Manegiral economics unit 2

Session I
Demand: Concept and Types
2

The process to satisfy human wants/ needs/desires.
Want: having a strong desire for something
Need: lack of means of subsistence
Desire: an aspiration to acquire something
Demand: effective desire
Demand is that desire which backed by willingness and ability to buy a particular commodity.
Things necessary for demand:
Time
Price of the commodity
Amount (or quantity) of the commodity consumers are willing to purchase at the price
3

TypesofDemand
Direct or Autonomous and Derived Demand
Direct demand is for the goods as they are such as Consumer goods
Derived demand is for the goods which are demanded to produce some other
commodities; e.g. Capital goods
Recurring and Replacement Demand
Recurring demand is for goods which are consumed at frequent intervals such
as food items, clothes.
Durables are purchased to be
used for a long period of time
4

TypesofDemand
Complementary and Competing Demand
Some goods are jointly demanded hence are complementary in
nature, e.g. software and hardware, car and petrol.
Some goods compete with each other for demand because they are
substitutes to each other, e.g. soft drinks and juices.
Demand for Perishable and Durable Goods
Durables: Last for a relatively long time and can be consumed
multiple times
 Demand can be postponed
Non-durables: Perishable, Non-perishable.
Individual and Market Demand
Individual demand: Demand for an individual consumer
Market demand: Demand by all consumers
5

Session II Demand: Determinants
6

DeterminantsofDemand Price of the product
Single most important determinant
Negative effect on demand
Income of the consumer
Normal goods: demand increases with increase in consumer’s income
Inferior goods: demand falls as income rises
Price of related goods
Substitutes
 If the price of a commodity increases, demand for its substitute rises.
Complements
 If the price of a commodity increases, quantity demanded of its complement falls.
7

DeterminantsofDemand
Tastes and preferences
Very significant in case of consumer goods
Expectation of future price changes
Gives rise to tendency of hoarding of durable goods
Population
Size, composition and distribution of population will influence demand
Advertising
Very important in case of competitive markets
Contd…
8

Session III Demand: Function
9

DemandFunction  Interdependence between demand for a product and its
determinants can be shown in a mathematical functional form
Dx = f(Px, Y, Py, T, A, N) …….. [Multivariate fx]
Independent variables: Px, Y, Py, T, A, N
Dependent variable: Dx
Px: Price of x
Y: Income of consumer
Py: Price of other commodity
T: Taste and preference of consumer
A: Advertisement
N: Macro variable like inflation, population growth, economic growth
10

LawofDemand A special case of demand function which shows relation between price and demand of the
commodity
Dx = f(Px)Dx = f(Px)
Reasons
 Substitution Effect
 Income Effect
11

DemandScheduleandIndividual
DemandCurve
Point on
Demand
Curve
Price (Rs per
cup)
Demand (‘000
cups)
a 15 50
b 20 40
c 25 30
d 30 20
e 35 10
e
b
a
c
10 20 30
15
20
30
35
5040
25
Quantity of coffee
PriceofCoffee
O
d
12

MarketDemand
Market: interaction between sellers and buyers of a good
(or service) at a mutually agreed upon price.
Market demand
Sum total of the quantities of a commodity that all buyers in the
market are willing to buy at a given price and at a particular point
of time (ceteris paribus)
Market demand curve: horizontal summation of individual
demand curves
13

Session IV Shifting Demand & Exceptions
14

Change in Demand
Or Demand Shifting
D1
D2
D0
Price
Quantity
0
 Shift in demand curve from D0 to D1
 More is demanded at same price
(Q1>Q)
 Increase in demand caused by:
 A rise in the price of a substitute
 A fall in the price of a complement
 A rise in income
 A change in tastes that favours the
commodity
 Shift in demand curve from D0 to D2
 Less is demanded at each price (Q2<Q)
P
Q1QQ2
15

ExceptionstotheLawofDemand
Law of demand may not operate due to the following reasons:
Giffen Goods: Sir Robert Giffen, Ireland
Snob Appeal: Veblen Goods, Thorstein Veblen
Demonstration Effect: Fashion
Future Expectation of Prices (Panic buying)
Addiction
Neutral goods
Life saving drugs
Salt
16
Goods with no substitute
Amount of income spent
Match box

Session V Elasticity of Demand
17

Elasticity
ofDem
and
“Elasticity” is a standard measure of the degree of
responsiveness (or sensitivity) of one variable to changes
in another variable.
price of the commodity, price of the other commodities,
income, taste, preferences of the consumer and other
factors.

