Professional Documents
Culture Documents
of
Demand and
Supply
DEMAND ELASTICITIES
Law of Demand – Direction of change in the
quantity
Elasticity of Demand – Degree of responsiveness
of consumers to a price change
Cont….
Classification of Demand Curves According to Their Elasticities
Depending on how the total revenue changes, when price changes we can
classify all demand curves in the following five categories:
i. Perfectly inelastic demand curve
ii. Inelastic demand curve
iii. Unitary elastic demand curve
iv. Elastic demand curve
v. Perfectly elastic demand curve
Cont….
A Variety of Demand Curves
• Inelastic Demand
– Quantity demanded does not
respond strongly to price
changes.
– Price elasticity of demand is less
than one.
• Elastic Demand
– Quantity demanded responds
strongly to changes in price.
– Price elasticity of demand is
greater than one.
A Variety of Demand Curves
$5.00
$4.00
1. An increase
in price…
0 100 Quantity
$5.00
$4.00
1. A 25%
increase in
price…
0 90 100 Quantity
$5.00
$4.00
1. A 25%
increase in
price…
0 80 100 Quantity
$5.00
$4.00
1. A 25%
increase in
price…
0 50 100 Quantity
$4.00 Demand
2. At exactly $4, consumers will buy any
quantity.
0
Quantity
Elasticity of Demand
Consumers’ responsiveness or
sensitivity to changes
in price.
Elasticity of Demand
uConsumers buy more or less
Elastic
Elastic of a product when the
Demand
Demand price changes
Down Up Elastic
Up Up Inelastic
Up Down Elastic
Ed Value
Term for Price increases Price decreases
Elasticity of
demand
Ed= Q 1- Q 0
Q0
P1 - P0
Where P0
P0 = Original Price
P1 = New price
Q0 = Original quantity demanded
Q1 = New quantity demanded
Sometimes we may also find this written as
Ed =
∆ Q
Q
∆P
P
Factors Determining Elasticity of Demand
Some important factors that determine the elasticity of demand are:
i. Luxury or Necessity Good s
ii. Percentage of Income
iii. Substitutes
iv . Time
Price Elasticity of Demand
The concept of price elasticity of demand is a numerical measure of the
extent to which quantity demanded responds to a change in price, other
determinants of demand being kept constant.
∆Q
× 100
ep Q ∆Q P
= (-) = ( −) .
∆P ∆P Q
× 100
P
Income Elasticity
The income elasticity of demand is a numerical measure of the degree to
which quantity demanded responds to a change in income, other determinants
of demand being kept constant.
For example, let there be two goods, clothing and salt. Let the consumers
income increase by 5%. Then the percentage change (increase) in quantity
demanded would be different for clothing and different for salt (the
percentage increase in quantity demanded for clothing is likely to be much
higher than that for salt). Thus, clothing and salt are said to have a
different income elasticity of demand. Thus, for the same percentage
increase in income (i.e., 5%) the percentage increase in the quantity
demanded for different goods is different. Income elasticity of demand
provides us with a numerical measure of this difference.
Thus, income elasticity of demand allows us to compare the sensitivity of
the demand for various goods for the same change in income. From the
definition,
e1 =
%change in quantity demanded
%change in income
CASE
dQ x dPx
÷
Q
=x Px
dQ x Px
⋅ Cont….
dPx Q x
Promotional / Advertising Elasticity of Demand
The relationship that exists between sales and advertising of any product
can be enumerated as:
i. Some sales are possible even if there is no advertising. Thus for the
minimum level of sales, no advertising is needed.
ii. Sales increase and decrease with advertisement respectively. That is,
there is a direct relationship between sales and advertising if other
things are assumed to be constant.
iii. In the initial stages of advertisement expenditure, the resulting
increase in sales will be more than proportionate to the increase in
advertisement expenditure.
Some goods are more responsive to advertising, e.g., cosmetics. Others are
less, e.g., heavy machinery. The factors that influence the advertising
elasticity of demand are:
a. Stage of the product in market, e.g., old or new product, growing or
established market etc.
b. Effect of advertising in terms of time
c. Influence of advertising by rivals.
The Optimal Level of Advertising Expenditure
The total revenue curve shows that increased advertising expenditure can
always increase physical volume, though after a point, diminishing returns
may set in. This implies that total revenue must vary with advertising
expenditure directly.
Total sales (revenue) total profit
C
Total cost
Total revenue
M
C
P1
0 P AP AC
P1 Cont….
Advertising expenditure (Rs)
MARGINAL UTILITY ANALYSIS
Assumptions
The basic propositions of this traditional approach are:
v Cardinal measure of utility : Utility is a measurable and
quantifiable concept. A person can specify that he gets five units of
utility by consuming one unit of good A etc. Utility is an imaginary
unit of measuring utility.
v Independent utilities : Utility is additive; the utilities derived
from different independent goods can be added to get the measure of total
utility.
v Constant marginal utility of money : The marginal utility of
money remains constant for a particular consumer when he spends money on
various goods. All other commodities except money are subject to the law
of diminishing marginal utility.
