones Ice-Cream
cone demanded Cones
1. A decrease
$0.00 12 $3.00 in price . . .
0.50 10 2.50
1.00 8 2. . . . increases quantity
1.50 6 2.00 of cones demanded.
2.00 4
1.50
2.50 2
3.00 0 1.00 Demand curve
The demand curve illustrates how 0.50
the quantity demanded of the good
changes as its price varies. Because
0 1 2 3 4 5 6 7 8 9 10 11 12
a lower price increases the quantity
Quantity of Ice-Cream Cones
demanded, the demand curve
slopes downward.
Demand (the Buyers)
• Market vs. Individual Demand
• Individual demand is a function of income, prices of related goods,
expectations and tastes
• Market demand is the sum of individual demands
• Increases (decreases) in aggregate demand move the demand curve to the
right (left)
 Market Demand as the Sum of Individual Demands
(Demand Schedule)

Price of ice-cream Catherine Nicholas Market

cone
$0.00 12 + 7 = 19
0.50 10 6 16
1.00 8 5 13
1.50 6 4 10
2.00 4 3 7
2.50 2 2 4
3.00 0 1 1

The quantity demanded in a market is the sum of the quantities demanded by all the
buyers at each price: e.g., If price = $2.00, then Catherine demands 4 ice-cream
cones, and Nicholas demands 3 ice-cream cones. The total quantity demanded in the
market at this price is 7 cones.

13
Market Demand as the Sum of Individual Demands

Catherine’s Nicholas’s Market

demand + demand = demand
Price of Price of Price of
Ice Ice Ice
Cream Cream Cream
Cones Cones Cones
$3.00 DCatherine $3.00 $3.00
DNicholas
2.50 2.50 2.50

2.00 2.00 2.00

1.50 1.50 1.50

DMarket
1.00 1.00 1.00

0.50 0.50 0.50

0 1 2 3 4 5 6 7 8 9 10 11 12 0 1 2 3 4 5 6 7 0 2 4 6 8 10 12 14 16 18
Quantity of Ice-Cream Cones Quantity of Quantity of Ice-Cream Cones
Ice-Cream Cones
14
Demand Analysis- Assumptions
 No change in taste and preference.
 Income of the consumer is constant.
 No change in customs, habit, quality of goods.
 No change in substitute products, related products and the price of
the product.
 No complementary goods.
Demand Function
 A Mathematical relationship between quantity demanded of
the commodity and its determinants is known as Demand
Function.
 When this relationship relates to the demand by an individual
consumer it is known as Individual demand function and while
it relates to the market its known as market demand function.
 Individual Demand Function :
• Qdx = f (Px, Y, P1……. Pn-1, T, A, Ey. Ep, U)
Market Demand Function

• Qdx = f (Px, Y, P1……. Pn-1, T, A, Ey, Ep, P, D, U, P)

• P = Population
• D = Distribution of consumers.
Demand Analysis
Causes of downward sloping of Demand Curve
• According to the law of demand there exists a opposite relationship between the PRICE and the
QUANTITY DEMANDED, and that is why demand curve is downward sloping
• Let the linear form of demand curve :

P = a + bq, where a, q constant and b < 0, i.e. dp/dq = b < 0

• (Assumption), so slope of the demand curve is negative.

• The various reasons for this downwards sloping of demand curves are as follows:
 Law of Diminishing Marginal Utility and Equi-Marginal utility.
Price Effect.
Income Effect.
Substitution Effect.
Different Uses ( eg: Electricity)
Demand Analysis
Factors Determining Demand:
• General Factors:
 Price of the product
 Taste and Preference
 Income
 Prices of the related goods
• Additional Factors: (Luxury Goods & Durables)
 Consumer’s Expectation of future price.
 Consumer’s Expectation of future income.
• Additional Factors:( Market Demand)
 Population
 Social, Economic & Demographic distribution of Consumer’s.
Exceptions to Law of Demand
1) Giffen Goods:
• Giffen goods are the inferior goods whose demand increases with the increase in its
prices.
• There are several inferior commodities, much cheaper than the superior substitutes
often consumed by the poor households as an essential commodity.
• Whenever the price of the Giffen goods increases its quantity demanded also
increases because, with an increase in the price, and the income remaining the
same, the poor people cut the consumption of superior substitute and buy more
quantities of Giffen goods to meet their basic needs.

