Lec2 Demand Model

Operations Management
Lecture
Forecasting and Demand Modeling
Yong Liang @SEM, Tsinghua
Agenda
• Introduction:
– Motivation and examples
• Classical Demand Forecasting Models:

– Moving Average
– Exponential Smoothing
– Linear Regression
– Relationship to Machine Learning
• Demand Model Techniques

– Bass Diffusion
– Choice Models Yong Liang
Copyright © SEM, Tsinghua University
(Contemporary) Demand Modeling Techniques
• Drawbacks of Classical models:

– Classical models rely on substantial historical data
– Some of these models are for “stable” or “time-invariant”
demand
– Today’s products have shorter and shorter life cycle, leads
to much less historical data
Yong Liang
Demand Modeling Techniques
• The name “Demand Modeling Techniques” is used

just to distinguish this class of methods from
traditional time-series based methods
• Other methods have different focus, for example, to

forecast the demand of short-life products:
– Bass diffusion model
– Leading-indicator method
– Choice model, etc.
Yong Liang
Discussion
• How do you make a purchase decision facing a new

released product?
– House
– Tire
– Cellphone
– Food
– Google Glass
Yong Liang
The Adoption Process for New Products
• The diffusion of innovations: how a new idea, a good, or a

service is assimilated into a social system over time. The
diffusion process is the spread of an idea or the penetration
of a market by a new product from its source of creation to its
ultimate users or adopters.
• The adoption process is the steps an individual goes through

from the time he hears about an innovation until final
adoption (the decision to use an innovation regularly).
– Diffusion through innovators
– Diffusion through imitators
Yong Liang
Bass Diffusion Model
• (Bass 1969) Famous parametric approach to

estimating the demand trajectory of a single new
product over time.
Yong Liang
Actual sales and predicted sales for room air
conditioners (1947-1961)
Yong Liang
Actual sales and predicted sales for clothes
dryers (1950-1960)
Yong Liang
• Has been proved to be able to provide accurate

forecasts for a huge variety of new product
introductions, regardless of pricing and ads decisions.
• Assumption: A fixed pool of customer, who can be
classified into innovators and imitators
– Innovators: purchase a new product without regard to the
decisions made by other individuals
– Imitators: are influenced in the timing of their purchases
by previous buyers through word-of-mouth
communication
– Or interpreted differently, everyone’s mind has two drivers:
innovation and imitation. Yong Liang
The Innovativeness
• The difference among individuals in their response to the new ideas

is called their innovativeness: the degree to which an individual is
relatively early or late in adopting a new product or idea.
Yong Liang
P (t) : the prob. that a given buyer makes an initial

purchase at time t.
q
P (t) = p + D(t)
m
p : coefficient of innovation
q : coefficient of imitation (contagion), usually, p ⌧q
m : market size
D(t): cumulative demand up to time t
Yong Liang
• Let d(t) be the derivative of D(t)

d(t)
P (t) =
m D(t)
then
q
d(t) = (p + D(t))(m D(t))
m
Generation Generation Remaining
of of imitators potential
innovators customers
Yong Liang
Solving Bass Diffusion Model
• Theorem:
1 e (p+q)t
D(t) = m q
1 + p e (p+q)t
p(p + q)2 e (p+q)t

d(t) = m
(p + qe (p+q)t )2
Yong Liang
• The peak demand (𝑑(𝑡)) occurs at:

⇤ 1 q
t = log
p+q p
• And at time t⇤
2 m(q p)
m(p + q) ⇤
d(t⇤ ) = D(t ) =
4q 2q
Yong Liang
⇤ 1 q
t = log
p+q p
• If 𝑝 is small, then demand grows very slowly
• If 𝑝 and q are large, then sales take off rapidly and
fall off quickly
• Note above equation is only well defined if q > p
– If q < p instead, then the innovation factor dominates
and demand falls off right after market introduction.
Yong Liang
The Two Cases
Yong Liang
Yong Liang
作业题
• HCT是一家亚洲的手机生产商。最近，他们想将最
新研发的LPhone5卖到美国市场。目前他们在和第
三方物流公司商定合约。其中，他们必须告诉第
三方物流公司需要租用多大的仓库，以及什么时
候LPhone5的销量会到达顶峰。在一些市场调研之
后，HCT发现整个市场规模为580万台，且创新指
数为0.008，追随指数为0.421。请计算销售的峰
值和出现时间。
Yong Liang
• The peak demand (𝑑(𝑡)) occurs at:

