Managerial Economics

Session 1

PART -TIME - Jan 2009

Instructions
External Exam - 60 marks
Class Participation & Attendance-10 Marks
Class Test & Case study - 15 marks
Group Presentations - 15 marks

Course Content
Introduction to Managerial Economics
Demand Analysis and Business Forecasting
Cost and Production Analysis
Revenue Analysis
Market Structures and Pricing Decisions & Revenue Analysis
Pricing Strategies and Practices
Capital Budgeting
Macroeconomics

References
Managerial Economics by D N Dwivedi
Managerial Economics in a Global Economy by Dominick Salvatore
Managerial Economics by R.L. Varshney & K.L. Maheshwari
Managerial Economics Theory and Applications by Dr. D. M. Mithani

Managerial Economics Page 1

Who is He? Adam Smith

What is Managerial Economics???

It is the integration of economic principles with business management practices
It is essentially applied economics in the field of business management.

Definitions: Managerial Economics

Integration of Economic theory with business practice for purpose of facilitating decision
making and forward planning by management
- Spencer & Siegelman

It is concerned with the application of economic concepts and economics to the problems of
formulating rational decision making
-Mansfield

Why do Managers need to know Economics?

Economic theories contribute in building analytical models, which help to recognize the
structure of managerial problems

Economic theories do enhance analytical capabilities of business analyst

They offer clarity to various concepts used in business analysis, which enables the managers to
avoid conceptual pitfalls

Decision Problems faced by firms

What should be the price of the product?
What should be the size of the plant to be installed?
How many workers should be employed?
What is the optimal level of inventories of finished products, raw material, spare parts,
etc.?
What should be the cost structure?

Relationship between Economics & Management

Significance: Managerial Economics

Reconciling traditional theoretical concepts in relation to the actual business behavior
and conditions
Estimating economic relationships
Predicting relevant economic quantities
Formulating business policies and plans

Characteristics: Managerial Economics

Microeconomic in character
Is Normative rather than positive in character
It is prescriptive rather than descriptive
Also uses Macroeconomics since it provides an intelligent understanding of environment

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Scope: Managerial Economics
Incorporate micro and macroeconomics to deal with business problems
Microeconomics - micro means a small part Concerned with analysis of behavior of
individual economic variables such as individual consumer or a producer or price of a
particular commodity
Macroeconomics - concerned with aggregate behavior of the economy as a whole

Microeconomics applied to (operational) internal issues

Demand Analysis
Production and Supply analysis
Cost analysis
Analysis of market structure and Pricing Theory
Profit Analysis
Capital and Investment Decisions

Macroeconomics applied to external issues-Economic Environment

Type of Economic system of a country
Study of Macro variables
Study related to foreign trade
Study of Government policies Monetary, Fiscal

Role of a Managerial Economist

He is an economic advisor to a firm
He not only studies the economic trends at macro level but also interpret their
relevance to the particular industry
Task of making specific decisions
General task of managers to use readily available information in outside environment to
make a decision that furthers the goals of organization

Decisions to be taken by Managerial economist

Production scheduling
Demand Estimation and Forecasting
Analysis of market to determine nature and extent of competition
Pricing problems of industry
Assist business planning process
Advising on investment and capital budgeting
Analyzing and forecasting environmental factors

Basic Economic Principles for Managerial Decision making

Opportunity Cost Principle
Marginal Principle
Incremental Principle
Equi - Marginal Principle
Time Perspective Principle
Discounting Principle

Opportunity Cost
Related to alternative uses of scarce resources
Opportunity cost of availing an opportunity is the expected income foregone from
second best alternative
Difference between actual earning and its opportunity cost is called economic gain.

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Marginal Principle
Refers to change (increase or decrease) in total of any quantity due to a unit change in its
determinant.
MC= TCn - TCn-1

MR = TRn-TRn-1

Decision Rule FOR Profit Maximization: MR=MC

Marginal value
The marginal value of a dependent variable is the change in this dependent variable associated
with a 1-unit change in a particular independent variable

Marginal Analysis in TV Advertising

No of Total revenue Marginal Total Cost Marginal Net benefit

TV Ads Revenue
TR TC Cost
MR
MC

1 20000 - 4000 - 16000

2 34000 14000 8000 4000 26000

3 42000 8000 12000 4000 30000

4 46000 4000 16000 4000 30000

5 48000 2000 20000 4000 28000

6 49000 1000 24000 4000 25000

Limitations of Marginalism
When used in cost analysis MC refers to change in variable cost only

