MANAGERIAL ECONOMICS

Chapter Two
Demand and Supply

1
 Chapter Two
DEMAND AND SUPPLY
• Meaning and Determinants of demand and supply
• Demand Function, Law of Demand, Market Demand
• Market Equilibrium
• Elasticity of demand, Types of elasticity, Measurement of
elasticity.
• Methods of Demand estimation, Demand forecasting

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1. Meaning and Determinants of demand and supply
Supply and demand analysis - one of the most powerful tools of economics for analyzing
the way market forces determine prices and output levels in competitive markets.
Demand Theory
 Demand for the good is the various quantities of that good consumer’s are willing
and able to buy at a given price over a given period of time.
- The amount of a good or service consumers are willing and able to purchase during a
given period of time (week, month, etc.).
 Desire + ability to pay for the good.
e.g. according to this definition, a hungry man that not able to pay for food has no
demand for it.
Law of Demand
the law of demand states that quantity demanded of a good decrease as price increase
and vise versa.

3
…demand Demand curve is a graph of r/n ship b/n
individual and market demand the quantity demand of the good and its price
schedule & curve citrus paribus.
 Demand schedule is the table The curve slopes down ward from left to
that presents the quantities right, shows the negative relation ship of
demanded at each price level between the price of a good and quantity
during a specific time period. demanded-law of demand.
Price
Price of A (birr Quantity demanded
20
per unit) ( Units per week)
16 Demand
4 28
12 curve
8 15
12 5 8
16 1 4
20 0
0 1 5 15 28
Quantity
4
…demand Com Price
binati (Birr
Consu
mer A
Consu
mer B
Total
Market
The market demand curve & schedule ons per (kg) (kg) demand
kg)
 Market demand is the sum total of goods A 4 28 16 700
bought by all individual consumers B 8 15 11 500
 To obtain market demand it is through C 12 5 9 350
adding the quantity demanded by each D 16 1 7 200
individuals at a given price for that E 20 0 6 100
period.
Price
Birr/kg

20 Market demand curve

16

12

5
 Chapter 2: Demand and Supply…

Determinants of demand
• When price changes, quantity demanded will change - a movement along the
same demand curve.
• When factors other than price changes, demand curve will shift - determinants of
the demand.
1. Income: A rise in a person’s income will lead to an increase in demand (shift
demand curve to the right)
- Goods whose demand varies inversely with income are called inferior goods
2. Consumer Preferences: Favorable change leads to an increase in demand,
unfavorable change lead to a decrease.
3. Number of Buyers: the more buyers lead to an increase in demand; fewer buyers
lead to decrease.
4. Price of related goods: a. Substitute goods - price of substitute and demand for
the other good are directly related. - Ex. If the price of coffee rises, the demand for tea should
increase. b. Complement goods - price of complement and demand for the other good
are inversely related. 6
…determinants of demand
5. Future Expectation: a. Future price: consumers’ current demand will increase if
they expect higher future prices b. Future income: consumers’ current demand will
increase if they expect higher future income
The demand function – is the mathematical equation that shows the relation
between quantity demanded of the good and its determinants.
e.g. the quantity demand function of good x can be written as;
 QxD = f ( Px , T, Y, Ps , Pc, E, ….) where QDx the quantity demanded of good X
• Px is the price of good X
• T is consumer taste
• Y is consumer income
• Ps is price of substitute
• PC is price of complement.
• E is expectation of consumers about future market.

