Module 5: Demand Forecasting

Session 10: Further Forecasting Techniques

Barometric Method:

1. Explain Barometric method of Demand Forecasting and atleast one of its advantage
and disadvantage?

Solution:

In barometric method, demand is predicted on the basis of past events or key variables which
are occurring in the present. This method is also used to predict various economic indicators,
such as saving, investment, and income. 

This technique helps in determining the general trend of business activities. For example,
suppose government allots land to the ABC society for constructing buildings. This indicates
that there would be high demand for cement, bricks, and steel.

 This consists in discovering a set of series of some variables which exhibit a close
association in their movement over a period or time.
 For example, it shows the movement of agricultural income (AY series) and the sale of
tractors (ST series). The movement of AY is similar to that of ST, but the movement in ST
takes place after a year’s time lag compared to the movement in AY. Thus if one knows the
direction of the movement in agriculture income (AY), one can predict the direction of
movement of tractors’ sale (ST) for the next year. Thus agricultural income (AY) may be
used as a barometer (a leading indicator) to help the short-term forecast for the sale of
tractors.

 Generally, this barometric method has been used in some of the developed countries for
predicting business cycles situation. For this purpose, some countries construct what are
known as ‘diffusion indices’ by combining the movement of a number of leading series in
the economy so that turning points in business activity could be discovered well in advance.
Some of the limitations of this method may be noted however. The leading indicator method
does not tell you anything about the magnitude of the change that can be expected in the
lagging series, but only the direction of change. Also, the lead period itself may change
overtime. Through our estimation we may find out the best-fitted lag period on the past data,
but the same may not be true for the future. Finally, it may not be always possible to find out
the leading, lagging or coincident indicators of the variable for which a demand forecast is
being attempted.
 The main advantage of this method is that it is applicable even in the absence of past data.
However, this method is not applicable in case of new products. In addition, it loses its
applicability when there is no time lag between economic indicator and demand.
 2. What are the different types of indicators used in forecasting future trends and
index?

Solution:

An index is constructed of relevant economic indicators and forecast future trends on the
basis of these indicators.

• Leading indicators

• Coincident indicators

• Lagging indicator

Leading Indicators :

• Series that go up or down ahead of other series.

Coincidence Indicators:

• Series that moves up or down simultaneously with level of economic activities

Lagging Indicators:

• Series which move with economic series after a time lag

Econometric Method:

1. Explain Econometric method of demand forecasting and state its advantages?

Solution:

Econometric method includes both the principles of economic theory and appropriate
statistical methods of estimation. It requires historical data (time series and/or cross section)
on the variable under forecasting and its determinants.

This method involves four steps:

 Identification of the variables that influence the demand for the good whose function
is under estimation.
 Collection of historical/cross section data on all the relevant variables.
 Choosing an appropriate form for the function.
 Estimation of the function.

Advantages:
1. Econometric methods force the forecaster to make explicit assumptions about the
linkages among the variables in the economic system being examined. In other words, the
forecaster must deal with causal relations. This produces logical consistency in the
forecast model and increases reliability.
2. Another advantage of econometric methods is that the forecaster can compare forecasts
with actual results and use insights gained to improve the forecast model. By feeding past
forecasting errors back into the model, new parameter estimates can be generated to
improve future forecasting results. 
3. The type of output provided by econometric forecasts is another major advantage.
Because econometric models offer estimates of actual values for forecasted variables,
these models indicate both the direction and magnitude of change. Finally, perhaps the
most important advantage of econometric models relates to their ability to explain
economic phenomena.

2. What are the problems included in the regression analysis of Econometric methods
of Demand Forecasting?

Solution:

Following are the problems included in regression analysis of Econometric method:

 Multicolinearity
 Autocorrelation
 Specification of error
 Identification problem
 Heteroscedasticity

Multicollinearity

• Two or more explanatory variables in the regression model are highly correlated

• Thus impact of each individual independent variable on the dependent variable becomes
difficult to ascertain

• Example: Consumption of an individual is affected by “income” and “wealth” of the

• Thus, detection and removal of multicollinearity is important.

Autocorrelation:

• Is the condition when error terms (“e”) in the regression equation are found to be
serially correlated. Also called “Serially Correlated”.

• Can occur in both time series as well as cross sectional data

• Detected by Durbin Watson test

Heteroscedasticity

• Classical regression model assumes that variance of error terms is constant for all
values of the independent variables in the model. If variables have different variances,
they are heteroscedastic.

• Heteroscedastic disturbances lead to a biased estimator of the true variance • There is no

• Can be overcome by running a Weighted Least Square Regression

Specification error

• Occurs when one or more independent variables in a regression model is omitted or

• Example-1: In a demand forecasting regression of consumer, omitting “income” of

• Example-2: A demand function is non linear. If it estimated to be linear, it leads to

Identification problem

• Example: If it is required to determine the effect of quantity demanded of a good when

• Historical data of monthly demand and price will not give the solution as price is part
of a multi-equation system. Supply of the good also needs to be taken into account to
avoid biased parameters.
Forecasting fluctuations on time series

1. Which of the following is an example of time series problem?

1. Estimating number of hotel rooms booking in next 6 months.

A) Only 3
B) 1 and 2
C) 2 and 3
D) 1 and 3
E) 1,2 and 3

Solution: (E)

All the above options have a time component associated.

2.In a time-series forecasting problem, if the seasonal indices for quarters 1, 2, and 3 are
0.80, 0.90, and 0.95 respectively. What can you say about the seasonal index of quarter 4?

(i) It will be less than 1

Solution:

(ii)

The seasonal indices must sum to 4, since there are 4 quarters. .80 + .90 + .95 = 2.65, so the
seasonal index for the 4th quarter must be 1.35 so (ii) is the correct answer.