• Eg: Barley, Bajra, Potatoes( this is classic example during Irish Famine- 1845-1849).
Exceptions to Law of Demand
2) Veblen Goods
• Another exception to the law of demand is given by the economist Thorstein
Veblen, who proposed the concept of “Conspicuous Consumption.”
• According to Veblen, there are a certain group of people who measure the utility
of the commodity purely by its price, which means, they think that higher priced
goods and services derive more utility than the lesser priced commodities.
• Eg: Diamond, Platinum etc.
Contd..

3) Expectation of Price Change in Future:

• When the consumer expects that the price of a commodity is likely to further
increase in the future, then he will buy more of it despite its increased price in
order to escape himself from the pinch of much higher price in the future.

• On the other hand, if the consumer expects the price of the commodity to
further fall in the future, then he will likely postpone his purchase despite less
price of the commodity in order to avail the benefits of much lower prices in the
future.
Contd..
• 4) Ignorance: Often people are misconceived as high-priced commodities are
better than the low-priced commodities and rest their purchase decision on such a
notion. They buy those commodities whose price are relatively higher than the
substitutes.
• 5) Emergencies: During emergencies such as war, natural calamity- flood, drought,
earthquake, etc., the law of demand becomes ineffective. In such situations,
people often fear the shortage of the essentials and hence demand more goods
and services even at higher prices
• 6) Change in fashion and Tastes & Preferences: The change in fashion trend and
tastes and preferences of the consumers negates the effect of law of demand. The
consumer tends to buy those commodities which are very much ‘in’ in the market
even at higher prices.
Contd..

• 7) Bandwagon Effect: This is the most common type of exception to the law of
demand wherein the consumer tries to purchase those commodities which are
bought by his friends, relatives or neighbors. Here, the person tries to emulate
the buying behavior and patterns of the group to which he belongs irrespective of
the price of the commodity.
• For example, if the majority of group members have smart phones then the
consumer will also demand for the smartphone even if the prices are high.
Change in Demand and Shift in demand

Due to changes in price of the commodity

Expansion
Contraction

Due to changes in factors other than price/ Shift in Demand

Increase
Decrease
Expansion of Demand
• Decrease in Price

Price Quantity
Price of good
E1
P-12,000 12,000 15 unit

P-8,000 E2
8,000 20 unit

Q -15 Q -20

Quantity demanded

An expansion of demand denote E1 to E2

is a rise in the quantity demanded because the price has changed , other
factors remaining the same (ceteris paribus).
Contraction of Demand
• Increase in the price
Price Quantity
E2
P-15,000
12,000 15 unit
E1
P-12,000

15,000 10 unit
Price of good

Q -10 Q -15

Quantity demanded

A CONTRACTION of demand is the fall in the quantity demanded because the price
has changed , other factors remaining the same. (from E1 to E2)
Shift in Demand: Demand Curve Shifters
• The demand curve shows how price affects quantity
demanded, other things being equal.
• These “other things” are non-price determinants of demand
(i.e., things that determine buyers’ demand for a good, other
than the good’s price).
• Changes in them shift the D curve…
Demand Curve Shifters: Number of Buyers
• Increase in number of buyers
increases quantity demanded at each price, shifts D curve to
the right.
 Demand Curve Shifters: Number of Buyers

P Suppose the number

$6.00 of buyers increases.
Then, at each P,
$5.00
Qd will increase
$4.00 (by 5 in this example).
$3.00
$2.00
$1.00
$0.00 Q
0 5 10 15 20 25 30
Demand Curve Shifters: Income
• Demand for a normal good is positively related to income.
• Increase in income causes
increase in quantity demanded at each price, shifts D curve to
the right.

• (Demand for an inferior good is negatively related to income. An increase

in income shifts D curves for inferior goods to the left.)
Elasticity of Demand
Contents
• Elasticity of demand
• Method and measurement of demand
• Types of elasticity of demand
 Elasticity of Demand

• Elasticity: a measure of the responsiveness of quantity demanded to one of its

determinants.