Elasticity of Demand
Mathematically, it is the percentage change in quantity
demanded of a commodity to a percentage change in any of
the (independent) variables that determine demand for the
commodity.
Four major types of elasticity:
◦Price elasticity,
◦Income elasticity,
◦Cross elasticity
◦Advertising (or promotional) elasticity.
ceteris paribus

Price Elasticity of Demand
Price is most important among all the independent
variables that affect the demand for any commodity.
Hence price elasticity of demand (“ep”) is considered to
be the most important of all types of elasticity of
demand.

Perfectly elastic demand
ep=∞ (in absolute terms).
Horizontal demand curve
Unlimited quantities of the commodity can be sold at
the prevailing price
A negligible increase in price would result in zero
quantity demanded
Perfectly inelastic demand
ep=0 (in absolute terms)
Vertical demand curve
Quantity demanded of a commodity remains the
same, irrespective of any change in the price
Such goods are termed neutral.
Degrees of Price Elasticity
Price
Quantity
O
P D
Q1 Q2
Price
Quantity
O
P1
P2
D
Q1

Degrees of Price ElasticityHighly elastic demand
Proportionate change in quantity demanded is more than a
given change in price
ep >1 (in absolute terms)
Demand curve is flatter
Unitary elastic demand
Proportionate change in price brings about an equal
proportionate change in quantity demanded
ep =1 (in absolute terms).
Demand curves are shaped like a rectangular hyperbola,
asymptotic to the axes
Relatively inelastic demand
Proportionate change in quantity demanded is less than a
proportionate change in price
ep <1 (in absolute terms) | Demand curve is steep
Price
Quantity
O
D
D
Q2
P2
Q1
P1
Price
Quantity
O
D
D
Q1
P1
Q2
P2
Price
Quantity
O
Q1
P1
Q2
P2
D
D
Contd.

Ratio (or Percentage) Method
◦The most popular method used to measure elasticity
◦Elasticity of demand is expressed as the ratio of proportionate change
in quantity demanded and proportionate change in the price of the
commodity
◦It allows comparison of changes in two qualitatively different variables
◦It helps in deciding how big a change in price or quantity is
ep=
◦ where Q1= original quantity demanded, Q2= new quantity demanded, P1= original price level, P2= new price level
MethodsofMeasuringElasticity
XcommodityofpriceinchangeateProportion
XcommodityofdemandedquantityinchangeateProportion
=ep
112
112
/)(
/)(
PPP
QQQ
−
−

Point Elasticity Method
◦ Elasticity measured at a point of demand curve is
referred as point elasticity of demand.
For nonlinear demand curve we need to apply calculus
to calculate point elasticity.
As changes in price become smaller and approach zero,
the ratio becomes equivalent to the first order
derivative of the demand function with respect to price
Point elasticity can be expressed as:
ep = =
PdP
QdQ
/
/
dP
dQ
Q
P
.
dP
dQ
P
Q
∆
∆

Arc Elasticity Method
◦Used when the available figures on price and
quantity are discrete, and it is possible to isolate and
calculate the incremental changes.
◦It is used to find the elasticity at the midpoint of an
arc between any two points on a demand curve, by
taking the average of the prices and quantities.
◦This method finds wider applications, as it reflects a
movement along a portion (arc) of a demand curve
ep= /
=
2/)( 21
12
QQ
QQ
+
−
2/)( 21
12
PP
PP
+
−
21
12
QQ
QQ
+
− .
12
21
PP
PP
−
+

Total Outlay Method (Marshall)
◦Elasticity is measured by comparing expenditure levels before and after
any change in price, i.e. whether the new expenditure is more than, or
less than, or equal to the initial expenditure level.
◦Helps a seller in taking a decision to raise price only if:
◦ Reduction in quantity demanded does not reduce total revenue or
◦ Reduction in price increases the quantity demanded to the extent that total revenue also increases.
◦ Degrees
◦ When demand is elastic, a decrease in price will result in an increase in the revenue (sales).
◦ When demand is inelastic, a decrease in price will result in a decrease in the revenue (sales).
◦ When demand is unit-elastic, an increase (or a decrease) in price will not change the revenue (sales)

