1. Theory of Demand
By:Asnakech .A
Managerial Economics
Chapter-Two

2. Unit Objectives
⚫T
o explainthe meaning of demand and types;
⚫T
o identify the factorsthat affect demand;
⚫ T
o explainthe concept of elasticity and its different types;
⚫T
o explain the different waysof measuring elasticity;
⚫Toexplain the uses and applications of different elasticities;
⚫ T
o understand different demand analysistechniques.

3. Introduction
⚫ The growing competition teaches the lesson of knowing our
customers in detail - in terms of their wants and needs which
ultimately leads to their desires, rather than looking at them as
sales prospective only.
⚫ Because; how good your product or service is, the simple truth is
that no-one will buy it if they don't want it or believe they don't
need it.
⚫ And you won't persuade anyone that they want or need to buy
what you're offering unless you clearly understand what your
customers really want.

4. ⚫After all, knowing and understanding customer needs
is at the centre of every successful business, whether it
sells directly to individuals or other businesses.
⚫Once you have this knowledge, you can use it to
persuade potential and existing customers that buying
from you is in their best interests.

5. Customer understanding….?
“Customer understanding is the overall process
of knowing your customers to build and
maintain profitable customer relationships by
delivering superior customer value and
satisfaction.”

6. Why Customer Understanding Matter?

7. Introduction to Demand Theory
⚫ The success of any business largely depends on sales, and sales depend on market demand
behaviour.
⚫ Consumer demand theory is aframework for thinking about whypeople make the choices they do.
⚫ The theory can potentially help business managers choose the types of products and services to
offer and the pricesto set to maximize profit.
⚫ Demand relationships determine revenues and indirectly affect output and costs; they thus have a
fundamental impact on profits.
⚫ Anunderstanding of demand is also relevant for planning purposes, involving production,
transportation, inventory
, sales, marketing and finance functions.
⚫ The identification of factors affecting demand and the precise effects that these have is therefore a
core element in managerial economics.

8. what is Demand???
⚫ The word ‘demand’can be used in avariety of senses, which
often causes misunderstanding and errors of analysis.
i. Mystery behind/Reason for production economic activity.
ii. Demand = Desire to acquire something + Willingness to pay
for the desired thing + Ability to Paythe required scarification

10. ⚫Tosum up, we can saythat the demand for aproduct is the desirefor
that product backed bywillingnessaswell asability to pay for it.
⚫It is always defined with reference to a particular time, place, price
and given values of other variables on which it depends.

11. Basics of Consumer Demand: The Utility
⚫ The central theme of the traditional theory of consumer
behaviour is a consumer’s utility maximizing behaviour.
⚫ The fundamental postulate of the consumption theory is that a
consumer—an individual or a household—is a utility
maximizing entity and all consumption decisions are directed
towards maximization of total utility.
⚫ At the individual level, consumer demand theory states that
consumers make choices based on utility: the value or benefit
that is derived from an action.

12. ⚫Consumers demand a commodity because
they derive or expect to derive utility from
the consumption of that commodity.
⚫The expected utility from a commodity is
the basis of demand for it.

13. The Meaning of Utility
⚫ The concept of utility can be looked upon two angles;-from the product angle
and from the consumer’s angle.
⚫ From the product angle - utility is the want-satisfying property of a
commodity.
⚫ From the consumer’s angle - utility is the psychological feeling of
satisfaction, pleasure, happiness or well-being , which a consumer derives
from the consumption, possession or the use of a commodity.

14. ⚫ On the other hand, from a consumer’s point of view, utility is a post-
consumption phenomenon as one derives satisfaction from a commodity only
when one consumes or use it.
⚫ Thus, Utility in the sense of such satisfaction is a “subjective” or “relative”
concept because:
i. a commodity need not be useful for all- cigarettes do not have any utility for
non-smokers, and meat has no utility for strict vegetarians;
ii. Utility of a commodity varies from person to person and from time to time;
and
iii. a commodity need not have the same utility for the same consumer at
different points of times, at different levels of consumption and for different
moods of a consumer.