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…determinants of demand
What increases demand?
1. A rise in consumer income
 If one makes more money, the demand curve shifts outward.
 This means, more normal goods are demanded at every price.
2. increase in price of a substitute good
 When price of the substitute good increase people switch of that good and the demand for the
good in question will increase.
3. Decrease in the price of complement
 When the price of complement decreases the demand for the good increase.
4. Positive change in consumer tastes
 If the taste of consumer on the good change positively, the demand for the good increase.
5. Consumer expectation-
 if consumers think that the price of the good increase in the future demand for the good
increase.
6. Number of buyers increase with in the market.
 For all the above the demand curve shift out ward.
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 Supply
Supply Theory
■ A market has two sides on one side are the buyers or demanders and on the
other are the sellers or suppliers.
– The quantity supplied of a good, service or resource is the amount of goods that
people are willing and able to sell at a specified price and at a specified period
of time.
– Supply is the relationship between the quantity supplied and the price of good
when all other influences on selling plans remain the same ( ceterius paribus)
The law of supply
Other things remaining constant if the price of a good raise the quantity supplied of
that good increase and vise versa

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…supply
Individual Supply schedule and curve
■ Supply schedule is a list of quantity supplied at each different price.
■ The following table shows the individual supply schedule for butter.
■ Supply curve A graph of relationship between the quantity supplied of a
good and its price citrus paribus

Price
Price Quantity
(birr/kg)
(birr) kg supplied( kg per
week)
30.00 100
25.00 90 Individual supply curve
20.00 80
15.00 70 quantity (kg/
10.00 60 week)

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…supply
Market supply schedule and curve
 Is the total quantity all firms or producers are willing and able to sell over a period of time at a
given price. e.g. the following table shows the market supply schedule.
 Market supply curve is a figure that shows the direct relation of quantity supplied and price of
the product.

combinat Price of Farmer Total ■ Price (birr/kg)

ions potatoes X’S market 20
(birr/kg) supply supply
( tones) (tones 16
000)
12
a 4 50 100
b 8 70 200 8

c 12 100 350
4
d 16 120 530
0 100 200 300 400 500 600 700 800 ( quantity tones: 000)

e 20 130 700
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Determinants of supply
1. Production technology: an improvement of production technology increases
the output. This lowers the average and marginal costs, since, with the same
production factors, more output is produced.
2. Prices of production factors: a rise in the price of one or more production
factors leads to an increase in the production costs and vice versa.
Resource and input prices influence production cost & the more its cost of
production, the less the quantity supplied of that good citrus paribus.
3. Prices of other products: the supply of a product may be influenced by the
prices of other products, especially if the products are complementary.
That is the price of the substitute and the supply of the original good move in
opposite direction. The supply of a good and price of its complement move in the
same direction.
4. Number of production units/sellers: as the number of production units
increases, the total supply of a product increases and vice versa.

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Determinants of supply
5. Government policies: when taxes increase, the quantity supplied decreases
because the cost of production increases. When subsidies increase, the
quantity supplied increases because the cost of production decreases.
6. Expectations of producers: if producers expect a rise in the price of a product,
they are likely to lower the quantity supplied and wait until the price goes up to
sell the product at a higher price.
If sellers assume the increase in price next time, they decrease current supply.
And the input cost also affect if they think that the cost of production will
increase in the future, produce now and increases supply.
7. Random, natural, and other factors: the supply of agricultural products is
influenced by natural phenomena and the weather conditions. Other factors
affecting supply can be extended strikes, floods, political instability etc.
8. Productivity- productivity is output per unit of input. An increase in
productivity lowers costs and increase supply and vise versa.

