What do you understand by demand forecasting? Explain its method
Ans.. After gathering information about various aspects of the
market and demand from primary and secondary sources, an attempt may be made to
estimate future demand. Several methods are available for demand forecasting.
The important ones are—
(i) Trend projection method
It consists of (i) determining the trend of consumption by
analyzing past consumption statistics, and (ii) projecting future consumption
by extrapolating the trend. The trend of consumption may be represented by one
of the following relationships:
Linear Relationship: Yt = a + bt … (1)
Exponential Relationship: Yt = aebt … (2)
On logarithmic transformation this becomes:
Log Yt = log a + bt
Polynomial Relationship: Yt = a0 + a1t + a2t2 + … + antn … (3)
Cobb Douglas Relationship: Yt = atb … (4)
On logarithmic transformation this becomes:
Log Yt = log a + b log t
In the above equations Yt represents demand for year t, t is the
time variable, a, b and aj’s are constants.
Out of the above relationships the most commonly used relationship
is-
Yt = a + bt
his relationship may be estimated by using one of the following methods:
(i) visual curve fitting method, and (ii) least squares method.
Evaluation— The basic
assumption underlying the trend projection method is that the factors which
influenced the behaviour of consumption in the past would continue to influence
the behaviour of consumption in the future. This hypothesis is sometimes
referred to asthe hypothesis of “mutually compensating effects”. Clearly, this
is a deterministic hypothesis of questionable validity. Notwithstanding this weakness,
the trend projection method is used popularly in practice. Often a starting
point in the forecasting exercise, it is likely to be relied upon heavily when
no other viable method seems available. The ease with which it can be applied
may induce a sense of complacency.
(ii) Consumption level method
Useful for a product which is directly consumed, this method
estimates consumption level on the basis of elasticity coefficients, the
important ones being the income elasticity of demand and the price elasticity
of demand.
Income elasticity of demand— The
income elasticity of demand reflects the responsiveness of demand to variations
in income. It is measured as follows:
Q2 – Q1 I1 + I2
E1 = ———— × ———
I2 – I1 Q2 + Q1
15
Where E1 = income elasticity of demand
Q1 = quantity demanded in the base year
Q2 = quantity demanded in the following year
l1 = income level in the base year
l2 = income level in the following year
Example— The following
information is available on quantity demanded and income level:
Q1 = 50, Q2 = 55, I1 = 1,000, and I2 = 1,020. The income
elasticity of demand is-
55 - 50 1,000 + 1,020
E1 = ——————— × ——————— = 4.81
1,020 – 1,000 55 + 50
The information on income elasticity of demand along with
projected income may be used to obtain a demand forecast. To illustrate,
suppose the present per capita annual demand for paper is 1 kg and the present per
capita annual income is Rs. 1,2000. The income elasticity of demand for paper
is 2. The projected per capita annual income three years hence is expected to
be 10 per cent higher than what it is now. The projected per capita demand for
paper three years hence will be-
Present per 1 + per capital change income elasticity capita income
in income level of demand
= (1) (1 + 0.10 x 2) = 1.2 kg.
The aggregate demand projection for paper will simply be-
Projected per capita demand × Projected population
The income elasticity of demand differs from one product to
another.Further, for a given product, it tends to vary from one income group to
another and from one region to another. Hence, wherever possible,disaggregative
analysis should be attempted.
Price elasticity of demand— The
price elasticity of demand measures theresponsiveness of demand to variations
in price. It is defined as—
Q2 – Q1 P1 + P2
Ep = ———— × ———
P2 – P1 Q2 + Q1
Where, Ep = price elasticity of demand
Q1 = quantity demanded in the base year
Q2 quantity demanded in the following year
P1 = price per unit in the base year
P2 = price per unit in the following year
Example— The following
information is available about a certain product:
P1 = Rs. 600, Q1 = 10,000, P2 = Rs. 800, Q2 = 9,000. The price
elasticity of demand is:
9000 – 10,000 600 + 800
Ep = ——————— × ——————— = - 0.37
800 - 500 9,000 + 10,000
The price elasticity of demand is a useful tool in demand
analysis. The future volume of demand may be estimated on the basis of the
price elasticity coefficient and expected price change. The price elasticity
coefficient may also be used to study the impact of variable price
that may obtain in future on the economic viability of the project. In using
the price elasticity measure, however, the following considerations should be borne
in mind: (i) the price elasticity coefficient is applicable to only small
variations. (ii) The price elasticity measure is based on the
assumption that the structure and behaviour remain constant.
(iii) End use method
Suitable for estimating the demand for intermediate products, the
end use method, also referred to as the consumption coefficient method involves
the following steps:
1. Identify the possible uses of the product.
2. Define the consumption coefficient of the product for various
uses.