Nature of commodity
◦Necessities are relatively price inelastic, while luxuries are relatively
price elastic
Availability and proximity of substitutes
◦Price elasticity of demand of a brand of a product would be quite
high, given availability of other substitute brands
Alternative uses of the commodity
◦If a commodity can be put to more than one use, it would be
relatively price elastic
Determinants of Price Elasticity of Demand

Proportion of income spent on the commodity
◦The greater the proportion of income spent on a commodity, the more sensitive
would the commodity be to price
◦Reason is income effect
Time
◦Demand for any commodity is more price elastic in the long run
Durability of the commodity
◦Perishable commodities like eatables are relatively price inelastic in comparison to
durable items
Items of addiction
◦Items of intoxication and addiction are relatively price inelastic
Determinants of Price Elasticity of Demand

Revenue and Price Elasticity of
Demand
For relatively inelastic demand, a change in price
would have a greater effect on revenue than a
change in quantity demanded
AR is same as the price of the product
◦Demand curve is also the AR curve of the firm.
Marginal Revenue is the revenue a firm gains in
producing one additional unit of a commodity

Till ep>1 MR is positive and
TR is rising
At the midpoint of the
demand curve, ep=1 and MR
is equal to 0 and TR is at its
peak
When ep<1, MR is negative
and TR is falling.
MR= AR [1-MR= AR [1- eepp]]
TR
Price,
Revenue
O
Quantity
MR
Revenue and Price Elasticity of
Demand

Income Elasticity of Demand (ey)
ey measures the degree of responsiveness of demand for a good to a
given change in income, ceteris paribus.
Degrees:
◦Positive income elasticity
◦Demand rises as income rises and vice versa
◦Normal good
◦Negative income elasticity
◦Demand falls as income rises and vice versa
◦Inferior good
consumerofincomeinchangeateProportion
=ey
Y1)/Y1-(Y2
Q1)/Q1-(Q2
=ey
Zero income elasticity
No impact of income
Neutral good

Cross Elasticity of Demand
ec measures the responsiveness of demand of one good to
changes in the price of a related good
Degrees
◦Negative Cross Elasticity
◦Complementary goods
◦Positive Cross Elasticity
◦Substitute goods
YcommodityofpriceinchangeateProportion
=ec

Promotional/Advertising Elasticity of Demand
Advertising (or promotional) elasticity of demand (ea) measures
the effect of incurring an “expenditure” on advertising, vis-à-vis
an increase in demand, ceteris paribus.
Some goods (like consumer goods) are more responsive to
advertising than others (like heavy capital equipment).
Degrees
◦ea>1 | Firm should go for heavy expenditure on advertisement.
◦ea <1 | Firm should not spend too much on advertisement
XofeexpenditurgadvertisininchangeateProportion
Xcommodityofsales)(ordemandedquantityinchangeateProportion
=ea

Importance of elastIcIty
Determination of price
◦Elasticity is the basis of determining the price of a product keeping its possible
effects on the demand of the product in perspective
Basis of price discrimination
◦Products having elastic demand may be sold at lower price, while those having
inelastic demand may be sold at high prices
Determination of rewards of factors of production
◦Factors having inelastic demand are rewarded more than factors that have
relatively elastic demand.
Government policies of taxation
◦Goods having relatively elastic demand are taxed less than those having relatively
inelastic demand.

Session VI
Demand
Forecasting 35

“An estimate of sales in dollars or physical units for a
specified future period under a proposed marketing plan.”
- American Marketing Association
Demand forecasting is the scientific and analytical estimation
of demand for a product (service) for a particular period of
time.
It is the process of determining how much of what products is
needed when and where.
Meaning of Demand
Forecasting

Categorization of Demand Forecasting
By Level of Forecasting
Firm (Micro) level: forecasting of demand for its product by an individual
firm.
◦decisions related to production and marketing.
Industry level: for a product in an industry as a whole.
◦insight in growth pattern of the industry
◦in identifying the life cycle stage of the product
◦relative contribution of the industry in national income.
Economy (Macro) level: forecasting of aggregate demand (or output) in
the economy as a whole.
◦helps in various policy formulations at government level.

