This slide also has an automatic response with ten second gaps in between each point. At this stage we have tried to keep things as simple as possible but to introduce issues that will be dealt with later in the course.
Elasticity & forecasting
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Elasticity and Its Application
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Elasticity – The concept <ul><li>The responsiveness of one variable to changes in another </li></ul><ul><li>When price rises what happens to demand? </li></ul><ul><li>Demand falls </li></ul><ul><li>BUT! </li></ul><ul><li>How much does demand fall? </li></ul>
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Elasticity – The concept <ul><li>If price rises by 10% - what happens to demand? </li></ul><ul><li>We know demand will fall </li></ul><ul><li>By more than 10%? </li></ul><ul><li>By less than 10%? </li></ul><ul><li>Elasticity measures the extent to which demand will change </li></ul>
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Elasticity . . . <ul><li>… is a measure of how much buyers and sellers respond to changes in market conditions </li></ul><ul><li>… allows us to analyze supply and demand with greater precision. </li></ul>
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Price Elasticity of Demand <ul><li>Price elasticity of demand is the percentage change in quantity demanded given a percent change in the price. </li></ul><ul><li>It is a measure of how much the quantity demanded of a good responds to a change in the price of that good. </li></ul>
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Determinants of Price Elasticity of Demand <ul><li>Necessities versus Luxuries </li></ul><ul><li>Availability of Close Substitutes </li></ul><ul><li>Definition of the Market </li></ul><ul><li>Time Horizon </li></ul>
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Determinants of Price Elasticity of Demand <ul><li>Demand tends to be more elastic : </li></ul><ul><li>if the good is a luxury. </li></ul><ul><li>the longer the time period. </li></ul><ul><li>the larger the number of close substitutes. </li></ul><ul><li>the more narrowly defined the market. </li></ul>
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Computing the Price Elasticity of Demand <ul><li>The price elasticity of demand is computed as the percentage change in the quantity demanded divided by the percentage change in price. </li></ul>The Percentage Method
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Computing the Price Elasticity of Demand Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones then your elasticity of demand would be calculated as:
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Ranges of Elasticity <ul><li>Inelastic Demand </li></ul><ul><li>Quantity demanded does not respond strongly to price changes. </li></ul><ul><li>Price elasticity of demand is less than one. </li></ul><ul><li>Elastic Demand </li></ul><ul><li>Quantity demanded responds strongly to changes in price. </li></ul><ul><li>Price elasticity of demand is greater than one. </li></ul>
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Ranges of Elasticity <ul><li>Perfectly Inelastic </li></ul><ul><li>Quantity demanded does not respond to price changes. </li></ul><ul><li>Perfectly Elastic </li></ul><ul><li>Quantity demanded changes infinitely with any change in price. </li></ul><ul><li>Unit Elastic </li></ul><ul><li>Quantity demanded changes by the same percentage as the price. </li></ul>
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A Variety of Demand Curves 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.
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Perfectly Inelastic Demand - Elasticity equals 0 Quantity Price 2. ...leaves the quantity demanded unchanged. 4 5 Demand 100 1. An increase in price...
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Inelastic Demand - Elasticity is less than 1 Quantity Price 4 5 1. A 25% increase in price... 100 90 2. ...leads to a 10% decrease in quantity.
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Unit Elastic Demand - Elasticity equals 1 Quantity Price 4 5 1. A 25% increase in price... 100 75 2. ...leads to a 25% decrease in quantity.
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Elastic Demand - Elasticity is greater than 1 Quantity Price 4 5 1. A 25% increase in price... 100 50 2. ...leads to a 50% decrease in quantity.
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Perfectly Elastic Demand - Elasticity equals infinity Quantity Price Demand 4 1. At any price above 4, quantity demanded is zero. 2. At exactly 4, consumers will buy any quantity. 3. At a price below 4, quantity demanded is infinite.
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Computing the Price Elasticity of Demand ( Other methods) <ul><li>Price elasticity of demand can also be calculated by a few other methods. These methods are : </li></ul><ul><li>Total Outlay Method </li></ul><ul><li>Midpoint Formula </li></ul><ul><li>Geometric Method </li></ul>
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Total Outlay Method <ul><li>This method, measures the change on expenditure on commodities due to a change in price. </li></ul><ul><li>If a given change does not cause any change in the total amount spent on the commodity, the demand is said to be unitary elastic. </li></ul><ul><li>If the total expenditure increases due to fall in price, the demand is said to be elastic and vice versa. </li></ul>
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Demand is Unitary elastic As price falls, the quantity demanded increases, But the total outlay remains constant. Hence, elasticity of demand is equal to unity. Price ( in Rs.) Quantity demanded Total expenditure 4.50 4 18 4.00 4.5 18 3.00 6 18
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Demand is Elastic As price falls, the quantity demanded increases, And the total outlay also increases. Hence, demand is elastic. ( Greater than unity) Price ( in Rs.) Quantity demanded Total expenditure 4.50 6 27 4 7 28 3 10 30
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Demand is inelastic As price falls, the quantity demanded increases, but the total outlay decreases. Hence, demand is inelastic. ( Lesser than unity) Price ( in Rs.) Quantity demanded Total expenditure 4.50 4 18 4 4.25 17 3 5 15
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Midpoint Formula The midpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the change.
