Business and Economic Forecasting

Chapter 5
Business and Economic Forecasting is a
critical managerial activity which comes in
two forms:
Quantitative Forecasting +2.1047%
Gives the precise amount
or percentage
 Qualitative Forecasting
Gives the expected direction
Up, down, or about the same
2008 Thomson * South-Western Slide 1
 Managerial Challenge
Excess Fiber Optic Capacity
• High-speed data installation
grew exponentially
100%
• But adoption follows a Color TVs
typical S-curve pattern,
similar to the adoption rate
of TV Internet
• Access grew too fast, Access
leading to excess capacity
around the time of the tech
bubble in 2001
• The challenge is to predict 1940 1960 1980 2000 2020
demand properly Slide 2
 The Significance of Forecasting
• Both public and private enterprises operate under
conditions of uncertainty.
• Management wishes to limit this uncertainty by
predicting changes in cost, price, sales, and
interest rates.
• Accurate forecasting can help develop strategies
to promote profitable trends and to avoid
unprofitable ones.
• A forecast is a prediction concerning the future.
Good forecasting will reduce, but not eliminate, the
uncertainty that all managers feel.
Slide 3
 Hierarchy of Forecasts
• The selection of forecasting techniques depends in
part on the level of economic aggregation involved.
• The hierarchy of forecasting is:
• National Economy (GDP, interest rates,
inflation, etc.)
»sectors of the economy (durable goods)
 industry forecasts (all automobile manufacturers)
> firm forecasts (Ford Motor Company)
» Product forecasts (The Ford Focus)
Slide 4
 Forecasting Criteria
The choice of a particular forecasting method
depends on several criteria:
1.costs of the forecasting method compared with
its gains
2.complexity of the relationships among
variables
3.time period involved
4.lead time between receiving information and
the decision to be made
5.accuracy needed in forecast Slide 5
 Accuracy of Forecasting
• The accuracy of a forecasting model is measured
by how close the actual variable, Y, ends up to the
^
forecasting variable, Y.
^
• Forecast error is the difference. (Y - Y)
• Models differ in accuracy, which is often based on
the square root of the average squared forecast
error over a series of N forecasts and actual figures
• Called a root mean square error, RMSE.

{  (Y - Y)2 / N
^
»RMSE = } Slide 6
 Quantitative Forecasting

• Deterministic Time
Series Like technical
» Looks For Patterns security analysis
» Ordered by Time
» No Underlying Structure
• Econometric Models
» Explains relationships
Like fundamental
» Supply & Demand
» Regression Models
security analysis

Slide 7
 Time Series
Examine Patterns in the Past
Dependent Variable

X
X
X

Forecasted Amounts

To TIME
The data may offer secular trends, cyclical variations, seasonal
variations, and random fluctuations. Slide 8
 Time Series
Examine Patterns in the Past
Dependent Variable
Secular Trend
X
X
X

Forecasted Amounts

To TIME
The data may offer secular trends, cyclical variations, seasonal
variations, and random fluctuations. Slide 9
 Time Series
Examine Patterns in the Past
Dependent Variable

Cyclical Variation Secular Trend

X
X
X

Forecasted Amounts

To TIME
The data may offer secular trends, cyclical variations, seasonal
variations, and random fluctuations. Slide 10
 Elementary Time Series Models
for Economic Forecasting
NO Trend
1. Naive Forecast
   
^  
Yt+1 = Yt
» Method best when there is time
no trend, only random
error Trend
» Graphs of sales over time 

with and without trends 
» When trending down, the  
Naïve predicts too high
time

Slide 11
 2. Naïve forecast with
adjustments for secular trends
^
Yt+1 = Yt + (Yt - Yt-1 )
» This equation begins with last period’s
forecast, Yt.
» Plus an ‘adjustment’ for the change in the
amount between periods Yt and Yt-1.
» When the forecast is trending up, this
adjustment works better than the pure
naïve forecast method #1.

Slide 12
3. Linear Trend & 4. Constant rate of growth
Linear Trend Growth Uses a Semi-log Regression

• Used when trend has a • Used when trend is a

constant AMOUNT of constant
change PERCENTAGE rate
Yt = a + b•T, where Log Yt = a + b•T,
Yt are the actual where b is the
observations and continuously
T is a numerical time compounded growth
variable rate

