Market Research Approaches To Demand Estimation

Many market research approaches are used for estimation of demand. Following are
the most important of these.
1. Consumer surveys and Observational Research
2. Consumer clinics, and
3. Market experiments.
Here we briefly examine these methods and point out their advantages and disadva
ntages and the conditions under which they might he useful to managers and econo
mists.
1. Consumer Surveys and Observational Research
Consumer surveys involve questioning a sample of consumers about how they would
respond to particular changes in the price of the commodity, incomes, the price
of related commodities, advertising expenditures, credit incentives and other de
terminants of demand. These surveys can be conducted by simply stopping and quest
ioning people at a shopping center or by administering sophisticated questionnair
es to a carefully constructed representative sample of consumers by trained inter
viewers.
In theory, consumer questionnaires can provide a great deal of useful information
to the firm. In fact, they are often very biased because consumers are either un
able or unwilling to provide accurate answers. For example, do you know how much
your monthly butter consumption would change if the price of butter rose by 10
cents per 100 gms.? If a butter producer doubled its advertising expenditures? If
the fat content of butter were reduced by 1 percent? Even if you tried to answ
er these questions as accurately as possible, your reaction might be entirely di
fferent if actually faced with any of the above situations. Sometimes consumers
provide a response that they deem more socially acceptable rather than disclose
their true preferences.
Depending on the size of the sample and the elaborateness of the analysis, consum
er surveys can also be expensive.
Because of the shortcomings of consumer surveys, many firms are supplementing or
supplanting consumer surveys with observational research. This refers to the gat
hering of information on consumer preferences by watching them buying and using
products. For example, observational research has led some automakers to conclud
e that many people think of their cars as art objects that are on display whenev
er they drive them.
Observational research does not, however, render consumer surveys useless. Somet
imes consumer surveys are the only way to obtain information about possible consu
mers' responses. For example, if a firm is thinking of introducing a new product
or changing the quality of an existing one, the only way that the firm can test
consumers' reactions is to directly ask them since no other data are available.
From the survey, the researcher then typically tries to determine the demograph
ic characteristics (age, sex, education, income, family size) of consumers who ar
e most likely to purchase the product. The same may be true in detecting changes
in consumer tastes and preferences and in determining consumers' expectations abo
ut future prices and business conditions. Consumer surveys can also be useful in
detecting consumers' awareness of an advertising campaign by the firm. Furthermo
re, if the survey shows that consumers arc unaware of price differences between
the firm's product and competitive products, this may be a good indication that t
he demand for the firm's product is price inelastic.
2. Consumer Clinics
Another approach to demand estimation is consumer clinics. These are laboratory
experiments in which the participants are given a sum of money and asked (to spe
nd it in a simulated store to see how they react to changes in the commodity pri
ce, product packaging, displays, price of competing products, and other factors
affecting demand. Participants in the experiment can be selected so as to close
ly represent the socioeconomic characteristics of the market of interest. Partic
ipants have an incentive to purchase the commodities they want the most.
The, consumer clinics are more realistic than consumer surveys. By being able to
control the environment, consumer clinics also avoid the pitfall of actual mark
et experiments which can be ruined by extraneous events.
Consumer clinics also have serious shortcomings, however. First, the results are
questionable because participants know that they are in an artificial situation
and that they are being observed. Therefore, they are not very likely to act no
rmally, as they would in a real market situation. For example, suspecting that th
e researchers might be interested in their reaction to price changes, participan
ts are likely to show more sensitivity to price changes than in their everyday s
hopping. Second, the sample of participants must necessarily be small because of
the high cost of running the experiment. Inferring, however, a market behavior
from the results of an experiment based on a very small sample can be dangerous.
Despite these disadvantages, consumer clinics can provide useful information ab
out the demand for the firm's product, particularly if consumer clinics are supp
lemented with consumer surveys.