15. The Law of Diminishing Marginal Utility(LDMU)
⚫ The LDMU is one of the fundamental laws of economics to the analysis of
consumer behavior.
⚫ This law states that as the quantity consumed of a commodity goes on
increasing, the utility derived from each successive unit consumed goes
decreasing, consumption of all other commodities remain constant.
⚫ This law stems from the facts that:
(i) the utility derived from a commodity depends on the intensity or urgency of
the need for that commodity, and
(ii) that as more and more quantity of a commodity is consumed, the intensity
of desire decreases and therefore the utility derived from the marginal unit
decreases.

16. Determinants (Influencing factors of Demand)
⚫ Demand for a commodity depends upon number of factors called determinants.
⚫ The demand function can be symbolically expressed as:
QdN=f(PN,PR,I,T,E,,A, O)
⚫ Where:
 QdN = Quantity demanded for the commodity
 PN = Price of the commodity itself
 PR = Price of related commodity
 I = Income of consumers
 T = Taste & preferences of the consumers
 E = Expectations about the future prices
 A=Advertisement
 O = Other factors

18. ⚫ It is useful from a managerial decision-making viewpoint to distinguish
between controllable and uncontrollable factors/determinants of demand.
⚫ Controllable in this context means controllable by the firm; the
distinction in practice between what can be controlled and what cannot is
somewhat blurred, aswill be seen.

19. ⚫ The law of demand states that, "conditional on all else being equal, as the
price of a good increases (↑), quantity demanded decreases (↓); conversely,
as the price of a good decreases (↓), quantity demanded increases (↑)".
⚫ In other words, the law of demand describes an inverse relationship between
price and quantity demanded of agood.
⚫ The factors held constant refer to other determinants of demand, such as the
prices of other goods and the consumer's income.
⚫ There are, however, some possible exceptions to the law of demand, such as
Giffen goods andV
eblen goods.

20. ⚫ There are at least three accepted explanationsof why demand curves
slope downwards:
1. The law of diminishing marginal utility
 This law suggests that asmore of aproduct is consumed the
marginal (additional) benefit to the consumer falls;hence consumers
are prepared to payless.
2.The income effect
 Theincome effect suggeststhat, asthe price ofagoodfalls,real
income- that is, what consumers canbuywith their moneyincome-
rises and consumersincrease their demand.
3. The substitution effect
 Asthe price of one good falls,it becomes relativelylessexpensive.
 Therefore,assuming other alternative products stay at the same
price, at lower prices the good appears cheaper,and consumers will
switch from the expensive alternative to the relatively cheaper one.

22. The Concept of Demand Elasticity
⚫ The 'Law of Demand' states that, all other factors being equal,
as the price of a good or service increases, consumer demand
for the good or service will decrease, and vice versa.
⚫ Demand elasticity is a measure of how much the quantity
demanded will change if another factor changes.

23. Changes in Demand
⚫Change in demand is a term used in economics to describe that
there hasbeen achange,or shift in, amarket's total demand.
⚫This is represented graphically in a price vs. quantity plane,
and is a result of more/less entrants into the market, and the
changing of consumer preferences.
⚫The shift can either be parallel or nonparallel.

24. Demand Elasticity
⚫Law of demand explains the inverse relationship
between price and demand of a commodity but it
does not explain to the extent to which demand of a
commodity changes due to change in price.
⚫A measure of a variable's sensitivity to a change in
another variable is elasticity.
⚫In economics, elasticity refers the degree to which
individuals change their demand in response to its
determinant.

25. Definition…
⚫ The demand elasticity (elasticity of demand) refers to how sensitive the
demand for a good is to changes in other economic variables, such as
prices and consumer income.
⚫ Elasticity of demand is the degree of responsiveness of change in demand
of a commodity due to a change in its determinants.
⚫ Demand elasticity is calculated as the percent change in the quantity
demanded divided by a percent change in another economic variable.
Demand Elasticity = %change in quantity demanded/ % change in
demand determinants
⚫ A higher demand elasticity for an economic variable means that consumers
are more responsive to changes in this variable.

26. ⚫ Importance of Elasticity of Demand
⚫ Importance to producer −A producer has to consider elasticity of
demand before fixing the price of a commodity.
⚫ Importance to government −If elasticity of demand of a product is
low then government will impose heavy taxes on the production of that
commodity and vice – versa.
⚫ Importance in foreign market −If elasticity of demand of a produce
is low in the international market then exporter can charge higher price
and earn more profit.