Generally firms do not have knowledge of MC & MR cos most firms produce in and sell their
products in bulk except cases such as airplanes, ships, etc

Incremental Principle
Applied to business decisions which involve a large change in total cost or total revenue
Incremental cost can be defined as the change in total cost due to a particular business
decision i.e change in level of output, investment, etc.
Includes both fixed & variable cost but does not include cost already incurred i.e sunk cost
Incremental revenue is a change in total revenue resulting from a change in level of output,
price etc
A business decision worthwhileness is always determined on the basis of criterion that
incremental revenue should exceed incremental cost

Equi - Marginal Principle

Deals with allocation of resources among alternative activities

According to this principle an input should be employed in different activities in such proportion
that the value added by last unit is the same in all activities or marginal products from various
activities are equalized.

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MPA=MPB=MPC=MPN

Time Perspective Principle

Short run & Long run time periods play an important role in Business decisions

Short run mean that period within which some of inputs cannot be altered (fixed inputs).
However in long run all inputs can be altered so they are variable in long run

Determination of time perspective is of great significance where projections are involved

Discounting Principle
A rupee now is worth more than a rupee earned a year after

To take decision regarding investment which will yield return over a period of time it is
necessary to find its present worth by using discounting principle

This principle helps to bring value of future rupees to present rupees

PV=1/1+i i=8%
PV=100/1.08=92.59

Variables and Functions

By definition, any economic quantity , value or rate that varies on its own or due to a change in
its determinant(s) is an economic variable.

Functions
A function is a mathematical technique of stating the relationship between any two variables
having cause and effect relationship
When a relation is established between two or more variables, it is said that they are
functionally related
When two variables are involved it is bi-variate and more than two it is Multi-variate

Functions
Of the two one is independent variable which may change on its own independently and other
is dependent which changes in relation to changes in the assigned independent variable in a
given function
In mathematical terms, Y= f (X)

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 Managerial Economics
Module-2
Demand & Supply Analysis

Analysis of Demand & Supply

&
Market Equilibrium

Concept of Market
A market is a mechanism by which buyers and sellers interact to determine the price and
quantity of a good or service

Demand side of the market for a product refers to all its consumers and the price they are
willing to pay for buying a certain quantity of a product during a period of time.

What is Demand???
Demand is the desire or want backed up by money

Always related to price and time

Statement of Law of Demand

All other things remaining constant, higher the price of a commodity, smaller is the quantity
demanded and lower the price, larger the quantity demanded
Dx = f (Px)

Reasons for Inverse Relationship

Income effect- the decline in the price of a commodity leads to an equivalent increase in the
income of a consumer because he has to spend less to buy the same quantity of goods. The
part of the money left can be used for buying some more units of commodity.
For e.g.- suppose the price of mangoes falls from Rs.100/- per dozen to 50/- per dozen. Then
with the same amount of 100/- you can buy one more dozen, i.e.,2 dozens at Rs. 50/-

Substitution effect- When the price of a commodity falls, the consumer tends to substitute
that commodity for other commodity which is relatively expensive.
For e.g. Suppose the price of the Urad falls, it will be used by some people in place of other
pulses. Thus the demand will increase.

Assumptions Underlying the Law

No change in Consumers Income
No change in Consumers Preferences
No change in Fashion
No change in Price of related goods
No Expectation of future price changes or shortages

Individual Demand Schedule

Tabular representation of Quantity of a commodity that an individual is willing and able to
purchase over a given period of time at each price of the commodity, while holding constant all
other relevant economic variables on which demand depends.

Price of Com X (Rs per Quantity demanded of Com X (Qty in

kg) kg)
80 2
70 4
60 6
50 10

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Market demand Schedule
Tabular representation of Quantity of a commodity that all individuals are willing and able to
purchase over a given period of time at each price of the commodity, while holding constant all
other relevant economic variables on which demand depends.