Market Experiments
Unlike consumer clinics, which are conducted under strict laboratory conditions,
market experiments are conducted in the actual marketplace. There are many diffe
rent ways of performing market experiments. One method is to select several mark
ets with similar socioeconomic characteristics, and change the commodity price i
n some markets or stores, packaging in other markets or stores, and the amount a
nd type of promotion in still other markets or stores, and record the different r
esponses (purchases) of consumers in the different markets. By using census data
or surveys for various markets, a firm can also determine the effect of age, sex
, level of education, income, family size, etc., on the demand for the commodity
. Alternatively, the firm could change, one at a time, each of the determinants o
f demand under its control in a particular market over time and record consumers
' responses.
The advantage of market experiments is that they can be conducted on a large sca
le to ensure the validity of the results and consumers are not aware that they a
re part of an experiment. Market experiments also have serious disadvantages, how
ever One of these is that in order to keep costs down, the experiment is likely
to be conducted on too limited a scale and over a fairly short period of time, s
o that inferences about the entire market and for a more extended period of time
are questionable. 'Extraneous occurrences, such as a strike or unusually bad we
ather, may seriously bias the results in uncontrolled experiments. Competitors co
uld try to sabotage the experiment by also changing prices and other determinant
s of demand under their control. They could also monitor the experiment and gain
very useful information that the firm would prefer not to disclose. Finally, a f
irm may permanently lose customers in the process of raising prices in the marke
t where it is experimenting with a high price.
Despite these shortcomings, market experiments may be very useful to a firm in d
etermining its best pricing strategy and in testing different packaging, promotio
nal campaigns, and product qualities. Market experiments are particularly useful
in the process of introducing a different product, where no other data exist. Th
ey may also be very useful in verifying the results of other statistical techniqu
es used to estimate demand and in providing some of the data required for these
other statistical techniques of demand estimation.
LINEAR PROGRAMMING
This is a very useful and powerful technique that is often used by large corporat
ions, not-for-profit organizations, and government agencies to analyze very comp
lex production, commercial, financial, and other activities.
The Meaning and Assumptions of Linear Programming
Linear programming is a mathematical technique for solving constrained maximizat
ion and minimization problems when there are many constraints and objective fun
ction to be optimized, as well as the constraints faced, are linear i.e. can be
represented by straight lines.
Linear programming was developed by Russian mathematician L.V. Kantorovich in 19
39 and extended by the American mathematician G. B. Dantzig in 1947. Its accepta
nce and usefulness have been greatly enhanced by the advent of powerful computer
s since the technique often requires vast calculations.
The usefulness of linear programming arises because firms and other organization
s face many constraints in achieving their goals of profit maximization, cost mi
nimization or other objectives. With only one constraint, the problem| easily be
solved with the traditional techniques that in order to maximize output i.e., r
each a given isoquant, subject to a given cost constraint (isocost), the firm sh
ould produce at the point where the isoquant is tangent to the firm's isocost. S
imilarly, in order to minimize the cost of producing a given level of output fir
m seeks the lowest isocost that is tangent to the given isoquant. In the world,
however, firms and other organizations often face numerous constraints trying to
achieve their objective. For example, in the short run, a firm may not be able
to hire more labor with some type of special skill, obtain more than a specified
quantity of some raw material, purchase some. advanced equipment, and it may be
bound by contractual agreements to supply a minimum quantity of certain product
s, to keep labor employed for a minimum number of hours, to abide by some pollut
ion regulations, .and so on. To solve such constrained optimization problems, tr
aditional methods break down and linear programming must be used.
Linear programming is based on the assumption that the objective function that t
he organization seeks to optimize (i.e., maximize or minimize), as well as the c
onstraints that it faces, are linear and can be represented graphically by strai
ght lines. This means that we assume that input and output prices are constant, t
hat we have constant returns to scale, and that production can rake place with l
imited technologically fixed input combinations. Constant input prices and const
ant returns to scale mean that average and marginal costs are constant and equal
(i.e., they are linear). With constant output prices, the profit per unit is co
nstant, and the profit function that the firm may seek to maximize is linear. Sim
ilarly, the total cost function that the firm may seek to minimize is also linear
.
Since firms and other organizations often face a number of constraints, and the
objective function that they seek to optimize as well as the constraints that the
y face are often linear over the relevant range of operation, linear programming
is applicable and very useful.
