Chapter 6

Forecastin
g
Managerial Economics:
Economic Tools for
Today’s Decision
Makers, 4/e By Paul
Keat and Philip Young
 Forecasting
• Introduction
• Subjects of Forecasts
• Prerequisites for a Good Forecast
• Forecasting Techniques
• Expert Opinion
• Surveys and market research
• Surveys of spending plans
• Economic indicators
• Projections
• Econometric models
2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
 Introduction
All organizations conduct their activities in an
uncertain environment. The major role of forecasting
is to reduce this uncertainty.

In order that corporate management can set reasonable

targets for its objectives, it must have available the
relevant forecasts, both for the short and long terms.

Corporate planners in all areas will utilize an array of

forecasts in constructing the various portions of the
business plan.

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

 Subjects of Forecasts
• Macro forecasts
• Gross domestic product
• Consumption expenditure
• Producer durable equipment expenditure
• Residential construction
• Industry forecasts
• Sales of an industry as a whole
• Sales of a particular product within an
industry
2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
 Subjects of Forecasts

• Firm-level forecasts
• Sales
• Costs and expenses
• Employment requirements
• Square feet of facilities utilized

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

 Prerequisites of a Good Forecast
A good forecast should
• be consistent with other parts of the
business.
• be based on adequate knowledge of the
relevant past.
• take into consideration the economic and
political environment.
• be timely.

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

 Forecasting Techniques
1. Expert opinion
2. Opinion polls and market research
3. Surveys of spending plans
4. Economic indicators
5. Projections
6. Econometric models

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

 Forecasting Techniques
Qualitative forecasting is based on
judgments of individuals or groups.

Quantitative forecasting utilizes

significant amounts of prior data as a
basis for prediction.

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

 Forecasting Techniques
Naïve methods project past data
without explaining future trends.

Causal (or explanatory) forecasting

attempts to explain the functional
relationships between the dependent
variable and the independent variables.

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

 Forecasting Techniques
Choosing the right technique depends
on various factors.
1. the item to be forecast
2. the relation between value and
cost
3. the quantity of historical data
available
4. the time allowed to prepare the
forecast
2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
 Expert opinion
Jury of executive opinion: A forecast
generated by experts (e.g, corporate
executives) in meetings.

The major drawback is that persons

with strong personalities may exercise
disproportionate influence.

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

 Expert opinion
Opinions of Sales Representatives

A drawback is that salespeople may be

overly optimistic or pessimistic.

Further, they may be unaware of the broad

economic patterns that may affect demand.

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

 Expert opinion
Delphi Method: A form of expert opinion forecasting
that uses a series of written questions and answers to
obtain a consensus forecast.

• Experts do not meet to discuss and agree on a

forecast, eliminating the potential pitfall resulting
from using a jury of executive opinion.

• There is no need for unanimity of opinion; the

forecast can include a range of opinions.

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

 Opinion polls and market research

Opinion polls: A forecasting method

in which sample populations are
surveyed to determine consumption
trends.
•may identify changes in trends
•choice of sample is important
•questions must be simple and clear

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

 Opinion polls and market research

Market research is closely related to opinion

polling.

Market research will indicate “not only why the

consumer is or is not buying, but also who the
consumer is, how he or she is using the product,
and what characteristics the consumer thinks
are most important in the purchasing decision.”

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

 Surveys of Spending Plans

Surveys of spending plans seek information

about “macro-type” data relating to the economy.

• Consumer intentions
• Survey of Consumers, Survey Research Center,
University of Michigan
• Consumer Confidence Survey, The Conference Board

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

 Surveys of Spending Plans

Surveys of spending plans seek

information about “macro-type” data
relating to the economy.

• Inventories and sales expectations

• Capital expenditure surveys

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

 Economic Indicators
Economic Indicators: A barometric
method of forecasting in which economic
data are formed into indexes to reflect the
state of the economy.

Indexes of leading, coincident, and lagging

indicators are used to forecast changes in
economic activity.

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

 Economic Indicators
Leading indicators predict changes in future
economic activity.

Coincident indicators identify peaks and

troughs in economic activity.

Lagging indicators confirm upturns and

downturns in economic activity.

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

 Economic Indicators

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

 Economic Indicators

General rule of thumb

If, after a period of increases, the leading
indicator index sustains three consecutive
declines, a recession (or a slowing) will follow.

(Economic indicators have predicted each recession since 1948.)

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

 Economic Indicators
Drawbacks
• Leading indicators occasionally
forecast recessions that do not occur.
• A change in the index does not indicate
the precise size of the decline or
increase.
• The data are subject to revision in the
ensuing months.
2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
 Projections
Trend projections: A form of naïve
forecasting that projects trends from
past data.
1. Compound growth rate
2. Visual time series projections
3. Least squares time series projection

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

 Projections
Compound growth rate: Forecasting
by projecting the average growth rate of
the past into the future.

• First, calculate the constant growth rate using

available data.
• Then project this constant growth rate into
the future.

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

 Compound Growth Rate

• Provides a relatively simple and timely

forecast

• Appropriate when the variable to be

predicted increases at a constant
percentage

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

 Compound Growth Rate
General formula:

E = B(1+i)n

E = final value n = years in the series

B = beginning value i = constant growth rate

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

 Compound Growth Rate
Solve the general formula for the
constant growth rate, i.

i = (E/B)1/n –1

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

 Compound Growth Rate
Then project this constant growth rate
forward.

E = B(1+i)n
E = projection n = years (series + projection)
B = beginning value

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

 Projections
Time series forecasting: A naïve
method of forecasting from past data by
using least squares statistical methods.

A time series analysis usually examines

•Trends
•Cyclical fluctuations
•Seasonal fluctuations
•Irregular movements.
2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
 Time Series Projections
Advantages
1. easy to calculate
2. does not require much judgment or
analytical skill
3. describes the best possible fit for past
data
4. usually reasonably reliable in the
short run
2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
 Time Series Projections
Yt = f(Tt, Ct, St, Rt)

Yt = Actual value of the data at time t

Tt = Trend component at t
Ct = Cyclical component at t
St = Seasonal component at t
Rt = Random component at t

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

 Time Series Projections
The task of the analyst is to decompose
the time series of Y into its four
components.

The method of moving averages is

used to isolate seasonal fluctuations.

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

 Time Series Projections

Computation of the trend utilizes the least

squares method.

The dependent variable is the deseasonalized

series.

The independent variable is time, starting

with period 1.

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

 Time Series Projections
Possible forms of the estimated
equation include:

• Straight line: Y = a + b(t)

• Exponential: Y = abt
• Quadratic: Y = a + b(t) + c(t)2

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

 Time Series Projections
To the isolate cyclical component
another smoothing operation can be
preformed with a moving average.

The length of the moving-average

period is determined individually for
each case.

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

 Time Series Projections
The remaining fluctuation is
considered the random component of
the series.

The random factors cannot be

predicted and therefore should be
ignored for projection purposes.

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young