27. Types of Elasticity of Demand
1. Price Elasticity of demand
 The price elasticity of demand is the percentage
change in the quantity demanded of a good or a
service, given a percentage change in its price.

29. 2. Income Elasticity of Demand
⚫ Income elasticity is a measure of the relationship between a
change in the quantity demanded for a commodity and a
change in real income.
⚫ Formula for calculating income elasticity is as follows −
Ei = %Change in quantity demanded/%Change in income
⚫ Followingare the Features of Income Elasticity−
 If the proportion of income spent on goods remains the same as income
increases, then income elasticity for the goods is equal to one.
 If the proportion of income spent on goods increases as income increases,
then income elasticity for the goods is greater than one.
 If the proportion of income spent on goods decreases as income increases,
then income elasticity for the goods is less than one.

30. 3.Cross Elasticity of Demand
⚫ An economic concept that measures the responsiveness in the quantity
demanded of one commodity when a change in price takes place in
another good.
⚫ The measure is calculated by taking the percentage change in the
quantity demanded of one good, divided by the percentage change in
price of the substitute good −
Ec = [Δqx/Δpy] × [py/qx]

31. Implication….
I. If two goods are perfect substitutes for each other, cross
elasticity is infinite.
II. If two goods are totally unrelated, cross elasticity
between them is zero.
III.If two goods are substitutes like tea and coffee, the cross
elasticity is positive.
IV.When two goods are complementary like tea and sugar to
each other, the cross elasticity between them is negative.

32. Total Revenue (TR) and Marginal Revenue
⚫ Total revenue is the total amount of money that a firm receives from
the sale of its goods.
⚫ If the firm practices single pricing rather than price discrimination,
thenTR is the total expenditure of the consumer
TR= P× Q
⚫ The total revenue test is a means for determining
whether demand is elastic or inelastic.
⚫ If an increase in price causes an increase in total revenue, then
demand can be said to be inelastic, since the increase in price does not
have a large impact on quantity demanded.

33. ⚫ If an increase in price causes a decrease in total revenue, then demand can
be said to be elastic, since the increase in price has a large impact on
quantity demanded.
⚫ The relationship between elasticity of demand and a firm's total revenue is
an important one.
1. When demand is inelastic – a rise in price leads to a rise in total revenue –
a 20% rise in price might cause demand to contract by only 5% (Ped = -0.25)
1. When demand is elastic – a fall in price leads to a rise in total revenue - for
example a 10% fall in price might cause demand to expand by only 25%
(Ped = +2.5).

34. Demand Analysis: Estimation and Forecasting
⚫ In the preceding sections, we have dealt with consumer’s decision-
making behavior — how consumers decide what quantity of a
commodity to consume; how they allocate the total consumption
expenditure on various goods and services; how collective decisions
of consumers reflect in market demand; and how total demand
responds to change in its determinants.
⚫ The theory of demand discussed so far deals with current demand
whereas a major concern of businessmen, especially the big one, is
‘what would be the future demand for their product?

35. ⚫ Demand analysiswas introduced asatool for managerial decision-making.
⚫ Demand forecasting and estimation gives businesses valuable
information about the markets in which they operate and the markets
theyplanto pursue.
⚫ The purpose of demand forecasting and estimation is to find a
business's potential demand so managers can make accurate decisions
about pricing,business growth and market potential.
⚫ Managers base pricing on demand trends in the market.
⚫ The first question which arises is,what is the difference between
demand estimation anddemand forecasting?

36. ⚫ The answer is that demand estimation attempts to quantify the links
between the level of demand and the variableswhich determine it.
⚫ Demand forecasting, on the other hand, attempts to predict the
overall level of future demand rather than looking at specific
linkages.
⚫ For this reason, the set of techniques used may differ, although there
will be some overlap between the two.
⚫ In general, an estimation technique can be used to forecast demand
but aforecasting technique cannot be used to estimate demand.

37. Methods of demand forecasting
⚫ The following points highlight the top seven methods of
demand forecasting:
1. Survey of Buyer’s Intentions
2. Collective Opinion or Sales Force Composite Method
3. Trend Projection
4. Executive Judgment Method
5. Economic Indicators
6. Controlled Experiments
7. Expert’s Opinions.

38. End of ChapterTwo