Categorization of Demand Forecasting
By nature of goods
Capital Goods: Derived demand
◦demand for capital goods depends upon demand of consumer
goods which they can produce.
Consumer Goods: Direct demand
◦durable consumer goods: new demand or replacement demand
◦Non durable consumer goods: FMCG

Techniques of Demand Forecasting
Subjective (Qualitative)
methods: rely on human
judgment and opinion.
◦Buyers’ Opinion
◦Sales Force Composite
◦Market Simulation
◦Test Marketing
◦Experts’ Opinion
◦Group Discussion
◦Delphi Method
 Quantitative
methods: use
mathematical or
simulation models based
on historical demand or
relationships between
variables.
Trend Projection
Smoothing Techniques
Barometric techniques
Econometric techniques

Subjective Methods of Demand Forecasting
Consumers’ Opinion Survey
Buyers are asked about future buying intentions of products, brand
preferences and quantities of purchase, response to an increase in the price, or
an implied comparison with competitor’s products.
◦Census Method: Involves contacting each and every buyer
◦Sample Method: Involves only representative sample of buyers
Merits
◦Simple to administer and comprehend.
◦Suitable when no past data available.
◦Suitable for short term decisions regarding product and promotion.
Demerits
• Expensive both in terms of resources and time.
• Buyers may give incorrect responses.

Sales Force Composite
Salespersons are in direct contact with the customers. Salespersons are asked about
estimated sales targets in their respective sales territories in a given period of time.
Merits
◦Cost effective as no additional cost is incurred on collection of data.
◦Estimated figures are more reliable, as they are based on the notions of salespersons in
direct contact with their customers.
Demerits
◦Results may be conditioned by the bias of optimism (or pessimism) of salespersons.
◦Salespersons may be unaware of the economic environment of the business and may
make wrong estimates.
◦This method is ideal for short term and not for long term forecasting
Contd…

Experts’ Opinion Method
i) Group Discussion: (developed by Osborn in 1953) Decisions may be taken with the help of brainstorming
sessions or by structured discussions.
ii) Delphi Technique: developed by the Rand Corporation at the beginning of the Cold War, to forecast impact
of technology on warfare.
◦Way of getting repeated opinion of experts without their face to face interaction.
◦Consolidated opinions of experts is sent for revised views till conclusions converge on a point.
Merits
◦Decisions are enriched with the experience of competent experts.
◦Firm need not spend time, resources in collection of data by survey.
◦Very useful when product is absolutely new to all the markets.
Demerits
◦Experts’ may involve some amount of bias.
◦With external experts, risk of loss of confidential information to rival firms.
Contd…

Market Simulation
Firms create “artificial market”, consumers are instructed to shop with some money.
“Laboratory experiment” ascertains consumers’ reactions to changes in price, packaging,
and even location of the product in the shop.
◦Grabor-Granger test (1960s)
Merits
◦Market experiments provide information on consumer behaviour regarding a change in
any of the determinants of demand.
◦Experiments are very useful in case of an absolutely new product.
Demerits
◦People behave differently when they are being observed.
Contd…..

Test Marketing
Involves real markets in which consumers actually buy a product without the consciousness
of being observed.
Product is actually sold in certain segments of the market, regarded as the “test market”.
Choice and number of test market(s) and duration of test are very crucial to the success of
the results.
Merits
◦Most reliable among qualitative methods.
◦Very suitable for new products.
◦Considered less risky than launching the product across a wide region.
Demerits
◦Very costly as it requires actual production of the product, and in event of failure of the product the entire
cost of test is sunk.
◦Time consuming to observe the actual buying pattern of consumers.
Contd….

Quantitative Methods of Demand Forecasting
Trend Projection
Statistical tool to predict future values of a variable on the basis of time
series data.
Time series data are composed of:
◦Secular trend (T): change occurring consistently over a long time and is relatively
smooth in its path.
◦Seasonal trend (S): seasonal variations of the data within a year
◦Cyclical trend (C): cyclical movement in the demand for a product that may have a
tendency to recur in a few years
◦Random events (R): have no trend of occurrence hence they create random
variation in the series.