Types of Elasticity of Demand:

1. Price Elasticity of Demand:
• Price elasticity of demand measures how much the quantity demanded responds
to a change in price.
• computed as the percentage change in quantity demanded divided by the
percentage change in price
Price Elasticity of Demand

Price elasticity Percentage change in Qd

=
of demand Percentage change in P
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Calculating Percentage Changes
Standard method
of computing the
Demand for percentage (%) change:
your websites
P end value – start value
x 100%
start value
B
$250
A Going from A to B,
$200
the % change in P equals
D
($250–$200)/$200 = 25%
Q
8 12
Calculating Percentage Changes
Problem:
The standard method gives
Demand for different answers depending
your websites on where you start.
P
From A to B,
$250
B P rises 25%, Q falls 33%,
A elasticity = 33/25 = 1.33
$200
From B to A,
D
P falls 20%, Q rises 50%,
Q elasticity = 50/20 = 2.50
8 12
Calculating Percentage Changes
• So, we instead use the midpoint method:

end value – start value

x 100%
midpoint
 The midpoint is the number halfway between
the start & end values, also the average of
those values.
 It doesn’t matter which value you use as the
“start” and which as the “end” – you get the
same answer either way!
Calculating Percentage Changes
• Using the midpoint method, the % change
in P equals

$250 – $200
x 100% = 22.2%
$225
 The % change in Q equals
12 – 8
x 100% = 40.0%
10
 The price elasticity of demand equals
40/22.2 = 1.8
Types of Price Elasticity of Demand
• 1. Perfectly Inelastic Demand
• 2. Inelastic Demand
• 3. Unitary elastic Demand
• 4. Elastic Demand
• 5. Perfectly Elastic Demand
 Perfectly Inelastic Demand
- Elasticity equals 0
Price Demand

1. An $5
increase
in price... 4

100 Quantity
2. ...leaves the quantity demanded unchanged.
 Inelastic Demand
- Elasticity is less than 1
Price

1. A 25% $5
increase
in price... 4

Demand

90 100 Quantity
2. ...leads to a 10% decrease in quantity.
 Unitary Elastic Demand
- Elasticity equals 1
Price

1. A 25% $5
increase
in price... 4

Demand

75 100 Quantity
2. ...leads to a 25% decrease in quantity.
 Elastic Demand
- Elasticity is greater than 1
Price

1. A 25% $5
increase
in price... 4

Demand

50 100 Quantity
2. ...leads to a 50% decrease in quantity.
 Perfectly Elastic Demand
- Elasticity equals infinity
Price
1. At any price
above $4, quantity
demanded is zero.

$4 Demand

2. At exactly $4,
consumers will
buy any quantity.

3. At a price below $4, Quantity

quantity demanded is infinite.
Determinants of Price Elasticity of Demand

 Necessities versus Luxuries

 Availability of Close Substitutes
 Definition of the Market
 Time Horizon
Determinants of Price Elasticity of Demand
• Demand tends to be more inelastic

 If the good is a necessity.

 If the time period is shorter.
 The smaller the number of close substitutes.
 The more broadly defined the market.
 Determinants of Price Elasticity of Demand

Demand tends to be more elastic :

 if the good is a luxury.

 the longer the time period.
 the larger the number of close substitutes.
 the more narrowly defined the market.
 Elasticity and Total Revenue
 Total revenue is the amount paid by buyers and received by sellers of
a good.
 Computed as the price of the good times the quantity sold.

TR = P x Q
 Elasticity and Total Revenue
Price

$4

P x Q = $400
P (total revenue)
Demand

0 100 Quantity
Q
Price Elasticity and Total Revenue
• Continuing our scenario, if you raise your price
from $200 to $250, would your revenue rise or fall?
Revenue = P x Q
• A price increase has two effects on revenue:
• Higher P means more revenue on each unit
you sell.
• But you sell fewer units (lower Q), due to
Law of Demand.
• Which of these two effects is bigger?
It depends on the price elasticity of demand.
Price Elasticity and Total Revenue
Price elasticity Percentage change in Q
=
of demand Percentage change in P

Revenue = P x Q
• If demand is elastic, then
price elast. of demand > 1
% change in Q > % change in P
• The fall in revenue from lower Q is greater
than the increase in revenue from higher P,
so revenue falls.
Income Elasticity of Demand

 Income elasticity of demand measures how much the quantity

demanded of a good responds to a change in consumers’ income.
 It is computed as the percentage change in the quantity demanded
divided by the percentage change in income.
Computing Income Elasticity

Percentage Change
Income Elasticity in Quantity Demanded
of Demand =
Percentage Change
in Income
Income Elasticity - Types of Goods
 Normal Goods
 Income Elasticity is positive.
 Inferior Goods
 Income Elasticity is negative.
 Higher income raises the quantity demanded for normal goods but
lowers the quantity demanded for inferior goods.
Cross Price Elasticity of Demand
• The cross-price elasticity of demand measures the response of
demand for one good to changes in the price of another good.

