Cross Elasticity, Demand Forecasting

Cross Elasticity of Demand

• Responsiveness of demand for one good relative to changes in the price of another
• Formula: Exy = (% change in quantity demanded of good x) / (% change in price of good y)
• Positive coefficient: goods are substitutes
• Negative coefficient: goods are complements

Demand Forecasting

• Goal: mitigate uncertainty for short-term operations and long-term growth
• Process: Uses macroeconomic forecasts for overall economic activity
• Firm uses macro forecasts for industry and company-specific micro forecasts

Qualitative Forecasts

• Utilizes survey techniques, since economic decisions precede actual expenditures
• Methods: Surveys of executive expenditure plans, inventory/sales expectations, and consumer spending plans

Opinion Polls

• Executive polling: Top management provides insights on sales outlook
• Sales force polling: Sales staff predict sales by region and product

Time Series Analysis

• Forecasts future values by examining past data observations

Reasons for Time Series Fluctuations

• Secular trend: Long-term increase or decrease (e.g., sales growth due to population)
• Cyclical fluctuations: Major economic shifts recurring over years (e.g., housing industry cycles)
• Seasonal variation: Regular fluctuations within a year (e.g., retail sales during holidays)
• Irregular influences: Variations from unique events (e.g., wars, disasters)

Smoothing Technique

• Predicts time series values using averages of past values
• Most helpful when data shows small trend/seasonal changes, but is mostly irregular

Moving Averages

• Forecasted value equals the average of previous periods
• Example: three-period moving average forecasts value using the prior three periods

Root Mean Squared Error (RMSE)

• Measures the difference between values in the sample and the population
• Indicates the difference of the values predicted by the model vs the actual observed values

Barometric Methods

• Leading economic indicators: predict broader economic trends

Leading Indicators

• Examples: orders for manufacturing, building permits, stock prices, money supply, and unemployment insurance claims

Coincident Indicators

• Examples: manufacturing/trade sales, industrial production, personal income, and nonagricultural payrolls

Lagging Indicators

• Examples: consumer price index, labor costs, duration of unemployment, and commercial/industrial loans

Production Theory

• Transforms inputs/resources into outputs (goods/services)
• Includes all activities from financing to quality control and cost accounting

Types of Inputs

• Fixed Inputs (FI): Cannot be easily altered in the short term
• Variable Inputs (VI): Can be easily adjusted

Time Horizon

• Short-run: At least one fixed production factor; insufficient time to change
• Long-run: All production factors can be adjusted

Production Function

• Shows maximum output with given input combinations

Production Assumptions

• Single output
• Two inputs: labor and capital
• Constant technology

Production Function with One Variable Input

• Total Product (TP): Total output from specific input quantity
• Marginal Product (MP): Additional output from one more input unit (MP = change in TP / change in variable input)
• Average Product (AP): Output per input unit (AP = TP / variable input)
• Output elasticity of labor: percentage change in output divided by the change in quantity of labor used

Diminishing Returns

• As variable input increases with fixed inputs, additional output eventually declines

Stages of Production

• Stage I: TP increases at increasing rate. AP & MP increase
• Stage II: TP increases at decreasing rate. AP decreases, MP decreases, TP is at maximum, MP is zero.
• Stage III: TP decreases, AP decreases. MP is negative

Optimal Variable Input Use

• Hire labor until extra revenue equals the cost

Marginal Revenue Product of Labor (MRPL)

• Extra revenue from hiring one more labor unit
• MRPL = (MPL) x (MR)

Marginal Resource Cost of Labor (MRCL)

• Cost of hiring one more labor unit
• Formula: MRCL = Change in Total Cost / Change in Labor
• Hire when MRPL exceeds MRCL, up to the point where MRPL = MRCL

Returns to Scale

• How output changes relative to proportional input changes

Constant returns to scale

• Output increases proportionally to input

Increasing returns to scale

• Output increases more than proportionally to input

Decreasing returns to scale

• Output increases less than proportionally to input

Explicit Costs

• Out-of-pocket costs for resources

Implicit Costs

• Opportunity cost of using owned resources

Accounting Costs

• Explicit costs for purchased/rented inputs

Economic Costs

• Explicit + implicit costs

Marginal Costs

• Cost of producing one more output unit

Incremental Costs

• Cost change from management decisions

Sunk Costs

• Irrelevant costs unaffected by decisions

Short-Run Costs

• Total Fixed Costs (TFC): Costs of firms fixed prices
• Formula: TFC = Total Cost - Total Variable Cost
• Total Variable Costs (TVC): Costs depending on variable inputs
• Formula: TVC = Total Cost - Total Fixed Cost
• Total Costs (TC): Fixed + variable costs
• Formula: TC= TFC + TVC
• Average Variable Cost (AVC): Variable input cost per output unit
• Formula: AVC = TVC/Q
• Average Fixed Cost (AFC): Fixed input cost per output unit
• Formula: AFC= TFC/Q
• Average Total Cost (ATC): Cost per output unit
• Formula: ATC = TC/Q
• Marginal Cost (MC): Cost of producing one more unit
• Formula: MC = Change in TC / Change in Q

Short-Run Analysis:

• TVC is zero when output is zero
• TC equals TFC when output is zero
• Fixed costs remain constant as output changes
• Variable and total costs increase with production
• AFC decreases as output increases
• AVC, ATC, and MC decrease then increase with output

Long-Run Total Cost Curves

• Shows minimum long-run costs for different output levels
• Long-Run MC (LRMC) = change in Long-Run Total Cost / change in Q
• Long-Run ATC (LRATC) = Long-Run Total Cost / Q

Scale Economics

• Economies of scale: cost advantage when output increases, LRATC decreases as output increases
• Diseconomies of scale: LRATC increases as output increases
• Constant economies of scale: LRATC is constant

Economies of Scope

• Producing multiple products together lowers cost

Learning Curves

• Average input cost declines with cumulative output due to efficiency gains

Market Structure

• Competitive environment of buyers and sellers

Market Structure Factors

• Number/size of buyers and sellers
• Product type
• Resource mobility
• Knowledge of prices, costs, supply, and demand

Perfect Competition

• Many small buyers/sellers cannot influence price, so they are price takers
• Homogeneous product and perfectly mobile resources
• Perfect information
• No barriers to entry/exit

Profit Maximization

• Compare Total Revenue (TR) and Total Cost (TC)
• Analyze Marginal Revenue (MR) and Marginal Cost (MC)
• Highest profit output is where MR = MC

Per Unit Profit/Loss

• Profit if Price/AR > ATC
• Loss if Price/AR < ATC
• Break-even if Price/AR = ATC
• Continue production if Price < ATC, but greater than AVC

Monopoly

• Single seller, no substitutes
• Price maker and difficult to enter
• No non-price competition

Reasons for Monopoly

• Control over raw materials
• Patents/copyrights
• Economies of scale
• Government franchise

Types of Monopoly

• Regulated monopoly: under social regulation, lower profit, and Price = MC
• Unregulated monopoly: no social regulation, higher profit, and Price > (MR = MC)