Quantitative Methods:
Methods of Trend Projection
Graphical method
◦Past values of the variable on vertical axis and time on horizontal axis
and line is plotted.
◦Movement of the series is assessed and future values of the variable
are forecasted
◦simple but provides a general indication and fails to predict future value
of demand
0
20
40
60
80
100
120
140
160
180
200
2001 2002 2003 2004 2005
Year
Demandformobiles(inlakhs)
Contd…

Quantitative Methods :
Smoothing Techniques
Moving Average: forecasts on the basis of demand values during the
recent past.
Dn= where Di= demand in the ith
period, n= number of periods in
the moving average
Weighted Moving Average: forecast the future value of sales on the
basis of weights given to the most recent observations. The formula for
computing weighted moving average is given as:
Dn= where Di= demand in the ith
period, wi= weight for
the ith
period, n= number of periods in the moving
average.
n
D
n
i
i∑=1
∑=
n
i
ii Dw
1

Smoothing Techniques
Exponential Smoothing: assign greater weights to the most recent
data, in order to have a more realistic estimate of the fluctuations.
Weights usually lay between zero and one
Ft+1=aDt+(1-a)Ft
where Ft+1= forecast for the next period, Dt=actual demand in the present period,
Ft=previously determined forecast for the present period, and a=weighting factor,
termed as smoothing constant.
New forecast equals old forecast plus an adjustment for the error that
had occurred in the last forecast
Ft+1=aDt+ a(1-a)Dt-1+ a(1-a)2
Dt-2+ a(1-a)3
Dt-3+...+a(1-a)t-1
D1+ a(1-a)2
Dt-2+ a(1-
a)t
F1)
Contd…

Barometric Techniques
Barometric Technique alerts businesses to changes in the overall
economic conditions.
Helps in predicting future trends on the basis of index of relevant
economic indicators especially when the past data do not show a
clear tendency of movement in a particular direction.
Indicators may be
◦Leading indicators: economic series that typically go up or down ahead of
other series
◦Coincident indicators: move up or down simultaneously with the level of
economic activities
◦Lagging series : which moves with economic series after a time lag.
Contd….

Quantitative Methods
Simple (or Bivariate) Regression Analysis:
◦deals with a single independent variable that determines the value of a dependent variable.
◦Demand Function: D = a+bP, where b is negative.
◦If we assume there is a linear relation between D and P, there may also be some random variation
in this relation.
Nonlinear Regression Analysis
◦Log linear function log D =A + B log P + e
where A and B are the parameters to be estimated and e represents errors or disturbances.
◦Linear form of log linear function D* = a + b P* + e
where D*= log D and P*=log P
Contd…..

Multiple Regression Analysis:
D = a1+a2.P+a3.A+e
(where A = advertising expenditure incurred).
D^ = a^1 + a^2P + a^3A,
(where a1, a2 and a3 are the parameters and e is the random error term (or
disturbance), having zero mean).
Similar to simple regression analysis, multiple regression analysis
would aim at estimation of the parameters a1, a2 and a3.
Choose such values of the coefficients that would minimize the
sum of squares of the deviations.
Contd…..

Simultaneous Equations Method
Based on the fact that in any economic decision every variable influences every
other variable.
Incorporates mutual dependence among variables.
It is a simultaneous and two way relationships,
A typical simultaneous equation model may comprise of:
◦Endogenous variables: included in the model as dependent variables
◦Exogenous variables: given from outside the model
◦Structural equations: which seek to explain the relation between a particular endogenous
variable and other variables
◦Definitional equations: which specify relationships that are considered to be true by definition

Limitations of Demand Forecasting
Change in Fashion
Consumers’ Psychology
Lack of Experienced Experts
Lack of Past Data
◦ Accurate
◦ Reliable

Supply
Indicates the quantities of a good or service that the seller is
willing and able to provide at a price, at a given point of time,
Ceteris Peribus.
Supply of a product X (Sx
) depends upon:
◦Price of the product (Px
)
◦Cost of production (C)
◦State of technology (T)
◦Government policy regarding taxes and subsidies (G)
◦Other factors like number of firms (N)
Hence the supply function is given as:
55
Sx
= (Px
, C, T, G, N)

