DEMAND FORECASTING

Demand forecasting is the activity of estimating the

quantity of a product or service that consumers will purchase. Demand forecasting involves techniques including both informal methods, such as educated guesses, and quantitative methods, such as the use of historical sales data or current data from test markets. Demand forecasting may be used in making pricing decisions, in assessing future capacity requirements, or in making decisions on whether to enter a new market.

METHODS OF DEMAND FORECASTING

Broadly speaking, there are two approaches to demand

forecasting- one is to obtain information about the likely purchase behavior of the buyer through collecting experts opinion or by conducting interviews with consumers, the other is to use past experience as a guide through a set of statistical techniques. Both these methods rely on varying degrees of judgment. The first method is usually found suitable for shortterm forecasting, the latter for long-term forecasting. There are specific techniques which fall under each of these broad methods

Simple Survey Method:

1) Experts Opinion Poll: In this method, the experts

are requested to give their opinion or feel about the product. These experts, dealing in the same or similar product, are able to predict the likely sales of a given product in future periods under different conditions based on their experience. If the number of such experts is large and their experience-based reactions are different, then an average-simple or weighted is found to lead to unique forecasts. Sometimes this method is also called the hunch method but it replaces analysis by opinions and it can thus turn out to be highly subjective in nature.

 2) Reasoned Opinion-Delphi Technique: This is a

variant of the opinion poll method. Here is an attempt to arrive at a consensus in an uncertain area by questioning a group of experts repeatedly until the responses appear to converge along a single line. The participants are supplied with responses to previous questions (including seasonings from others in the group by a coordinator or a leader or operator of some sort). Such feedback may result in an expert revising his earlier opinion. This may lead to a narrowing down of the divergent views (of the experts) expressed earlier. The Delphi Techniques, followed by the Greeks earlier, thus generates reasoned opinion in place of unstructured opinion; but this is still a poor proxy for market behavior of economic variables.

 3) Consumers Survey- Complete Enumeration

Method: Under this, the forecaster undertakes a complete survey of all consumers whose demand he intends to forecast, Once this information is collected, the sales forecasts are obtained by simply adding the probable demands of all consumers. The principle merit of this method is that the forecaster does not introduce any bias or value judgment of his own. He simply records the data and aggregates. But it is a very tedious and cumbersome process; it is not feasible where a large number of consumers are involved. Moreover if the data are wrongly recorded, this method will be totally useless.

 ) Consumer Survey-Sample Survey Method: Under this

method, the forecaster selects a few consuming units out of the relevant population and then collects data on their probable demands for the product during the forecast period. The total demand of sample units is finally blown up to generate the total demand forecast. Compared to the former survey, this method is less tedious and less costly, and subject to less data error; but the choice of sample is very critical. If the sample is properly chosen, then it will yield dependable results; otherwise there may be sampling error. The sampling error can decrease with every increase in sample size.

 End-user Method of Consumers Survey: Under this

method, the sales of a product are projected through a survey of its end-users. A product is used for final consumption or as an intermediate product in the production of other goods in the domestic market, or it may be exported as well as imported. The demands for final consumption and exports net of imports are estimated through some other forecasting method, and its demand for intermediate use is estimated through a survey of its user industries.

Complex Statistical Methods

1) Time series analysis or trend method: Under this

method, the time series data on the under forecast are used to fit a trend line or curve either graphically or through statistical method of Least Squares. The trend line is worked out by fitting a trend equation to time series data with the aid of an estimation method. The trend equation could take either a linear or any kind of non-linear form. The trend method outlined above often yields a dependable forecast.

 The advantage in this method is that it does not

require the formal knowledge of economic theory and the market, it only needs the time series data. The only limitation in this method is that it assumes that the past is repeated in future. Also, it is an appropriate method for long-run forecasts, but inappropriate for short-run forecasts. Sometimes the time series analysis may not reveal a significant trend of any kind. In that case, the moving average method or exponentially weighted moving average method is used to smoothen the series

(2) Barometric Techniques or Lead-Lag indicators method

This consists in discovering a set of series of some variables

which exhibit a close association in their movement over a period or time. For example, it shows the movement of agricultural income (AY series) and the sale of tractors (ST series). The movement of AY is similar to that of ST, but the movement in ST takes place after a years time lag compared to the movement in AY. Thus if one knows the direction of the movement in agriculture income (AY), one can predict the direction of movement of tractors sale (ST) for the next year. Thus agricultural income (AY) may be used as a barometer (a leading indicator) to help the short-term forecast for the sale of tractors.

