Published on March 3, 2014
1 DEMAND ANALYSIS DEMAND DETERMINANTS, LAW OF DEMAND AND ITS EXCEPTIONS Introduction: The scope of economics broadly comprises 1. Consumption: - it deals with the behaviour of consumers to plan his operations. 2. Production: - a producer has to understand the consumer’s behaviour pattern before he commits his funds for production. This is the reason why consumption proceeds production. 3. Exchange: - it deals with how the goods, once produced, are sold for a price to customers. 4. Distribution: - it deals with how the sale proceeds the goods sold are distributed among the various factors of production towards the rents, wages, interest & profits. BASIC LAWS OF CONSUMPTION:1. 2. 3. 4. 5. Law of diminishing marginal utility. The law of equi-marginal utility. Consumer surplus. The concepts of indifference curves. Consumer equilibrium. Law of diminishing marginal utility: The law of diminishing marginal utility states that the marginal utility derived on the consumption of every additional unit goes on diminishing other things remaining the same. Ex: - first sweet will give more utility. Second sweet gives lesser utility. Third sweet gives still lesser utility. If additional units of the same sweets are consumed the amount of total utility goes on increasing but at diminishing rate. This implies that the marginal utility is reducing from one level to the other level of consumption. Table: This law holds good when the remaining things are same. The remaining things include nature, size and quality of the sweets, time intervals between the two levels of the consumption, prices of related goods and soon. The Law of equi-marginal utility: It explains the pre requisite for the consumer is in equilibrium. It states that the consumer to be in equilibrium when the marginal utilities obtained from the products bought are equal, in other words, the consumer maximizes his total utility by allocating his income among the goods and services available to him in such a way that the marginal utility from one good equals the marginal utility from the other good. In other words: Marginal utility of product ‘X’ = Marginal utility of product ‘Y’ Price of ‘X’ price of ‘Y’ Where X and Y refers to the products bought. Ex:-marginal utility schedule of consumer C: Unit bought 1 2 3 4 pants 40 32 28 20 shirts 35 28 20 10
2 5 10 8 Suppose each pant or shirt cots 100/- the consumer C has 500/- with him. He will not buy all the pants or only shirts, with the money available. A combination of 3 pants and 2 shirts will give him maximum satisfaction. Total satisfaction of buying 3 pants is more than 3 shirts. It is because the marginal utility derived on the 3rd pant is equal to that obtained on the second shirt. Consumer surplus:It is defined as the difference between the price that the consumer is prepared to pay the price that he is exactly paying. In other words, it is the value consumers get from a good without paying for it. Ex:- salt or sugar: if the price of salt or sugar goes up to 10/- per kg. The consumer would be prepared to pay for it. If the salt is available for 5/- per kg, then the consumer surplus is 5/- per kg. The indifference curve:A consumer is said to be in equilibrium, when he maximizes his utility, given the budget constraint. When the budget line is tangential to any of the indifference curves, then he is said to be in equilibrium. An indifference curve is which reveals certain combinations of goods or services which yields him the same utility. The consumer is indifferent to a particular combination as every combination is yielding him the same utility. From the above figure it is clear that any combination of AD,BE,CF of goods X and Y yield the consumer 200 units of satisfaction. When the consumer is indifferent for a particular combination it is called indifference curve. In case he wants higher satisfaction, he has to operate on the next level of indifference curve which yields him 300 units. Assumptions for indifference curve:1. the consumer behaves rationally(to maximize his satisfaction) 2. the prices and incomes of the consumer are defined for analysis(tastes and preferences of the consumer do not change during the analysis) Properties of indifference curve:1. It slopes downwards from left to right 2. It is convex to the origin 3. It can’t intersect with another indifference curve because each is defined at a particular level of satisfaction. Consumer equilibrium:A consumer is said to be equilibrium when he maximizes his utility, given the budget constraint, when the budget line is tangential to any of the indifference curves, then he is said to be in equilibrium. Indifference curve showing consumer equilibrium.