Market Demand Schedule

Price in (Rs) Units of Commodity X demanded per day by Maket Demand
Individuals or total
A B C
4 1 1 3 5
3 2 3 5 10
2 3 5 7 15
1 5 9 10 24

Determinants of Individual Demand

Income
Price of Substitute & Complementary products
Taste & Preferences
Advertisement
Expectation regarding future price changes
Climatic Conditions

Determinants of Market Demand

Price of Product
Distribution of Income & wealth
Communitys Common Habits and Scale of Preferences
Spending Habits of People
Growth of Population
Age Structure and Sex ratio of Population
Future Expectations
Level of Taxation
Fashions
Climate Conditions
Customs
Advertisement

Multivariate Demand Function

Dx = D (Px, Py, Pz, B, W, A, E, T, U)
Here Dx, stands for demand for item x (say, a car)
Px, its own price (of the car)
Py, the price of its substitutes (other brands/models)
Pz, the price of its complements (like petrol)
B, the income (budget) of the purchaser (user/consumer)
W, the wealth of the purchaser
A, the advertisement for the product (car)
E, the price expectation of the user
T, taste or preferences of user
U, all other factors.

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Demand equation
D= a bP
Where a is constant parameter signifying initial demand irrespective of price
b represents slope of demand curve

functional relationship between price and demand, having minus sign denotes negative
function

Exceptions to Law of Demand

Conspicuous consumption
The goods which are purchased for Snob appeal are called as the conspicuous consumption.
For e.g.- diamonds. They are the prestige goods. They would like to hold it only when they are
costly and rare.

Speculative market:
in this case the higher the price the higher will be the demand. It happens because of the
expectation to increase the price in the future.
For e.g. shares, lotteries

Giffens goods:
It is a special type of inferior goods where the fall in the price results into the decrease In the
quantity demanded. This happens because of peoples preference for superior commodity

Consumers Psychological bias:

Many a times consumer judges the quality of a good from its price. Such consumers may
purchase high price goods because of the feeling of possessing a better quality.
The exceptional demand curve shows a positive relation between the price and the quantity
demanded.

Shifts in Demand Curve

Extension and Contraction of Demand occurs due to changes in price, other factors
remaining constant
When more of a commodity is purchased with a fall in price then it is known as
extension of Demand and vice versa
Refer to movement along same demand curve

Increase and Decrease in Demand refers to changes in demand due to factors other than
price
An increase in demand signifies that more will be purchased at a given price than before
.
Refer to movement from one demand curve to another

Reasons for shifts (increase or decrease in Demand)

Changes in Income
Changes in Taste, habits and Preferences
Change in Fashions and Customs
Change in Distribution of Wealth
Change in Substitutes
Change in demand for Complementary goods
Advertisement and Publicity Persuasion
Change in level of taxation

Nature of Demand
Demand for Consumers goods & Producer's goods
Autonomous & Derived Demand
Demand for Durables and Non-Durables (Perishables)
Joint Demand and Composite Demand

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Managerial Economics Page 9
Supply Analysis
Supply during a given period of time means the quantities of goods which are offered
for sale at particular prices
Supply is what seller is able and willing to offer for sale
Supply and Stock are related but distinct terms-Supply comes out of Stock
Stock determines potential supply
Stock is outcome of production

Determinants of Supply
Cost of factors of production
State of Technology
Factors outside Economic Sphere such as weather conditions, natural calamities, etc
Tax and Subsidy

Law of Supply
Other things remaining same , supply of a commodity rises with a rise in price and falls with a
fall in price

Supply schedule

Assumptions :
Cost of production is unchanged
Technology is constant
Govt policies are unchanged
No change in Transport costs
No speculation
Prices of other goods constant

Positions: Supply Curve

Extension and Contraction : refer to change in supply due to price, other things remaining
same.
o Movement along the supply curve
Increase and Decrease in Supply: refer to change in supply due to determinants other
than price
o Shifts in Supply Curve

Causes for change in Supply

Change in Cost of Production
Supply also depends on Natural Factors
Change in Technique of Production
Policies of Government
Business Combines

When market is in Equilibrium?

Equilibrium price of a commodity is price at which quantity demanded of commodity
equals quantity supplied and market clears
Equilibrium is condition which once achieved tends to persist in time.

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Equilibrium of Supply and Demand

Effect of Shift in Supply or Demand

Demand & Supply shifts Effect on price and

quantity
If demand rises Demand curve shifts to Both P & Q increases
right
If demand falls Demand curve shifts to left Both P & Q falls
If supply rises Supply curve shifts to right P falls but Q increases
If supply falls Supply curve shifts to left P increases & Q decreases

Simultaneous shifts of Supply and Demand

New equilibrium price and quantity may be greater than, equal or even less than initial
equilibrium levels depending on the magnitude and direction of two curves
If both D & S shift to right by same amount , the equilibrium point shifts to right by
same amount and hence equilibrium price remains same.

