Dr.P.

Madhusoodanan Pillai
MA, MS, MBA, MSc, MIB, PGDBI, MIB, MPhil, PhD
Head of the Department in Management
Gurudev Institute of Management Studies

MBA106 MANAGERIAL ECONOMICS
Unit I
University Syllabi
Unit I
Relevance of Economics for business
decisions - Role of Managerial Economist
and Business decision making - Demand
Analysis - Demand curve and demand
function - Elasticity of demand and its
estimation - Demand Forecasting.

What do you mean by Economics?
Economic analysis evolves the problem of
scarcity
The purpose of economic activities
Definition of economics - Meaning of economics
from OIKONOMIA to Classical Political Economy-
Adam Smith, David Ricardo, T. R. Malthus, J.S.
Mill and Classical economic thought- Karl Marx
and the Marxian Economic Thought- Alfred
Marshall and the Neo-Classical Economic
Thought- J.M. Keynes and the Keynesian
Economic Thought- P.A. Samuelson and
Economic Growth- including definitions

The meaning of economy
Economic systems
Methods of economics Deduction and Induction
Positive and Normative Economics-
Economic Laws and Assumptions-
Statics and Dynamics-
Equilibrium - Short run and Long run equilibrium

What is Managerial Economics?
Managerial economics is the study of how Economic Theories are
applied to solve business problems with a view to achieve a
managerial objectives.
Managerial economics deals with the concepts and analysis of demand,
cost, profit, competition and so on, that are appropriate for decision
making
Business Economics is more comprehensive and broad based than
Managerial Economics
Business Economics attempts to indicate how business policies are firmly
rooted in economic principles.
It takes a pragmatic approach towards facilitating integration between
economic theory (principles) and business practices (policies).
Business economics uses microeconomic analysis of the business unit,
and macroeconomic analysis of the business environment. Thus,
Business Economics can simply be viewed as the application of
economics for the analysis of business.


Economics & Business
Business is an economic activity.
Each business essentially performs the task of transforming a set of
inputs into output. This transformation is, in fact, the essence of
economic activity.
In a business, a manager is a person who directs resources to
achieve certain stated goal(s). These goals/ objectives of a manager
are stated below:
Maximization of the value of the firm (profit
maximization)
Market share maximization
Maximization of sales revenue
Growth maximization
Maximization of own benefits
Maximization of shareholder value, etc.

Skills required to study Business Economis
Logical and intuitive thinking
Interpretation of graphs
Mathematics


The main thinking tool
= MODELS
Reduce complex
situations to their
fundamentals to
develop general
principles
Role of Managerial Economist and Business decision making
Managerial economics, or business economics, is a division of
microeconomics that focuses on applying economic theory directly to
businesses. The application of economic theory through statistical methods
helps businesses make decisions and determine strategy on pricing,
operations, risk, investments and production. The overall role of managerial
economics is to increase the efficiency of decision making in businesses to
increase profit.
Pricing
Managerial economics assists businesses in determining pricing strategies
and appropriate pricing levels for their products and services. Some
common analysis methods are price discrimination, value-based pricing and
cost-plus pricing.
Elastic vs. Inelastic Goods
Economists can determine price sensitivity of products through a price
elasticity analysis. Some products, such as milk, are consider a necessity
rather than a luxury and will purchase at most price points. This type of
product is considered inelastic. When a business knows they are selling an
inelastic good, they can make marketing and pricing decisions easier.

Operations and Production
Managerial economics uses quantitative methods to analyze production
and operational efficiency through schedule optimization, economies of
scale and resource analyses. Additional analysis methods include marginal
cost, marginal revenue and operating leverage. Through tweaking the
operations and production of a company, profits rise as costs decline.
Investments
Many managerial economic tools and analysis models are used to help
make investing decisions both for corporations and savvy individual
investors. These tools are use to make stock market investing decisions
and decisions on capital investments for a business. For example,
managerial economic theory can be used to help a company decide
between purchasing, building or leasing operational equipment.
Risk
Uncertainty exits in every business and managerial economics can help
reduce risk through uncertainty model analysis and decision-theory
analysis. Heavy use of statistical probability theory helps provide potential
scenarios for businesses to use when making decisions
Role of Managerial Economics in Managerial Decision Making
Traditional
Economics: Theory &
Methodology
Business Management
Decision Problems
Decision Sciences Tools
& Techniques of analysis
Optimal Solution to
Business Problems
Managerial Economics

Application of Economic theory &
Methodology to solve business
problems
Microeconomics
Macroeconomics
Economics provides basic tools to analyse ...
production and exchange
(both in markets and other organisations)
prices
competition
investments
changes in markets over time
strategic interaction between firms & customers

Provides a toolkit that can be applied to a huge range of
firm decisions.