3 From the above figure, it can be seen that the budget line is tangential to the indifference curve which yields the consumer a satisfaction of 200 units. DEMAND ANALYSIS DEMAND: Every want supported by the willingness and ability to buy constitutes demand for a particular product or service. In other words, if we want a car and I can’t pay for it, there is no demand for the car for my side. A product or service is said to have demand when three conditions are satisfied. 1. Desire on the part of the buyer to buy. 2. Willingness to pay for it. 3. Ability to pay the specified price for it. Unless all these conditions are fulfilled, the product is not said to have any demand. NATURE AND TYPES OF DEMAND:Demand always implies at a given price how much is the quantity demanded at a given level of price? This is the volume of demand. The use and characteristics of Different products affect their demand. In other words a product with more number of uses is naturally more in demand than one with a single use. 1. CONSUMER GOODS VS. PRODUCER GOODS: Consumer goods means the products and services which capable of satisfactory human needs. Goods can be grouped into consumer goods and producer goods. Consumer goods are those which are available for ultimate consumption, these give direct and immediate satisfaction. Ex: - bread, apple, rice. Producer goods are those which are used foe further processing or production of goods or services to cash income. Ex: - machinery, tractor. These goods yield satisfaction indirectly, these are used to produce consumer goods and sometimes these goods can be producer goods as well as consumer goods. Ex: - Paddy. A farmer having 10 bags of paddy may use 5 bags for his personal consumption and the other 5 bags as seeds for next crop. So here paddy is both producer good and a consumer good. The demand for producer good in “indirect” and demand for consumer goods in “direct”. 2. AUTONOMOUS DEMAND VS DERIVED DEMAND:Autonomous demand refers to the demand foe products & services directly. Ex: - The demand for the services of a super specialty hospital can be considered as autonomous, where as the demand for hotels around that hospital is called a derived demand, if there is no demand for houses, there may not be demand for steel, cement, bricks, demand for houses is autonomous whereas demand for these inputs is derived demand. 3. DURABLE VS. PERISHABLE GOODS: -
4 Here the demand for goods is classified based on their durability. Durable goods are those goods which give service relatively for a long period. The life of perishable goods is very less, may be in hours or days. Ex: - milk, vegetables, fish. Rice, wheat, sugar, these are examples for durable goods. Freezing facilities, the life of perishable goods can be extended for sometime. Products such as: TV, refrigerator, and washing machines are useful for a longer period, hence they are classified as consumer durables. 4. FIRM DEMAND VS INDUSTRY DEMAND: The firm is a single business unit where as industry refers to group of firms carrying on similar activities. The quantity of goods demanded by a single firm is called firm demand and the quantity demanded by the industry as a whole is called industry demand. Ex: - one construction company may use 100 tonnes of cement during a given month. This is a firm demand. The construction industry in a particular state may have used ten million tonnes. This is industry demand. 5. SHORT-RUN DEMAND VS LONG-RUN DEMAND: Joel dean defines short-run demand as, “the demand with its immediate reaction to price changes, income fluctuations”. Long-run demand is that demand, which will ultimately exist as a result of the changes in pricing, promotion or product improvement, The demand for a particular product or service in a given region for a particular day can be viewed as short-run demand. The demand for a longer period for the same region can be viewed as long-run demand. The demand that can be created in the long-run by changes in the design as a result of changes in technology is long-run demand. Short-run refers to a period of shorter duration & long-run refers to the relatively period of longer duration. In short-run additional changes can’t be made, but in long-run it can be made like living of additional plant, we can’t expand the output overnight. The short-run is a period in which the firms can adjust their production by changing variable factors such as material & labour. 6. NEW DEMAND VS REPLACEMENT DEMAND: New demand refers to the demand for the new products and it is addition to the existing stock. In replacement demand, the item is purchased to maintain the asset in good condition. Ex: - the demand for cars is new demand and demand for spare parts is Replacement demand. 7. TOTAL MARKET AND SEGMENT MARKET DEMAND: The consumption of sugar in a given region, the total demand for sugar in the region is the total “market demand”. The demand for sugar from the sweet, making industry from this region is the segment market demand. Ex: - sugar FACTORS DETERMINING DEMAND: The demand for a particular product depends on several factors, the following factors determine the demand for a given product
5 Demand determinants: Factors determine demand General Factors Additional Factors related to luxury goods & durables Price of the Product Income of the consumer Advertisements consumer expectation of future income Price related goods Additional factors related to market demand. geographical area population Taste & Preferences consumer expectation of future prices Price of commodities: A consumer generally purchases large amount of commodities when price declines, and vice versa. thus we can say that for a normal good the price and demand inversely. A fall in the price increase consumer purchasing, power, and vice versa. Income level of the consumer (I). With in increase income of house hold buy increased amount of commodities. normally the income of the house hold and quantity of demand goes in same direction. Prices of related goods which may be substitutes or complimentary: When a change in price of one commodity influences the demand of other commodity. Commodities are two types. 1. Substitutes 2. Complements When price of one commodity and quantity of other commodity move in same direct are called substitutes. Ex: tea and coffee. On the other hand the price of one good increase and quantity of other commodity is also increase. Ex: pen and ink
6 Car and petrol. Tastes and preferences of the consumer (T): If the consumers have particular taste and preference to particular product also increase. Ex: jeans catches by young stars. Advertising efforts A lot of money spent on advertisement to influence taste and preferences of consumer. Expectations: Consumer may have two kinds of expectations. 1. expectations related to future income 2. expectations related to future price If the customer expects a higher income he spent more so demand increases in future. If the consumer expects a future price of good to increase he would rather than like to buy the good now than later. In this same way population and geographical area. 1. Price of the product (P). 2. Income level of the consumer (I). 3. Tastes and preferences of the consumer (T). 4. Prices of related goods which may be substitutes or complimentary (Pr). 5. Expectations about the prices in future (Ep). 6. Expectations about the income in future (EI). 7. Size of population (Sp). 8. Distribution of consumers over different regions (Dc). 9. Advertising efforts (A). 10. Any other factor capable of affecting the demand (O). DEMAND FUNCTION: Demand function is a function which describes a relationship between one variable and its determinants it describes how much quantity of goods is bought at alternative prices of goods and related goods, alternative income levels and alternative values of other variables affecting demand. Thus the demand function for a good relates the quantity of a good which consumers demand during a given period to the factors which influence the demand. If we see mathematically, the demand function for a product A can be expressed like. Qd = f (P, I, T, PR, Ep, Ei, Sp, Di, A, O) Some impacts:1. Price of the product. 2. Income of the consumer 3. Prices of substitutes or complimentaries. 4. Tastes and preferences. LAW OF DEMAND;The Law of Demand states: other things remaining the same, the amount of quantity demanded rises with every fall of in the price and vice versa. The Law of demand states the relationship between price and demand of a particular product or service it makes an assumption that all other demand determinants remain the same or do not change. ASSUMPTIONS OF THE LAW OF DEMAND:-