Impact of Excise tax on Price and Quantity

An excise is a tax on each unit of commodity
If collected from sellers tax causes supply curve to shift upward by the amount of tax
Result is that consumers purchase a smaller quantity at a higher price while sellers
receive a smaller net price after payment of tax

Impact of Excise tax on Price and Quantity

Impact of Rent Control on Housing Markets

Rent control is a type of price ceiling or maximum rent set below equilibrium price that
government use for making rented housing affordable, however the effect has been opposite ie
shortage of apartments

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Rent Control create shortages

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 Managerial Economics
Module-2
Elasticity of Demand

Elasticity
Often in economics we look at how the value of one variable changes when another variable
changes. The concept called elasticity is a summary statement about those changes.

The law of demand or the law of supply is a statement about the direction of change of the
quantity demanded, or supplied, respectively, when there is a price change.

The concept of elasticity adds to these concepts by indicating the magnitude of the change
in quantity, given the price change. The magnitude of the change is reported in percentage
terms.

Types of Elasticity of Demand

Price elasticity of demand
Income elasticity of demand
Cross elasticity of demand
Promotional Elasticity of Demand

Price Elasticity of Demand

Indicates the extent to which demand changes when price of the commodity changes.
Ep = percentage change in quantity demanded / percentage change in price
Ep = Q/Q
P/P
where represents any change in Q and P.
Here P = price;
And Q = quantity demanded.

Elasticity can have three basic values

If (Ed) > 1 we say demand is elastic. This means the % change in the Qd is greater than the %
change in price.

If (Ed) = 1 we say demand is unit elastic. This means the % change in the Qd is equal to the %
change in price.

If (Ed) < 1 we say demand is inelastic. This means the % change in the Qd is less than the %
change in price.

Price elasticity of demand

Ed = (% change in Q)/(% change in P)

As an example, if Ed = -2 we say for every 1 % change in the price of the good the quantity
demand changed in the opposite direction by 2 %.

Perfectly Inelastic Demand (e=0)

Any change in the price do not affect the quantity demanded for the good
The demand curve is a vertical straight line
This violates the law of demand

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Relatively elastic demand (e>1)
Percentage change in quantity demanded is greater than that in price
When the price is raised, the total revenue of producers falls, and vice versa.

Relatively Inelastic demand (e<1)

Percentage change in quantity is smaller than that in price.
When the price is raised, the total revenue of producers rises, and vice versa.

Unitary Elastic demand (e=1)

Percentage change in quantity is equal to that in price.

Numerical Value Terminology Description

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 e=0 Perfectly Inelastic Demand remains unchanged
whatever be change in price
e>1 Relatively elastic Quantity demanded changes by a
larger percentage than does price
e<1 Relatively inelastic Quantity demanded changes by a
smaller percentage than does
price
e=1 Unitary Elastic Quantity demanded changes
exactly by a same percentage as
does price

Factors Influencing Elasticity of Demand

Nature of Commodity
Availability of Substitutes
Number of Uses
Consumers Income
Proportion of Expenditure
Durability of Commodity
Time Period
Recurrence of Demand
Possibility of Postponement
Influence of habit and customs
Demonstration effect

Measurement of Price Elasticity

Point Elasticity
Arc Elasticity
Total Revenue Method

Ratio Method: Point Elasticity

Ep = Q/Q = Q x P
P/P P Q

Where Q=original demand (sayQ1)

P=original price (sayP1 )
Q=Q2-Q1
P=P2-P1
Ep = %Q
%P
Since price & quantity move in opposite directions value of e is negative
However for comparison absolute value is used

Examples: Compute Price elasticity of Demand

When the price decreases from $10 per unit to $8 per unit, the quantity sold increases from 4
units to 6 units.

When the price deceases from $12 to $6 (50%), the quantity of demand increases from 40 to
only 50 (25%).