Cross-price elasticity % change in Qd for good 1

=
of demand % change in price of good 2
 For substitutes, cross-price elasticity > 0
E.g., an increase in price of tea causes an increase in
demand for coffee.
 For complements, cross-price elasticity < 0
E.g., an increase in price of computers causes decrease in
demand for software.
Promotional Elasticity of Demand (Advertisement Elasticity)

• The advertisement elasticity of demand measures the responsiveness

of the quantity demanded through the changes in the advertisement
expenditure. (assuming other factors unchanged).
• It can be calculated through the following formula

Promotional % change in Qd
=
elasticity % change in advertisement
of demand expenditure
Demand Forecasting
“Prediction is very difficult,
especially if it's about the future.”
(Niels Bohr)
What is forecasting?

Forecasting is a tool used for predicting

future demand based on
past demand information.

Is essentially a judgement of future probabilities of the future demand.

Is an attempt to predict the future demand based on past data under

conditions of uncertainty.

Prediction or estimation of a future situation, under given conditions

Why is forecasting important?

Demand for products and services is usually uncertain.

Forecasting can be used for…
• Strategic planning (long range planning)
• Finance and accounting (budgets and cost controls)
• Marketing (future sales, new products)
• Production and operations
What is forecasting all about?

Demand for Mercedes E Class We try to predict the

future by looking back
at the past

Predicted
demand
looking
Time back six
Jan Feb Mar Apr May Jun Jul Aug months
Actual demand (past sales)
Predicted demand
 Some general characteristics of forecasts
 Forecasts are more accurate for groups or families of items
 Forecasts are more accurate for shorter time periods
 Every forecast should include an error estimate
 Forecasts are no substitute for calculated demand.
Classification of Demand Forecasts
Active vs passive forecasting
• Active forecasting is a method of forecasting the demand on the
consideration that a firm is likely to initiate some action like changes in
product quality, size, price etc.
• Passive forecasting based on the assumption that the same product is
being offered without any changes.
Short-run vs long run forecasting
• Short-run forecasting normally extends up to one year. These forecasts
are useful for product scheduling, inventory planning, and mobilization
of working capital etc.
• Long-run forecasts extend beyond one year. They are helpful in capital
budgeting, product diversification, personnel recruitment etc.
Contd..
Company forecasting vs Industry forecasting
• Forecasting the demand for the products of a particular firm
is company forecasting.
• These are firm specific and designed to serve the individual
firms in planning their policies.
• Industry forecasting forecasts the demand for the products of
the industry as a whole.
• The association of manufacturers or trade associations
undertake them and serve the needs of all the firms in the
industry.
 Contd…

• Durable Vs. Perishable goods

• Durable goods forecasting involves forecasting of goods which are
durable in nature.
• Eg: furniture, electronics products etc.
• Perishable goods forecasting is for those goods which are
perishable.
• Eg: vegetables, fruits etc.
Contd..
Micro level forecasting vs Macro level forecasting
• Micro level forecasting may take the form of company forecasting or industry
forecasting.
• Macro level forecasting on the other hand is concerned with forecasting
general economic environment and business conditions in the country as a
whole.
• The national income growth rates, production indices, price indices provide
useful insights into the future demand for most of the commodities.
Governmental organizations provide the base data to forecast the demand.
Steps in Demand Forecasting

Identification of the objective

Identify Nature of the product

Determination of demand

Choice of appropriate method

Analysis
Key issues in forecasting

1. A forecast is only as good as the information included in the

forecast (past data)
2. History is not a perfect predictor of the future (i.e.: there is
no such thing as a perfect forecast)

Forecasting is based on the assumption that the past

predicts the future! When forecasting, think carefully
whether or not the past is strongly related to what you
expect to see in the future…
Example: Mercedes E-class vs. M-class Sales
Month E-class Sales M-class Sales
Jan 23,345 -
Feb 22,034 -
Mar 21,453 -
Apr 24,897 -
May 23,561 -
Jun 22,684 -
Jul ? ?