7 The phrase other things remaining the same is the assumption under the law of demand. Here other things include income level of the consumer, tastes and preferences of the consumer, price of related goods, expectations about the prices or incomes in the future, size of population, advertising, efforts and any other factor capable of affecting the demand. OPERATIONS OF THE LAW OF DEMAND:The law of demand explains that with every fall in price of a particular product, its demand goes on increasing and vice versa. This holds good as long as other determinants of demand do not change. Once there is change in the other demand determinants the law does not hold good. Graph: From the figure in the normal course, at OP price, the quantity demanded is OQ. If the price falls from P to P1 then the higher quantity OQ1 is bought. DD is the demand curve. This shows that there is n inverse relationship between the demand and the price. it can be seen that the demand curve is sloping downwards from left to right. There are certain exceptions to this law. In other words, the law does not hold good in the following cases. 1. Where there is a shortage of necessities feared:If the customers fear that there could be shortage of necessities. Then this law does not hold good. They may tend to buy more than what they require immediately, even if the price of the product increases. 2. Where the product is such that it confers distinction:products such as jewels diamonds and so on, confer distinction on the part of the user. In such a case, the consumers tends to buy (to maintain their prestige) even though there is increase in its price, such products are called ‘veblen’ goods. 3. Giffen’s paradox: people whose incomes are low purchase more of a commodity such as broken rice, bread, etc.(which is their staple food). when its price rises conversely when its price falls, instead of buying more, they buy les of this commodity and use the savings for the purchase of better goods such as meat. This phenomenon is called Giffen’s paradox & such goods are called Inferior giffen goods. 4.In case of ignorance of price changes:At times the customer may not keep track of changes in price in such a case, he tends to buy even if there is increase in price. In case of these exceptions, the demand curve slopes upwards. This exceptional curve is shown below Exceptional demand curve
8 CHANGE IN DEMAND: The increase or decrease in demand due to change in the factors other than prices to change in the factors other than price is called change in demand. Change in demand leads to a shift in the demand curve to the right or the left. INCREASE IN DEMAND:If the consumers are willing and able to buy more of rainbow shirts at the same price, the result will be an increase in demand. The demand curve will shift to the right. From the above figure, how the demand increases from D, D to D1, D1, it shows that the buyers are ready to buy more quantity of arrow shirts at the same price. DECREASE IN DEMAND:A decrease in demand occurs when buyers are ready to buy less of a product at the same price because of factors like fall in income, rise in price of complementary goods and so on. A decrease in demand will shift the demand curve to the left. From the above figure the demand curve D, D decreases to D1, D1 at the same price level OP, the quantity demanded also decreases from OQ to OQ1. Increase or decrease in demand involves a shift in the demand curve.
9 EXTENSION AND CONTRACTION IN DEMAND:An extension is the downward movement along a demand curve, which indicates that a higher quantity is demanded for a given fall in the price of the good. A contraction is the upward movement along a demand curve, which indicates that a lower quantity is demand for a given increase in the price of the good. From above figure it can be seen that at OP, the quantity demanded is OQ. When the price decreases from OP to OP1, the quantity demanded extends from OQ to OQ1 along the same curve. There is no shift, here in the demand curve, This is called extension in demand. Contraction refers to movement upwards along the same demand curve, when the price increases from OP to OP2, the demand contracts from OQ to OQ2 along the same demand curve, this is called contraction in demand. In the case of extension and contraction, the change is along the same demand curve, either downwards or upwards respectively. SIGNIFICANCE OF LAW OF DEMAND:The law of demand is the primary law in the consumption theory in economics, it indicates the consumer behaviour for a given change in the variables in the study, despite the assumption that other things remaining the same, the results of the law of demand are time tested and have been the basis for further decisions relating to costs, outputs, investments, appraisals and so on. This provides the basis for analysis of other economic laws.
10 UNIT-II DEMAND ELASTICITY AND DEMAND FORECASTING INTRODUCTION TO ELASTICITY OF DEMAND: The changes occurs in quantity demanded of a product because of price, income of the consumer, prices of related goods, taste and preferences of consumers, and advertising effects. These changes are not so far quantified. Measuring these changes is necessary to study the changes in quantity demanded in relation to changes in demand determinants. For measuring these changes we ha tool that is elasticity of demand. By using this tool we can measure the effect of changes in any one of the demand determinants. ELASTICITY OF DEMAND: Most of the times it is not enough to understand the increase or decrease in price and its consequential impact of change in the quantity demanded. It is necessary to find out the extent of increase or decrease in each of the variables for taking certain managerial decisions. This paves the way for the concept of elasticity of demand. DEFINITION: The term ‘elasticity’ is defined as the rate of responsiveness in the demand of a commodity for a given change in price or any other determinants of demand. Elasticity of demand is defined as the percentage change in quantity demanded caused by one percentage change in demand determinant of consideration, by other determinants held constraint. Ed= percentage change in quantity demanded of good “Q” Percentage change in determinant “Z” MEASUREMENT OF ELASTICITY: The elasticity is measured in the following ways. 1. Perfectly elastic demand. 2. Perfectly inelastic demand. 3. Relatively elastic demand. 4. Relatively inelastic demand. 5. Unity elasticity. 1. Perfectly elastic demand:When any quantity can be sold at a given price, and when there is no need to reduce the price, the demand is said to be perfect elastic. Even a small increase in price will lead to complete fall in demand. Ex: - umbrella, drinks. Price P O Q Q1 Q2 Quantity Demended The quantity demanded increases from OQ to OQ1 from OQ1 to OQ2 even through there is no change in price. Price is fixed at OP.