Applications of Linear Programming
Linear programming has been applied to a wide variety of constrained optimization
problems. Some of these are
1. Optimal process selection.
Most products can be manufactured by using a, number of processes,
each requiring a different technology and combination of inputs. Given input pric
es and the quantity of the commodity that the firm wants to produce, linear prog
ramming can be used to determine the optimal combination of processes needed to
produce the desired level and output at the lowest possible cost, subject to the
labor, capital, and other constraints, that the firm may face.
2. Optimal product mix.
In the real world, most firms produce a variety of products rather than a single
one and must determine how to best utilize their plants, labor, and other input
s to produce the combination or mix of products that maximizes their total profi
ts subject to the constraints they face. For example the production of a particu
lar commodity may lead to the highest profit per unit but may nor utilize all th
e firm's resources. The unutilized resources can be used to produce another comm
odity, bur this product mix may not lead to overall profit maximization for the
firm as a whole. The product mix that would lead to profit maximization while sa
tisfying all the constraints under which the firm is operating can be determined
by linear programming.
3. Satisfying minimum product requirements.
Production often requires that certain minimum product requirements be met at mi
nimum cost. For example, the manager of a college dining hall may be required to
prepare meals that satisfy the minimum daily requirements of protein, minerals,
and vitamins at a minimum cost. Since different foods contain various proportio
ns of the various nutrients and have different prices, the problem can be very c
omplex. This problem, however, can be solved easily by linear programming by spec
ifying the total cost function that the manager seeks to minimize and the variou
s constraints that he or she must meet or satisfy. The same type of problem is f
aced by a chicken farmer who wants to minimize the cost of feeding chickens the
minimum daily requirements of certain nutrients; a petroleum firm that wants to m
inimize the cost of producing a gasoline of a particular octane subject to its r
efining, transportation, marketing, and exploration requirements.
4. Long-run capacity planning.
An important question that firms seek to answer is how much contribution to profi
t each unit of the various inputs makes. If this exceeds the price that the firm
must pay for the input, this is an indication that the firm's total profits wou
ld increase by hiring more of the input. On the other hand, if the input is unde
rutilized, this means that some units of the input need not be hired or can be s
old to other firms without affecting the firm's output. Thus, determining the ma
rginal contribution shadow price of an input to production and profits can be ve
ry useful to the firm in its investment decisions and future profitability.
5. Other specific applications of linear programming.
Linear programming has also been applied to determine
(a) the least-cost route for shipping commodities from plants in different locat
ions to warehouses in other locations, and from there to different markets (the
so-called transportation problem)
(b) the best combination of operating schedules, payload, cruising altitude spee
d, and seating configurations for airlines;
Although these problems are very different in nature, they all basically involve
constrained optimization, and they can all be solved and have been solved by lin
ear programming. This clearly points out the great versatility and usefulness of
this technique. While linear programming can be very complex and is usually condu
cted by the use of computers, it is important to understand its basic principles
and how to interpret its results.
PROCEDURE USED IN FORMULATING AND SOLVING LINEAR PROGRAMMING PROBLEMS
The most difficult aspect of solving a constrained optimization problem by linea
r programming is to formulate or state the problem in a linear programming forma
t or framework. The actual solution to the problem is then straightforward.
Simple linear programming problems with only a few variables are easily solved,
graphically or algebraically. More complex problems are invariably solved by the
use of computers. It is important, however, to know the process by which even t
he most complex linear programming problems are formulated and solved and how th
e results are interpreted. To show this, we begin by defining some important term
s and then using them to outline the steps to follow in formulating and solving
linear programming problems.
The function to be optimized in linear programming is called the objective funct
ion. This usually refers to profit maximization or cost minimization. In linear p
rogramming problems, constraints are given by inequalities (called inequality con
straints). The reason is that the firm can often use up to, but not more than sp
ecified quantities of some inputs, or the firm must meet some minimum requiremen
t. In addition, there are non negativity constraints on the solution to indicate
that the firm cannot produce a negative output or use a negative quantity of any
input. The quantities of each product to produce in order to maximize profits o
r inputs to use to minimize costs are called decision variables.
The steps followed in solving a linear programming problem are
1. Express the objective function of the problem as an equation and the co
nstraints as
inequalities.