Question: Can we predict the new model M-class sales based on

the data in the the table?

Answer: Maybe... We need to consider how much the two

markets have in common
What should we consider when looking at
past demand data?
Data = historic pattern + random variation

• Trends

• Seasonality

• Cyclical elements

• Autocorrelation

• Random variation
Some Important Questions
1. What is the purpose of the forecast?
2. Which systems will use the forecast?
3. How important is the past in estimating the future?

Answers will help determine time horizons, techniques, and level of

detail for the forecast.
Types of forecasting methods

Qualitative methods Quantitative methods

Rely on subjective Rely on data and

opinions from one or analytical techniques.
more experts.
Qualitative Models

Collective
Expert opinion
Consumer’s
opinion survey or
Opinion
method or sales force
Survey
Delphi opinion
Method
method survey
method
Qualitative Methods
Consumer's opinion survey

• The consumer opinion survey can be either census or sample survey.

Where the numbers of buyers are limited, census survey methods hold. In
this case, the opinion of the entire universe is obtained.
• On the other hand, where the number of buyers is large, universal survey
is not feasible; hence, sample survey methods are used.
• The sample survey can be either purposive sampling or random sampling
based on the nature of the product or the objectives of the survey.
Limitations
• consumer opinion surveys are not perfectly reliable
• expensive and time-taking.
 Expert opinion method or Delphi method

 Expert opinion method is a variant of the consumer's opinion survey method. It was also
popular as Delphi method and first used by Rand Corporation in USA for predicting the
demand under conditions of intractable technological changes. It is used under conditions of
nonexistence of data or when a new product is being launched.
 The fairest step in this method is the identification of experts and eliciting their opinions
about the likely demand for the product. The experts may differ in their views in which case
the firm has to pass on the opinions of one expert to the other, of course under strict
anonymity and seek their reactions. This exercise should go on until a common line of
thinking emerges.
 This method will be useful tool of demand forecasting provided the experts did not have
biased opinions.
Collective opinion survey or sales force opinion survey method

• In this method, the firm will extract the opinions of the sales team, which is on
the payrolls of the company about the future demand for the product. The sales
personnel are very close to the consumers and dealers. They express their
opinions about the future demand for the product.

• The opinions so gathered are tabulated and the demand forecasts will be arrived
at.

• However, care be taken before forming an opinion about the future demand. The
opinions of the sales team should not be taken on the face value as an ambitious
sales man gives an over estimate of the demand for the product while a sceptic
fearing the fixation of higher sales targets always quotes a lesser figure.

• This method is an inexpensive but more reliable method of demand forecasting .

End – Use Method

• This method is quite useful for industries which are mainly producer’s goods. In
this method, the sale of the product under consideration is projected as the basis of
demand survey of the industries using this product as an intermediate product.
• The end user demand estimation of an intermediate product may involve many
final good industries using this product at home and abroad. It helps us to
understand inter-industry’ relations. An intermediate product may have many end-
users, for e.g., steel can be used for making various types of agricultural and
industrial machinery, for construction, for transportation, etc.
• It may have demand both in the domestic market as well as the international
market. Thus, end – use demand estimation of an intermediate product may involve
many final goods ’ industries using this product, at home and in abroad.
• After we know the demand for final consumption of goods including their exports,
we can estimate the demand for the product which is used as intermediate goods
in the production of these final goods with the help of input – output coefficients.
 Quantitative Methods

1.Statistical Methods
• Trend Projection
• Simple Moving Average
• Weighted moving Average
• Regression Method
2. Barometric Method
How should we pick our forecasting model?

1. Data availability
2. Time horizon for the forecast
3. Required accuracy
4. Required Resources
Time Series: Moving average

• The moving average model uses the last t periods in order to

predict demand in period t+1.
• There can be two types of moving average models: simple
moving average and weighted moving average
• The moving average model assumption is that the most
accurate prediction of future demand is a simple (linear)
combination of past demand.
Time series: simple moving average

In the simple moving average models the forecast value is

At + At-1 + … + At-n
Ft+1 =
n

t is the current period.