3. Project the output levels for the consuming industries.
4. Derive the demand for the product.
Projected Demand
Consumption
coefficient*
Projected output
in Year X
Projected demand
in Year X
Alpha 2.0 10,000 20,000
Beta 1.2 15,000 18,000
Kappa 0.8 20,000 16,000
Gamma 0.5 30,000 15,000
Total = 69,000 tones
*This is expressed in tones per unit of output of the consuming
industry. As is clear from the foregoing discussion, the key inputs required
for the application of the end-use method are— (i) projected output levels of consuming
industries (units), and (ii) consumption coefficients. It may be difficult to
estimate the projected output levels of consuming industries (units). More
important, the consumption coefficients may vary from one period to another in
the wake of technological changes and improvements in the methods of
manufacturing. Hence, the end-use method should be used judiciously.
(iv) Leading Indicator Method
Leading indicators are variables which change ahead of other
variables, the lagging variables. Hence, observed changes in leading indicators
may be used to predict the changes in lagging variables. For example, the change
in the level of urbanization a leading indicator may be used to predict the
change in the demand for air conditioners a lagging variable.Two basic steps
are involved in using the leading indicator method: (i)First, identify the
appropriate leading indicator(s). (ii) Second, establish the relationship
between the leading indicator(s) and the variable to be forecast.The principal
merit of this method is that it does not require a forecast of an explanatory
variable. It, however, is characterized by certain problems.
(i) It may be difficult to find an appropriate leading indicator(s).
(ii) The lead-lag relationship may not remain stable over time. In
view of these problems this method has limited use.
(v) Econometric method
An econometric model is a mathematical representation of economic relationship/s
derived from economic theory. The primary objective of econometric analysis is
to forecast the future behaviour of the economic variables incorporated in the
model.
Two types of econometric models are employed: the single equation
model and the simultaneous equation model. The single equation model assumes
that one variable, the dependent variable (also referred to as the explained
variable), is influenced by one or more independent variables (also referred to
as the explanatory variables). In other words, one-way causality is postulated.
An example of the single equation model is given below:
Dt = a0 + a1Pt + a2Nt
Where, Dt = demand for a certain product in year t
Pt = price for the product in year t
Nt = income in year t
The simultaneous equation model portrays economic relationships in
terms of two or more equations. Consider a highly simplified three equation econometric
model of Indian economy.
GNPt = Gt + It + Ct … (5)
It = a0 + a1 GNPt … (6)
Ct = b0 + b1 GNPt … (7)
Where GNPt = gross national product for year t
Gt = governmental purchases for year t
It = gross investment for year t
Ct = consumption for year t
In the above model, Eq. (5) is just a definitional equation which
says that the gross national product is equal to the sum of government
purchases, gross investment and consumption. Eq. (6) postulates that investment
is a linear function of gross national product; Eq. (7) posits that consumption
is a linear function of gross national product.The construction and use of an
econometric model involves four broad steps.
1. Specification— This refers to the expression of an
economic relationship in mathematical form. Equation (6), for example, posits
that investments is a linear function of gross national product.
2. Estimation— This involves the determination of the
parameter values and other statistics by a suitable method. The principal methods
of estimation are the least squares method and the maximum likelihood method,
the former being the most popular method in practice.
3. Verification— This step is concerned with accepting or
rejecting the specification as a reasonable approximation to truth on the basis
of the results of estimation and appropriate statistical tests applied to them.
4. Prediction— This involves projection of the value of the
explained variable(s).
Evaluation— The econometric
method offers certain advantages- (i) The process of econometric analysis
sharpens the understanding of complex cause-effect relationships, (ii) the
econometric model provides a basis for testing assumptions and for judging how
sensitive the results are to changes in assumptions.
The limitations of the econometric method are— (i) it is expensive
and data-demanding. (ii) to forecast the behaviour of the dependent variable, one
needs the projected values of independent variable (s). The difficulty in
obtaining these may be the main limiting factor in employing econometric method
for forecasting purposes.
Market penetration for the product— Once
a reasonably good handle over the aggregate demand is obtained, the next
logical question is: What will be the likely demand for the product of the
project under examination? The answer to this question depends on—
1. Aggregate potential supply
2. Nature of competition
3. Consumer preferences
4. Sales promotion efforts
If the aggregate potential domestic supply is likely to be
significantly less than the aggregate potential domestic demand, the demand for
the product of the project under examination is likely to be very strong, provided
liberal imports which may hurt domestic manufacturers are not allowed. The
nature of competition and market-sharing arrangement (if any) has a bearing on
the demand for the product of the project under examination. Consumer
preferences for competing products and the sales promotional efforts of various
competitors obviously influence the relative market shares enjoyed by them.
Comments
Post a Comment