11 2. Perfectly inelastic demand:When a significant degree of change in price leads to little (or) no change in the quantity demanded. Then the elasticity is said to be perfectly inelastic. In other words, the demand is said to be perfectly inelastic when there is no change in the quantity demanded even though there is big change (increase or decrease) in price. Ex:- diamond, salt. Price P2 P1 P O Q Quantity Demanded From the above figure, there is no change in the quantity demanded though there is change in price, say increase or decrease. In other words, despite the increase in price from OP to OP1. The quantity demanded has not fallen down. Similarly, though there is a fall in price from OP3 TO OP2, the quantity demanded remains unchanged. 3. Relatively elastic demand:The demand is said to be relatively elastic when the change in demand is more than the change in the price. Ex:- gold. Price P1 P2 O Q1 Q2 Quantity demanded From the above figure, the quantity demanded increases from OQ1 to OQ2 because in price from OP1 to OP2. The extent of increase in the quantity demanded is greater than the extent of fall in the price. 4. Relatively inelastic demand:The demand is said to be relatively inelastic when the change in demand is less than the change in the price. Ex:- Rice.
12 P1 P2 O Q1 Q2 From the above figure, the quantity demanded increases from OQ1 to OQ2, because of the decrease in price from OP1 to OP2. The extent of increase in the quantity demanded is lesser than the extent of fall in price. 5. Unity elasticity:The elasticity in demand is said to be unity when the change in demand is equal to the change in price. D P1 P2 D O Q1 Q2 From the above figure the quantity demanded increases from OQ1 to OQ2 because of the decrease in price from OP1 to OP2. The extent of increase in the quantity demanded is equal to the extent of fall in price. TYPES OF ELASTICITY : There are 4 types of elasticity of demand 1. 2. 3. 4. Price elasticity of demand. Income elasticity of demand. Cross elasticity of demand. Advertising elasticity of demand. 1. Price elasticity of demand:Elasticity of demand in general refers to the price elasticity of demand. In other words, it refers to the quantity demanded of a commodity in response to a given change in price. Price elasticity is always negative which indicates that the customer tends to buy more with every fall in the price. The relationship between the price & the demand in inverse. It is measured as follows….. Price elasticity of demand = Proportional change in the quantity demanded for product X Proportional change in the price of X. Edp= (Q2-Q1)/Q1/ (P2-P1)/P1. Q1= quantity demanded before price change. Q2= quantity demanded after price change.
13 P1= price before change. P2= price after change. Example 1: Elastic demand (e>1). Determine the price elasticity The quantity demanded for product is 1000 units at a price of 100/-. The price declines to 90/- & the quantity demanded increases to 1500 units Sol: - Edp= (Q2-Q1)/Q1/(P2-P1)/P1 Q1=1000 units Q2=1500 units P1= 100/P2= 90/Edp= (1500-1000)/1000/(90-100)/100 = -5 Since Edp in -5,it means for a 10% change in price, there is a change in demand by 50% where the numerical value of elasticity is more than one the demand is elastic in other words, the % of increase in quantity demanded is more than the % change in decrease in price. Example 2: Inelastic price demand (e<1) Determine the price elasticity The quantity demanded for product is 1000 units at a price of 100/-. The price declines to 70/- & the quantity demanded increases to 1100 units. Sol: - Edp= (Q2-Q1)/Q1/(P2-P1)/P1 Q1=1000 units Q2=1100 units P1= 100/P2= 70/Edp= (1100-1000)/1000/(70-100)/100 = -0.33 Since Edp in -0.33, it means for a 10% fall in price, there is an increase in demand by 3.3%. Where the numerical value of elasticity is less than one, the price demand is inelastic. In other words, the % of increase in quantity demanded is less than the % of decrease in price. Example 3:Unity price elasticity (e=1) Determine the price elasticity The quantity demanded for product is 1000 units at a price of 100/-. The price declines to 50/- & the quantity demanded increases to 1500 units. Sol: - Edp= (Q2-Q1)/Q1/(P2-P1)/P1 Q1=1000 units Q2=1500 units P1= 100/P2= 50/Edp= (1500-1000)/1000/(50-100)/100 = 1.0 Since Edp in 1, it means for a 50% fall in price, there is an increase in demand by 50%. Where the numerical value of elasticity is equal to one, the price demand is unity elastic. In other words, the % of increase in quantity demanded is less than the % of decrease in price. Significance of price elasticity of demand: It is necessary that the trader should be aware of the impact of changes in the quantity demanded for a given change in price. He can take a decision as to how much he can supply if he is aware of the likely change in quantity demanded as a result of change in price.