Ft+1 is the forecast for next period
n is the forecasting horizon (how far back we look),
A is the actual sales figure from each period.
Example: forecasting sales at Kroger

Kroger sells (among other stuff) bottled water

Month Bottles
Jan 1,325
Feb 1,353
Mar 1,305 What will
the sales be
Apr 1,275
for July?
May 1,210
Jun 1,195
Jul ?
What if we use a 3-month simple moving average?

AJun + AMay + AApr

FJul = = 1,227
3

What if we use a 5-month simple moving average?

AJun + AMay + AApr + AMar + AFeb

FJul = = 1,268
5
 1400
1350
1300
5-month
1250
MA forecast
1200 3-month
1150 MA forecast
1100
1050
1000
0 1 2 3 4 5 6 7 8

What do we observe?

5-month average smoothes data more;

3-month average more responsive
Time series: weighted moving average
We may want to give more importance to some of the data…

Ft+1 = wt At + wt-1 At-1 + … + wt-n At-n

wt + wt-1 + … + wt-n = 1

t is the current period.

Ft+1 is the forecast for next period
n is the forecasting horizon (how far back we look),
A is the actual sales figure from each period.
w is the importance (weight) we give to each period
Why do we need the WMA models?
Because of the ability to give more importance to what
happened recently, without losing the impact of the past.

Demand for Mercedes E-class Actual demand (past sales)

Prediction when using 6-month SMA
Prediction when using 6-months WMA

For a 6-month
SMA, attributing
equal weights to all
past data we miss
Time the downward trend
Jan Feb Mar Apr May Jun Jul Aug
Example: Kroger sales of bottled water

Month Bottles
Jan 1,325
Feb 1,353
What will
Mar 1,305
be the sales
Apr 1,275 for July?
May 1,210
Jun 1,195
Jul ?
6-month simple moving average…

AJun + AMay + AApr + AMar + AFeb + AJan

FJul = = 1,277
6

In other words, because we used equal weights, a slight downward

trend that actually exists is not observed…
What if we use a weighted moving average?

Make the weights for the last three months more than the first
three months…

6-month WMA WMA WMA

SMA 40% / 60% 30% / 70% 20% / 80%

July
1,277 1,267 1,257 1,247
Forecast

The higher the importance we give to recent data, the more we

pick up the declining trend in our forecast.
How do we choose weights?

1. Depending on the importance that we feel past data has

2. Depending on known seasonality (weights of past data
can also be zero).

WMA is better than SMA

because of the ability to
vary the weights!
Time Series: Exponential Smoothing (ES)

Main idea: The prediction of the future depends mostly on the

most recent observation, and on the error for the latest forecast.

Smoothin
g constant
Denotes the importance
alpha α of the past error
Why use exponential smoothing?

1. Uses less storage space for data

2. Extremely accurate
3. Easy to understand
4. Little calculation complexity
5. There are simple accuracy tests
Exponential smoothing: the method

Assume that we are currently in period t. We calculated the

forecast for the last period (Ft-1) and we know the actual demand
last period (At-1) …

Ft  Ft1   ( At1  Ft 1 )

The smoothing constant α expresses how much our forecast will

react to observed differences…
If α is low: there is little reaction to differences.
If α is high: there is a lot of reaction to differences.
Example: bottled water at Kroger

Month Actual Forecasted  = 0.2

Jan 1,325 1,370

Feb 1,353 1,361

Mar 1,305 1,359

Apr 1,275 1,349

May 1,210 1,334

Jun ? 1,309
Example: bottled water at Kroger

Month Actual Forecasted  = 0.8

Jan 1,325 1,370

Feb 1,353 1,334

Mar 1,305 1,349

Apr 1,275 1,314

May 1,210 1,283

Jun ? 1,225
Impact of the smoothing constant

1380
1360
1340
1320
Actual
1300
a = 0.2
1280
1260 a = 0.8
1240
1220
1200
0 1 2 3 4 5 6 7
Trend..

What do you think will happen to a moving average or

exponential smoothing model when there is a trend in
the data?
Impact of trend

Sales
Actual
Data
Forecast

Month
Linear regression in forecasting

Linear regression is based on

1. Fitting a straight line to data
2. Explaining the change in one variable through changes in
other variables.

dependent variable = a + b  (independent variable)

By using linear regression, we are trying to explore which

independent variables affect the dependent variable
Example: do people drink more when it’s cold?

