demand forecasting basics

8/10/2019 Demand Forecasting Basics

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PGDM PT) 2012-15

PCPadhan

[email protected]

Demand and Business Forecasting

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Demand Analysis:

Theory, Estimation and Forecasting

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Types of GoodsBased on Income

Normal Goods:An increase in income causes an increase in demand. Ex. Rice, Toothpaste, soap, sampoo.

Luxury Goods:A luxury good means an increase in income causes a bigger % increase in demand.

Ex. high Definition TVs would be luxury. (Note: a luxury good is also a normal good, but a normal good isntnecessarily a luxury good)

Inferior Goods:An inferior good means an increase in income causes a fall in demand. Ex. Tesco value bread.When your income rises you buy less Tesco value bread and more high quality organic bread.

Based on Related Goods

Complementary Goods: Goods which are used together, e.g. TV and DVD player.

Substitute Goods: Goods which are alternatives, e.g. Pepsi and coca-cola. .

Giffen Goods:A rare type of good, where an increase in price causes an increase in demand. Ex., if the price ofwheat rises, a poor peasant may not be able to afford meat any more, so has to buy more wheat.

Veblen Goods:.A good where an increase in price encourages people to buy more of it. This is because theythink more expensive goods are better. Ex. Rollys Royce, D&G

Snob Goods:A goods where a decrease in demand occurs due to more purchase of the same good. Ex.Piccaso Painting, Sports Car

Based on Market Failure

Public Goods: goods with characteristics of non-rivalry and non-excludability, e.g. national defence.

Merit Goods: Goods which people may underestimate benefits of. it Also often has positive externalities, e.g.education.

Demerit Goods: Goods where people may underestimate costs of consuming it. Often has negativeexternalities, e.g. smoking, drugs.

Private Goods: Goods which do have rivalry and excludability. The opposite of a public good, Ex. house

Free Goods:A good with no opportunity cost, e.g. breathing air. 3

Demand Analysis An important contributor to firm risk

arises from sudden shifts in demand forthe product or service.

Demand analysis serves two managerialobjectives:

(1) it provides the insights necessary for

effective management of demand, and

(2) it aids in forecasting sales andrevenues.

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Demand Analysis

Market System

Firms sell goods/services to buyers

Consumers (individuals) : utility

Firms : make profits

Buyers / Consumer's buy the goods andservices by paying a price of it.

Maximum price the buyer will pay for thegoods

Lower prices is always preferred by consumer

So what do you mean by demand?5

Demand for a Commodity: Meaning

Demand is the willingness and capacity

of a customer to purchase the product

(s) or service(s) at each possible priceduring a given period of time.

Price is a tool by which the marketcoordinates individual desires.

Manufacturer

ConsumerCustomer

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Demand for a Commodity: Meaning

The Quantity demand is the amount of aproduct that people are willing and able topurchase at one specific price.

The Law of demand Inverse relationshipbetween Price of a good and QuantityDemanded (Q) of it, assuming other thing heldconstant (ceteris paribus)

A rational consumer maximizes satisfaction by

reorganizing consumption until the marginal utility in

each good per price(rupees) is equal:

Two Reasons for Law of Demand

1. Income Effect2. Substitution Effect

P

Q

D

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Components of Demand: The Income

Effect

Income Effect: The change in quantity demanded that occurswhen the purchasing power of income is altered as a result of pricechanges.

Ex: When the price of a commodity falls , a consumer can purchasemore of a commodity with given money income( i.e his /her realincome increases)

A change in the real value of income: will have a direct effect on quantity demanded if a good is

normal. will have an inverse effect on quantity demanded if a good is

inferior.( Hotdogs. Bread etc.)

The income effect is consistent with the law of demand only if agood is normal. 8


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Components of Demand: The SubstitutionEffect Substitution Effect: When the price of a good falls, the

quantity demanded of the commodity by the individualincreases because the individual substitutes in consumptionof commodity X for other commodities.

Assuming that real income is constant:

If the relative price of a good rises, then consumers willtry to substitute away from the good. Less will bepurchased. ( Ex. Coffee, Tea)

If the relative pr ice of a good falls, then consumers will try

to substitute away from other goods. More will bepurchased.

The substitution effect is consistent with the law ofdemand.

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Law of Demand(Market): Where it Fails?

Bandwagon Effect: Extent to which demand for a consumer goodsincreased owing to the fact that others are consuming more of the samecommodity. The tendency to follow the actions or beliefs of others.

Ex.Ronaldo hair style during football world cup

Snob Effect: Extent to which demand for a consumer goodsdecreasedowing to the fact that others are consuming more of the same commodity.Opposite to Bandwagon effect.

EX. rare works of art, designer clothing, and sports cars.