2. Graph the inequality constraints, and define the feasible region
3. Graph the objective function as a series of isoprofit (i.e. equal profit
) or isocost lines, one for
each level of profit or costs, respectively.
4.. Find the optimal solution (i.e., the values of the decision variables) a
t the extreme point or
corner of the-feasible region that touches the highest isoprofit line or the low
est isocost line. This represents the optimal solution to the problem subject to
the constraints faced.
RISK AND UNCERTAINTY IN MANAGERIAL DECISION MAKING
Managerial decisions are made under conditions of certainty, risk, or uncertaint
y. Certainty refers to the situation where there is only one possible outcome to
a decision and this outcome is known precisely. For example, investing in Treasu
ry bills leads to only one outcome (the amount of the yield), and this is known
with certainty. The reason is that there is virtually no chance that the federal
government will fail to redeem these securities at maturity or that it will defa
ult on interest payments. On the other hand, when there is more than one possible
out-come to a decision, risk or uncertainty is present.
Risk refers to a situation where there is more than one possible outcome to a de
cision and the probability of each specific outcome is known or can be estimated.
Thus, risk requires that the decision maker knows all the possible outcomes of t
he decision and have some idea of the probability of each outcome's occurrence.
For example, in tossing a-coin, we can get either a head or/a rail, and
In the analysis of managerial decision making involving risk, we will use such c
oncepts as strategy, states of nature, and payoff matrix.
A strategy refers to one of several alternative courses of action that a decisi
on maker can take to achieve a goal.
States of nature refers to conditions in the future that will have a significant
effect on the degree of success or failure of any strategy, but over which the
decision maker has little or no control. For example, the economy may be in boom
normal, or in a recession in the future. The decision maker has no control over
states of nature that will prevail in the future but the future states of natur
e certainly affect the outcome of any strategy that he or she may adopt.
a payoff matrix is a table that shows the possible outcomes or results of strat
egy under each state of nature. For example, a payoff matrix may show the level
of profit that would result if the firm builds a large or a small plant and if
economy will be booming, normal, or recessionary in the future.
MEASURING RISK WITH PROBABILITY DISTRIBUTIONS
Risk is the situation where there is more than one possible outcome to a decisio
n and the
probability of each possible outcoik is known or can be estimated.
Probability Distributions
The concept of probability distributions is essential in evaluating and comparing
investment projects. In general, the outcome or profit of, an investment projec
t is highest when the economy is booming and smallest when the economy is in a r
ecession. If we multiply each possible outcome or profit of an investment by its
probability of occurrence and add these products, we get the expected value or
profit of the project. That is,
' Expected profit =
where tt, is the profit level associated with outcome i, P, is the probability t
hat outcome / will occur, and i' = 1 to n refers to the number of possible outco
mes or states of nature. Thus, the expected profit of an investment is the weigh
ted average of all possible profit levels that can result from the investment und
er the various states of the economy, with the probability of those outcomes or
profits used as weights. The expected profit of an investment is a very importan
t consideration in deciding whether or not to undertake the project or which of t
wo or more projects is preferable.
Probability Distribution of States of the Economy
State of the Economy Probability of Occurrence
Boom 0.25
Normal 0.50
Recession 0.25
Calculation of the Expected Profits of Two Projects
Expected profit from project A
$500
State of economy Probabiity of occurance Outcome of investment
Expected value
Boom 0.25 $600 150
Normal 0.50 $500 250
Recession 0.25 $400 100
Expected Profit from project (A) 500
Expected profit from project B
State of economy Probabiity of occurance Outcome of investment
Expected value
Boom 0.25 $800 200
Normal 0.50 $500 250
Recession 0.25 $200 50
Expected Profit from project (B) 500
Tablespresent the payoff matrix of project A and project B and shows how the ex
pected value of each project is determined. In this case the expected value of e
ach of the two projects is $500, but the range of outcomes for project A (from $
400 in recession to $600 in boom) is much smaller than for project B (from $200
in recession to $800 in boom). Thus, project A is less risky than and, therefore
, preferable to project B.