Law of Supply
Law of Supply states that other things remaining the same, the higher the
price of a commodity the greater is the quantity supplied.
Price of the product is revenue to the supplier; therefore higher price means
greater revenue to the supplier and hence greater is the incentive to supply.
Supply bears a positive relation to the price of the commodity.
Point on
Supply
Curve
Price (Rs.
Per cup)
Supply (‘000
cups per
month)
a 15 10
b 20 20
c 25 30
d 30 45
e 35 60
Supply Schedule
56
c
e
d
Supply Curve
3010 20 605040
15
20
30
35
25
PriceofCoffee Quantity of Coffee
0
b
a

Change in Supply
 Shift in the supply curve from S0
to S1
 More is supplied at each price
(Q1>Q)
 Increase in supply caused by:
 Improvements in the
technology
 Fall in the price of inputs
 Shift in the supply curve from S0
to S2
 Less is supplied at each price
(Q2<Q)
 Decrease in supply caused by:
 A rise in the price of inputs
 Change in government policy
(VAT)
57
S2
S1
S0
Price
Quantity
O
Q2
P
Q0 Q1

 Equilibrium occurs at the price where the quantity demanded and
the quantity supplied are equal to each other.
Market Equilibrium
Price
(Rs)
Supply
(‘000 cups/
month)
Demand
(‘000 cups/
month)
15 10 50
20 15 40
25 30 30
30 45 15
35 70 10
58
D
S
Quantity
Price
O
25
E
30

 For prices below the equilibrium
◦ Quantity demanded exceeds quantity supplied (D>S)
◦ Price pulled upward
 For prices above the equilibrium
◦ Quantity demanded is less than quantity supplied (D<S)
◦ Price pulled downward.
Market Equilibrium
Price
(Rs)
Supply
(‘000 cups/
month)
Demand
(‘000 cups/
month)
15 10 50
20 15 40
25 30 30
30 45 15
35 70 10
59
D
S
Quantity
Price
O
25
E
30
20
30
4515

Changes in Market Equilibrium
(Shifts in Supply Curve)
 The original point of equilibrium is at E, the
point of intersection of curves D1 and S1, at
price P and quantity Q
 An increase in supply shifts the supply
curve to S2
 Price falls to P2 and quantity rises to Q2,
taking the new equilibrium to E2
 A decrease in supply shifts the supply curve
to S0. Price rises to P0 and quantity falls to
Q0 taking the new equilibrium to E0
 Thus an increase in supply raises quantity
but lowers price, while a decrease in supply
lowers quantity but raises price; demand
being unchanged
Q2
P2
E2
S2
S2
Q
P
E
D1
D1
S1
S1
Price
Quantity
O
E0P0
Q0
S0
S0
60

The original point of equilibrium is at E, the point
of intersection of curves D1 and S1, at price P and
quantity Q
An increase in demand shifts the demand curve
to D2
◦ Price rises to P1and quantity rises to Q1 taking the new equilibrium to E1
A decrease in demand shifts the demand curve to
D0
◦ Price falls to P* and quantity falls to Q* taking the new equilibrium to
E2.
Thus, an increase in demand raises both price and
quantity, while a decrease in demand lowers both
price and quantity; when supply remains same.Q1
P1
E1
D2
D2
Q*
P*
E2
Changes in Market Equilibrium
(Shifts in Demand Curve)
D0
D0
D1
D1S1
S1
Price
Quantity
O
E
P
Q
61

Change in Both Demand and Supply
P2
Q2
E2
S2
S2
D1
D1
Quantity
Price
O
S1
S1
D2
D2
Q1
P1
E1
 Whether price will rise, or remain at the
same level, or will fall, will depend on:
 the magnitude of shift and
 the shapes of the demand and supply
curves.
 Therefore, an increase in both supply and
demand will cause the sales to rise, but
the effect on price can be:
 Positive (D increases more than S)
 Negative (S increases more than D)
 No change (increase in D=increase in
S)
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Manegiral economics unit 2

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Manegiral economics unit 2

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