Decision Making
Decision making can be regarded as the mental processes (cognitive process)
resulting in the selection of a course of action among several alternative
scenarios. Every decision making process produces a final choice.

The output can
be an action or an opinion of choice.
Problem Analysis vs Decision Making
It is important to differentiate between problem analysis and decision making.
The concepts are completely separate from one another. Traditionally it is argued
that problem analysis must be done first, so that the information gathered in that
process may be used towards decision making.
Steps in Problem Analysis:
Analyze performance, what should the results be against what they actually are
Problems are merely deviations from performance standards
Problem must be precisely identified and described
Problems are caused by a change from a distinctive feature
Something can always be used to distinguish between what has and hasn't been
effected by a cause
Causes to problems can be deducted from relevant changes found in analyzing
the problem
Most likely cause to a problem is the one that exactly explains all the facts




The Process of decision-making
Identify objectives
Define the problem
Identify possible solutions
Select the best possible
solution
Implement the decision
The role of managerial economics in managerial decision making
14
Decisions and Decision Making
Many decisions that managers deal with every day
involve at least some degree of uncertainty and
require nonprogrammed decision making
May be difficult to make
Made amid changing factors
Information may be unclear
May have to deal with conflicting points of view
Decision = choice made from available alternatives
Decision Making = process of identifying problems and
opportunities and resolving them
15
Certainty, Risk, Uncertainty, Ambiguity


Certainty
all the information the decision maker needs is fully available

Risk
decision has clear-cut goals
good information is available
future outcomes associated with each alternative are subject to
chance

Uncertainty
managers know which goals they wish to achieve
information about alternatives and future events is incomplete
managers may have to come up with creative approaches to
alternatives

Ambiguity
by far the most difficult decision situation
goals to be achieved or the problem to be solved is unclear
alternatives are difficult to define
information about outcomes is unavailable
Six Steps in the Managerial
Decision-Making Process
16
16
Evaluation
and
Feedback
Diagnosis
and Analysis
of Causes
Recognition of
Decision
Requirement
Development of
Alternatives
Selection of
Desired
Alternative
Implementation
of Chosen
Alternative
Decision-Making
Process
O
O
O
O
O
O
O
O
Steps in Decision Making
Objectives must first be established
Objectives must be classified and placed in order of importance
Alternative actions must be developed
The alternative must be evaluated against all the objectives
The alternative that is able to achieve all the objectives is the
tentative decision
The tentative decision is evaluated for more possible consequences
The decisive actions are taken, and additional actions are taken to
prevent any adverse consequences from becoming problems and
starting both systems (problem analysis and decision making) all over
again
There are steps that are generally followed that result in a decision
model that can be used to determine an optimal production plan.
[5]

In a situation featuring conflict, role-playing is helpful for predicting
decisions to be made by involved parties.
[6]

Decision Planning
Making a decision without planning is fairly common, but does
not often end well. Planning allows for decisions to be made
comfortably and in a smart way. Planning makes decision
making a lot more simpler than it is.
Decision will get four benefits out of planning:
1. Planning give chance to the establishment of independent
goals. It is a conscious and directed series of choices.
2. Planning provides a standard of measurement. It is a
measurement of whether you are going towards or further
away from your goal.
3. Planning converts values to action. You think twice about the
plan and decide what will help advance your plan best
4. Planning allows to limited resources to be committed in an
orderly way


Decision-Making Stages
Developed by B. Aubrey Fisher, there are four stages that should be
involved in all group decision making. These stages, or sometimes
called phases, are important for the decision-making process to begin
Orientation stage- This phase is where members meet for the first
time and start to get to know each other.
Conflict stage- Once group members become familiar with each
other, disputes, little fights and arguments occur. Group members
eventually work it out.
Emergence stage- The group begins to clear up vague opinions by
talking about them.
Reinforcement stage- Members finally make a decision, while
justifying themselves that it was the right decision.
It is said that critical norms in a group improves the quality of
decisions, while the majority of opinions (called consensus norms) do
not. This is due to collaboration between one another, and when
group members get used to, and familiar with, each other, they will
tend to argue and create more of a dispute to agree upon one
decision.