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Determinants of supply
What increases supply?
When the price of the product changes, there is movement along the supply curve.
This is due to the law of supply.
An increase in supply
 If the price of substitute in production falls
 If the price of complement in production rises
 A resource price or other input price fall
 The number of sellers increases.
 Productivity increases.
 Profitability of the joint product decrease.
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Market Equilibrium
Demand and supply equilibrium
 Equilibrium means opposing forces are in balance in a market; the opposing
forces are those of demand and supply.
 Buyers want the lowest possible price and the lower the price, the greater is
the quantity that they plan to buy
 Sellers want the highest possible price and the higher the price, the greater is
the quantity that they plan to sell.
Market equilibrium occurs when the quantity demanded equals the quantity
supplied when buyer’s and sellers plan are consistent.
 The equilibrium price is the price at which the quantity demanded equals the
quantity supplied and market-clearing price
 The equilibrium quantity is the quantity bought and sold at the equilibrium
price
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…market equilibrium
■ Surplus and Shortage
Surplus
– If the market price is above the equilibrium
price, quantity supplied is greater than
quantity demanded, creating a surplus.
– Market price will fall.
• Example: if you are the producer, you have a lot of excess
inventory that cannot sell, you lower the price of your product,
your product’s quantity demanded will rise until equilibrium is
reached.
• Therefore, surplus drives price down.
– If the market price is below the equilibrium price,
quantity supplied is less than quantity
demanded, creating a shortage. The market is
not clear.
– Market price will rise because of this shortage.
• Example: if you are the producer, your product is always out of
stock. you raise the price to make more profit, your product’s
quantity demanded will drop until equilibrium is reached.
• Therefore, shortage drives price up.
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 Chapter 2: Demand and Supply…
…market equilibrium
Changes In Equilibrium Price and Quantity
– It is determined by the intersection of supply and demand.
– A change in supply, or demand, or both, will necessarily change the equilibrium price, quantity or both.
– It is highly unlikely that the change in supply and demand perfectly offset one another so that equilibrium
remains the same.

by
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 The Price System: allocating resources and government
regulations
The price adjustments bring equilibrium. But suppose that for some reason, the
price in a market doesn’t adjust. What happen then?
 It is answered depending on the question why the price doesn’t adjust and there
are different mechanisms to adjust:
1. Price rationing
 The process by which the market system allocates goods and services to
consumers when quantity demanded exceeds quantity supplied.
 Example When supply is fixed or something for sale is unique, its price is demand determined.
Price is what the highest bidder is willing to pay. In 2004, the highest bidder was willing to pay
$104.1 million for Picasso’s Boy with a Pipe
 And on occasion, both governments and private firms decide to use some
mechanism other than the market system to ration an item for which there is
excess demand at the current price. But, it may result in
 Attempts to bypass price rationing in the market and are much more
difficult and costly
 costs and benefits among households in unintended ways.
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…the Price System: allocating resources and government regulations
2. Price ceiling and Price floor /
Government regulations
– Price Ceiling- is legally
imposed maximum price on the
market. Transactions above this
price is prohibited.
• Policy makers set ceiling price
below the market equilibrium price
which they believed is too high.
• Intention of price ceiling is keeping
stuff affordable for poor people.
• Price ceiling generates shortages on
the market.
– Example: Rent Control, MRP
(Maximum retail Price)
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…the Price System: allocating resources and government regulations
– Price Floor- is legally
imposed minimum price on
the market. Transactions
below this price is prohibited.
• Policy makers set floor price above the
market equilibrium price which they
believed is too low.
• Price floors are most often placed on
markets for goods that are an important
source of income for the sellers, such as
labor market.
• Price floor generate surpluses on the
market.
– Example: Minimum Wage, Oil price
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…the Price System: allocating resources and government regulations
3. Other Price adjustment mechanisms
i. Queuing - waiting in line as a means of distributing goods and services
ii. favored customers - those who receive special treatment from dealers during
situations of excess demand.
iii. ration coupons - tickets or coupons that entitle individuals to purchase a
certain amount of a given product per month.
iv. black market - a market in which illegal trading takes place at market-
determined prices
 No matter how good the intentions of private organizations and governments,
it is very difficult to prevent the price system from operating
 the final distribution using favored customers and black markets may be even
more unfair than that which would result from simple price rationing.
 At the core of the system, supply, demand, and prices in input and output
markets determine the allocation of resources and the ultimate combinations
of things produced.
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Supply and Demand and Market Efficiency
Consumer and producer surplus
 Consumer surplus (CS): is the amount consumer’s benefit by being able to
purchase a product for a price that is less than what they would be willing to
pay. (the difference between the maximum amount a person is willing to pay
for a good and its current market price

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Supply and Demand and Market Efficiency
■ Producer surplus (PS): is the difference between the price for which a
producer would be willing to provide a good or service and the actual
price at which the good or service is sold (the difference between the
current market price and the full cost of production for the firm)

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 Supply and Demand and Market Efficiency
■ competitive markets maximize the sum of producer & consumer surplus
■ However, due to overproduction or underproduction there could be loss,
deadweight loss - the net loss of producer and consumer surplus from
underproduction or overproduction or market failure
■ When supply and demand interact freely, competitive markets produce
what people want at least cost – market efficient.

