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Unit II: Demand and Supply

Demand theory and analysis


Application of price, income and
cross and advertisement elasticity of
demand
The theory of consumer choice
Regression techniques
Demand forecasting techniques

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Demand theory and analysis
Demand- Need, want and desire
backed by the purchasing power and
willingness of the consumer to part
with his money
Demand indicates how much of a
product consumers are both willing
and able to buy at each possible
price during a given period, other
things remaining constant.
The law of demand says that quantity
demanded varies inversely with price,
other things constant. Thus, the
higher the price, the smaller the
quantity demanded.
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Demand Schedule

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Demand Curve for Apple

a
$15
Price per apple
b
12
c
9
d
6
e
3
D
0
8 14 20 26 32
Millions of apple per week
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Market Demand is the Sum of Individual
Demands
Market Demand Curve: The horizontal summation of all the individual demand
curves.

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Demand Determinants
The law of demand says that quantity demanded varies
inversely with price, other things constant. Thus, the
higher the price, the smaller the quantity demanded.

QdX = f (PX , PR,Y,NB,T,E,G)

The demand function


Price of related goods
Complements
Substitutes
Income
Number of Buyers
Tastes
Expectations
Government: Taxes and Subsidies

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Demand Determinants
Substitution effect
The change in the relative price (the price of one good relative to the
prices of other goods) causes the substitution effect
If all prices changed by same margin, there would be no substitution
effect
Giffen goods- In case of inferior goods income effect is stronger than
substitution effect for ex. Potatoes and meat, bidi and cigerattee
Income effect
Money income the number of dollars you receive per period
Real income measure in terms of how many goods and services
you can buy
Diminishing marginal utility
Marginal utility additional satisfaction you derive from each item
Law of marginal utility you derive from each additional item
consumed decreases as your consumption increases (example:
pizza slices)

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Nature of Demand
Derived Demand and Autonomous demand
-Demand which is depend on the purchase of the
final product is called derived demand.
eg: purchase of the fuel for the car
-Autonomous demand is independent of the other
product or main product. Its not linked or tie-up with the
other goods or commodity.
Demand for producers goods and Consumers goods
-Demand for consumer goods is based on marginal
utility, whereas the demand for producer goods is based
on marginal productivity

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Nature of Demand

Durable and non-durable goods


- a durable good or a hard good is a good that does
not quickly wear out, or more specifically, one that yields
utility over time rather than being completely consumed in
one use
-Nondurable goods or soft goods are defined either as
goods that are immediately consumed in one use or ones
that have a lifespan of less than 3 years.
Industry demand and firm demand
-Firm Demand (company demand) denotes the
demand for the product/s of a particular firm. While
Industry demand means the demand for the product of a
particular industry.
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Nature of Demand

Total demand and market segment demand


- Total demand refers to the total demand for the
product from all market segments.
- Market segment demand refers to demand for the
product in a specific market segment.
Short-run demand and long-run demand
- Short run demand refers to demand with its
immediate reaction to price changes.
Long run demand refers to demand which does not
react immediately to price change.

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Elasticity of Demand/ Demand Sensitivity
Analysis
Product demand is a critical determinant of profitability,
and demand estimates are key considerations in virtually
all managerial decisions
For constructive managerial decision making, the firm
must know the sensitivity or responsiveness of demand to
changes in factors that make up the underlying demand
function
is a measure of how much buyers and sellers respond
to changes in market conditions
allows us to analyze supply and demand with greater
precision.

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The Elasticity Concept
Elasticity is the percentage change in a dependent
variable, Y, resulting from a 1 percent change in the value
of an independent variable, X
Elasticity = percentage change in Y
percentage change in X
Elasticity-
Price Elasticity
Income Elasticity
Cross Elasticity
Advertisement Elasticity

Percentage change in quatity demanded


Price elasticity of demand
Percentage change in price
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Elasticity, Percentage Change and Slope
Because the price elasticity of demand measures how
much quantity demanded responds to the price, it is
closely related to the slope of the demand curve.
But instead of looking at unit change, elasticity looks at
percentage change. What do we mean by percentage
change?
If there are 50 tomatoes in a store and you picked 16 of
them, what percentage of the total did you pick?
Paul used to weigh 200 Kg last year, but now he only
weighs 175 Kg. How many Kg did he lose? What is the
percent change of the loss?
What is the average of 300 and 330? What is the
midpoint?