New
Decision
Approaches
for Turbulent
Times
New Decision Approaches
for Turbulent Times
21
Introduction. The nature of managerial economic decision
making
The role of managerial economics in managerial decision making
Demand
4Demand is the quantity customers are
willing to buy under current market
conditions.
4Direct demand is demand for
consumption.
Derived Demand
4Derived demand is input demand.
4Firms demand inputs that can be
profitably employed.

Market Demand Function
Determinants of Demand
Demand is determined by price, prices
of other goods, income, and so on.
Industry Demand Versus Firm
Demand
Industry demand is subject to general
economic conditions.
Firm demand is determined by
economic conditions and competition.
Law of Demand
The quantity demanded is the number of units of a good that consumers
are willing and can afford to buy over a (specified) period of time.
A crucial assumption of ceteris paribus i.e. other things being equal is
made at the outset.
The quantity demanded of any product normally depends on its price.
It also depends on a number of other determinants, including population
size, consumer incomes, tastes & preferences, prices of other
products, etc.
Law of Demand: There exists inverse relation between price and
quantity demanded, all other things held constant

Demand Schedule
It is a table showing how quantity demanded of some product during
a specified period of time changes as the price of that product
changes, holding all other determinants of quantity demanded
constant.

Demand Curve
A demand curve is a graphical representation of a demand schedule.
It shows how the quantity demanded of a product will change as the price of
that product changes during a specified period of time, holding all other
determinants of quantity demanded constant.
The curve shows the highest quantity of a good at each price the consumer
is willing to buy, ceteris paribus.
The demand curve slopes downward: as the
price of the commodity decreases more
people would be willing to purchase the
commodity at larger quantities.
Demand Function
It is a mathematical function that shows the relationship between the quantity
demanded and all variables that influence the quantity demanded. It can be
expressed as:



Where Q
x
is the quantity of good X, P
x
is the price of price of good X, P
s
& P
c
are
prices of substitute & complementary goods, respectively, Y is income, W is
wealth, E is expectations, T is tastes & preferences, A is advertisement
expenditure.


Movement along the demand curve
27
A movement along the demand curve happens if there is
change in price of the good that results in change in the
quantity demanded. E.g. if price of good X falls from Rs. 9 to
Rs. 8, there will be increase in quantity demanded from 60
units to 70 units.


Price
Quantity demanded
Move along
demand curve
when price
changes.
Shift to another
demand curve
when non-price
variables change.
A shift in
demand curve
occurs when
demand
determinants
other than price
change. If
income level
increases
demand curve
will shift to the
right, indicating
more is
demanded at
the existing
prices as
consumers are
now better off.
Utility Analysis
Meaning of utility
Cardinal utility- basic features of Marshallian Utility-
the fundamental theoretical concepts of Cardinal Utility
analysis- Law of Diminishing Marginal Utility and point of
satiety- Law of Equi-Marginal Utility Consumers Surplus-
Limitations of Cardinalism.
Ordinal Utility Analysis - Hicksian view Indifference
Curve Analysis- Meaning of Indifference Curves- features-
indifference map- properties of indifference curves- Price Line
and the Budget- Consumers equilibrium- subjects to changes
in price, income and substitutes with PCC, ICC and SE-
superiority of indifference analysis over cardinal utility
analysis- Utility and Demand
29
Indifference Curve
An indifference curve represents all combinations of
market baskets that provide same level of
satisfaction to a person.
Clothing
Food
A
C
D
B
E
Indifference curve a
curve that shows
combinations of goods
among which an
individual is indifferent.
The slope of the
indifference curve is the
ratio of marginal utilities
of the two goods.
Graphing the Budget Constraint
Consumers Equilibrium
An indifference curve represents all combinations of
market baskets that provide same level of satisfaction to
a person.
Clothing
Food
A
C
D
B
E
Deriving a Demand Curve from the Indifference Curve
Demand is the quantity of a good that a person will
buy at various prices.
The point of tangency of the indifference curve and the
budget line gives the quantity that a person would buy at a
given price.
By varying the price of one of the goods while holding the
price of other constant, the points of tangency will change.
This gives alternative price/quantity combinations.