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ELASTICITY OF DEMAND AND SUPPLY

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 Elasticity
 Elasticity is a measure of how quantity Q (demanded or supplied) responds to
change in the determining factors F (such as own price, income or price of
other goods).
 Elasticity is a measure of a variable's sensitivity to a change in another
variable.
 In business and economics, elasticity refers the degree to which individuals,
consumers or producers change their demand or the amount supplied in
response to price or income changes.
 Elasticity as an economic concept is predominantly used to assess the
change in consumer demand as a result of a change in a good or service's
price.

%A
elasticity of A with respect to B 
%B
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…elasticity of demand
How Elasticity Works
 A product is considered to be elastic if the quantity demand of the product
changes drastically when its price increases or decreases.
 Conversely, a product is considered to be inelastic if the quantity demand of
the product changes very little when its price fluctuates.
 When the value of elasticity is greater than 1, it suggests that the demand for
the good or service is affected by the price. A value that is less than 1 suggests
that the demand is insensitive to price.
– For example, insulin is a product that is highly inelastic. For diabetics who
need insulin, the demand is so great that price increases have very little
effect on the quantity demanded. Price decreases also do not affect the
quantity demanded; most of those who need insulin aren't holding out for a
lower price and are already making purchases.

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Elasticity of Demand
Elasticity of Demand
 Is the situation of demand as price of the good, income and price of the
related goods change - Price elasticity of demand, income elasticity of
demand and cross elasticity of demand.
1. Price elasticity of demand
• Is the responsiveness of quantity demanded to a change in price.
• When Price increases, the quantity demanded falls but we want to know how
fast quantity demanded will fall.
Ed= %∆Q
%∆P
E.g. 1 if a 40% rise in price caused the quantity demanded to fall by 10% the price elasticity of
demand over this range would be; Ed= 10 %/ 40% = 0.25
E.g. 2. If a 5% fall in price of cauliflower caused a 15% raise in the quantity demanded, the price
elasticity of demand for can lowers would be; Ed= 15 %/ 5% = 3
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Price Elasticity of Demand

29
…price elasticity of demand
Interpreting Elasticity
a) Enables comparison of two qualitatively different things, which are measured by
two different units i.e. it allows comparison of quantity changes with monetary
changes.
b) It avoids the problem of what size units to use - e.g. the change from $ 2 - $4 is 2
price units and the change from 20 birr to 40 birr is 20 price units. By using %
age the same result will be obtained.
c) It is the only sensible way of deciding how big the change in price or quantity will
be e.g. a change in 16 birr may be large or small but depends on original price
when we explain it as original price we can decide.
d) The sign is negative b/c the price of the law of demand. If we ignore about sign
and talk about figure this will tell us whether the demand is elastic, unitary
elastic or inelastic.
Ed > 1; demand is elastic. i.e. quantity demanded is more sensitive to price change
Ed < 1; demand is inelastic. i.e. quantity demanded is less sensitive to price change
Ed =1; unitary elastic; i.e. the proportionate change in both Q and P is the same
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…price elasticity of demand
 There are three exceptional cases where elasticity of demand remains the
same.
a) Perfectly elastic demand
b) perfectly inelastic demand and
c) Unitary elastic demand
 Perfectly inelastic demand - Ed=0 - there is no change in quantity demanded
what ever price changes. It is represented by vertical demand curve.
 Perfectly elastic demand - Ed= ∞ - Indicated by horizontal demand curve.
Consumers buy infinitely large quantity at the set price.
 Unitary elastic demand - Ed= 1 - The percentage change in quantity and price
will be exactly the same