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Price elasticity of demand
measures the responsiveness of the quantity
demanded of a product to changes in the price of
that same product, ceteris paribus

(Q2 Q1 ) P1
P
( P2 P1 ) Q1
(Q2 Q1 ) ( P2 P1 )
EP
( P2 P1 ) (Q2 Q1 )
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Degrees of Price Elasticity
Elastic Demand situation in which a price
change leads to a more than proportionate
change in quantity demanded. Consumers are
extremely responsive to price changes.
Demand is elastic if the absolute value of the
price elasticity of demand is greater than one

P 1
Example:
P 3.2
P 3.2
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Degrees of Price Elasticity
Unit Elastic Demand situation in which price and
quantity changes exactly offset each other.
Response is equal to change in price
Demand is unit elastic if the absolute value of the
price elasticity of demand is equal to one

Example:
P 1 P 1
P 1
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Degrees of Price Elasticity
Inelastic Demand situation in which a price
change leads to a less than proportionate change
in quantity demanded. Consumers are extremely
unresponsive to price changes.
Demand is inelastic if the absolute value of the
price elasticity of demand is less than one

P 1
Example:
P 0.5
P 0.5
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Methods of measuring elasticity of demand
Point elasticity of demand

Arc elasticity of demand

Slope approach or mathematical approach

Total outlay approach

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Point elasticity of demand
measures elasticity at a given point on a function
used to measure the effect on a dependent
variable Y of a very small (less than 5%) or
marginal change in an independent variable X
% Y
X
% X
Y / Y
X
X / X
Y X
X
X Y
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Point elasticity of demand

When price increase from $20 to $30, the quantity


demanded decreases from 3 to 2.

E= (2 3) / 3
.33 / .5 .67
(30 20) / 20

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Arc elasticity of demand
measures the average elasticity over a given
range of a function
used to measure the effects on a dependent
variable Y of large-scale changes in an
independent variable X
Y / Av eY
E
X / Av eX
(Y2 Y1 )
(Y2 Y1 ) / 2
E
( X 2 X1)
( X 2 X1) / 2
Y X 2 X1
E
X Y2 Y1
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Slope method or mathematical approach
P L mehta page 102

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Total outlay method
If demand is price elastic:
Increasing price would reduce TR (% Qd > % P)
Reducing price would increase TR
(% Qd > % P)

If demand is price inelastic:


Increasing price would increase TR
(% Qd < % P)
Reducing price would reduce TR (% Qd < % P)

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Income elasticity of demand
Income elasticity of demand for a commodity shows the
extent to which a consumers demand for the commodity
changes as a result of a change in his income.
Its a ratio of percentage change in the quantity demanded
of a good, say X, to the percentage change in income of
the consumer.
If income increases from $80 to $120, consumption of
bagels increases from 6 to 12.
A positive sign denotes a normal good
A negative sign denotes an inferior good

(12 6) / 6
1 / .5 2
(120 80) / 80

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Income elasticity of demand

The ratio of percentage change in the quantity demanded of a


good to the percentage change in the income of the consumer
E=Qx . Y1
Yx Q1
Types of income elasticity Income
Unitary income elasticity of demand
Change in quantity demanded=change
in money income
EY=1
Eg: gold

Quantity Qx

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Income elasticity of demand

Income
HIGH INCOME ELASTICITY OF DEMAND
when income increases, the quantity
increases in large proportion
EY>1
Eg:Branded items

Quantity Qx

LOW INCOME ELASTICITY OF Income


DEMAND
When income increases in large
proportion, quantity increases slightly
EY<1
Eg:Inferior goods

