Demand Estimation & Forecasting

Direct Methods of Demand Estimation Consumer interviews – Range from stopping shoppers to speak with them to administering detailed questionnaires – Potential problems Selection of a representative sample, which is a sample (usually random) having characteristics that accurately reflect the population as a whole Response bias, which is the difference between responses given by an individual to a hypothetical question and the action the individual takes when the situation actually occurs Inability of the respondent to answer accurately

Direct Methods of Demand Estimation Market studies & experiments – Market studies attempt to hold everything constant during the study except the price of the good – Lab experiments use volunteers to simulate actual buying conditions – Field experiments observe actual behavior of consumers

Empirical Demand Functions Demand equations derived from actual market data Useful in making pricing & production decisions In linear form, an empirical demand function can be specified as

Empirical Demand Functions In linear form – b =  Q/  P – c =  Q/  M – d =  Q/  P R Expected signs of coefficients – b is expected to be negative – c is positive for normal goods; negative for inferior goods – d is positive for substitutes; negative for complements

Empirical Demand Functions Estimated elasticities of demand are computed as

Nonlinear Empirical Demand Specification When demand is specified in log-linear form, the demand function can be written as

Demand for a Price-Setter To estimate demand function for a price- setting firm: – Step 1: Specify price-setting firm’s demand function – Step 2: Collect data for the variables in the firm’s demand function – Step 3: Estimate firm’s demand using ordinary least-squares regression (OLS)

Time-Series Forecasts A time-series model shows how a time-ordered sequence of observations on a variable is generated Simplest form is linear trend forecasting – Sales in each time period (Q t ) are assumed to be linearly related to time (t)

Linear Trend Forecasting – If b > 0, sales are increasing over time – If b < 0, sales are decreasing over time – If b = 0, sales are constant over time

Estimated trend line A Linear Trend Forecast (Figure 7.1) Sales Time Q t           2007   12

Forecasting Sales for Terminator Pest Control (Figure 7.2)

Seasonal (or Cyclical) Variation Can bias the estimation of parameters in linear trend forecasting To account for such variation, dummy variables are added to the trend equation – Shift trend line up or down depending on the particular seasonal pattern – Significance of seasonal behavior determined by using t -test or p -value for the estimated coefficient on the dummy variable

Sales with Seasonal Variation (Figure 7.3)                

Dummy Variables To account for N seasonal time periods – N – 1 dummy variables are added Each dummy variable accounts for one seasonal time period – Takes value of 1 for observations that occur during the season assigned to that dummy variable – Takes value of 0 otherwise

Effect of Seasonal Variation (Figure 7.4) Sales Time QtQt t Q t = a’ + b t a’ a Q t = a + b t c

Some Final Warnings The further into the future a forecast is made, the wider is the confidence interval or region of uncertainty Model misspecification, either by excluding an important variable or by using an inappropriate functional form, reduces reliability of the forecast Forecasts are incapable of predicting sharp changes that occur because of structural changes in the market

Demand estimation through Marketing Research Approach

Demand estimation through marketing Research approach We know that Production of a good or supplying of product to the market depends on correct estimation of demand in case of incorrect estimation of demand firm would decrease the profit Similarly excess supply of product to the market tends to fall the price of good, and profit margin of a firm would decline

We can estimate demand through the following techniques Consumer surveys and observational Research Consumer Clinics Market Experiments

Consumer surveys and observational Research  The survey conducted at a big shopping centers by trained interviewers with sophisticated questions  Consumers questionnaires provide useful information to the firm

sample of questionnaires Do you know how much your monthly consumption of Coke would change if  price of Coke rose by 10%  your income increase by 20%  Coke producer doubled its advertising expenditures  caffeine content of Coke were reduced by 1% point  price of competitor product (Coke) reduced by 2%

 Through answer of these questions manager can get a rough idea about the market demand  Some time consumers are unable or unwilling to provide accurate information  In this case manager is not able to estimate the market demand, so consumer survey is replace by observational research

Observational research: This refers to the gathering of information on consumer preferences by watching them buying and using goods However consumer survey is useful and is the only way to obtain information about possible consumer response  Especially if a firm is thinking of introducing a new product or changing the quality of an existing one  The only way that the firm can test consumer reaction is to directly ask them, since no other data are available

Consumer Clinics These are laboratory experiments in which the participants are given a sum of money and asked to spend it in a simulated stores to see the react, change the price of product in different stores Different product packing in different stores Different product displays in different stores Different price of competing product in different stores etc

Advantages of the Methods  Participants have the incentive to purchase the commodities they want the most  This method is more realistic than consumer survey, because in this method we are observing the actual market behavior

Shortcomings of this method The results are questionable because participants know that they are in an artificial situation and that they are being observed  So they are not likely to act normally  The sample of participants must necessarily small because of the high cost of running the experiment  Inference or results from small sample are dangerous

Market Experiments  Market experiments are conducted in the actual market place  There are many ways of performing market experiments  One way is to select several markets with similar socioeconomic characteristics

Market experiments can be conducted by  Changing the commodity price in some markets or stores  Packing in other markets or stores  Different amount of promotion in the markets and stores Then record the response (purchase) of consumers in the different markets  By using census data or survey for various markets, a firm can also determine the effect of age,sex, level of education, income, family size and so forth on demand for the commodity

Advantages of this method  We can ensure the validity of the results by conducting on a large scale  Consumers act /behavior is normal as consumers are not aware that they are part of an experiment

Disadvantages of this method:  In order to keep costs down, the experiment is likely to be conducted on too limited a scale  The experiment is conducted for short period of time  So inference or results about entire market and or more extended period of time are questionable  Irregular factors such as strike or bad weather seriously effect the result (Continue)

Competitors could try to sabotage the experiment by changing prices and other determinants of demand under their control Competitors also monitor the experiment and gain useful information that the firm would prefer not to disclose Firm might permanently lose customers in the process of raising prices in the market where it is experimenting with a high price