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…price elasticity of demand
What determinates price elasticity demand
1. Availability of close substitute goods: as there is large number of close
substitute goods, the demand will be more elastic.
2. Proportionate of income spent on the good: as less income spent on the
good it is more inelastic and vise versa. E.g. salt, matches,…
3. Durability of the product: postponing purchase, possibility of repair or visit
used product market
4. Time period: The longer the time period, the more elastic the demand is to
be; because consumers can get substitute. Example:- If the price of cigarettes goes
up 20 Br per pack, a smoker with very few available substitutes will most likely continue buying
his or her daily cigarettes. If that smoker finds that he or she cannot afford to spend the extra
20 per day and begins to kick the habit over a period of time, the price elasticity of cigarettes
for that consumer becomes elastic in the long run.
5. Nature of the product/ good: demand of necessary goods inelastic and that
of luxury good is elastic. It is possible to postpone luxury goods. Example -
gas; even if the price of gas doubles or even triples, people will still need to
fill up their tanks.
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…price elasticity of demand
Price elasticity of demand and total Revenue/consumer expenditure
■ Total consumer expenditure is the same as the revenue (TR) that is revenue by firms
from the sale of the product (before any taxes or other deductions)
– Elasticity is important because it tells you how revenue changes as you change price,
– What will happen to TE hence TR if price change?
– The answerer depends on the price elasticity of demand and which effect is stronger
For Elastic demand
Price and total revenue change in opposite direction
– P falls – Q rises; Therefore, TE – rises – TR rises
For Inelastic demand
Total revenue change in the direction of price.
■ P rises - Q falls proportionately less; therefore TE rises – TR rises
■ Revenue reaches its peak if elasticity is 1
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…price elasticity of demand and total Revenue
■ When demand is elastic, quantity changes by a greater percentage than price,
so revenue will rise following a price decrease and revenue fall following a
price increase.
■ On the other hand, if you increase price when demand is elastic, revenue will
go down
– To illustrate, let’s look at Mayor Marion Barry’s tax increase on gasoline sales
in the District of Columbia. Before the tax was put into law, D.C. gas station
owners argued against it, predicting that the 6% price increase would reduce
quantity by 40%. Indirectly, the gas station owners were arguing that the price
elasticity of demand for gasoline sold in the District was–6.7. Because of this
very elastic demand, the gas station owners predicted that gasoline revenue,
and the taxes collected out of revenue, would decline.
– In fact, after the tax was instituted, quantity fell by 38%, very close to what
gas station owners had predicted. Sure enough, tax revenue fell, as would be
predicted.
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Mathematical approach to price elasticity of demand

■ Marginal revenue (MR) is the

change in revenue following a
one-unit expansion in output,
∆TR/∆Q, and can be written

35
…mathematical approach to price elasticity of demand
■ As a practical matter, firms devote enormous
resources to obtain current and detailed information
concerning the price elasticity of demand for their
products.
■ Price elasticity estimates represent vital information
because these data, along with relevant unit cost
information, are essential inputs for setting a pricing
policy that is consistent with value maximization.
■ This stems from the fact that there is a relatively
simple mathematical relation between marginal
revenue, price, and the point price elasticity of demand
■ Hence, the optimal or profit-maximizing
price, P*, equals; at MC=MR

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The Importance of Price Elasticity in Business
– Understanding whether or not a business's good or service is elastic is
integral to the success of the company.
– Companies with high elasticity ultimately compete with other businesses
on price and are required to have a high volume of sales transactions to
remain solvent
– Firms that are inelastic, on the other hand, have goods and services that
are must-haves and enjoy the luxury of setting higher prices.
– Beyond prices, the elasticity of a good or service directly affects the customer
retention rates of a company.
– Businesses often strive to sell goods or services that have inelastic demand;
doing so means that customers will remain loyal and continue to purchase
the good or service even in the face of a price increase.