December 3, 2017 Vidya Suresh Quantity 27


Qx
Income elasticity of demand
Income
NEGATIVE INCOME ELASTICITY OF
DEMAND
more is bought in lower incomes and
less is bought in higher incomes
EY<0
Eg: low branded goods

Quantity Qx

ZERO INCOME ELASTICITY OF Income


DEMAND
Change in income has no effect
on the quantity demanded
EY=0
Eg: salt

Quantity Qx
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Cross elasticity of demand

The ratio of the percentage change in demand for one good to


the percentage change in the price of some other related good
Ec=Q of X
P of Y

Price of the product increases,


Price Py
quantity of the complementary product
decreses
EC=1
Eg:pen and ink

December 3, 2017 Vidya Suresh Quantity 29


Qx
Cross elasticity of demand
Price of one products change does not affect Price Py
the quantity of another product.
EC=0
Eg:

Quantity Qx

Price Py

Price of one product goes up, demand of


Substitute product raises.
Eg: tea and coffee

December 3, 2017 Vidya Suresh


Quantity30Qx
Advertisement elasticity of demand

It measures the response of quantity demanded to change in


expenditure on advertising
Ea=Q . A
A Q
HIGHLY EFFECTIVE PERFECTLY
INEFFECTIVE
ADVERTISEMENT ADVERTISEMENT
Income
Income

December 3, 2017 Vidya Suresh Quantity31Qx


Quantity Qx
Consumer choice
Utility analysis

Utility
Satisfaction derived from consumption
Subjective
Assumption
Tastes are given
Tastes are
relatively stable

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The Law of Diminishing Marginal Utility

Total utility
Total satisfaction
Marginal utility
Change in total
utility from
one-unit change
in consumption

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The Law of Diminishing Marginal Utility

The more of a good consumed


The smaller the increase in total utility
Marginal utility from each additional unit
Declines as more is consumed
Disutility
Negative marginal utility
Been there; done that

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An Indifference Curve

An indifference curve (I) shows all


combinations of two goods that
Video rentals per week

provide a particular consumer with


10
the same total utility.
8
Indifference curve:
negative slope
5
convex to origin
4
3 c
2 I

0 1 2 3 4 5 10
Pizzas per week
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Indifference Curves and Utility Maximization

Marginal rate of substitution MRS


Willingness to trade
Slope of indifference curve
Law of diminishing MRS
Diminishing slope of I curve

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Indifference Curves and Utility Maximization

Indifference map
Graphical representation of consumers tastes
Each I: different utility levels
The further indifference curve from origin
The higher the utility
More of both goods

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An Indifference Map

Indifference curves I1 through I4


are examples from a consumers
particular indifference map.
Video rentals per week

10
Indifference curves farther
from origin depict higher levels
of utility.

5
I4 A line intersects each higher
I3 indifference curve, reflecting
I2
I1 more of both goods.

0 5 10
Pizzas per week
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Indifference Curves Do Not Intersect

If indifference curves crossed


Video rentals per week

(i) every point on I and every


point on I would have to reflect
k
the same level of utility as i.

j k: more pizzas and


i videos than j; higher
I utility than j
I

0 Pizzas per week

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Demand forecasting

Definition

Factors

Purposes of Forecasting

Criteria for a good forecasting

Methods of demand forecasting

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Definition

Is a process by which an individual or a firm


predicts future demand for product or products

Accurate forecasting-enables these firms to


produce required quantities at the right time and
arrange well in advance for the various factors
of production

Better planning and allocation of national


resources.
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Factors Influencing DF
How far ahead?