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Arc Elasticity of Demand
Is used to calculate price elasticity over some range ie between two distant points on demand
curve (say between a & b)
Ep = Q x (P1+P2)
P (Q1 +Q2)

Arc Elasticity is generally used for decision making when price change is more than 5%

Example
Initial Price is Rs 100 and 1000 units are demanded. New price is Rs 120 and 800 units are
demanded. Thus:
Point Elasticity at P1

e= -200/1000 X 100/20 =-1

Point Elasticity at P2

e= 200/800 X 120/20 = -1.5

earc = (-200/20)/ (100+120/1000 + 800)

Total Revenue Method

Total Revenue= Price x Quantity
When with a change in price TR remains unchanged Demand is unit elastic

With a rise in price TR falls or fall in price TR rises than demand is relatively elastic (e>1)

With a rise in price TR rises or fall in price TR falls than demand is relatively inelastic (e<1)

Total Revenue Method

Price Quantity TR Elasticity of
Demand

ORIGINAL 2 10 20

Change 4 5 20 e=1
1 20 20 e=1
Change 4 4 16 e>1
1 24 24 e>1
Change 4 6 24 e<1
1 16 16 e<1

Marginal revenue
Marginal revenue is defined as the change in total revenue as the number of units cold
changes.
If price falls and demand is elastic we know TR rises so MR is positive.
If Price falls and demand is inelastic we know TR falls and so MR is negative.
If price fall and demand is unit elastic we know TR does not change.

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Income Elasticity of Demand
Income elasticity of demand measures the relationship between a change in quantity
demanded and a change in income. The basic formula for calculating the coefficient of income
elasticity is:

Percentage change in quantity demanded of good X

Percentage change in income of consumer
Ey = Q/Q
Y/Y
Income elasticity is positive

Types of Income Elasticity

Zero income elasticity (Ey=0)- Neutral good
Negative income elasticity (Ey<0) Inferior good
Positive income elasticity (Ey >0) Normal good
o More than Elasticity (Ey>1) - luxury
o Less than Elasticity (Ey < 1)- necessity
o Unitary elasticity (Ey = 1)

Income Elasticity of different goods

Income Elasticity
REFER SLID No.25

Use of Concept of Income Elasticity in Business

Planning for Firms growth: If firms are selling commodities that are highly income
elastic will have greater sales volatility depending on economic growth
Forecasting Demand
Formulating marketing strategy: Number, nature and location of sales outlets depend
on income elasticity of target group of buyers

Cross Elasticity of Demand

Measures responsiveness of demand for a product to a change in price of other related goods

Ec= Percentage change in demand for commodity X

Percentage change in Price of Y

Exy = Qx/Qx
Py/Py

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 Points to remember:
1. Positive cross elasticity indicates that two products are substitutes since increase or
decrease in price of one causes an increase/ decrease in quantity demand for other
2. Negative cross elasticity indicates that two products in consideration are
complementary to each other
3. Cross elasticity is zero when goods are unrelated

For Substitutes: Positive Cross Elasticity

D1
Price of Y

Exy>0

Demand for X

For Complementary: Negative Cross Elasticity

Price of Y

Exy<0

D2

Demand for X

For Unrelated goods: Zero Cross Elasticity

Price of Y

Exy=0

Demand for X

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Promotional Elasticity of Demand
Advertising elasticity of demand measures the response of quantity demand to change in
expenditure on advertising and other sales promotion activities

EA= Percentage change in sales

Percentage change in advertisement expenditure

Factors influencing Promotional Elasticity

Type of commodity
Stage of product market :
o New and old
o Established market and growing market
Influence of advertising by rivals
State of economy

Applications of Price Elasticity

Pricing decisions of business organizations
Price discrimination
Government Policies
Factor Pricing
Use in international trade

Elasticity of supply
The elasticity of supply is used to indicate the percentage change in the quantity supplied
given a percentage change in price.

The elasticity of supply is calculated in a manner similar to the other elasticities we have seen
and has a similar interpretation in terms of the range of values the elasticity might take, i.e.
elastic, inelastic and unit elastic.

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 Demand Forecasting
Demand Forecasting
It means expectation about future course of the market demand for a product based on
statistical data about past behavior and empirical relationships of demand determinants

Types:
Short term
Long term
Passive & Active Forecasts

Short Term Forecasting

It normally relates to a period not exceeding a year
Benefits of Short term forecasting
Evolving a Sales Policy
Determining Price Policy
Fixation of Sales Target

Long Term Forecasting

It refers to the forecasts prepared for long period during which the firms scale of operations
or the production capacity may be expanded or reduced
Benefits of Long term forecasting
Business Planning
Manpower Planning
Long-Term Financial Planning

Factors involved in Demand Forecasting

Undertaken at three levels:
a) Macro-level
b) Industry level eg., trade associations
c) Firm level
Should the forecast be general or specific (product-wise)?
Problems or methods of forecasting for new vis--vis well established products.
Classification of products producer goods, consumer durables, consumer goods, services.
Special factors peculiar to the product and the market risk and uncertainty.