37
 Income elasticity of demand
2. Income elasticity of demand Edy
 measures the responsiveness of demand to a change in consumer income (y)
 It enables us to predict how much the demand curve will shift for a given change
in income
 Income elasticity is positive for normal good and negative for inferior good. Is the
above good normal good or inferior good?
Example 1 - If the income of consumer changed from 600 to 630 birr and
the demand for meat increased from 8kg to 12 kg per month the income
Edy= %∆Q
elasticity demand for meat would be Given - y1=600, y2= 630 & Q1=8,
%∆y Q2=12; Edy = 5

Example 2 – For an individual monthly quantity demanded for a good

decrease from 40 units to 35 units as a result of her income rise from 180
ETB to 210 ETB. What is the income elasticity of demand and what is the
nature of the product? 38
…income elasticity of demand

• Engel’s Law – as income rises, the proportion of income spent on food falls –
even if absolute expenditure on food rises. Consumers increase their
expenditure for food products in percentage terms less than their increases
in income. Services have higher income elasticity of demand than goods

Determinants of income elasticity of demand

i. Degree of necessity of the good – for developing countries the demand
increase for normal goods and decrease for inferior goods.
ii. The rate at which the resource satisfy human need - satisfy immediately
less demand as income increase and vise versa.
iii. Level of income of consumers - Poor people will respond differently from
rich people to the rise in income. E.g. poor people buy more butter than
rich people if their income increases. 39
3. Cross price elasticity of demand
 It is a measure of the responsiveness of demand for product as price of the other
good change (either a substitute or complement)
 It enables us to predict how much the demand curve for the first product shift
when the price of the second product changes.
Example - Knowing the cross elasticity of demand for Coca cola to the price of Pepsi enables coca
cola to predict the effect on it’s demand if price of Pepsi is to change.
If good b is substitute for good a, a’s demand rise as b’s price
■ CEdab= %∆Qa rises. Hence CEdab is positive.
%∆Pb If good b is complementary good for a, a’ s demand will fall as
b’s price rises. Hence CEdab will be negative.
■ What will be the cross price elastic of two unrelated goods?
Example 1 - If a 4% rise in the price of butter results in a 3% rise in the demand of oil, then cross elasticity of
oil with respect to better would be. CEdab = ¾ = 0.75
Example 2 - If a 4 percent rise in the price of bread lead to 1% fall in demand for jam, the cross elasticity of
demand for jam with respect to bread will be. CEdab = -¼ = 0.25
■ What makes cross elasticity of demand elastic/inelastic is their closeness, The higher the
closeness (either substitute or complementary) the higher is the cross elasticity either positive or
negative. 40
Elasticity of supply (Es)
■ Price elasticity of supply is how responsive is supply to a change in price
Es = %∆Q Example - If the price of banana rise from 2 birr/kg to 3 birr/kg
%∆P the quantity supplied rise from 20 kg to 25kg, then the price
elasticity of supply would be: Es = 0.5
Here the quantity increased only by 25% when the price increased by 50%.
■ Unlike the elasticity of dd, the price elasticity of supply is positive because
quantity supply and price move in the same direction.
■ If Es <1, the supply curve is inelastic. The % age change in quantity supplied is
less than the percentage %age change in price.
■ If Es= 1, the supply curve is unitary elastic. The percentage change in quantity
equals the percentage change in price.
■ If Es> 1, the supply curve is elastic the percentage change in quantity is great
than the percentage change in price.