Deriving a Demand Curve from the
Indifference Curve
Concepts of Elasticity of Demand
Knowing the direction of change in demand is not enough for a
manager. It is important to know to what extent the demand for his
product is going to change with the change in any of the determinants.
An elasticity is a measure of the sensitivity of one variable to another.
Specifically, it is a number that tells us the percentage change that will
occur in one variable in response to a 1 per cent change in another
variable. It measures the responsiveness of a variable to the changes in
its causal factors.
Various elasticity measures are:
4 Price elasticity
4 Income elasticity
4 Cross elasticity, etc.
Types of Price Elasticity of Demand
Perfectly Elastic Demand
Perfectly Inelastic Demand
Elastic Demand
Inelastic Demand
Unitary Elastic Demand

Demand is elastic if the percentage change in quantity is greater than
the percentage change in price. E > 1
Demand is inelastic if the percentage change in quantity is
less than the percentage change in price : E < 1
When price elasticity is -1, we say demand is unit elastic.
: E = 1






Price Elasticity
37
The price elasticity of demand is the percentage
change in quantity demanded divided by the
percentage change in price-
Price elasticity of demand measures the sensitivity of
quantity demanded to price changes.
It tells us what the percentage change in quantity
demanded for a good will be following a 1 per cent
increase in the price of that good.
Two different types of price elasticity can be
calculated:
4 Percentage Method
4Point Method
4 Arc Method




Calculating Elasticities: Price elasticity
Percentage Method
D
P
Q
20
10
26
14
Midpoint
B
A
E
D
=

%Q
%P

C
12
23
7-38
pri ce i n change Percentage
demanded quanti ty i n change Percentage
= ED
Price Elasticity- Point Method
Point elasticity of demand is defined as:



1
1
1
1 2
1
1 2
Q
P
P
Q
P
P P
Q
Q Q
e
p
) /( ) (
Since the demand curve is downward sloping, and quantity
demanded increases with the fall in price, the measure has a
negative sign. However, as a matter of convention in economics,
we show price elasticity by a positive number.
Price Elasticity- Arc Method
For appreciable change in prices, arc elasticity is more appropriate.
In arc elasticity, average price and quantity is considered because
when there is appreciable change in price, the value of elasticity
calculated on the basis of two points on the arc.


2 1
2 1
2 1
1 2
1 2
1 2
2 / ) (
2 / ) (
* ) (
Q Q
P P
P
Q
Q Q
P P
P P
Q Q
e
Arc
p
Price Elasticity
41
0
p
e
p
e
1
p
e
For a linear demand curve, the price elasticity depends not only on the
slope of the demand curve, but also on the price and quantity. The elasticity,
therefore, varies along the demand curve.
Price Elasticity
42
Determinants of Price Elasticity
43
1. Greater the number of close substitutes, more will be the price-
elasticity since whenever there is a change in the price of the
commodity, it will be substituted by and for the substitutes depending
on the increase and decrease of the price respectively.
2. The nature of the commodity used whether luxury or necessity. For
necessities, like food, medicines, etc. the elasticity will be low enough.
Changes in their prices are not going to change quantities demanded
appreciably. For luxuries, one can postpone the consumption.
3. The durability of goods particularly HH goods like TV, car, washing
machines, etc. also affects the elasticity. These goods are used for
longer periods. If prices fall, there may be considerable replacement
activities causing an increase in the quantity demanded, making
elasticity higher.
4. The proportion of income spent on the commodity. If it is extremely
low, the consumer may not feel the impact of price changes on the
consumption of the commodity. It is low in such cases, e.g. match
boxes, newspapers, etc.
Uses of Price Elasticity
Price elasticity has important applications in business
decision-making.
The most common use of price elasticity is in pricing
policy formulation. How much increase in total revenue
a firm can get by reducing the price of its product
depends upon price elasticity of demand.
The price elasticity is an important determinant to find
the impact of taxes.
There are substantial uses of price elasticity in adaptation
of a new technology.
Income Elasticity
The income elasticity shows the percentage change in quantity
demanded when income of the consumer changes by one percent,
that is
1
1
1
1 2
1
1 2
Q
Y
P
Q
Y
Y Y
Q
Q Q
e
y
) /( ) (
Generally, per capita disposable income is taken as a measure of income in
practice.
For most of the goods (normal goods) the income elasticity of demand will be
positive.
For inferior goods, income elasticity turns out to be negative. For luxury
goods, it is greater than one.
For necessities and semi-luxury goods, it may vary between zero and one.
Uses of Income Elasticity
The knowledge of income elasticity is a vital piece of information for
the firm.
A firm whose demand functions show high income elasticity will
have good opportunities for business particularly for expansion. For
certain goods, there may be consumption limit from the consumers
point of view. A firm supplying such goods will be stagnant if it
continues to produce them. The firm in such situation can grow only
through diversification of its business.
The income elasticity helps in making such decisions. Even for future
assessment of demand, the firm will take income elasticity into
account.
Cross-Price Elasticity
The cross-elasticity is used to measure the responsiveness of quantity
demanded of goods, say X, when there is a change in the price of some other
goods, say Y. The two goods X and Y, may be either substitute or
complementary to each other.