Alcohol Sales

Which line best

fits the data?

Average Monthly
Temperature
The best line is the one that minimizes the error

The predicted line is …

Y  a  bX

So, the error is …

εi  y i - Yi

Where: ε is the error

y is the observed value
Y is the predicted value
Least Squares Method of Linear Regression

The goal of LSM is to minimize the sum of squared errors…

Min i
 2
What does that mean?

Alcohol Sales ε ε
ε

So LSM tries to
minimize the distance
between the line and
the points!

Average Monthly
Temperature
Least Squares Method of Linear Regression

Then the line is defined by

Y  a  bX

a  y  bx

b
 xy  nx y
 x  nx
2 2
 Barometric Methods

• The barometric method is based on the approach of developing

an index of relevant economic indicators and forecasting the
future trends by analyzing the movements in these indicators.
• A time-series of several indicators is developed to study the
future trend.
 Contd..
• Leading Series: The leading series is comprised of indicators which move up or
down ahead of some other series.
• The most common examples of leading indicators are- net business
investment index, a new order for durable goods, change in the value of
inventories, corporate profits after tax, etc.
Contd..

• Coincidental Series: The coincidental series include indicators

which move up and down simultaneously with the general level of
economic activities.
• The examples of coincidental series – the rate of unemployment,
the number of employees in the non-agricultural sector, sales
recorded by manufacturing, retail, and trading sectors
Contd..

• Lagging Series: A series consisting of those indicators, which after some

time-lag follows the change. Some of the lagging series are-
outstanding loan, labor cost per unit production, lending rate for short-
term loans, etc.
Contd..

• The only advantage of the barometric method of forecasting is that is helps to

overcome the problem of finding the value of an independent variable under
regression analysis.
• The major limitations of this method are;
• First, Often the leading indicator of the variable to be forecasted is difficult to
find out or is not easily available.
• Secondly,  the barometric technique can be used only for a short-term
forecasting.
How can we compare across forecasting models?

We need a metric that provides estimation of accuracy

Errors can be:

Forecast Error 1. biased (consistent)

2. random

Forecast error = Difference between actual and forecasted value

(also known as residual)
Measuring Accuracy: MFE

MFE = Mean Forecast Error (Bias)

It is the average error in the observations

A F t t
MFE  i 1
n

1. A more positive or negative MFE implies worse

performance; the forecast is biased.
Measuring Accuracy: MAD

MAD = Mean Absolute Deviation

It is the average absolute error in the observations

 A F t t
MAD  i 1
n

1. Higher MAD implies worse performance.

2. If errors are normally distributed, then σε=1.25MAD
Key Point

Forecast must be measured for accuracy!

The most common means of doing so is by measuring

the either the mean absolute deviation or the
standard deviation of the forecast error
Criteria for Good Demand Forecasting
1. Time frame
2. Pattern of the data
3. Cost /economy of forecasting
4. Accuracy desired
5. Availability of data
6. Plausibility/ Ease of understanding
7. Durability
8. Flexibility
Supply

• Supply comes from the behavior of sellers.

• The quantity supplied of any good is the amount that sellers are
willing and able to sell.
• Law of supply: the claim that the quantity supplied of a good
rises when the price of the good rises, other things equal
The Supply Schedule
• Supply schedule: Quantity
Price
A table that shows the of X
of X
supplied
relationship between the price
of a good and the quantity $0.00 0
supplied. 1.00 3
2.00 6
• Example:
Firm A supply of X. 3.00 9
4.00 12
 Notice that supply
5.00 15
schedule obeys the
6.00 18
Law of Supply.
Market Supply versus Individual Supply
• The quantity supplied in the market is the sum of the quantities
supplied by all sellers at each price.
• Suppose Firm A and Firm B are the only two sellers in this market.
(Qs = quantity supplied)