Cont….
The Law of Diminishing Marginal Utility
Marginal utility refers to the change in satisfaction which results when a
little more or little less of that good is consumed. For example, when a
thirsty person takes five bottles of cold drink continuously, the
consumption of first bottle gives him utility, second bottle gives him
lesser utility than first but his total utility increases. Third bottle
gives him still less utility but increases total utility. The utility from
fourth bottle may be zero as he is no more thirsty. But the fifth bottle
may cause uneasiness and thus give negative utility, i.e., the total utility
may now actually go down.
Bottle consumed Total Utility ( Units )
Marginal Utility ( Units )
0 0 –
1 14 14
2 23 9
3 27 4
4 27 0
5 24 –3
6 18 –6
Cont….
T.U.
M.U.
Cont….
INDIFFERENCE CURVE ANALYSIS
Assumptions
The following assumptions about the consumer psychology are implicit in
this analysis:
v Transitivity : If a consumer is indifferent to two combinations of
two goods, then he is unaware of the third combination also.
v Diminishing marginal rate of substitution : The scarcer a good
the greater is its substitution value.
v Rationality : The consumer aims to maximise his total satisfaction
and has got complete market information.
v Ordinal Utility : Utility in this approach is not measurable. A
consumer can only specify his preference for a particular combination of
two goods, he cannot specify how much.
Cont….
The Indifference Curve
If a consumer is asked whether he prefers combination 1 of two goods X and
Y (assuming that the market price of X and Y are fixed) or combination 2,
he may give one of the following answers:
v he prefers combination 1 to 2
v he prefers combination 2 to 1
v he is indifferent about combinations 1 and 2.
Cont….
The I ndifferenc e Curve
Cont….
The Budget Line
The budget line is also known as
the price line, the consumption
possibility line or the price
opportunity line. It represents
different combinations of two goods
X and Y which the consumer can buy
by spending all his income.
Example
A consumer having Rs 1200 as income can
buy 600 units of Y at Rs 2 per unit or
300 units of X at Rs 4 per unit as
shown in Figure 12. The straight line
joining the two points A and B is
called the budget line.
At any point on AB, the consumer spends
all his income but point C is
unattainable. At point D or any other
point in DOAB he does not spend all his
income. Cont….
Demand
Forecasting
Introduction
Forecasts can be classified into two broad categories
i. Passive forecasts
ii. Active forecasts
Passive forecast is one where prediction about the future is based on
the assumption that the firm does not change the course of its action,
and active forecast is where forecasting is done under the condition
of likely future changes in the actions by the firm.
Choice of the Right Forecasting Technique
To handle the increasing variety and complexity of managerial
forecasting problems, many forecasting techniques have been developed
in recent years. Each has its special use, and care must be taken to
select the correct technique for a particular application. The manager
as well as the forecaster has a role to play in technique selection;
and the better he understands the range of forecasting possibilities,
the more likely it is that a company's forecasting efforts will bear
fruit.
Manager , Forecaster and Choice of Methods
Successful forecasting begins with collaboration between the manager and
the forecaster in which they work out answers to the following questions.
v What is the purpose of the forecast - how is it to be used?
v What are the dynamics and components of the system for
which the forecast will be made?
v How important is the past in estimating the future?
Determinants of Demand Forecast
Goods can be broadly classified into three categories :
i. Capital goods
ii. Durable consumer goods
iii. Non durable consumer goods
Methods of Demand Forecasting
Forecasting of demand is done for knowing the future demand of a
product. The choice of method of demand forecasting will depend
on various factors like convenience to handle, relevance of
purpose (knowing future demand) applicable to available data and
also inexpensive.
Methods of Demand Forecasting
Survey Methods
Statistical
Methods
Complete Sample
Enumeration Survey
Method Method
Survey Methods of Demand Forecasting
Survey Methods
Cont….
Statistical Methods of Demand Forecasting
Statistical Methods
Trend Line
Actual Sales
Sales
( $)
85 86 87 01
8
Time
Sale of Passenger Cars Cont….
Lease Square Method : The trend line can be projected for knowing the
future demand by two methods – linear trend and exponential trend.
When the time series data shows a rising trend in the sales, then a
straight line trend equation of the following kind is used
S=a+bt
where S=annual sales, t-time (in years) a and b are constants. The
parameter b gives the measures of annual increase in sales. The
coefficients of a and b are estimated by the following two equations:
Σ S= na+bΣ t
Σ St=aΣ t + bΣ L2
where n is the number of time period (years). Solving such equations can be
learnt from the following example.
Barometric Method of Forecasting
Barometric method uses economic indicators as barometer to forecast trends
in business activities. This method is based on the work done by NBEF
(national Bureau of Economic Research) of U.S. Barometric method are
classified into three categories – leading indicators, coincident
indicators and lagging indicators.