Examples of substitutes: teas & coffee, coal & gas, petrol & diesel, etc.
Examples of complements: tea & sugar, petrol & car, pen & ink, etc.
For substitute goods, cross-elasticity will be positive and for
complementary goods it will be negative. It will be positive in case of
derived demand also, i.e. when X is used for production of Y.
If cross-elasticity is zero, then the two goods are unrelated.
1
1
1
1 2
1
1 2
x
y
y
x
y
y y
x
x x
y x
Q
p
P
Q
p
p p
Q
Q Q
e ) /( ) (
.
Uses of Cross-Price Elasticity
The knowledge of cross-elasticity is very essential when the
goods are competing with each other or when they are
required in some combination with others
In case of different brands competing with each other, it is
used to find the effect of prices of other brands of
commodities supplied by the competitors on its own
Demand Forecasting
Uncertainty in business environment makes decision making difficult &
critical. Forecasting is a critical tool for scientific decision making process in
any business. Forecasts help managers by reducing some of the uncertainties,
thereby enabling them to develop more meaningful plans.
A forecast is a quantitative estimate (set of estimates) about the likelihood of
future events, which is developed on the basis of past & current information.
In other words, a Forecast is a statement about the future value of a variable,
such as demand.
Business forecasting pertains to more than predicting demand. Forecasts are
also used to predict profits, revenues, costs, productivity changes, prices,
interest rates, stock prices, movements of key economic indicators like GDP,
inflation, exchange rate, etc.
Steps in Forecasting
The following steps are necessary for an efficient forecast:

1. Identification of objective: It is necessary to be clear about what one wants
to get from the forecast.
2. Determining the nature of goods under consideration: Different categories
of goods like consumer goods, durables and non-durables, have their own
characteristic and distinct demand patterns.
3. Selecting a proper method of forecasting: It is based on type of data
available, period for which the forecast is to be made, etc.
4. Interpretation of results: Efficiency of forecast depends, to a large extent,
upon the efficiency in the interpretation of its results.
Forecasting future demand
Demand forecasting is based on:
extrapolating to the future past trends observed in the company
sales;
understanding the impact of various factors on the company
future sales:
1. Market data
2. Strategic plans of the company
3. Technology trends
4. Social/economic/political factors
5. Environmental factors

Remark: The longer the forecasting horizon, the more
crucial the impact of the factors listed above.

Demand Patterns
52
The observed demand is the cumulative result of:
systematic variation, due to a number of identified factors,
and
a random component, incorporating all the remaining
unaccounted effects.
Patterns of systematic variation
seasonal: cyclical patterns related to the calendar (e.g.,
holidays, weather)
cyclical: patterns related to changes of the market size, due
to, e.g., economics and politics
business: patterns related to changes in the company
market share, due to e.g., marketing activity and
competition
product life cycle: patterns reflecting changes to the product
life

Why Forecast?
Lead times require that decisions be made in advance of
uncertain events.
Forecasting is an important for all strategic and planning
decisions in a supply chain.
Forecasts of product demand, materials, labor, financing are
an important inputs to scheduling, acquiring resources, and
determining resource requirements.
Demand management is the interface between manufacturing
planning and control and the marketplace. Activities include:
1. Forecasting.
2. Order Processing.
3. Making delivery promises sting.
4. Order Processing
5. Making delivery
Demand Management
Marketplace Demand Mgt.
Production
Planning
Master
Production
Planning
Resource
Planning
55
Principles of Forecasting
1. Forecasts are almost always wrong.
2. Every forecast should include an estimate of
the forecast error.
3. The greater the degree of aggregation, the
more accurate the forecast.
4. Long-term forecasts are usually less accurate
than short-term forecasts
Forecasting Methods
Qualitative methods are subjective in nature
since they rely on human judgment and
opinion.
Quantitative methods use mathematical or
simulation models based on historical
demand or relationships between variables.
Demand Forecasting
General considerations:

1. Factors involved in demand forecasting
2. Purposes of forecasting
3. Determinants of demand
4. Length of forecasts
5. Forecasting demand for new products
6. Criteria of a good forecasting method
7. Presentation of a forecast to the management
8. Role of macro-level forecasting in demand forecasts
9. Recent trends in demand forecasting
10. Control or management of demand
Methods of demand forecasting
Approach to forecasting
Accurate demand forecasting is essential for a firm
to enable it to produce the required quantities at the
right time and arrange well in advance for the various
factors of production, viz., raw materials, equipment,
machine accessories, labour, buildings, etc.
In a developing economy like India, supple
forecasting seems more important. However, the
situation is changing rapidly.
The National Council of Applied Economic Research.
Factors involved in Demand Forecasting
1. How far ahead?
a. Long term eg., petroleum, paper, shipping.
Tactical decisions. Within the limits of resources
already available.
b. Short-term eg., clothes. Strategic decisions.
Extending or reducing the limits of resources.
Factors involved in Demand Forecasting
2. Undertaken at three levels:
a. Macro-level
b. Industry level eg., trade associations
c. Firm level
3. Should the forecast be general or specific (product-wise)?
4. Problems or methods of forecasting for new via well
established products.
5. Classification of products producer goods, consumer
durables, consumer goods, services.
6. Special factors peculiar to the product and the market risk
and uncertainty. (eg., ladies dresses)
Purposes of forecasting
60
Purposes of short-term forecasting
a. Appropriate production scheduling.
b. Reducing costs of purchasing raw materials.
c. Determining appropriate price policy
d. Setting sales targets and establishing controls and incentives.
e. Evolving a suitable advertising and promotional campaign.
f. Forecasting short term financial requirements.
Purposes of long-term forecasting
a. Planning of a new unit or expansion of an existing unit.
b. Planning long term financial requirements.
c. Planning man-power requirements.
Demand forecasts of particular products form guidelines for related
industries (eg., cotton and textiles). Also helpful at the macro
level.


Determinants of Demand
1. Non-durable consumer goods:
A. Purchasing power disposable personal income (personal
income direct taxes and other deductions). Published by C.S.O.
Discretionary income :Disposable income less (a) imputed income
and income in kind, (b) major fixed outlay payments, (c ) essential
expenditures such as food and clothing.
B. Price.
C. Demography: d= f (Y, D, P)
Eg., cotton cloth vs. cost of food grain.

2. Durable consumer goods:
A. Choice between (a) using the goods longer by repairing it, or (b)
disposing it off and replacing it with a new one.
Length of forecasts
62
Short-term forecasts up to 12 months, eg., sales quotas,
inventory control, production schedules, planning cash flows,
budgeting.
Medium-term 1-2 years, eg., rate of maintenance, schedule of
operations, budgetary control over expenses.
Long-term 3-10 years, eg., capital expenditures, personnel
requirements, financial requirements, raw material
requirements.
(Most uncertain in nature)
Forecasting demand for new products Joel Dean
1. Project the demand for a new product as an outgrowth of an
existing old product.
2. Analyse the new product as a substitute for some existing
product or service.
3. Estimate the rate of growth and the ultimate level of demand
for the new product on the basis of the pattern of growth of
established products.


Forecasting demand for new products
63

4. Estimate the demand by making direct enquiries from the ultimate
purchasers, either by the use of samples or on a full scale.
5. Offer the new product for sale in a sample market, eg., by direct mail
or through one multiple shop organisation.
6. Survey consumers reactions to a new product indirectly through the
eyes of specialised dealers who are supposed to be informed about
consumers need and alternative opportunities.
Criteria of a good forecasting method
1. Accuracy measured by (a) degree of deviations between forecasts
and actual, 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
64
In presenting a forecast to the management, a
managerial economist should:
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. Avoid making undue qualifications.
6. Omit details about methodology and calculations.
7. Make use of charts and graphs as much as possible for
easy comprehension.



Role of Macro-level forecasting in
demand forecasts
Various macro parameters found useful for
demand forecasting:
1. National income and per capita income.
2. Savings.
3. Investment.
4. Population growth.
5. Government expenditure.
6. Taxation.
7. Credit policy.