41
Determinants of price elasticity of supply
1. Time
 If the time is very short supply can not respond and Es= 0 (perfectly inelastic)
 The short run- the firm can increase out put using their existing plant and equipment, so supply
can be increased some what.
 in the long run there is sufficient time to increase input and therefore supply is highly elastic.
2. Substitute or complement in production
 If the inputs used to produce the good switched to other - the elasticity of supply will be high.
Example - If there are many grain producers and if there is little price change the supply
elasticity of one of the grains will be very high.
3. The amount of cost rise - if the cost is lesser to produce additional out put firms will be
encouraged to produce more as price increase and the higher is the elasticity of supply.

42
Rules of Differentiation – Just to remind

43 of 29
Exercise
■ A firm has been selling 5,000 T-shirts per month for 255
ETB. When they increased the price to 285 ETB they sold
only 4,000 T-shirts. What is the demand elasticity? If the
marginal cost is 120 per shirt, what will be the desired
markup price? Was raising the price profitable?

44 of 29
DEMAND ESTIMATION AND DEMAND FORECASTING

45
Demand estimation

Specification of the model – variable identification

46 of 29
Data Collection
■ Data for studies pertaining to countries, regions or industries are readily
available
■ Data analysis of specific product categories may be more difficult to obtain
– Buy from data providers
– Perform a consumer survey
– Focus group
– Technology, point of sale, bar codes

47
Regression Analysis
■ Regression Analysis : a procedure commonly used by economists to estimate
consumer demand with available data
■ Two Types of regression
– Cross-sectional – analyze several variables for a single period of time
– Time series data – analyze a single variable over multiple period of time

48
Interpreting the regression results

■ T-test: - test of statistical significance of each estimated coefficient

■ b – estimates coefficient
■ SEb – standard error of estimated coefficient
49
Statistical evaluation of regression results
■ Rule of 2 (1.96) – if absolute value of t is greater than 2, estimated coefficient is
significant at 5% level
■ If coefficient passes t-test, the variable has a true impact on demand
■ R2 (Coefficient of determination) – percentage of variation in the variable (Y)
accounted for by variation in all explanatory variables (Xn)
– R2 value ranges from 0.0 to 1.0
– The closer to 1.0, the greater the explanatory power of the regression

50
 Reading Assignment
Mark Hirschey and
Eric Bentzen (2016). Managerail Economics,
14th edition
Page 169

51
Reading Assignment

Trefor Jones (2005).

Business Economics
and Managerial
Decision Making
Page 115

52
Regression Problems
■ Identification Problems – the estimation of demand may produce biased results
due to simultaneous shifting of supply and demand curves
– Solution – use advances correction techniques; such as two stage least
squares and indirect least squares
■ Multicollinearity problem – two or more independent variables are highly
correlated, thus it is difficult to separate the effect each has on the dependent
variable
– Solution – a standard remedy is to drop one of the closely related independent
variables from the regression
■ Autocorrelation problems – also known as serial correlation, occurs when the
dependent variable relates to the Y variable according to a certain pattern
– Possible causes include omitted variables, non-linearity, ….
– Solution – transforming the data into a different order of magnitude or
introducing leading or lagging data and use of Durbin-Watson statistic
53
Demand Forecasting
■ Common business forecasts
– GDP
– Components of GDP (Consumption expenditure, residential construction, producer durable
equipment expenditure)
– Industry forecasts (sales of products across an industry)
– Sales of a specific product
■ A good forecast should:
– Be consistent with other parts of the business
– Be based on knowledge of the relevant past
– Consider the economic and political environment as well as changes
– Be timely
■ Factors in choosing the right forecasting technique
– Item to be forecast
– Interaction of the situation with the forecasting methodology
– Amount of the historical data available
– Time allowed to prepare forecast 54
Forecasting techniques
■ Approaches to forecasting
– Qualitative – forecasting is based on judgements expressed by individuals or
group
– Quantitative – forecasting utilizes significant amounts of data and equations
– Naïve – forecasting projects past data without explaining future trends
– Causal (explanatory) forecasting attempt to explain the functional relationships
between the dependent variable and the independent variables
 Forecasting techniques
– Expert opinion
– Opinion polls and market research
– Surveys of spending plans
– Economic indicators’
– Projections
– Econometric models
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Forecasting techniques
Expert Opinion techniques
■ Jury of executive opinion: forecasts generated by a group of corporate executives
assembles together
– Drawback – persons with strong personalities may exercise disproportionate
influence
■ The Delphi method: a form of expert opinion forecasting that uses a series of
questions and answers to obtain a consensus forecast, where experts do not
meet
■ Opinion Polls: sample population are surveyed to determine consumption trends
– May identify changes in trends
– Choice of sample is important
– Questions must be simple and clear