14 2. Income elasticity of demand:Income elasticity of demand refers to the quantity demanded of a commodity in response to a given change in income of the consumer. Income elasticity is normally positive, which indicates that the consumer tends to buy more and more with every increase in income. Income elasticity of demand= Proportional change in quantity demanded for product X Proportional change in income. Edi= (Q2-Q1)/Q1/ (I2-I1)/I1 Q1= quantity demanded before change, Q2= quantity demanded after change. I1= income before change. I2= income after change. Positive income elasticity indicates that the demand for the product rises more quickly them the rise in disposable income. In other words, the demand is more responsive to a change in income. Example 1: Elastic income demand (e>1) Determine the income elasticity The quantity demanded for product is 1000 units at a price of 100/-. The income declines to 80/- & the quantity demanded decreases to 700 units. Sol: - Edp= (Q2-Q1)/Q1/ (I2-I1)/I1 Q1=1000 units Q2=700 units I1= 100/I2= 80/Edp= (700-1000)/1000/(80-100)/100 = 1.5 Since Edi in 1.5, it means for a 10% fall in income, there is a decrease in demand by 15%. Where the numerical value of elasticity is more than one, the price demand is relatively elastic. In other words, the % of decrease in quantity demanded is more than the % of fall in income. In times of depression, the incomes fall & consequently the demand for the goods & services also decrease. Significance of income elasticity of demand:In determining the effects of changes in business activity it is necessary for the trader to be aware of the income elasticity of demand for given commodities. With the help of income elasticity of demand, he can estimate the likely changes in the demand for his product as a result of changes in the national income. 3. Cross elasticity of demand:Cross elasticity of demand refers to the quantity demanded of a commodity in response to a change in the price of a related good, which may be substitute or compliment. Cross elasticity of demand= proportional change in quantity demand for product X Proportional changes in price of product X. Edc= (Q2-Q1)/Q1/ (P2y-P1y)/P1y. Q1= quantity demanded before change. Q2= quantity demanded after change. P1y= price before change P2y= price after change. Example 1: Inelastic cross demand (e<1) Determination of cross elasticity The quantity demanded for a product is 1000 units at a price of 20/-. The income increases to 30/- & the quantity demanded increases to 1200 units. Sol: - Edp= (Q2-Q1)/Q1/(P2y-P1y)/P1y Q1=1000 units Q2=1200 units P1y= 20/P2y= 30/Edp= (1200-1000)/1000/(30-20)/20 = 0.4
15 Since Edp in 0.4, it means for a 10% increase in price, there is an increase in demand by 4%. Where the numerical value of elasticity is less than one, the cross demand is relatively inelastic. In other words, the % increase in quantity demanded is less than the % of increase in price of related good say sugar. Significance of cross elasticity of demand:Knowledge of cross elasticity of demand helps a firm to estimate the likely effect of pricing decision of its traders dealing in related products on sales. It also helps in defining industry. 4. Advertising elasticity:It refers to increase in the sales revenue because of change in the advertising expenditures. In other words, there is a direct relationship between the amount of money spent on advertising and its impact on sales. Advertising elasticity is always positive. Advertising elasticity= Proportionate change in quantity demanded for product X Proportionate change in advertisement costs. Eda= (Q2-Q1)/Q1/ (A2-A1)/A1 Q1= quantity demanded before change. Q2= quantity demanded after change. A1= amount spent on advertisement before change. A2= amount spent on advertisement after change Example 1:Elastic advertising demand (e>1) Determination of cross elasticity The quantity demanded for a product is 100000 per day at a monthly advertising budget of 10000/-. The monthly advertising budget is slashed to 5000/- & the quantity demanded will fall down to 30000 units per day. Sol: - Eda= (Q2-Q1)/Q1/ (A2-A1)/A1. Q1=100000 units Q2= 30000 units A1= 10000/A2= 5000/Eda= (30000-100000)/100000/(5000-10000)/10000 = 1.4 Since Eda in 1.4, it means for a 10% decrease in advertisement budget, there is a decrease in demand by 14%. Where the numerical value of elasticity is more than one, the advertising elasticity is relatively elastic. In other words, the % decrease in advertising budget is less than the % of decrease in the quantity demanded. Similarly, the inelastic advertising demand (where e<1).and unity elasticity of advertising (where e=1). Significance of advertising elasticity:The advertising agencies richly depend on this concept to provide consultancy for their clients about the advertisement budgets for a given level of sales activity. FACTORS GOVERNING ELASTICITY OF DEMAND:1. Nature of product. 2. Time frame 3. Degree of postponement. 4. No .of alternative uses. 5. Tastes & preferences of the consumer. 6. Availability of close substitutes. 7. in case of complimentaries or joint goods. 8. Level of prices. 9. Availability of substitutes.