 Generally, this barometric method has been used in some of the

developed countries for predicting business cycles situation. For this purpose, some countries construct what are known as diffusion indices by combining the movement of a number of leading series in the economy so that turning points in business activity could be discovered well in advance. Some of the limitations of this method may be noted however. The leading indicator method does not tell you anything about the magnitude of the change that can be expected in the lagging series, but only the direction of change. Also, the lead period itself may change overtime. Through our estimation we may find out the best-fitted lag period on the past data, but the same may not be true for the future. Finally, it may not be always possible to find out the leading, lagging or coincident indicators of the variable for which a demand forecast is being attempted.

3) Correlation and Regression:

These involve the use of econometric methods to determine the

nature and degree of association between/among a set of variables. Econometrics, you may recall, is the use of economic theory, statistical analysis and mathematical functions to determine the relationship between a dependent variable (say, sales) and one or more independent variables (like price, income, advertisement etc.). The relationship may be expressed in the form of a demand function, as we have seen earlier. Such relationships, based on past data can be used for forecasting. The analysis can be carried with varying degrees of complexity. Here we shall not get into the methods of finding out correlation coefficient or regression equation; you must have covered those statistical techniques as a part of quantitative methods. Similarly, we shall not go into the question of economic theory. We shall concentrate simply on the use of these econometric techniques in forecasting.

 Given the estimated value of and bi, you may forecast the expected

sales (DX), if you know the future values of explanatory variables like own price (PX), related price (Py), income (B) and advertisement (A). Lastly, you may also recall that the statistics R2 (Co-efficient of determination) gives the measure of goodness of fit. The closer it is to unity, the better is the fit, and that way you get a more reliable forecast. The principle advantage of this method is that it is prescriptive as well descriptive. That is, besides generating demand forecast, it explains why the demand is what it is. In other words, this technique has got both explanatory and predictive value. The regression method is neither mechanistic like the trend method nor subjective like the opinion poll method. In this method of forecasting, you may use not only time-series data but also cross section data. The only precaution you need to take is that data analysis should be based on the logic of economic theory

(4) Simultaneous Equations Method

: Here is a very sophisticated method of forecasting. It

is also known as the complete system approach or econometric model building. In your earlier units, we have made reference to such econometric models. Presently we do not intend to get into the details of this method because it is a subject by itself. Moreover, this method is normally used in macro-level forecasting for the economy as a whole; in this course, our focus is limited to micro elements only. Of course, you, as corporate managers, should know the basic elements in such an approach.

 The method is indeed very complicated. However, in the

days of computer, when package programmes are available, this method can be used easily to derive meaningful forecasts. The principle advantage in this method is that the forecaster needs to estimate the future values of only the exogenous variables unlike the regression method where he has to predict the future values of all, endogenous and exogenous variables affecting the variable under forecast. The values of exogenous variables are easier to predict than those of the endogenous variables. However, such econometric models have limitations, similar to that of regression method.

PRODUCTION FUNCTION

What Is Production Function

Production function deals with the maximum output

that can be produced with a limited and given quantity of inputs.

PRODUCTION FUNCTION 1. The tool of analysis used to explain the input-output relationship

2. Describes the technological relationship between inputs and outputs in physical terms
3. It tells that the production of a commodity depends on specific inputs 4. It represents quantitative relationship between inputs and output 5. It represents the technology of a firm, of an industry, or of the economy as a whole

Production Function
Mathematical representation

of the relationship:
Q = f (K, L, La) Output (Q) is dependent upon the amount of capital

(K), Land (L) and Labour (La) used

THE LAWS OF PRODUCTION LAWS OF VARIABLE PROPORTIONS

SHORT RUN

LAWS OF RETURNS TO SCALE

LONG RUN

Relates to the study of input output relationship in the short run with one variable input while other inputs are held constant

Relates to the study of input output relationship in the long run assuming all inputs to be variable

TOTAL PRODUCT, AVERAGE PRODUCT, MARGINAL PRODUCT

TOTAL PRODUCT- is the total output resulting from

the all factors of production combine together at any time.