Recent trends in demand forecasting
66
1. More firms are giving importance to demand forecasting than a
decade ago.
2. Since forecasting requires close cooperation and consultation
with many specialists, a team spirit has developed.
3. Better kind of data and improved forecasting techniques have
been developed.
4. There is a greater emphasis on sophisticated techniques such as
using computers.
5. New products forecasting is still in infancy.
6. Forecasts are usually broken down in monthly forecasts.
7. In spite of the application of newer and modern techniques,
demand forecasts are still not too accurate.
8. The usefulness of personal feel or subjective touch has been
accepted.
9. Top-down approach is more popular then bottom-up approach.
Control or management of demand
The key to management of demand is the effective
management of the purchases of final consumers.
The management of demand consists in devising a
sales strategy for a particular product. It also
consists in devising a product, or features of a
product, around which a sales strategy can be built.
Product design, model change, packaging and even
performance reflect the need to provide what are
called strong selling points.
Methods of demand forecasting
1. Survey of buyers intentions
2. Delphi method
3. Expert opinion
4. Collective opinion
5. Nave models
6. Smoothing techniques
a. Moving average
b. Exponential smoothing
1. Analysis of time series and trend projections
2. Use of economic indicators
3. Controlled experiments
4. Judgmental approach
Methods of demand forecasting
69
Though statistical techniques are essential in clarifying
relationships and providing techniques of analysis, they
are not substitutes for judgment. What is needed is some
common sense mean between pure guessing and too much
mathematics.
1. Survey of buyers intentions: also known as Opinion
surveys. Useful when customers are industrial producers.
(However, a number of biases may creep up). Not very
useful for household consumers.
Limitation: passive and does not expose and measure the
variables under managements control
2. Delphi method: it consists of an effort to arrive at a
consensus in an uncertain area by questioning a group of
experts repeatedly until the results appear to converge
along a single line of the issues causing disagreement are
clearly defined.
Developed by Rand Corporation of the U.S.A in 1940s by
Olaf Helmer, Dalkey and Gordon. Useful in technological
forecasting (non-economic variables).
Advantages
1. Facilitates the maintenance of anonymity of the
respondents identity throughout the course.
2. Saves time and other resources in approaching a large
number of experts for their views.
Limitations/presumptions:
1. Panelists must be rich in their expertise, possess wide
knowledge and experience of the subject and have an
aptitude and earnest disposition towards the
participants.
2. Presupposes that its conductors are objective in their
job, possess ample abilities to conceptualize the
problems for discussion, generate considerable
thinking, stimulate dialogue among panelists and
make inferential analysis of the multitudinal views of
the participants.
3. Expert opinion / hunch method
71
To ask experts in the field to provide estimates, eg., dealers, industry
analysts, specialist marketing consultants, etc.
Advantages:
1. Very simple and quick method.
2. No danger of a group-think mentality.
4. Collective opinion method
Also called sales force polling, salesmen are required to estimate
expected sales in their respective territories and sections.
Advantages:
1. Simple no statistical techniques.
2. Based on first hand knowledge.
3. Quite useful in forecasting sales of new products.
Disadvantages:
1. Almost completely subjective.
2. Usefulness restricted to short-term forecasting.
3. Salesmen may be unaware of broader economic changes.
5. Nave models
72
Nave forecasting models are based exclusively on historical
observation of sales (or other variables such as earnings, cash
flows, etc). They do not explain the underlying casual
relationships which produces the variable being forecast.
Advantage: Inexpensive to develop, store data and operate.
Disadvantage: does not consider any possible causal relationships
that underlie the forecasted variable.
3-nave models
1. To use actual sales of the current period as the forecast for the next
period; then, Y
t+1
= Y
t
2. If we consider trends, then, Y
t+1
= Y
t
+ (Y
t
Y
t-1
)
3. If we want to incorporate the rate of change, rather than the
absolute amount; then, Y
t+1
= Y
t
(Y
t
/ Y
t-1
)
6. Smoothing techniques
73
Higher form of nave models:
A. Moving average: are averages that are updated as new information
is received. With the moving average a manager simply employs,
the most recent observations, drops the oldest observation, in
the earlier calculation and calculates an average which is used as
the forecast for the next period.
Limitations:
One has to retain a great deal of data.
All data in the sample are weighed equally.
B. Exponential smoothing: uses weighted average of past data as the
basis for a forecast.
Y
t+1
= aY
t
+ (1-a) Y
t
or Y new = a Y old + (1-a) Y old, where,
Y new = exponentially smoothed average to be used as the forecast
Y old = most recent actual data; Yold = most recent smoothed
forecast
a = smoothing constant
Smoothing constant (or weight) has a value between 0 and 1 inclusive.
Exponential smoothing
The following rules of thumb may be given :
1. When the magnitude of the random variations is large, give a lower
value to a so as to average out the effects of the random variation
quickly.
2. When the magnitude of the random variation is moderate, a large
value can be assigned to the smoothing constant a.
3. It has been found appropriate to have a between 0.1 and 0.2 in
many systems.
Advantages:
Exponential smoothing is a forecasting method easy to use and
efficiently handled by computers. Although a type of moving
average technique, it requires very little record keeping of past
data. This method has been successfully applied by banks,
manufacturing companies, wholesalers and other organizations.
7. Analysis of time series and trend
projections
The time series relating to sales represent the past pattern of effective
demand for a particular product. Such data can be presented either
in a tabular form or graphically for further analysis. The most
popular method of analysis of the time series is to project the trend of
the time series. A trend line can be fitted through a series either
visually or by means of statistical techniques. The analyst chooses a
plausible algebraic relation (linear, quadratic, logarithmic, etc.)
between sales and the independent variable, time. The trend line is
then projected into the future by extrapolation.
Popular because: simple, inexpensive, time series data often exhibit a
persistent growth trend.
Disadvantage: this technique yields acceptable results so long as the
time series shows a persistent tendency to move in the same direction.
Whenever a turning point occurs, however, the trend projection breaks
down.
The real challenge of forecasting is in the prediction of turning points
rather than in the projection of trends.
Analysis of time series and trend
projections
Four sets of factors: secular trend (T), seasonal
variation (S), cyclical fluctuations (C ), irregular or
random forces (I).
O (observations) = TSCI
Assumptions:
1. The analysis of movements would be in the order of
trend, seasonal variations and cyclical changes.
2. Effects of each component are independent of each
other.