Criteria of a good forecasting method

1. Accuracy measured by (a) degree of deviations between forecasts and actuals, and (b)
the extent of success in forecasting directional changes.
2. Simplicity and ease of comprehension.
3. Economy.
4. Availability.
5. Maintenance of timeliness.

Presentation of a forecast to the Management

1. Make the forecast as easy for the management to understand as possible.
2. Avoid using vague generalities.
3. Always pin-point the major assumptions and sources.
4. Give the possible margin of error.
5. Omit details about methodology and calculations.
6. Make use of charts and graphs as much as possible for easy comprehension.

Various macro parameters found useful for demand forecasting

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 1. National income and per capita income.
2. Savings.
3. Investment.
4. Population growth.
5. Government expenditure.
6. Taxation.
7. Credit policy.

Significance of Demand Forecasting

1. Production Planning
2. Sales Forecasting
3. Control of Business
4. Inventory Control
5. Growth and Long Term Investment Program
6. Economic Planning and Policy Making

Sources of Data
Primary: which are collected for first time for purpose of analysis
Secondary : are those which are obtained from someones else records

Techniques of Demand Forecasting

Survey
Methods
Consumer Opinion Poll
Survey Methods

Market Studies
Complete Expert
&
Enumeration Opinion Experiments

Sample Delphi
Method Market Test
Survey

Laboratory
Test

Techniques of Demand Forecasting

Statistical Methods

Econometric
Time series analysis
Methods

Smoothing techniques Regression Method

Least Square Method Simple

Multivariate

Consumer Survey Methods

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Complete enumeration Method: All potential users of product are contacted and are asked
about their future plan of purchasing the product in question
Limitations
Very expensive in case of widely dispersed market
Consumers may not know their actual demand and may br unable to answer query
Their plans may change with a change in factors not included in questionnaire

Sample Survey: Only a few potential consumers and users selected from relevant market are
surveyed
Method is simpler, less costly and less time consuming.
Surveys are done to understand market demand, tastes ad preferences, Consumer
expectations etc

Opinion Poll Method

Aim at collecting opinions of those who are supposed to possess the knowledge of the market
e.g sales representatives, sales executives, consultants and professional marketing experts
This method includes
Expert opinion
Delphi method

Expert opinion
Under this method each expert is asked independently to provide a confidential estimate and
results could be averaged.

Experts may include executives directly involved in the market such as suppliers, distributors
or dealers or marketing consultants, officers of trade association etc.

Advantage is that there is no danger that group of experts develop a group- think mentality.
Moreover, forecasting is done quickly and easily without need of elaborate need of statistics.

Delphi Method
This method is an attempt to arrive at a consensus on some issues by questioning a group of
experts repeatedly until the responses appear to converge along a single line or the issues
causing disagreement are clearly defined.

Generally a panel consisting 9 to 12 experts

A coordinator is required for the process

Market Experimentation
Test marketing
A test area is selected, which should be a representative of the whole market in which the new
product is to be launched.

A test area may include several cities having similar features i.e. population, income levels,
cultural and social background, choice and preferences of consumers

Market experiments are carried out by changing prices, advertisement expenditure and other
controllable variables influencing demand

After such changes are introduced in the market, consequent changes in demand over a
period of time are recorded.

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Experiments in laboratory or consumer clinic method
Under this method consumers are given some money to buy in a stipulated store goods with
varying prices, packages, displays etc.

They are also requested to fill a questionnaire asking reasons for the choices they have made

The experiment reveals the consumers responsiveness to the changes made in prices,
packages and displays.