Short term
Long- term
Should forecast be general or specific
Problems and methods
Classification of goods
- consumer
- durable
- consumer goods and services

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Factors

Forecasting at different levels

Macro

Industrial

Firm-level

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Purposes of forecasting

Purposes of short-term forecasting

Purposes of long term forecasting

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Short-term Forecasting
Short-term forecasting
Production scheduling
Reducing cost of purchasing raw materials
Determining appropriate price policy
Setting sales targets and establishing controls and
incentives
Evolving a suitable advertising and promotion
programme
Forecasting short-term financial

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Long -term Forecasting

Planning of a new unit or expansion of an


existing unit

Planning of long-term financial requirements

Planning of man-power requirements

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Criteria for a good Forecasting

Accuracy
- It is generally measured in terms of the past forecasts on
the present sales and by the number of times it is correct.
Plausibility
- The techniques used and the assumptions made should
be intelligible to the management. It is essential for a
correct interpretation of the results.
Simplicity
- It should be simple, reasonable and consistent with the
existing knowledge. A simple method is always more
comprehensive than the complicated one.

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Criteria for a good Forecasting
Economy
- It should involve lesser costs as far as possible. Its
costs must be compared against the benefits of
forecasts.
Availability
- Immediate availability of required data is of vital
importance to business. It should be made available on
an up to date basis.
Durability
- depends on the relationships of the variables
considered and the stability underlying such relationships

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Methods of demand forecasting

Survey or buyers Smoothing techniques


intention
Analysis of time series
Delphi method and trend projections

Expert opinion Use of economic


indicators

Collective opinion
Controlled experiments

Nave models
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Judgmental approach49
Vidya Suresh
Survey or buyers method
Direct method of estimating sales in the near future
Asking customers what the buyers are planning to buy
Known as opinion survey
The burden of forecasting goes to buyer
Method is best when bulk of sales is made.
Customers may misjudge or mislead or may be uncertain
about quantity
Not useful in case of house old customers
Does not measure and expose the variables under
managements control

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Methods of demand forecasting

Survey methods
- experts opinion
- consumer survey
- complete enumeration
- sample survey
- end- use
- Delphi method

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Methods of demand forecasting

- market experimentation
- stimulated market method
- actual market method

Statistical method
- trend analysis
- heading indicator analysis
- regression method
- simultaneous equation

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Survey Methods

conducted by sales agencies

a direct method of addressing people

helps in gaining first hand information

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Experts opinion

business firm prefers to depend on survey of


experts
Experts are those who have the feel about the
product
opinion poll is conducted among experts
Sometimes this method is also called the
hunch method

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Advantages

This method is very easy and less costly to


carry out.
This method produces quick results
When a firm intends to bring a new product, this
method is very useful to elicit the opinion of
experts on its marketing plans

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Disadvantages

The experts must have wide knowledge and


experience otherwise their opinion may be
personal based on guess work.

Experts opinion may be biased for a number


of reasons.

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Consumer survey

interviewing the consumers directly to get


information about their purchase plans at a
number of possible prices over a particular
period of time.

information collected through questionnaire

The data will have to be classified and


tabulated for systematic presentation and
analysis.
Complete enumeration method/ census method:

All consumers of a product are contacted and


they are interviewed to know their probable
demand for the forecast period.
This individual probable demand is added to
ascertain the demand forecast for the firms
product.
For example there are N consumers, each
demanding commodity X, then the total demand
forecast would be EN * n. where n=1.

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Advantages

This method simply records the data and


aggregates; it does not introduce any value
judgment of his own.

The demand forecast through this method is


likely to be more accurate than many other
methods.

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Disadvantages

It is time consuming and costly method

There can be large number of errors in the


data collection, as it is a tedious and
cumbersome process.

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Sample survey

Only few consumers are selected by using some


appropriate sampling technique.
They are interviewed to ascertain their probable
demands for the product for the forecast period.
Their average demand is then calculated.
This average demand for the sample is multiplied by
the total number of consumers to obtain the aggregate
demand forecast for the product in question.

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Advantages

It is a direct method of collecting data from


consumers. The information obtained is first
hand, it is more reliable.

This method saves time, cost and energy. It is


economical, if information is collected by postal
questionnaire.