Slide 13
More on Constant Rate of Growth Model
a proof
^
• Suppose: Yt = Y0( 1 + G) t where g is the
annual growth rate
• Take the natural log of both sides:
^
» Ln Yt = Ln Y0 + t • Ln (1 + G)
» but Ln ( 1 + G )  g, the equivalent
continuously compounded growth rate
» SO: Ln Yt = Ln Y0 + t • g
Ln Yt = a + b • t
where b is the growth rate Slide 14
 Numerical Examples: 6 observations
MTB > Print c1-c3.
Sales Time Ln-sales Using this sales
data, estimate
sales in period 7
100.0 1 4.60517 using a linear and
a semi-log
109.8 2 4.69866
functional
121.6 3 4.80074 form
133.7 4 4.89560
146.2 5 4.98498
164.3 6 5.10169
Slide 15
The linear regression equation is
Sales = 85.0 + 12.7 Time

Predictor Coef Stdev t-ratio p

Constant 84.987 2.417 35.16 0.000
Time 12.6514 0.6207 20.38 0.000

s = 2.596 R-sq = 99.0% R-sq(adj) = 98.8%

The semi-log regression equation is
Ln-sales = 4.50 + 0.0982 Time

Predictor Coef Stdev t-ratio p

Constant 4.50416 0.00642 701.35 0.000
Time 0.098183 0.001649 59.54 0.000

s = 0.006899 R-sq = 99.9% R-sq(adj) = 99.9%

Slide 16
 Forecasted Sales @ Time = 7
• Linear Model
• Sales = 85.0 + 12.7 Time
• Semi-Log Model
• Ln-sales = 4.50 + 0.0982
• Sales = 85.0 + 12.7 ( 7)
Time
• Sales = 173.9 • Ln-sales = 4.50 +
0.0982 ( 7 )
linear • Ln-sales = 5.1874
• To anti-log:

 » e5.1874 = 179.0

Slide 17
Sales Time Ln-sales
Semi-log is
exponential
100.0 1 4.60517
109.8 2 4.69866
121.6 3 4.80074
133.7 4 4.89560
146.2 5 4.98498 7
164.3 6 5.10169
179.0 7 semi-log Which prediction
do you prefer?
173.9 7 linear
Slide 18
 5. Declining Rate of Growth Trend
• A number of marketing penetration models
use a slight modification of the constant rate
of growth model
• In this form, the inverse of time is used
Ln Yt = b1 – b2 ( 1/t ) Y
• This form is good for patterns
like the one to the right
• It grows, but at continuously
a declining rate time
Slide 19
6. Seasonal Adjustments: The Ratio to Trend Method

 Take ratios of the actual to

12 quarters of data
the forecasted values for past
 years.

 Find the average ratio. This
  is the seasonal adjustment
  
   Adjust by this percentage by
 multiply your forecast by the
 seasonal adjustment
» If average ratio is 1.02, adjust
I II III IV I II III IV I II III IV forecast upward 2%
Quarters designated with roman numerals.
Slide 20
7. Seasonal Adjustments: Dummy Variables
• Let D = 1, if 4th quarter and 0 otherwise
• Run a new regression:
Yt = a + b•T + c•D
» the “c” coefficient gives the amount of the adjustment for the
fourth quarter. It is an Intercept Shifter.
» With 4 quarters, there can be as many as three dummy variables;
with 12 months, there can be as many as 11 dummy variables
• EXAMPLE: Sales = 300 + 10•T + 18•D
12 Observations from the first quarter of 2005 to 2007-IV.
Forecast all of 2008.
Sales(2008-I) = 430; Sales(2008-II) = 440; Sales(2008-III) = 450;
Sales(2008-IV) = 478
Slide 21
 Soothing Techniques
8. Moving Averages
• A smoothing forecast Dependent Variable
method for data that
jumps around *
* *
• Best when there is no Forecast
trend * Line is
* Smoother
• 3-Period Moving Ave is:
Yt+1 = [Yt + Yt-1 + Yt-2]/3
• For more periods, add
TIME
them up and take the
average Slide 22
 Smoothing Techniques
9. First-Order Exponential Smoothing
• A hybrid of the Naive • Each forecast is a function of
and Moving Average all past observations
methods • Can show that forecast is
^ t+1 = w•Yt +(1-w)Y
• Y ^t based on geometrically
declining weights.
• A weighted average of ^Yt+1 = w .•Yt +(1-w)•w•Yt-1 +
^
2•w•Y
past actual and past (1-w) t-1 + …
forecast, with a weight
of w Find lowest RMSE to pick the
best w.

Slide 23
 First-Order Exponential
Smoothing Example for w = .50
Actual Sales Forecast
1 100 100 initial seed required
2 120 .5(100) + .5(100) = 100
3 115
4 130
5 ?

Slide 24
 First-Order Exponential
Smoothing Example for w = .50
Actual Sales Forecast
1 100 100 initial seed required
2 120 .5(100) + .5(100) = 100
3 115 .5(120) + .5(100) = 110
4 130
5 ?