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Computing the Price Elasticity of Demand Example: If the price of an ice cream cone increases from 2.00 to 2.20 and the amount you buy falls from 10 to 8 cones the your elasticity of demand, using the midpoint formula, would be calculated as:
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Geometric method <ul><li>Elasticity at a point on a straight line demand curve can be calculated as follows : </li></ul><ul><li>e = Length of the lower segment </li></ul><ul><ul><li>-------------------------------------------------- </li></ul></ul><ul><ul><li>Length of the upper segment </li></ul></ul><ul><li>At the midpoint of the demand curve e = 1 </li></ul><ul><li>At all points above the midpoint e >1 </li></ul><ul><li>At all points below the midpoint e < 1 </li></ul>
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Geometric Method <ul><li>At the point M, the demand curve is unit elastic. M is the midpoint of this linear demand curve </li></ul><ul><li>Above M, demand is elastic, </li></ul><ul><li>Below M, demand is inelastic </li></ul>Price Quantity M Elasticity = 1 Elasticity > 1 Elasticity < 1
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Perfectly Inelastic Supply - Elasticity equals 0 Quantity Price 2. ...leaves the quantity supplied unchanged. 4 5 Supply 100 1. An increase in price...
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Inelastic Supply - Elasticity is less than 1 Quantity Price leads to a 10% increase in Supply 4 5 1. A 25% increase in price... 90 100
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Unit Elastic Supply - Elasticity equals 1 Quantity Price leads to a 25% increase in Supply 4 5 1. A 25% increase in price... 75 100
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Elastic Demand - Elasticity is greater than 1 Quantity Price 4 5 Leads to a 50% increase in quantity supplied 1. A 25% increase in price... 50 75
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Perfectly Elastic Supply Elasticity equals infinity Quantity Price Supply 4 1. At any price above 4, quantity supplied is infinite. 2. At exactly 4, Producers will sell any quantity. 3. At a price below 4, quantity supplied is zero.
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Elasticity Price Quantity Demanded D The importance of elasticity is the information it provides on the effect on total revenue of changes in price. 5 100 Total revenue is price x quantity sold. In this example, TR = 5 x 100 = 500. This value is represented by the shaded rectangle. Total Revenue
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Elasticity Price Quantity Demanded D If the firm decides to decrease price to (say) 3, the degree of price elasticity of the demand curve would determine the extent of the increase in demand and the change therefore in total revenue. 5 100 3 140 Total Revenue
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Elasticity Price Quantity Demanded 10 D 5 5 6 % Δ Price = -50% % Δ Quantity Demanded = +20% Ped = -0.4 (Inelastic) Total Revenue would fall Producer decides to lower price to attract sales Not a good move!
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Elasticity Price (£) Quantity Demanded D 10 5 20 Producer decides to reduce price to increase sales 7 % Δ in Price = - 30% % Δ in Demand = + 300% Ped = - 10 (Elastic) Total Revenue rises Good Move!
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Elasticity <ul><li>If demand is price elastic: </li></ul><ul><li>Increasing price would reduce TR (%Δ Qd > % Δ P) </li></ul><ul><li>Reducing price would increase TR </li></ul><ul><li>(%Δ Qd > % Δ P) </li></ul><ul><li>If demand is price inelastic: </li></ul><ul><li>Increasing price would increase TR </li></ul><ul><li>(%Δ Qd < % Δ P) </li></ul><ul><li>Reducing price would reduce TR (%Δ Qd < % Δ P) </li></ul>
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Importance of Elasticity <ul><li>Relationship between changes in price and total revenue </li></ul><ul><li>Importance in determining what goods to tax (tax revenue) </li></ul><ul><li>Importance in analysing time lags in production </li></ul><ul><li>Influences the behaviour of a firm </li></ul>
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Importance of Elasticity Concepts <ul><li>For a Businessman : If a businessman finds that the demand is inelastic, he is free to increase prices. In case if the demand is elastic, by slightly reducing the price, the demand will increase sharply and hence the total revenue will also increase. </li></ul><ul><li>The better a company can assess future demand, the better it can plan its resources. Each company is exposed to three types of factors influencing demand: company, competitive and macroeconomic factors. </li></ul>
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Demand Forecasting <ul><li>A forecast is a prediction or anticipation of any event which is likely to happen in future. </li></ul><ul><li>Demand forecast is the prediction of the future demand for a firm’s product. </li></ul><ul><li>It can either be made through experience or by statistical methods. </li></ul>
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Forecasts are necessary for : <ul><li>Fulfillment of the objectives. </li></ul><ul><li>Preparations of budgets. </li></ul><ul><li>Stabilization of employment and production. </li></ul><ul><li>Decisions about expansion of a firm. </li></ul><ul><li>Other decisions like long term investment plans, warehousing and inventory decisions. </li></ul>
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<ul><ul><li>A forecast becomes a basis for setting and maintaining a production schedule – manufacturing. </li></ul></ul><ul><ul><li>It determines the quantity and timing of needs for labor, equipment, tools, parts, and raw materials – purchasing, personnel. </li></ul></ul><ul><ul><li>It influences the amount of borrowed capital needed to finance the production and the necessary cash flow to operate the business – controller. </li></ul></ul><ul><ul><li>It provides a basis for sales quota assignments to various segments of the sales force – sales management. </li></ul></ul><ul><ul><li>It is the overall base that determines the company’s business and marketing plans, which are further broken down into specific goals – marketing offer. </li></ul></ul>A forecast is important for at least five reasons:
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Methods of Demand forecasting <ul><li>There are two different sets of methods for demand forecasting : </li></ul><ul><li>Interview & survey methods ( for short term forecasts ) </li></ul><ul><li>Projection Approach ( for long term forecasts ) </li></ul>
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Interview and Survey approach <ul><li>To anticipate the demand for a product, information needs to be collected about the expected expenditure patterns of consumers. Depending on the various approaches to collect this information, different sub – methods are formulated. </li></ul><ul><li>We will study them one by one. </li></ul>
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Interview and Survey approach <ul><li>Executive Opinion : </li></ul><ul><li>In small companies, usually the owner takes the responsibility of forecasting. </li></ul><ul><li>As a result of the experience and knowledge he is expected to have, he can predict what would be the course of activities in future and plan his own activities accordingly. </li></ul>
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Interview and Survey approach <ul><li>Opinion polling method : Information about the consumer’s expenditure can be collected either by the market research department or through the wholesalers and retailers. </li></ul><ul><li>As a result of technological advancements, it is now possible to collect this information by the means of internet. </li></ul>
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Interview and Survey approach <ul><li>Collective opinion method : </li></ul><ul><ul><li>Jury is a group of individuals, usually the top bosses or sales, production, marketing managers having experience in different fields. </li></ul></ul><ul><ul><li>The advantage of this method is that instead of basing the forecast on the opinion of one single individual, a more accurate forecast can be drawn. </li></ul></ul>
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Interview and Survey approach <ul><li>Sample survey method : </li></ul><ul><li>The total number of customers of a company is called as its population. When this number is more, it is not possible to collect information for all the customers. When only a few customers are contacted, it is called as a Sample Survey. </li></ul>
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User’s Expectations Consumer and industrial companies often poll their actual or potential customers. Some Industrial manufacturers ask about the quantities of products their customers may purchase in future and take this as their forecast.
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Delphi Method Administering a series of questionnaires to panels of experts. This method gathers information from all experts and the opinion of all the experts is shared by all other experts. In case if an expert finds that his own forecast is unrealistic, after going through the opinion of other experts, there is a chance for corrections.
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Projection Approach <ul><li>In this method, the past experience is projected for the future. This can be done by tow methods : </li></ul><ul><li>Correlation or regression analysis. </li></ul><ul><li>Time series analysis. </li></ul>
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<ul><ul><li>Past sales can be used to forecast future demand. Past sales are viewed from the angles of trends, various cycles of business, seasonality and then a forecast is drawn after checking the possibility of the same treads, cycles and seasonality factors. </li></ul></ul><ul><ul><li>This method is easy to use, it is based on past behavior and does not include new company, competitor or macroeconomic developments. </li></ul></ul>Classical approach to time series analysis:
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Naïve Method Next Year’s Sales = This Year’s Sales X This Year’s Sales Last Year’s Sales
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Moving Average Moving averages are used to allow for marketplace factors changing at different rates and at different times.
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EXAMPLE OF MOVING-AVERAGE FORECAST P ERIOD S ALES V OLUME S ALES FOR THREE- Y EAR P ERIOD T HREE- Y EAR M OVING A VERAGE 1 200 2 250 3 300 750 4 350 900 300 5 450 1100 ( 3) = 366.6 6 ? Period 6 Forecast = 366.6
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Trend Projections – Least Squares Eyeball fitting is simply a plot of the data with a line drawn through them that the forecaster feels most accurately fits the linear trend of the data.
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Categories of New Products New-To-The-World New Product Lines Product Line Additions Improvements/Revisions Repositioned Products Lower-Priced Products Six Categories of New Products
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Forecasting of New Products <ul><li>Evolutionary method : Whenever a new product has been evolved from an existing product ( eg. Colour TV from Black & White TV ), the information of the existing product may be used for prediction of future for the new product. </li></ul><ul><li>Substitution method : Many new goods are purchased by customers for replacing the old ones. ( Eg. LCD TV’s in place of Colour TV’s). </li></ul>
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Forecasting of New Products <ul><li>Growth pattern methods : To predict the demand for a new product, the growth pattern of an established related goods can be understood. </li></ul><ul><li>Opinion polling method : This method advocates the direct questioning to the probable buyers or the influencers of sales of such products. (Eg. demand for drugs can be ascertained by asking the doctors ) </li></ul>
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Forecasting of New Products <ul><li>Sample survey method : A product is first introduced in a test market ( small city having profiles of customers of metros ). Responses from these markets are taken as a base for forecasts. </li></ul><ul><li>Indirect opinion polling : Instead of asking the probable buyers, here, the resellers are consulted. </li></ul>
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