The expected value of a probability distribution need not equal any of the possi
ble outcome (although in this case it does). The expected value is simply a weig
hted average of all the possible outcomes if the decision or experiment were repe
ated a very large number of times. Had the expected value of project A been lowe
r than of project B, the manager would have had to decide whether the lower expe
cted profit from project A was compensated by its lower risk.
An Absolute Measure of Risk: The Standard Deviation
We know that the tighter or the less dispersed is a probability distribution, the
smaller is the risk of a particular strategy or decision. The reason is that th
ere, is a smaller probability that the actual outcome will deviate significantly
from the expected value. We can measure the tightness or the degree of dispersion
of a probability distribution by the standard deviation, which is indicated by
the symbol δ , Thus, the stan ar eviation (δ) measures the ispersion of possible o
utcomes from the expecte value. The smaller the value of (t, the tighter or les
s, isperse is the istribution, an the lower the risk.
To fin the value of the stan ar eviation (δ) of a particular probability istrib
ution, we follow the three steps outline below.
Subtract the expecte value or the mean ( ) of the istribution from each possib
le outcome ( ) to obtain a set of eviations ( ) from the expecte value. That i
s,
(1)
2. Square each eviation, multiply the square eviation by the probability of i
ts expecte outcome, an then sum these pro ucts. This weighte average of squar
e eviations from the mean is the variance of the istribution (δ2), That is,
Variance = δ2 =
3. Take the square root of the-variance to fin the stan ar eviation (o-):
Stan ar eviation =δ2 =
If we calculate the stan ar eviation of the probability istribution of profits
for any two project A an project B. If the stan ar eviation of the probabili
ty istribution of profits for project A is Rs. 100, while that for project B is
Rs. 200. These values provi e a numerical measure of the absolute ispersion of
profits from the mean for each project an confirm the greater ispersion of pr
ofits an risk for project B than for project A.
A Relative Measure of Risk: The Coefficient of Variation
The stan ar eviation is not a goo measure to compare the ispersion (relative
risk) associate with two or more probability istributions with ifferent expec
te values or. means. The istribution with the largest expecte value or mean m
ay very well have a larger stan ar eviation (absolute measure of ispersion) b
ut not necessarily a larger relative ispersion. To measure relative ispersion,
we use the coefficient of variation (v). This is equal to the stan ar eviatio
n of a istribution ivi e by its expecte value or mean. That is,
Coefficient of variation =v=
The coefficient of variation, thus, measures the stan ar eviation per Rupee of
expecte value or mean. As such, it is imension-free, or, in other wor s, it i
s a pure number that can be use to compare the relative risk of two or more pro
jects. The project with the largest coefficient of variation will be the most ris
ky.
Managerial Economic
Topic 1
Nature an Scope of Managerial Economics
Q-1 Managerial Economics is often sai to help the business stu ent integrat
e the Knowle ge gaine in other courses. How is this integration accomplishe ?
Ans: Managerial economics may be efine as the “ The application of economic t
heory an the tools of ecision science to examine how an organization can achie
ve its aims or objectives most efficiently”
(1) Relationship to economic theory
Stu y of economics is ma e from two perspectives
(a) Macro economic (b) Micro economics
In macro economics we stu y the economy as a whole. In this type of analysis we
iscuss about national income, inflation, unemployment etc.
In micro economics we iscuss about the in ivi ual units of the economy
like in ivi ual an market eman , consumer behavior an equilibrium of firm. In
managerial economics the theories about firm are the most important because ec
ision are ma e about the functioning of firms. Besi e theory of firm, informatio
n about the behavior of consumer is also important for estimation of eman for
the pro uct of the firm. As firm operates in economy therefore changes in struc
ture an nature of economy is also important for managerial ecision making. We
can, therefore say, that economic theories are very important for managerial ec
ision making.
(2) Relationship to ecision science
The ecision sciences like mathematical tools an econometric techniques are im
portant for eriving information about the market ata interpretation an for ta
king accurate ecision. Market ate collection, eman analysis, cost calculatio
n an profit estimations are very much base upon ecision science.
Therefore “ Managerial economics” refers to the application of economic theory an
ecision science tools to fin the optimal solution to managerial ecision proble
ms
Note Stu ents must explain various topics of economics an explain relation with
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