⇤ 1 q
t = log
p+q p
• And at time t⇤
2 m(q p)
m(p + q) ⇤
d(t⇤ ) = D(t ) =
4q 2q
Yong Liang
• Seasonal factors can be added as well to Bass model:

q
d(t) = (p + D(t))(m D(t))↵t
m
• Solving above ODE:
" Rt #
(p+q) ↵⌧ d⌧
1 e 0
D(t) = m q
Rt
(p+q) ↵⌧ d⌧
1+ pe
0
Yong Liang
Parameter Estimation with Discrete Bass
Diffusion Model
• However, we have not mentioned how to get the
parameters.
– If historical data is available, then we can use linear
regression:
• Discrete Bass Diffusion Model comes in handy. Again,
the adoption rate can be written as:
q
dt = (p + Dt 1 )(m Dt 1)
m
Where D0 ⌘ 0
Yong Liang
Discrete Bass Diffusion Model
• Expanding the Discrete Bass Diffusion Model yields:
2
dt = a + bDt 1 + c(Dt 1) , t = 2, 3, . . .
– What are the coefficients to be estimated here?
– What method shall we use?
– Why use an LR with quadratic terms?
Yong Liang
Discrete Bass Diffusion Model
• After learning 𝑎, 𝑏, and 𝑐, we can estimate the

parameters by: p
b b2 4ac
m=
2c
a
p=
m
q = mc
• Typically there is no sales data available.
– Rely on similar products.
Yong Liang
Agenda
• Introduction:
– Motivation and examples
• Classical Demand Forecasting Models:

– Moving Average
– Exponential Smoothing
– Linear Regression
– Relationship to Machine Learning
• Demand Model Techniques

– Bass Diffusion
– Choice Models Yong Liang
Continuous vs. Discrete Goods
Yong Liang
Discrete Choice Model
• Discrete Choice Model involves making choice between
two or more discrete alternatives:
– For example, mac or pc, iPhone or Android or BlackBerry
– The choice set is assumed to be discrete
• A tedious way is to list the choice probabilities for each

item in each possible assortment set
– Generally Intractable
• Idea：
– Build statistical model that predicts the choice made by an
individual based on the individual’s own attributes, as well as
the attributes of available choices.
Yong Liang
• The Discrete Choice Model seems to be only capable

of making classification predictions
– But it has been used to make quantified predictions, e.g.:
number and duration of phone calls that households make
(Train et al. 1987), etc.
• Choice model estimate the probability that a

individual selects a particular alternative, thus,
aggregating the decisions across the population
returns answers to “how many” questions
Yong Liang
Basic Idea of Discrete Choice Model
• Suppose we can give a full ordering of all items based on
the utilities perceived by consumers, then what would
happen?
• Consumers maximize utility:

– Choose the alternative that has the maximum utility (and falls
within the income constraint)
If U(bus) > U(auto), then choose bus
If U(bus) < U(auto), then choose auto
• Then the question is:

– What is U(bus)
– What is U(auto) Yong Liang
Utility Function
• U(bus) = U(walk time, in-vehicle time, fare, …)

U(auto) = U(travel time, parking cost, …)
• Assume linear (in the parameters)

U(bus) = 𝛽1×(walk time) + β2 ×(in-vehicle time) + …
• Parameters represent tastes, which may vary over people.

– Include socio-economic characteristics (e.g., age, gender, income)
– U(bus) = β1 ×(walk time) + β2 ×(in-vehicle time) +β3
×(cost/income) + …
Yong Liang
Deterministic Binary Choice
• If the Utility Function has no uncertainties:

– If U(bus) - U(auto) > 0 , Probability(bus) = 1
– If U(bus) - U(auto) < 0 , Probability(bus) = 0
Yong Liang
Probabilistic Choice
• Random utility model
𝑈" = 𝑉(attributes of 𝑖; parameters) + 𝜖"
• What is in the 𝜖" ?

• Analysts’ imperfect knowledge:
– Unused/Unobserved attributes
– Unused/Unobserved taste variations
– Measurement errors
– Use of proxy variables
• More model features

– 𝑈(bus) = 𝛽1 ×(walk time) + 𝛽2 ×(in-vehicle time +𝛽3
×(cost/income) + … + 𝜖!"#
Yong Liang
Probabilistic Binary Choice
Yong Liang
• Consumer Utility:
– 𝑁 decision makers
the set of options that are available to the decision
– Choice set I maker must be mutually exclusive, exhaustive, and finite
– A decision maker choose i 2 I
– The discrete model assumes consumer n choose i when
Uni > Unj , 8j 2 I, j 6= i

– Since in most cases we do not know the utility exactly, we
must estimate them
Yong Liang
The Random Utility Model
– To estimate:
Uni = Vni + ✏ni
– Vni : representative utility
– ✏ni : random estimation error
• Choice prob.:
Pni = P (Uni > Unj , 8j 6= i)
= P (Vni + ✏ni > Vnj + ✏nj , 8j 6= i)
Yong Liang
Random Terms
• Capture imperfectness of information

• Distribution of epsilons
• Variance/covariance structure
– Correlation between alternatives
– Multidimensional decision
• Example: Mode and departure time choice
• Typical models
– Logit model (i.i.d. “Extreme Value” error terms, a.k.a
Gumbel)
– Probit model (normal error terms)
Yong Liang
Pni = P (✏nj < Vni + ✏ni Vnj , 8j 6= i)
• Need to know the prob. dist. of ✏ni
• Multinomial Logit model:

– Assume ✏ni is i.i.d. of Gumbel dist.
x
x e
f (x) = e e
x
e
F (x) = e
Yong Liang
pdf of Gumbel Distribution
Yong Liang
Pni = P (✏nj < Vni + ✏ni Vnj , 8j 6= i)
• Then: Z
Pni = (Pni |✏ni )f (✏ni )d✏ni
Z
x
x e
= (Pni |✏ni )e e d✏ni
Z Y
e(✏ni +Vni Vnj )
x e x
= e e e d✏ni
j6=i
Yong Liang
• And we get (when we have only two alternatives 𝑖

and 𝑗)
𝑒 ##$ “Attraction of item 𝑖”
𝑃!" = # ##%
𝑒 +𝑒
#$
• When there are many alternatives:
𝑒 ##$
𝑃!" =
∑$∈& 𝑒 ##%
Yong Liang
Generalization: Basic Attraction Model
• BAM model
𝑣"
𝑃" =
𝑣# + ∑$∈& 𝑣$
– 𝑣! captures the attraction of external alternatives
• GAM Model
– In BAM, 𝑣! is fixed.
𝑣"
𝑃" =
𝑣! + ∑#∈(&\() 𝑣# + ∑#∈* 𝑣#
– Where 𝑆\I is the set of items not offered in the assortment
but may attracts the customer
Yong Liang
Why Logit?
• Probit does NOT have a closed form – the choice

probability is an integral.
• The logistic distribution is used because:
– It approximates a normal distribution quite well.
– It is analytically convenient
– Gumbel can also be “justified” as an extreme value
distribution
• Logit does have “fatter” tails than a normal
distribution.
Yong Liang
Conclusion
• The process of giving the business plan forecast its deserved

place is not easy. This is so for many reasons, including:
– Forecasting is difficult (if not impossible) to do accurately. Key
assumptions required for good forecasting are not always evident, and
key metrics are not always clear.
– Forecasting is easy to over-simplify. The proverbial “Hockey Stick”
graph of revenue growth is a classic example of this.
– Forecasting is often not based on reality. Demand, competition,
market size, pricing marketing expense etc. must all be considered,
quantified and explained in developing a solid and credible forecast.
Yong Liang
Conclusion
• Recognize that the playing field is never level. For example, Owners of competing businesses
may have more contacts in your industry, they may have access to more capital (deeper
pockets), and they may even have a stronger support network of family, friends and investors
• Understand the various factors in your business and market to produce better quality, more
accurate and credible forecasts that support your plans to succeed and grow
• Have a clear marketing strategy. You never know where, when, or how a new prospect is
going to hear of your business. If you have a mix of messages out there, the prospects will
have an unclear expectation of what your business has to offer. Your company must present a
consistent, clear message on all fronts
• Understand pricing and pricing dynamics . Lower prices don’t necessarily mean more
customers. Many customers are willing to buy more expensive items because of the greater
quality or the added convenience.
• Clarify the purpose of your company beyond just making money.
• Set specific, measurable, accountable, realistic and time specific goals to ensure continual
progress.
• Even if you have the latest, greatest, never-been-done-before approach to something, don’t
assume that you have no competition. Competition is more than just the direct, obvious
competitors. Competition is also all the available alternatives
• If you go in expecting to be rich overnight, you may become discouraged early on and give up
your dream prematurely. Success takes time, perseverance, and a little bit of luck. Give your
business time to grow. Yong Liang

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Operations Management

• Classical Demand Forecasting Models:

• Demand Model Techniques

• Drawbacks of Classical models:

• The name “Demand Modeling Techniques” is used

• Other methods have different focus, for example, to

• How do you make a purchase decision facing a new

• The diffusion of innovations: how a new idea, a good, or a

• The adoption process is the steps an individual goes through

• (Bass 1969) Famous parametric approach to

• Has been proved to be able to provide accurate

• The difference among individuals in their response to the new ideas

P (t) : the prob. that a given buyer makes an initial

• Let d(t) be the derivative of D(t)

p(p + q)2 e (p+q)t

• The peak demand (𝑑(𝑡)) occurs at:

• The peak demand (𝑑(𝑡)) occurs at:

• Seasonal factors can be added as well to Bass model:

• Expanding the Discrete Bass Diffusion Model yields:

• After learning 𝑎, 𝑏, and 𝑐, we can estimate the

• Classical Demand Forecasting Models:

• Demand Model Techniques

• A tedious way is to list the choice probabilities for each

• The Discrete Choice Model seems to be only capable

• Choice model estimate the probability that a

• Consumers maximize utility:

• Then the question is:

• U(bus) = U(walk time, in-vehicle time, fare, …)

• Assume linear (in the parameters)

• Parameters represent tastes, which may vary over people.

• If the Utility Function has no uncertainties:

• What is in the 𝜖" ?

• More model features

Uni > Unj , 8j 2 I, j 6= i

• Capture imperfectness of information

Pni = P (✏nj < Vni + ✏ni Vnj , 8j 6= i)

• Need to know the prob. dist. of ✏ni

• Multinomial Logit model:

• And we get (when we have only two alternatives 𝑖

• When there are many alternatives:

• Probit does NOT have a closed form – the choice

• The process of giving the business plan forecast its deserved

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