Veblen Effect( Conspicuous consumptions). Extent to which demand fora consumers goods is increasedbecause it bears a higher price than alower price. Higher the price, higher the demand. Veblen effect is a

function of price.Ex. high-status goods, such as high-end wines, designer handbags (D&G, Gucci) and luxury cars ( Rolls Royce, BMW).

Giffen Goods Effects: people paradoxically consumemore of it as theprice rises ( not the same as Veblen good). Here income effect dominatesandsubstitution effect doesnt work.

Ex. Inferior quality staple foods whose demand is driven by poverty.

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How to Determine the Demand Function?

Based on the definition of demand:

a. Willingness to pay is determined by

Buyers tastes or needs

Types of goods/products:

Necessity or luxurious

Inferior or superior

Durable or perishable

Conspicuous or griffin etc.

Prices of the product

Substitutes goods

Complementary goods

Other factors

b. Capacity to pay is determined by

Income and wealth11

Individual Consumers DemandFunction

QdX =quantity demanded of commodity X by an individual per timeperiod

PX =price per unit of commodity X

I =consumers income

PY =Price of related (substitute or complementary) commodity

T =tastes of the consumer

QdX = f(PX, I, PY, T.)

An equation representing the demand curve

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PriceperDVDs(indollars)

A Demand Curve

Quantity of DVDs demanded (per week)

1 2 3 4 5 6 7 8 9 10111213

$6.00

5.00

4.00

3.00

2.00

1.00

.500

3.50

E

D

C

BFA

Individual Demand Table and DemandCurve

Price per

cassette

A

B

C

D

E

A Demand Table

DVD rentalsdemanded per

week

$0.50

1.00

2.00

3.00

4.00

9

8

6

4

2

Demandfor DVDs

G

The demand table assumes other things remaining the same

The demand curve is the graphic representation of the law of demand which slopesdown ward to the right

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Market Demand Function

QDx=quantity demanded of commodity X

Px=price per unit of commodity X

N=number of consumers on the market

I=consumer income

PY=price of related (substitute or complementary)commodity

T=consumer tastes

D= Demographic distribution

Ms= Market Saturation

QDX = f(PX, N, I, PY, T, D, Ms..)

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How to Derive Market Demand Curves

A market demand curve is the horizontal sum of allindividual demand curves.

This is determined by adding the individual demandcurves of all individual consumers each price.

Arrays individual buyers in order of willingness to pay Identical goods? Product differentiation?

Sellers estimate total market demand for their product which becomes smooth and downwardsloping curve.

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From Individual Demand to a Market

Demand Curve

(1)Price percassette

$.0.501.001.502.002.50

3.003.504.00

(2)Alicesdemand

(3)Brucesdemand

(2)Cathysdemand

(3)Marketdemand

98765

432

65432

100

11000

000

16141197

532

ABCDE

FGH Cathy Bruce Alice

D

A

C

E

F

G

Quantity of cassettes demanded per week

2

$4.00

3.50

3.00

2.50

2.00

1.50

1.000.50

0

Price

percassette(indollars)

4 6 8 10 12 14 16

B

Market demand

Market Demand curve is the horizontal summation of individual demand curve

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D

Price

(perunit)

0

Quantity demanded (per unit of time)

PA

QA

A

A Sample Demand Curve

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Assumption of Law of Demand: OtherThings Constant

Other things constant places a limitation on theapplication of the law of demand.

All other factors that affect quantity demanded areassumed to remain constant, whether they actuallyremain constant or not.

These factors may include changing tastes, prices ofother goods, income, weather etc.

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A. Changes in Quantity Demanded

D1

Change in quantity demanded(a movement along the curve)

B

0

Price

(perunit)

Quantity demanded (per unit of time)100

$2

$1

200

A

Amovement along a demand curve is the graphical representation of the effect of a change in price on thequantity demanded. In other words it refers to Change in Quantity Demanded - movement along the same

demand curve in response to a price change.

Changes in Demand Versus Changes in QuantityDemand

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D0

D1

B. Change/Shift in Demand

Price

(perunit)

Quantity demanded (per unit of time)100

$2

$1

200

B A

Change in demand(a shift of the curve)

250

Change in Demand - shift in entiredemand curve in response to achange in a determinant of demand(a ceteris paribus variable)

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Determinants and Shift Factors of Demand

Tastes

Taxes or subsidiesto consumers

Number of buyers Expectations

Prices of related goods

SocietysIncome

Shift factors of demand are factors that cause shifts in the demand curve:21

The Income

The demand for any goods and services depends upon income.The higher the income the higher the quantity demanded.