AVERAGE PRODUCT- is the total product per unit of

variable factor.
MARGINAL PRODUCT- is the change in total product

per unit change in the quantity of variable factor.

 In other word, it is the addition made to total product

by an additional unit of input.

Quantity of labor Total product Average product Marginal Product

1
2 3 4 5 6 7

100
210 330 430 520 600 560

100
105 110 107.5 104 100 80

100
110 120 100 90 80 -20

SHORT RUN PRODUCTION FUNCTION

Short run is the period of time which is too short for a

firm to install capital equipment like new plant, machinery an equipment to increase the production. So in this capital is kept fixed and other factor like labor are kept variable.
This is done till the law of variable is achieved.

Law of variable proportion

This law states that as more an more of factor input is

employed and all other input quantity remain constant eventually a point will be reached when addition quantity of varying inputs will yield diminishing marginal contribution to total product.

Assumptions in law of variable proportion

Constant Technology
Short Run- Only one input factor will be varied and

others remain fixed.

Variable input ratio- The law suppose that possibility

of the ratio of fixed factor to variable factor being changed. In other word it is possible to use various amount of a variable factor with fixed factors of production.

Production function with one variable input.

Stages of Variable proportion-

There are three stages of short run production function Stage-1 Increasing Returns Stage-2 Diminishing Returns Stage-3 Negative Returns

Labor 1 2 3 4

Total product(Kg) 50 110 135 150

Average product(Kg) 50 55 45 37.50

Marginal Product(Kg) 50 60 25 15

REMARKS

stage1

5 6
7 8 9

160 165
165 160 153

32 27.50
23.57 20 17

10 5
0 -5 -7

Stage 2

Stage-3

Total Product
STAGE 1- Increase at an increasing rate.

Marginal Product
Increases and reaches at it maximum.

Average product
Increases but slower than Marginal product.

Stage 2- Increase at diminishing rate and became maximum. Stage-3 Reaches it maximum become constant and then start declining.

Starts diminishing and equal to zero.

Starts diminishing.

Keep on declining an became negative

Continues to diminishes but must be greater than zero.

What is long run production function ?

Long run refers to that time in the future when

all inputs are variable inputs.

In the long run both capital and labour are

included
Output can be varied by changing the levels of

both L & K and the long run production function is expressed as: Q = f (L, K)

Isoquants
Isoquants are geometrical representation of production

function. Combination of two wordsiso- same quant- quantity. Isoquants deals with how the same level of output can be produced by various combination of factor input. Assuming continuous variation in the possible combination of labor an capital we can draw a curve by plotting all this alternative combination for given level of output. This curve which is the locus off all possible combination is called isoquant.

Type of Isoquants
1.

Linear isoquant- A given commodity may be produced by using only labor or only capital or infinite combination of labor an capital.

2. I/O or leontiff Isoquant- There is only one method of

producing a commodity.

3. Kinked isoquant- It talks about limited

substitutability between capital an labor. There is only few process for producing a commodity. More realistic approach. 4. Smooth,Convex,Isoquants- Continous suitability of capital and labor only over a certain range.

Example Isoquant Curve

The following combinations of inputs X and Y produce 100 units of output:
2,6 3,4 4,3 6,2 8,2
7 6 5 4 3 2 1 0 0

Units of capital Y Units of

Isoquant; TP = 100 units

2
Units

10

of Labour Units of X

ISOQUANT MAP- A family or a

group of isoquants is called an ISOQUANT MAP

K4 Units of K

A B C D Iq2 Iq4 = 400 Iq3 = 300 = 200 = 100

K3
K2 K1

Iq1 0 L1 L2

L3
Units of L

L4

Marginal rate of Technical substitution

MRTS(L,K) is defined as no. of inputs of unit K that a

producer is willing to sacrifice for additional unit of L or vice versa so as to maintain the same level of output. Let us suppose production of commodity= 5 units
Combination 1 2 3 4 5 Units of L 1 2 3 4 5 Units of K 16 11 7 4 2 MRTS 5 4 3 2

MRTS CURVE

CAPITAL

LABOR

LONG RUN TOTAL PRODUCTION-Returns to scale

During the short period, some factors of production

are relatively scarce, therefore , the proportion of the factors may be changed but not their scale. But in the long run, all factors are variable, therefore, the scale of production can be changed in the long run
run.