16 10. Expectation of prices. 11. Durability of the product. 12. Government policy. SIGNIFICANCE OF ELASTICITY OF DEMAND:The concept of elasticity is very useful to the producers and policy – makers alike. It is very valuable tool to decide the extent of increase or decrease in price for a desired change in the quantity for the products & services in the firm or the economy. The following are its applications:1. To fix the prices of factors of production. 2. To fix the prices of goods & services provided rendered. 3. To formulate or revise government policies. 4. To forecast demand. 5. To plan the level of output & price. They are explained below: 1. Prices of factors of production: The factors of production are land, labour, capital, organization and technology. These have a cost. We have to pay rent, wages, interests, profits, and prices for these factors of production. Now the question is how much we have to pay each of these factors. The elasticity here depends upon the supply of each factors vis-à-vis the demand for each of them respectively. 2. Price fixation: The manufacture can decide the amount of price that can be fixed for his product based on the concept of elasticity. If there is no competition, in otherwords, in case of monopoly, the manufacture is free to fix his price as long as it does not attract the attention of the government. If the product ahs close substitutes then the price of the product can not be fixed very high. 3. Government policies i) Tax policies: government extensively depends upon this concept to finalise the policies relating to taxes and revenues. The finance minister uses elasticity concept to identify the various products and services where taxes can be levied. ii) Raising bank deposits: if the government wants to mobilize larger deposits from the customers, it proposes to raise the rates of fixed deposits marginally and vice versa. iii) Public utilities: government uses the concept of elasticity in fixing charges for the public utilities such as electricity tariff, water charges, ticket fair in case of road or rail transportation and so on. iv) Revaluation or devaluation of currencies: the government has to study the impact of revaluation or devaluation on the interest of the exports and imports. v) Formulate government policy: if the product demand is inelastic, the government would like to exercise close control over the matters relating to its supply and demand. 4. Forecasting demand: Income elasticity used to forecast demand for particular product or service. The demand for the products can be forecasted at a given income level. the trader can estimate the quantity of goods to be sold at different income levels to realize the targeted revenue with the help of income elasticity. 5.) planning the levels of output and price: The knowledge of price elasticity is very useful to producers. The producer can evaluate whether a change in price will bring in adequate revenue or not. if the product demand is elastic, it would benefit to the trader to charge low prices. On the other hand if the product has inelastic demand, a little high price may be helpful to him to get huge profits with out loosing sales. To sum up, elasticity is an equally valuable tool for the producer, trader and policy maker. POINT ELASTICITY & ARC ELASTICITY:A demand curve does not have the same elasticity throughout its entire length. in general, elasticity differs at different points on a given demand curve. However this does not hold good in the following three cases:-
17 i. ii. iii. Perfectly elastic. Perfectly inelastic. Unity elasticity. The demand curves in each of these cases possess a single elasticity throughout its entire length. Ep = ∞ D Elastic (Ep> 1) Price P1 Ep = 1 Inelastic (Ep< 1) O Ep = 0 C X1 Quantity demanded Elasticity changing at different points of demand curve From the above figure it can be seen that elasticity at point ‘C’ where the demand curve meets the quantity axis is equal to zero, and elasticity at point D where the demand curve meets the price axis is equal to infinity. If P1 is the mid-point of DC, elasticity at P1 is equal to 1. At all the points between P1 and C, the elasticity is greater than zero but less than unity and at the points between P1 and D elasticity is greater than unity but less than infinity. At point D, elasticity is equal to ∞. Thus the range of values of elasticity is between zero and infinity. 0≤e≤∞ The elasticity computed at a single point on the demand curve for an infinitesimal change in price is called ‘point’ elasticity. The elasticity between two separate points of demand curve is called ‘arc’ elasticity. Point elasticity is more precise than arc elasticity concept. Definition: The point elasticity is defined as the proportionate change in quantity demanded resulting from a very small change in price of that commodity. It is expressed as Point Ep = - ∆Q/∆P x P/Q ARC ELASTICITY: Arc elasticity measures the average responsiveness to price change over a finite stretch on the demand curve. In the figure where MN refers to the stretch on the demand curve D1D2, it is not clear whether point M or point N should be considered to determine elasticity. It makes a difference from which point we start. Moving from point M to N is different from N to M. it is because the percentage changes in quantity and price is different, depending upon the price and quantity from which it is taken. The difference in the starting point reveals the different values of elasticity coefficients. The arc elasticity is defined as below: Arc Ep = ∆Q (P1+P2)/2 / ∆P (Q1+Q2)/2 = ∆Q (P1+P2)/∆P (Q1+Q2) Where P1 and P2 are prices before and after changes Q1 and Q2 are quantities demanded before and after changes respectively. Is ∆Q and ∆P refer to change in the quantity demanded and change in the price respectively. To make the arc elasticity more meaningful, compute between the points on the demand curve that are close enough.
18 D1 M Price of good X 6 3 N D2 0 400 500 Quantity demanded To conclude, elasticity of demand is a very important concept for decision makers whether it is a finance minister or a monopolist. The concept of elasticity of demand helps to measure the changes in the quantity demanded in relation to changes in income or price and analyze how price or income can be a decisive factor to bring desired change in the quantity demanded. TOTAL OUTLAY OR EXPENDITURE METHOD:s The proportionate method is used when price and demand information is available. Sometimes one may have the information about the price and expenditure incurred on a commodity then the expenditure method comes in handy to estimate the elasticity of demand. Given the price and expenditure information one can easily identify the elasticity of demand by applying the principles of demand. Observe the following expenditure schedule to identify the elasticity of demand by applying the expenditure method. Price 7.50 7.40 7.30 7.20 Expenditure 2,25,000 2,50,000 2,50,000 2,25,000 It can be observed from the above table that when the price decreased from Rs.7.50 to Rs.7.40 the expenditure increased that indicates the relatively elastic demand. Between Rs.7.40 and Rs.7.30 the expenditure remined constant indicating that the elasticity is equal to unity. Between Rs.7.30 and Rs.7.20 the expenditure increased that shows the relatively elastic demand. The above information can be translated in to a diagram as shown in figure From the figure ‘ABCD’ is the expenditure line. When the price falls from ‘OP’ to ‘OP1’ the expenditure increased from OM to ON. Therefore on the expenditure line between points A and B the elasticity of demand is relatively elastic or >1. Where as when the price decreased from ‘op1’ to ‘op2’ i.e. between B and C the expenditure remained constant at ON indicating unitary elasticity of demand or =1 When the price decline from op2 to op3 .On the expenditure line between points C and D the elasticity of demand is relatively inelastic or <1.