Price Firm A Firm B Market Qs

$0.00 0 + 0 = 0
1.00 3 + 2 = 5
2.00 6 + 4 = 10
3.00 9 + 6 = 15
4.00 12 + 8 = 20
5.00 15 + 10 = 25
6.00 18 + 12 = 30
 The Market Supply Curve
QS
P
(Market)
P
$6.00 $0.00 0
1.00 5
$5.00
2.00 10
$4.00 3.00 15
$3.00 4.00 20
$2.00 5.00 25
6.00 30
$1.00
$0.00 Q
0 5 10 15 20 25 30 35
The Law of Supply
P rice of soybeans per bushel ($)
• The law of supply states
6 that there is a positive
5 relationship between
4 price and quantity of a
3 good supplied.
2 • This means that supply
1 curves typically have a
0 positive slope.
0 10 20 30 40 50
Thousands of bushels of soybeans
produced per year
Determinants of Supply
• The price of the good or service.
• The cost of producing the good, which in turn depends on:
• The price of required inputs (labor, capital, and land),
• The technologies that can be used to produce the product,
• The prices of related products.
• The law of supply states that other things being equal, the supply of a
commodity extends with a rise in price and contracts with a fall in price.
There are however a few exceptions to the law of supply.
• 1. Exceptions of a fall in price
• If the firms anticipate that the price of the product will fall further in
future, in order to clear their stocks they may dispose it off at a price
that is even lower than the current market price.
• 2. Sellers who are in need of cash
• If the seller is in need of hard cash, he may sell his product at a price
which may even be below the market price.
• 3. When leaving the industry
• If the firms want to shut down or close down their business, they may sell their
products at a price below their average cost of production.
• 4. Agricultural output
• In agricultural production, natural and seasonal factors play a dominant role. Due to
the influence of these constraints supply may not be responsive to price changes
• 5. Backward sloping supply curve of labor
• The rise in the price of a good or service sometimes leads to a fall in its supply. The
best example is the supply of labor. A higher wage rate enables the worker to
maintain his existing material standard of living with less work, and he may prefer
extra leisure to more wages. The supply curve in such a situation will be ‘backward
sloping’ SS1 as illustrated in figure.
A Change in Supply Versus a Change in Quantity Supplied

• A change in supply is
not the same as a
change in quantity
supplied.
• In this example, a higher
price causes higher
quantity supplied, and
a move along the
supply curve.
• In this example, changes in determinants of supply, other
than price, cause an increase in supply, or a shift of the
entire supply curve, from SA to SB.
A Change in Supply Versus a Change in Quantity Supplied

• When supply shifts

to the right, supply
increases. This
causes quantity
supplied to be
greater than it was
prior to the shift, for
each and every price
level.
A Change in Supply Versus a Change in Quantity Supplied

To summarize:

Change in price of a good or service

leads to

Change in quantity supplied

(Movement along the curve).

Change in costs, input prices, technology, or prices of

related goods and services
leads to

Change in supply
(Shift of curve).
From Individual Supply to Market Supply

• The supply of a good or service can be defined for an

individual firm, or for a group of firms that make up a
market or an industry.
• Market supply is the sum of all the quantities of a
good or service supplied per period by all the firms
selling in the market for that good or service.
Market Supply

• As with market demand, market supply is the

horizontal summation of individual firms’ supply
curves.
Market Equilibrium
• The operation of the market depends on the
interaction between buyers and sellers.
• An equilibrium is the condition that exists when
quantity supplied and quantity demanded are equal.
• At equilibrium, there is no tendency for the market
price to change.
Market Equilibrium
• Only in equilibrium is
quantity supplied equal
to quantity demanded.

• At any price level

other than P0, the
wishes of buyers
and sellers do not
coincide.
Market Disequilibria
• Excess demand, or
shortage, is the
condition that exists
when quantity
demanded exceeds
quantity supplied at the
When quantity
• current price. demanded
exceeds quantity
supplied, price tends to
rise until equilibrium is
restored.
Market Disequilibria
• Excess supply, or surplus, is
the condition that exists
when quantity supplied
exceeds quantity demanded
at the current price.

• When quantity supplied

exceeds quantity
demanded, price tends to
fall until equilibrium is
restored.
Increases in Demand and Supply

• Higher demand leads to • Higher supply leads to

higher equilibrium price and lower equilibrium price and
higher equilibrium quantity. higher equilibrium quantity.
Decreases in Demand and Supply

• Lower demand leads to • Lower supply leads to

lower price and lower higher price and lower
quantity exchanged. quantity exchanged.