Returns to scale is a factor that is studied in the long Returns to scale show the responsiveness of total

product when all the inputs are increased proportionately.

Returns to Scale
When all inputs are changed in the same

proportion (or scale of production is changed),the total product may respond in three possible ways: 1) Increasing returns to scale 2) Constant returns to scale, and 3) Diminishing returns to scale

INCREASING RETURNS TO SCALE

The law of increasing returns to

scale operates when the percentage increase in the total product is more than the percentage increase in all the factor inputs employed in the same proportion. Many economies set in and increase in return is more than increase in factors. For e.g 10 percent increase in labour and capital causes 20 percent increase in total output. Similarly, 20 percent increase in labour and capital causes 45 percent increase in total output.

Reason of IRS
Due to technical advancement
Mass production- Economies of scale Accumulate production Better use of machinery on Large scale.

CONSTANT RETURNS TO SCALE

Law of constant returns to scale operates when a given percentage increase in the factor inputs in the same proportion causes equal percentage increase in total output.

Economies of scale are

counter balanced by diseconomies of scale.

DIMINISHING RETURNS TO SCALE

The law of diminishing returns to scale occurs when a given percentage increase in all factor inputs in equal proportion causes less than percentage increase in output. Output increases in a smaller proportion.

Diseconomies outweigh

economies of scale

Reasons of DRS
Communication Problem.
Management not able to co-ordinate the activities. New labor are not well trained.

Graphically, the returns to scale concept can be illustrated using the following graphs

IRTS

CRTS

DRTS

X,Y

X,Y

X,Y

 ASSUMPTIONS
1. THERE ARE ONLY TWO FACTORS OF

PRODUCTIONCAPITAL (K) AND LABOUR (L) TO PRODUCE A COMMODITY X

2. THE TWO FACTORS CAN SUBSTITUTE

EACH OTHER UP TO A CERTAIN LIMIT

3. THE TECHNOLOGY IS GIVEN OVER A

PERIOD

The Isocost Line

Capital, K (machines rented)

A
10 8 6 4 2

b c

Cost = Rs50 Per unit price of labor input = Rs10/hour Per unit price of capital input = Rs5/machine
d e f

B 2 3 4 5 6 7 8 9 Labor, L (worker-hours employed)

10
48

Slope of isocost line

M=PL.QL+PK.QK

Where, M=total outlay PL= price per unit of labor QK= price per unit of capital QL= units of labor QK= units of capital
Slope of isocost line= OA/OF

price per unit of labour input price per unit of capital input

Slope of isocost line can be change in two ways: 1) Change in the factor price, and 2) Change in total outlay or total cost

Long run average cost

LRAC refers to
minimum possible per unit cost of producing different quantities of output of a good in the long period. SRAC curves represent various plant sizes Once a plant size is chosen, per-unit production costs are found by moving along that particular SRAC curve
LRAC is made up of SRACs. Since LRAC envelopes all short run curves, hence Called ENVELOPE CURVE

Envelope curve
LRAC can never cut SRAC but it will be tangential to each SRAC at some point. Average cost can not be higher in the long run than in the short run; Explanation; 1.Any adjustment which will reduce costs possible to be made in the short run must also be possible in the long run 2.It is not always possible in the short run to produce a given output in the cheapest possible way as all the factors are not variable.

Long run average cost curve

properties U-shaped curve. Based on assumption of unchanging technology. LRAC is flatter curve than the SRAC. In economics ,we define long period as that during which size of the organization can be altered to meet changed conditions. Normally; Output increases and average costs also increases But in long run, size of the firm Can be increased therefore Variable costs are likely to rise less sharply. Hence a flatter curve. Minimum efficient scale is the lowest output level for which LRAC is minimized

Application of the concept

In the long run, a firm exercises its choice

with regard to the size of the plant and scale of production, on the basis of long run average cost. Selection of the optimal plant size according to the expected demand. Avoid unnecessary costs due to inappropriate plant size.