A change in the real value of income

will have a direct effect on quantity demanded if a good isnormal. So an increase in income will increase demand fornormal goods. Ex. Rice, wheat, soap, toothpaste etc.

will have an inverse effect on quantity demanded if a good is

inferior. So an increase in income will decrease demand forinferior goods. Ex. Corn, bread.

The income effect is consistent with the law of demand only if agoods are normal.

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Prices of Related Goods: The Substitution:

Assuming that real income is constant:

If the relative price of a good rises, then consumers will tryto substitute away from the good. Less will be purchased.

If the relative price of a good falls, then consumers will tryto substitute away from other goods. More will be purchased.

The substitution effect is consistent with the law of demand.

When the price of a substitute good falls, demand falls for thegood whose price has not changed. Ex. BMW and MercedesBenz

When the price of a complement good falls, demand rises forthe good whose price has not changed. Ex. Car and Petrol

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Tastes and Expectations and Number ofbuyers

a) A change in taste will change demand with no change in price.

b) If you expect your income to rise, you may consume more now.

If you expect prices to fall in the future, you may put offpurchases today.

c) Number of Buyers: Higher the number of buyers, greater the

demand for the product

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QdX = f(PX, I, PY, T)1. Price(Px): QdX/PX < 0

2. Income(I): QdX/I > 0 if a good is normal, Ex. Rice, wheat, tooth paste etc.

QdX/I < 0 if a good is inferior, Ex. Corn, bread.An increase in income will increase demand for normal goods.An increase in income will decrease demand for inferior goods.

3. Price of Related Goods(Py):

QdX/PY > 0 if X and Y are substitutes Ex. BMW and Mercedes Benz

QdX/PY < 0 if X and Y are complements, Ex. Car and PetrolWhen the price of a substitute good falls, demand falls for the good whose price hasnot changed.When the price of a complement good falls, demand rises for the good whose price

has not changed.

4. Taste(T): QdX/taste > 0 for Good taste/choiceQdX/taste < 0 for Bad taste /choice

Shift Factors of Demand: Math Notations

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Factors Affecting Demand for a commodity

(Internal vs External Factors)

Product life-cyclemanagement

Planned price changes

Changes in the sales force

Resource constraints

Marketing and sales

promotion

Advertising

Product substitution

o Income

o Prices of Substitutes

o Prices of Complements

o Expectations,

o Changing customer Tastes andpreferences

o Random fluctuation

o Seasonality

o Competition

o New customers

o Plans of major customerso Government policies

o Regulatory concerns

o Economic conditions/cycles

o Environmental issues

o Weather conditions

o Global and local trends26


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The Elasticity of Demand

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The Concept of Elasticity

Elasticity is a measure of the degree of responsivenessof one variable to another.

The greater the elasticity, the greater theresponsiveness.

Elasticity = % change in quantity demand%change in independent variable

Types: Price Elasticity of Demand Income Elasticity of Demand Cross Elasticity of Demand

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Defining Elasticities

1) Demand is Inelastic if E1

orWhen price elasticity isbetween -1 and - infinity, wesay demand is elastic.

3) Unitary Elastic if E=1

or When price elasticity is -1, wesay demand is unit elastic.

4) Perfectly Elastic E=

5) Perfectly inelastic E=0

Perfectly inelastic E=0

Perfectly elastic E=

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1. Price Elasticity and Its sign

The price elasticity of demand is

Economists use the average of the end points to calculate thepercentage change.

According to the law of demand, whenever the price rises, the quantitydemanded falls. Thus the price elasticity of demand is alwaysnegative.

Because it is always negative, economists usually state the valuewithout the sign.

priceinchangePercentage

demandedquantityinchangePercentage=ED

)(

)(0

P%

Q%

2121

12

2121

12

12

12

PP

PP

QQ

QQ

r

P

PP

Q

QQ

E

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a. Point Elasticity: Calculating Elasticity at a Point

66.6

4

4

241

4

4

2434

2428

A

atE

66.

5.

33.

24

16

24

4*

45

2420A

atE

P

Q

lineSlopeofthe

Quantity

$1098765432

1

C

BA

24 402820

To calculate elasticity at a point determinea range around that point and calculatethe arc elasticity.

P

PP

Q

QQ

E12

12

P%

Q%

1. Price Elasticity of Demand: Calculation

31

b. Arc Elasticity : Calculating Elasticity of Demand Between Two Points

27.126.

33.