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Forecasting techniques
■ Market Research: is closely related to opinion polling and will indicate not only
why consumer is (or is not) buying, but also
– Who the consumer is
– How he or she is using the product
– Characteristics the consumer thinks are most important in the purchasing
decision
■ Surveys of spending plans: yields information about macro-type data relating to
the economy, especially;
– Consumer intensions – Example – survey of consumer, consumer confidence
survey
– Inventories and sales expectations
■ Economic indicators: a barometric method of forecasting designed to alert
business to changes in conditions -
– Leading, coincident, and lagging indicators
– Composition index – one indicator alone may not be very reliable, but a mix of
leading indicators may be effective 57
…forecasting techniques ..economic indicators  Drawbacks of
■ Leading Indicators – predict future economic activity economic
– Manufacturers’ new orders for consumer goods and materials indicators
– Vendor performance, slower deliveries  Leading indicator
– Building permits – housing units index has forecast
– Money supply, stock prices, interest rates a recession when
– Consumer expectations none succeeded
■ Coincident indicators identify trends in current economic activity  The data are
– Industrial production subject to revision
– Manufacturing and trade sales in the future
– Personal incomes – transfer payments months
■ Lagging indicators confirm swings in past economic activity  A change in the
– Average durations of unemployment index doesn’t
indicate the
– Change in labor cost per unit of output
precise size of the
– Change in consumer price index - inflation
decline or increase
– Commercial and industrial loan outstanding
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…forecasting techniques - Trend Projection
■ Trend Projection – a form of naïve forecasting
that projects trends from past data without
taking into consideration reasons for change
– Visual time series projections
– Compound growth rate
– Least squares time series projection
■ Visual time series Projections – plotting
observations on a graph and viewing the shape
of the data and any trends
■ Compound growth rate
– Forecasting by projecting the average growth
rate of the past in the future
– Provides a relatively simple and timely forecast
– Appropriate when the variable to be predicted
increases at constant percentage
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…forecasting techniques – Time Series Analysis
■ Time series analysis – a naïve method of forecasting from past data by
using least squares statistical method to identify trends, cycles,
seasonality and irregular movements

Advantages
- Easy to calculate
- Doesn’t require much judgment or
analytical skill
- Describes the best possible fit for
past data
- Usually reasonably reliable in the
short run

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…forecasting techniques – time series analysis
■ Time series component – seasonality
– Need to identify and remove seasonal factors, using moving averages to
isolate those factors
– Remove seasonality by dividing data by seasonal factor
■ Time series component – Trend
– To remove trend line, use least squares method
– Possible best-fit line styles
– Choose the one with best R2
■ Time series component – cycle, noise
– Isolate cycle by smoothing with a moving average
– Random factors cannot be predicted and should be ignored

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62
…forecasting techniques – time series analysis
■ Smoothing techniques
– Moving average
– Exponential smoothing – works best when no strong trend in series
- identifies historical patterns of trend or seasonality in the data and then extrapolates these
patterns forward into the forecast period.
- Fluctuations are random rather than seasonal or cyclical

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…forecasting techniques – Econometric model
■ Econometric Model – causal or explanatory model of forecasting
a) Multiple equation systems – for complex relations among economic variables
■ Endogenous variables – dependent variables that may influence other dependent variable
■ Exogenous variables – from outside the system, truly independent variables
b) Regression analysis

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