Leading Indicators
Indicator
Level Coincident Indicators
(Value)
Lagging Indicators
Time
Peak Trough
Business Cycle
Barometric Indicators
Econometric Method
The econometric methods incorporate statistical tools with economic
theories to estimate the economic variables and to forecast economic
events. The forecasts made through econometric methods are more reliable.
An econometric method consists of a single-equation regression model or a
system of simultaneous equations. Single equation regression serves the
purpose of demand forecasting in case of many commodities. But, in case of
economic variables due to complex relationships, a single equation
regression model is not appropriate. In this case, a system of simultaneous
equations is used to estimate and forecast. The econometric methods are
described here under two methods:
v Regression method;
v Simultaneous equations method.
Regression Methods of Demand Forecasting
In regression techniques of demand forecasting, the analysts estimate the
demand function for a product. In the demand function, quantity to be
forecast is a “department variable” and the variables that affect or
determine the demand (the department variable) one called as “independent
or explanatory variables”.
The hypothetical data of consumption of sugar given in table.
Cont….
Consumption of Sugar
Calculation of Terms
∑n= 7 ∑X t
= 152 ∑Y t
= 490 ∑X 2
t
= 3994 ∑X t
Y t = 12 , 000
Simultaneous Equation Method
Simultaneous equation method considers the interdependence of both
dependent and independent variables.
The steps of simultaneous method can be presented in simple
form as :
v To develop a complete model and specify the assumptions regarding the
variables included in the model.
v Endogenous variables are variables that are determined within the
model.
v Exogenous variables are those that are determined outside the model.
Examples of exogenous variables are money supply, tax rates, time,
climate etc.
v To collect data on both exogenous and endogenous variables.
v To estimate the model through some appropriate method (e.g. least
square method) and predict the values of exogenous variables.
v The model is solved for each endogenous variable in terms of exogenous
variable.
v Prediction is mode by putting the values of exogenous variables into
the equations.
Forecasting the demand of colour television in
India
Various Factor Affecting the Demand of Colour TV
v CPI : Consumer Price Index
v WPI : Wholesale Price Index
v Consumer Electronic Industry Growth
v GDP ( Gross domestic Product45)
40
v Per Capita Income 35
30
v Price of TV 25
20
15
10
5
0
1 9 9 2 -9 3 0 .7 9 .4 8 2 0 .1 2 2 .4 6 6 .5 1 5 .2 5
1 9 9 3 -9 4 1 .1 8 .6 8 .6 8 .8 2 3 .6 1 7 .3 1 1 4 .5
1 9 9 4 -9 5 1 .4 8 .9 1 0 .3 1 1 .9 2 5 .1 8 .4 14
1 9 9 5 -9 6 1 .8 5 8 .3 1 0 .4 40 2 6 .7 1 9 .3 1 13
1 9 9 6 -9 7 2 .2 8. 25 9 .8 3 4 .4 2 8 .3 1 1 0 .2 6 1 2 .5
Protection-1 1 9 9 7 -9 8 2 .5 6 .07 8 8 0 .9 8 4 3 0 .1 5 1 1 .2 1 1 1 .7 5
Correlation -0 .8 6 4 1 9 8 8 0 .7 5 2 0 8 2 0 .7 0 7 7 6 8 5 2 4 0 .9 9 7 1 9 5 0 .9 9 6 7 5 1 1 6 -0 .9 9 8 3 4 4
Price of Tv Inco m e GDP Industry CPl W PI C onst b
M n ,..,m 1 ,b -0 .0 1 8 0 2 5 2 0 .0 4 1 6 8 4 0 .1 8 4 1 9 7 6 2 5 -0 .0 0 2 3 7 5 6 0 .0 3 4 2 9 7 7 1 -0 .2 6 8 3 3 8 -1 .2 5 8 0 8
Y= m 1 * x 1 + m 2 0 S en,..,s e1 ,s eb 0 0 0 0
x 2 + .....+ b r2 ,s ey 1 1 8 E-1 8
.5 # N /A # N /A # N /A # N /A # N /A
Cont….
Market Demand
( millions )
3.5
2.5
1.5
0.5
0
1992- 1993-
93 1994- 1995- Market Demand (millions)
94 95 1996-
96 1997-
97 1998-
98
99
Review Questions
1. What is the significance of sales forecast for making (a) pricing decision (b)
advertising decision (c) distribution decision and (d) new produce decision.
2. What is the role of time element in the context of demand forecasting? What
factors would you normally consider in choosing a forecasting technique?
3. What is the importance of forecasting for managers? What are the factors
determining the process of demand forecasting?
4. Discuss critically any four important methods of demand forecasting.
5. The annual turnover of a company is an follows:
Project the business expenditure on new plant and equipment for the year 1995.
7. Explain how a manager can choose the right forecasting technique.
8 . Outline the various steps which would be necessary for forecasting demand for
a typical mass consumption item.