23

612

4

)2026(

2026

)1014(

1410

E

21

21

D

Quantity of software (in hundred thousands)

$26

24

22

20

18

1614

0

Demand

B

A

10 12 14

Cmidpoint

Elasticity of demand

between A and B:

)PP(

PP

)QQ(

QQ

P%

Q%E

2121

12

2121

12

1. Price Elasticity of Demand: Calculations

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1.Price Elasticity of Demand: Shapes of curves

Inelastic

demand

Elastic

demand

Unitary Elastic

demand

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1.Price Elasticity of Demand: Shapes of curves

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Price elasticity Types of goods Examples

Relatively Elastic

Demand Ed>1

Luxurious Goods

Close Substitutes Gods

Heinz soup, shell petrol, Tesco bread,

Newspaper, Chocolates, Sports car,

different types of meat

Relatively Inelastic

Demand: Ed


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2. Income Elasticity of Demand

Linear Function

a. Point Definition

b. Arc Definition

Normal Goods EY>0,

Inferior Goods EY


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2. Income Elasticity of Demand Curve Shapes

EY>0 EY1 EY


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2. Income Elasticity of Demand: Examples

Consider these examples:

1. Expenditures on new automobiles

2. Expenditures on new Chevrolets

3. Expenditures on 1996 Chevy Cavaliers with 150,000 milesWhich of the above is likely to have the largest income elasticity?

Which of the above might have a negative income elasticity?

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3. Cross-Price Elasticity of Demand

2 1 2 1

2 1 2 1

X X Y YXY

Y Y X X

Q Q P PE

P P Q Q

Linear Function

a. Point Definition //

X X X YX Y

Y Y Y X

Q Q Q PE

P P P Q

4Y

X Y

X

PE a

Q

b. Arc Definition

Substitutes Goods : EXY>0 Ex. Butter & MargarineComplements Goods: EXY


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D0

P0

D1

P0

104

Quantity of Beef

108

Shift due to 33% risein price of pork

12.33.

038.

33.

)104108(

104)-(108

E 21

cross

3. Cross-Price Elasticity of Demand: Calculations

43

3. Cross Price Elasticity of Demand (Exy) Curve Shape

(A) (B) (C)

QX

QX QX

PYPY PY

EXY0EXY=0

D DD

(A) Two goods thatcomplement each othershow a negative crosselasticity of demand: asthe price of good Y rises,the demand for good Xfalls

(B)Two goods that aresubstitutes have apositive cross elasticityof demand: as the priceof good Y rises, thedemand for good Xrises

(C) Two goods that areindependent have azero cross elasticity ofdemand: as the price ofgood Y rises, thedemand for good Xstays constant

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Combined Effect of Demand Elasticities

Most managers find that prices and incomechange every year. The combined effect ofseveral changes are additive.

%Q = ED(% P) + EY(% Y) + EX(% PR) where P is price, Y is income, and PR is the price of a related good.

If you knew the price, income, and cross

price elasticit ies, then you can forecast thepercentage changes in quanti ty.

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Total Revenue, Marginal Revenueand

Elasticity of Demand

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Elasticity, Total Revenue(TR), MarginalRevenue (MR) and Demand

The elasticity of demand tells suppliers how their total revenue willchange if their price changes.

a. Total Revenue equals total quantity sold multiplied by price of good.

TR=PQ

b. Marginal Revenue equals the change in total revenue due to changein output

MR=TR/Q or TR/ Q

If ED is elastic (ED > 1), a rise in price lowers total revenue. If ED is inelastic (ED < 1), a rise in price increases total revenue.

P & TR move in opposite directions. If ED is unit elastic (ED = 1), a rise in price leaves total revenue

unchanged. P & TR move in the same direction.

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Elasticity and Total Revenue

A

Unit Elastic Demand: E = 1

TR constant

C

06

Price

Quantity

$10

8

6

4

2

1 2 3 4 5 7 8 9

B

ELost

revenue

FGained revenue

TRE= $4x6=$24TRF= $6x4=$24

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A

Price

Inelastic Demand: E < 1

Quantity

$10

8

6

4

2

0 1 2 3 4 5 6 7 8 9

TR rises if price increases

C

H

G

Lostrevenue

Gainedrevenue

TRG = $1 x 9 = $9

TRH = $2 x 8 = $16

B

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C

B


A

Price

Elastic Demand: E > 1

Quantity

$10

8

6

4

2

01 2 3 4 5 6 7 8 9

TR falls if price increases.K

J

Lostrevenue

Gainedrevenue

TRJ = $8 x 2 = $16TRK = $9 x 1 = $9

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Let the demand function is Q= 600-100P

=> P=(600-Q)/100Since TR=PQ

=>TR=600Q-Q2/100

So, MR= 6-Q/50

With elastic demand a rise inprice lowers total revenue.

With inelastic demand a rise inprice increases total revenue.

Total Revenue Along a Demand Curve:

Example:

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With elastic demand a rise in price lowers total revenue.

With inelastic demand a rise in price increases total revenue.

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Thanks !!!!!!!

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demand forecasting basics

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