19 A Price P Ed > 1 P1 B Ed = 1 P2 C D Ed < 1 O M N Expenditure DEMAND FORECASTING: The Need For Demand Forecasting:It is customary in all advanced countries to estimate demand for goods and services in a realistic manner so as to carry out the production plans. Where the supply is not in accordance with demand, it results in the development of black market or excessive prices. The demand forecasting guides the entrepreneurs to set up there business/industrial activities. Where there is a lot of competition, the entrepreneur has to estimate the demand for this product and services so that he can plan his material inputs, such as manpower, finance advertising and others. In India, the services of the National Council of Applied Economics Research (NCAER) are very valuable in terms of demand estimates. It estimates the probable demand for both industrial and consumer goods at regional and national levels. These estimates guide the entrepreneurs to plan there production. FACTORS GOVERNING DEMAND FORECASTING:There are several factors which govern the forecasting process they are: 1) Functional nature of demand: Market demand for a particular product are service is not a single number but it is a function of no.of factors. For instance, higher levels of sales can be realized with higher levels of advertising or promotional efforts. 2) Types Of Forecasting:Based on the period under forecast, the demand forecasting can be of two types short-run forecasting long-run forecasting i) short run forecast: It covers the period of 1 year. It helps to foresee the fluctuations in the demand based on seasonal and cultural factors such as festivals and plan this schedules of production or supply accordingly. It forecasts facilitate decisions by which the utilization of resources can be optimized. The annual requirements of inventory can be procured at competitive prices. In the light of short run forecasts, the trader can formulate an appropriate pricing policy in tune with seasonal fluctuations.
20 ii) long run forecast: It covers any period ranging from 1 to 20 years. It provides information for major strategic decision that results in extension or reduction of limiting resources, it take takes long run finances. It provides an appropriate basis to recruit human resources with a required specialization. A long range forecast of regional demand for its major product line helps to provide the basis for considering market expansion. 3) Forecasting Level: Forecasting may be at the following levels: Firm level Industry level National or global level. Forecasting at Firm level means estimating the demand for the products and services offered by single firm. Industry demand means the aggregate demand estimated by goods and services of all the firms. The total estimate of different trade associations can also been viewed as Industry level forecasting. National level forecasting is for the whole economy. These are worked out based on the levels of income, savings of the consumers. It is essential to consider the appropriate indices of industrial production to work out national forecasts. With globalization and deregulation, the entrepreneurs have started exploring the foreign markets for the global level forecasts 4) Established and New Products It is relatively easy to forecast for established products or products which are currently in use. But forecasting of demand of a new product is not an easy task. To estimate the demand of a new product. there are some approaches they are as follows: Joel deans suggested some number of possible approaches to forecast demands for new products 1. Find out the demand for a related existing product and project the demand for the new product as its outgrowth. 2. The new product, in consideration, can be analyzed ass a substitute for some existing product. 3. Asses the pattern of growth of established products and estimate the rate of growth and the likely level of demand for the new product over the given period. 4. Asses the demand through a sample or total survey of consumers’ intentions over the new product features and price. 5. Contact dealers to know the customers reaction to the new product. 5) Nature of Goods:The goods are classified into... Producer goods Consumer goods Consumer durable and services. The patterns of forecasting in each of these differ. 6) Degree of competition: These may be a single trader or a few traders depending upon the nature of goods and services. 7) Other factors:
21 Every forecast of demand should clearly list the assumptions made about the demographic, economic, technological, political, cultural environment. Other factors like… Political developments. Changing fashions. Customer references. Changes in technology. Changes in price level or inflation. 8) Market demand: Market demand for a particular product is the total volume that would be bought by a defined customer group in a marked geographical area in a certain marketing program. Market demand is affected by a host of controllable factors such as the demographic, economic, technological, political &cultural environment, as elasticity with respect to industry price promotion ,product improvements & distribution efforts at given industry prices & marketing outlays. METHODS OF DEMAND FORECASTING: Demand forecasting methods Survey methods Statistical methods Trend projection method Other methods Expert opinion Trend line by observation Judgmental approach Collective method Moving averages method Survey of sales force Least squares method Time series analysis Survey of buyers method Controlled experiments Economic indicator method Exponential smoothing Census method Sample method Delphi method SURVEY METHODS i) Survey of buyer’s intention:To anticipate what buyers are likely to do under a given set of circumstances, a most useful source of information would be the buyers themselves. It is better to draw a list of all potential buyers, approach each buyer to ask how much does her plans to buy of the given product at a given point of time under particular conditions. This is the most effective method because the buyer is the ultimate decision maker and we are collecting the information directly from him. The survey of the buyers can be conducted either by covering the whole population or by selecting a sample group of buyers.