Limitations of market experiment methods

Very expensive
Being costly, carried out on a scale too small to permit generalization with a high degree of
reliability
Based on short term and controlled conditions which may not exist in an uncontrolled
market
Tinkering with price increases may cause a permanent loss of customers to competitive
brands

Types of data used in Statistical methods

Time series data refer to data collected over a period of time recording historical changes
in price , income and other relevant variables influencing demand for a commodity

Cross sectional analysis is undertaken to determine the effects of changes like price,
income etc on demand for a commodity at a point in time

Types of Statistical Methods

Consumption level Method
Time series Analysis (Trend Projection)
Smoothing Techniques
o Moving Averages
o Least Squares Method
o Exponential Smoothing Technique
Econometric Method
Barometric Method

Consumption Level Method

Under this method consumption level method may be estimated on basis of co-efficient of
Income elasticity and price elasticity of Demand

D* = D(1+M*.e)

D* =Projected per capita demand

D= Actual Per capita Demand
M*= Percentage change in per capita income/price
E=elasticity of demand

Illustration
Suppose Income elasticity of demand for chocolates is 3. In year 1995 per capita income is
$500 and per capita annual demand for chocolates is 10 million in a city. It is expected that in
year 2000 per capita income will increase by 20 % . Then projected per capita demand for
chocolates in 2000 will be?

Time Series Analysis

It attempts to forecast future values of time series by examining past observations of data
Reasons for fluctuations in time series data
o Secular Trend : value of a variable tends to increase or decrease over a period of time

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 o Cyclical Fluctuations are major expansions and contractions that seem to recur every
several years
o Seasonal variation refers to regularly recurring fluctuation in economic activity during
each year
o Irregular influences are variations in data series resulting from wars, natural disasters
or other unique events

Trend Projection
Simplest form of time series analysis is projecting trend based on assumption that factors
responsible for past trends in variable to be projected will remain same in future.

Trends refer to long term persistent movement of data in one direction-increase or decrease

Trend component of time series is the overall direction of the movement of the variable
over a long period.

Reasons for studying Trends

Studying secular trends permits us to project past patterns, or trends, into the future
In many situations studying the secular trend of a time series allows us to eliminate the
trend component from the series.
Methods for trend Projections: Smoothing Techniques
o Moving Average
o Exponential smoothing
o Least square

Moving average Method

This method assumes that demand in future year equals the average of demand in past
years
Under this method 3 yearly,4 or 5 yearly etc moving average is calculated by moving total
of values in group of years(3,4,5)is calculated, each time by ignoring first entry and
incorporating last one
For Three period Moving average the forecasted value of time series for next period is
average value of previous three periods in time series
In order to decide which of these moving averages forecasts is better ie closer to actual
data root-mean-square-error (RMSE) is calculated for each forecast and using moving
average that results in smaller RMSE
The greater the number of periods used in moving average the greater is the smoothing
effect because each new observation receives less weight. Useful when time series data is
more erratic.

Three-quarter Moving Average forecasts

Quarter Firms Actual Three Quarter A-F (A-F)2
Market Share Moving
(A) Average
Forecast (F)
1 20 - -
2 22 - -
3 23 - -
4 24 21.67 2.33. 5.4289
5 18 23 -5 25
6 23 21.67 1.33 1.7689
7 19 21.67 -2.67 7.1289
8 17 20 -3 9

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 9 22 19.67 2.33 5.4289
10 23 19.33 3.67 13.4689
11 18 20.67 -2.67 7.1289
12 23 21 2 4
13 - 21.33 Total=
78.3534

Five Quarter Moving Average forecasts

Quarter Firms Actual Fiv3 Quarter A-F (A-F)2
Market Share Moving Average
(A) Forecast (F)
1 20 - - -
2 22 - - -
3 23 - - -
4 24 - - -
5 18 - - -
6 23 21.4 1.6 2.56
7 19 22 -3 9
8 17 21.4 -4.4 19.36
9 22 20.2 1.8 3.24
10 23 19.8 3.2 10.24
11 18 20.8 -2.8 7.84
12 23 19.8 3.2 10.24
13 - 20.6 Total= 62.48

Three & Five year Moving Average Comparison

RMSE= {(A-F)2 / n}1/2

RMSE = 78.3534/9 = 2.95

RMSE = 62.48/7 = 2.99

Thus Three Year Moving Average is marginally better than corresponding Five year

Exponential Smoothing
A serous criticism of using moving averages in forecasting is that they give equal weight to
all observations in computing the average even though more recent observations are more
important
It uses a weighted average of past data as basis for a forecast by giving heaviest weight to
more recent information and smaller weights to observations in more distant past on
assumption that future is more dependent on recent past than on distant past
The value of time series at period t (At) is assigned a weight (w) between 0 and 1 both
inclusive, and forecast for period t (Ft) is assigned 1-w . The basic Equation :
Ft+1 = wAt + (1-w)Ft