8. Use of economic indicators
77
The use of this approach bases demand forecasting on certain economic
indicators, eg.,
1. Construction contracts sanctioned for the demand of building
materials, say, cement;
2. Personal income for the demand of consumer goods;
3. Agricultural income for the demand of agricultural inputs,
implements, fertilizers, etc,; and
4. Automobile registration for the demand of car accessories, petrol,
etc.
Steps for economic indicators:
1. See whether a relationship exists between the demand for the
product and certain economic indicators.
2. Establish the relationship through the method of least squares and
derive the regression equation. (Y= a + bx)
3. Once regression equation is derived, the value of Y (demand) can
be estimated for any given value of x.
4. Past relationships may not recur. Hence, need for value
judgement.
Use of economic indicators
Limitations:
1. Finding an appropriate economic indicator may be
difficult.
2. For new products no past data exists.
3. Works best when the relationship of demand with
a particular indicator is characterized by a time
lag. Eg., construction contracts will result in a
demand for building materials but with a certain
amount of time lag.
9. Controlled experiments
Under this method, an effort is made to vary
separately certain determinants of demand which
can be manipulated, e.g., price, advertising, etc.,
and conduct the experiments assuming that the
other factors remain constant.
Example Parker Pen Co.
Still relatively new and untried:
1. Experiments are expensive as well as time
consuming.
2. Risky may lead to unfavourable reaction on
dealers, consumers, competitors, etc.
3. Great difficulty in planning the study.difficult to
satisfy the condition of homogeneity of markets.
10. Judgmental approach
Required when:
1. Analysis of time series and trend projections is not feasible
because of wide fluctuations in sales or because of anticipated
changes in trends; and
2. Use of regression method is not possible because of lack of
historical data or because of managements inability to predict or
even identify causal factors.
Even statistical methods require supplementation of judgement:
1. Even the most sophisticated statistical methods cannot
incorporate all the potential factors, e.g., a major technological
breakthrough in product or process design.
2. For industrial products if the management anticipates loss or
addition of few large buyers, it could be taken into account only
through judgement approach.
3. Statistical forecasts are more reliable for larger levels of
aggregations.
Approach to forecasting
81
1. Identify and clearly state the objectives of forecasting.
2. Select appropriate method of forecasting.
3. Identify the variables.
4. Gather relevant data.
5. Determine the most probable relationship.
6. For forecasting the companys share in the demand, two different
assumptions may be made: Ratio of company sales to the total
industry sales will continue as in the past.
(a) On the basis of an analysis of likely competition and industry
trends, the company may assume a market share different
from that of the past. (alternative / rolling forecasts)
7. Forecasts may be made either in terms of units or sales in rupees.
8. May be made in terms of product groups and then broken for
individual products.
9. May be made on annual basis and then divided month-wise, etc.

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