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Disadvantages

There may be sampling error. The smaller the


size of the sample, the larger the sampling
error.

This method provides scope for errors. The


consumer may not understand the significance
of the questions asked, they may be dishonest,
reluctant or shy to reply or they may be either
vague or imaginary replies. This reduces the
usefulness of information collected.
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End-use Method
the demand for a product is forecasted through a
survey of its users.

A product may be used for final consumption by house


old sector and government and as an intermediate
product by different industries as well as may be
exported and imported.

purposes can be obtained through a survey of all or


selected consumers, exporters and importers and
industries using it as an input thus the total demand
forecast can be obtained as the sum of the demand
forecast of all three components.
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Advantages

It provides use-wise or sector-wise demand


forecasts.

This method is used now as a standard tool in


economic analysis and are extensively used by
governmental and no-governmental agencies.

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Disadvantages
This method assumes that technical structure of
production remains unchanged overtime, which
is not true. Because with economic
development technical innovations continue to
take place and lead to technological changes in
the industrial structure.

This method needs extensive information on


the probable demands of the final goods sector.
No company how so ever large can hope to
possess
December 3, 2017
this information.
Vidya Suresh 66
Delphi method

In this method an attempt is made to arrive at a


consensus in an uncertain area by questioning
a group of experts repeatedly until some sort of
unanimity is arrived among all experts.

These meetings help to narrow down different


views of experts.

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Advantages

In this method it is possible to pose the problem


to experts directly

It generates a reasonable opinion in place of


unstructured opinion.

It is a cheap method, save time and resources.

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Disadvantages

The success of this method depends upon wide


knowledge and experience of experts.

It could be tedious and costly method if the


experts are not too large and are cooperative
and forecaster has the necessary funds and
ability to perform the task.

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Statistical method

Time series data: Refers to data collected


over a period of time recording historical
changes in variables like price, income, etc.
that influenced demand for a commodity
Time series analysis relate to determination
of change in variable in relation to time.

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Statistical method
Trend analysis: A firm which has been in existence for
a long time will have accumulated data on sales
pertaining to different time periods.
When such data is arranged, chronologically it is know
as Time Series.
A typical time series has four components, trend,
cyclical fluctuations, seasonal variations and random
or irregular fluctuations.
This method is highly subjective and considerably
depends on the bias of the person drawing the curve.
The main advantage of this method is that it does not
require the formal knowledge of economic theory and
the market, it only needs the time series data.

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Regression method

involves a study of the dependence of one


variable on the other variables.

In demand forecasting demand is estimated


with the help of a regression equation where in
demand is the dependent variable and price,
advertising expenditure, consumers income,
etc is the independent variable.

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Forecasting

An important management activity


Major decisions in business are always
based on some forecasts
Generated by the firms economists or
consultants specialised in forecasting

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Sources of data

Forecasting requires a good set of data


Data serves as the base for analysis
3 important sources of data
expert opinion
surveys
market experiment

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Expert opinion

Collective judgment of knowledgeable


persons
This include the opinion of people closely
connected with the organisation
Ex: Delphi technique
-it aids individual panel member in
assessing their forecasts
-generates more precise forecasts with
each iteration
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Contd..

The problem is Delphi method can be


expensive
Usefulness of the expert opinion depends
on their skill to make predictions which
may turn out to be wrong
Some experts may be unwilling to be
influenced by the predictions of others

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Surveys

Surveys of managerial plans serve as


important source of data
Rationale for conducting such surveys is
that plans generally form basis for future
actions
If data available does not meet the specific
needs then the firm conducts its own
survey

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Market experiment

Problem with survey is, the responses


may not be the actual consumer behaviour
Designed to generate data prior to the full-
scale introduction of a product
Factors affecting market experiment
-location
-residents should be applicable to that
area
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Time-series analysis

To identify the components of change in


the data.
It includes:
-Trend
-Seasonality
-Cyclic patterns
-Random fluctations (refer book)

December 3, 2017 Vidya Suresh 79

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