Where Ft+1 = forecast for next period

At = Actual value of time t (most recent actual data)
Ft = forecast for present period
w = weight ie smoothing constant

Rules of Thumb:
When magnitude of random variations is large, w is taken as lower value so as to even out
the effects of random variation quickly

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 When magnitude of random variations is moderate, a large value is assigned to w
It has been found appropriate to have w between 0.1 and 0.2 in many systems
To identify best forecast amongst many arrived from different values of W,RMSE is used and
forecast having least RMSE is considered as best

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Illustration : Exponential Smoothing
Time period Actual Sales Forecasted Sales
(Rs 000)
1 60
2 64
3 58
4 66
5 70
6 60
7 70 63
8 74
9 62
10 74

Forecast sales of time period 8,9and 10

Take a smoothing constant w= 0.2

Econometric Methods
Combine statistical tools with economic theories to estimate economic variables and to
forecast intended economic variables
An econometric model may be a single equation regression model
Types of Econometric Method
o Regression Method

Regression Method
It attempts to find out relationship between dependent and independent variables
It is a statistical technique for obtaining the line that best fits data points
It is obtained by minimizing sum of squared vertical deviations of each point from
regression line and method used is called Ordinary Least Squares method (OLS)

Linear Equation
Y= a +bX Where X and Y are averages
Objective of regression analysis is to estimate linear relationship ie a and b
a = Y-bX
b = NXY (X) (Y)
N X2 - (X)2

Year t Advertising Xt Sales X2 XY

(million-Rs) Yt (000
units)
1 5 45 25 225
2 8 50 64 400
3 10 55 100 550
4 12 58 144 696
5 10 58 100 580
6 15 72 225 1080
7 18 70 324 1260
8 20 85 400 1700
9 21 78 441 1638
10 25 85 625 2125
N= X = 144 Y=656 X2=2448 XY=10254
10

Estimating Linear equation

b = 10(10254) (144)(656)
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 10(2448) (144)2
b = 2.15
a = Y bX where Y & X are averages
Y = 34.54 + 2.15X

It means that an increase of Rs 1 million in ad expenditure will bring an increase of 2.15

thousand units in sales ie 2,15000 units

Estimating Linear Trend-Least Squares Method

When a time series data reveals rising trend for e.g. in sales then equation is:
S= a +bT where a and b are estimated using following two equations
S= na + bT
ST = a T + b T2

Illustration: Suppose that a local bread manufacturer company wants to assess demand for
its product for years 2002,2003 and 2004. for this purpose it uses time series data of its sales
over past 10 years.

Year Sales of Bread(000 in tonnes)

1992 10
1993 12
1994 11
1995 15
1996 18
1997 14
1998 20
1999 18
2000 21
2001 25

Estimation of Trend Equation

Year Sales T T2 ST
1992 10 1 1 10
1993 12 2 4 24
1994 11 3 9 33
1995 15 4 16 60
1996 18 5 25 90
1997 14 6 36 84
1998 20 7 49 140
1999 18 8 64 144
2000 21 9 81 189
2001 25 10 100 250
n=10 S=164 T=55 T2 = 385 ST= 1024

Contd.
164 = 10a + 55b
1024 = 55a + 385b
S = 8.26 + 1.48T
For 2002, S2 = 8.26 + 1.48(11) = 24,540 tonnes

Problems: Demand Forecasting

1. Using method of least squares, fit straight line trend and estimate the annual sales of 1997.
Year Sales( lacs in Rs)

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 1991 45
1992 56
1993 78
1994 46
1995 75

2. Suppose number of refrigerators sold in past 7 years in a city is given in table. Forecast
demand for refrigerator for year 2002 and 2003 by calculating 3-yearly moving average
Year Sales
199
5 11
199
6 12
199
7 12
199
8 13
199
9 13
200
0 15
200
1 15

3. Estimate demand for sugar in 2003-04 if population in 2003-04 is projected to be 70 million

by using method of least squares to estimate regression equation of form: Y= a+ bX

Data on Consumption of Sugar:

Year Population Sugar consumed (000tonnes)
(millions)
95-96 10 40
96-97 12 50
97-98 15 60
98-99 20 70
99-2000 25 80
2000-01 30 90
2001-02 40 100

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