Slide 25
 First-Order Exponential
Smoothing Example for w = .50
Actual Sales Forecast
1 100 100 initial seed required
2 120 .5(100) + .5(100) = 100
3 115 .5(120) + .5(100) = 110
4 130 .5(115) + .5(110) = 112.50
5 ? .5(130) + .5(112.50) = 121.25
MSE = {(120-100)2 + (110-115)2 + (130-112.5)2}/3 = 243.75 Period 5
RMSE = 243.75 = 15.61 Forecast
Slide 26
 Qualitative Forecasting
10. Barometric Techniques
Direction of sales can be indicated by other variables.
PEAK Motor Control Sales
peak

Index of Capital Goods

TIME
4 Months
Example: Index of Capital Goods is a “leading indicator”
There are also lagging indicators and coincident indicators
Slide 27
 Time given in months from change
LEADING INDICATORS* COINCIDENT
» M2 money supply (-14.4) INDICATORS
» S&P 500 stock prices (-11.1) » Nonagricultural payrolls
» Building permits (-15.4) (+.8)
» Initial unemployment claims
» Index of industrial
(-12.9)
production (-1.1)
» Contracts and orders for
plant and equipment (-7.3) » Personal income less
transfer payment (-.4)
LAGGING INDICATORS
» Prime rate (+17.9)
» Change in labor cost per unit
*Survey of Current Business, 1995 of output (+6.4)
See pages 182-183 in the textbook
Slide 28
 Handling Multiple Indicators
Diffusion Index: Suppose 11
forecasters predict stock prices in 6 months,
up or down. If 4 predict down and seven
predict up, the Diffusion Index is 7/11, or
63.3%.
• above 50% is a positive diffusion index
Composite Index: One indicator rises
4% and another rises 6%. Therefore, the
Composite Index is a 5% increase.
• used for quantitative forecasting Slide 29
 Qualitative Forecasting
11. Surveys and Opinion Polling Techniques
Common Survey Problems
New Products have no • Sample bias--
historical data -- Surveys » telephone, magazine
can assess interest in new
ideas. • Biased questions--
» advocacy surveys
Survey Research Center
of U. of Mich. does repeat
• Ambiguous questions
surveys of households on • Respondents may lie on
Big Ticket items (Autos)
questionnaires

Slide 30
 Qualitative Forecasting
12. Expert Opinion
The average forecast from several experts
is a Consensus Forecast.
» Mean
» Median
» Mode
» Truncated Mean
» Proportion positive or negative

Slide 31
 EXAMPLES:

• IBES, First Call, and Zacks Investment --

earnings forecasts of stock analysts of companies

• Conference Board – macroeconomic predictions

• Livingston Surveys--macroeconomic forecasts

of 50-60 economists

Individual economists tend to be less

accurate over time than the ‘consensus
forecast’.

Slide 32
 13. Econometric Models
• Specify the variables in the model
• Estimate the parameters
» single equation or perhaps several stage methods
»Qd = a + b•P + c•I + d•Ps + e•Pc
• But forecasts require estimates for future prices,
future income, etc.
• Often combine econometric models with time series
estimates of the independent variable.
» Garbage in Garbage out

Slide 33
 example
• Qd = 400 - .5•P + 2•Y + .2•Ps
» anticipate pricing the good at P = $20
» Income (Y) is growing over time, the estimate
is: Ln Yt = 2.4 + .03•T, and next period is T
= 17.
• Y = e2.910 = 18.357
» The prices of substitutes are likely to be
P = $18.
• Find Qd by substituting in predictions for P, Y,
and Ps
• Hence Qd = 430.31 Slide 34
 14. Stochastic Time Series
• A little more advanced methods incorporate into time
series the fact that economic data tends to drift
yt = a + byt-1 + et
• In this series, if a is zero and b is 1, this is essentially
the naïve model. When a is zero, the pattern is called a
random walk.
• When a is positive, the data drift. The Durbin-Watson
statistic will generally show the presence of
autocorrelation, or AR(1), integrated of order one.
• One solution to variables that drift, is to use first
differences.
Slide 35
 Cointegrated Time Series
• Some econometric work includes several stochastic
variable, each which exhibits random walk with drift
» Suppose price data (P) has positive drift
» Suppose GDP data (Y) has positive drift
» Suppose the sales is a function of P & Y
» Salest = a + bPt + cYt
» It is likely that P and Y are cointegrated in that they
exhibit comovement with one another. They are not
independent.
» The simplest solution is to change the form into first
differences as in: DSalest = a + bDPt + cDYt
Slide 36