22 Suppose there are 10,000 buyers for a particular product and the company wishes to collect the information of all its buyers, this method is called Census method or Total Enumeration method. This method is time consuming and costly. The firm can select a group of buyers who can represent the whole population .This method is called Sample method. It can be done in less time and with fewer costs. Advantages of the survey methods:1. Where the product is new in the market for which no data exists previously. 2. When the buyers are few and they are accessible. 3. When the cost of reaching them is not significant. 4. When consumers stick to their intentions. 5. When they are willing to disclose what they are willing to do. Disadvantages:1. Survey may be expensive. 2. Sample size and timing of survey. 3. Methods of sampling. 4. In consisted buying behavior. ii) Sales force opinions:Another source of getting reliable information about possible level of sales or demand for a given product or services is the group of people who sell the same. The sales people are those who are in constant touch with the main and large buyers of particular market. The sales force is capable of assessing the likely reaction of the costumers in their sales regions quickly, so they give valid information. Here also there is a danger /disadvantages that salesmen may sometimes become biased with their views. The sales people are paid based on their results. Targets are set for the salesmen. The salary of the salesmen depends upon the targets. Incentives are paid to the salesmen who achieved the targets. Salespersons having more knowledge about the information of sources. Salesmen are cooperative. STATISTICAL METHODS For forecasting the demand for goods and services in the long-run, statistical and mathematical methods are used considering the past data. (a)Trend projection methods:This is based on past sales patterns. The necessary information is already available in company files with different time periods. There are five main techniques: 1. Trend line by observation. 2. Least square method. 3. Time series analysis. 4. Moving average method. 5. Exponential smoothing. (1)Trend line by observation:It is easy and quick as it involves plotting the actual sales data on a chart and then estimating just by observation when the trend line lies. (2) Least square method:In this statistical method is used. The trend line is the basis to extrapolate the line for future demand for the given product or service on graph. Here it is assumed that there is a proportional exchange in sales over a period of time. In such a case the trend line equation is in linear form. The estimated linear trend equation of sales is written as:
23 S = x + y (T) Here, x & y have been calculated from past data. S = sales; T = year no. for which the forecast is made. 3) Time series analysis:Where the surveys or market tests are costly and time consuming, statistical and mathematical analysis of past sales data offers another method to prepare the forecasts that is time series analysis. Considerable data on the performance of the product or service over significantly large period should be available for better results under this method. Time series emerge from a data when arranged chronologically, given significantly large data. The following 4 major components analyzed from time series while forecasting the demand. Trend (T): It also called as long term trend, is the result f basic developments in the population, capital formation & technology. These developments relate to over a period of long time say 5 t0 10 years, not definitely over night. Cycle Trend (C): It is wave like movement of sales inflation. The sales data is quite often affected by swings in the levels of general economic activity. For insistence during the period of inflation prices go up and down. Seasonal Trend (S): It refers to a consistent period of sales movements with in the year. More goods are sold in festivals seasons, weather factors, holidays. Erratic Trend (E): Results from the sporadic occurrence of strikes, riots etc. these erratic components can damage the impact of more systematic components, and thus make forecasting process more complex. The linear time series equation can be represented as follows: Y= T+C+S+E. Advantages: It is simple and in expensive. It considers the significantly large data which reflects a continuous growth trend. Disadvantages: It is difficult to identify the turning points causing the changes in the trend. This method calls for expert knowledge in the use of mathematics and statistics to forecast demand for a given product or service 4) Moving average method: This method considers that the average of past events determine the future events. This method provides consistent results when the past events are consistent and unaffected by wide changes. This method is easy to compute. One major advantage with this method is that the old data can be dispensed with once the averages are calculated. These averages, not original data, are further used as the forecast for next period. It gives equal weightage to data both in the recent past and the earlier one. Example: - Compute 3-day moving average from the following daily sales data. Date month and Daily sales (lakhs) 3-day moving average
24 Jan 1 Jan 2 Jan 3 Jan 4 Jan 5 40 44 48 45 53 44 45.7 Sol:To calculate 3-days moving avg… S4 = (40 + 44 + 48)/ 3 == 44 S5 = (44 + 48 + 45)/3 == 45.7 5) Exponential smoothing: This is a more popular technique used for short-run forecasts. This method is an improvement over moving averages method. All time periods ( ranging from the immediate part to distant part ) here are given varying weights , that is the value of the given variable in the recent times are given higher weights and the values of the given variable in the distant past are given relatively lower weights for further processing. The formula used for exponential smoothing, S t + 1 == c S T + (1 -- C) S MT S t + 1 == exponentially smoothed average for New Year. S t == actual data in the most recent part. S Mt == most recent smoothed forecast. C = smoothing constant. OTHER METHODS Expert opinion: Well informed persons are called experts. Experts constitute yet another source of information. These persons are generally the generally the outside experts and they do not have any vested interests in the results of a particular survey. Main advantages are: 1. Results of this method would be more reliable as the expert is unbiased, has no direct commercial involvement in its primary activities. 2. Independent demand forecast can be made relatively quick and cheap. 3. This method constitutes a valid strategy particularly in the case of new products. The main disadvantage is that an expert can’t be held accountable if his estimates are found incorrect. Controlled experiments: Controlled experiments refer to such exercises where some of the major determinants of demand are manipulated to suit to the customers with different tastes and preferences, income groups and such others. This method can not provide better results, unless these markets are homogenous in terms of, tastes and preferences of customers, their income and soon. This method is in infancy state and not much tried because of following reasons: It is costly and time consuming. It involves elaborate process of studying different markets and different permutations and combinations that push the product aggressively. If it fails in one market, it may affect other markets also. Judgment approach: When none of the above methods are directly related to the given product or service, the management has no other alternative than using its own judgment. Even when the above methods are used, the forecasting process is supplemented with the factor of judgment for the following reasons:
25 1. Historical data for significantly long period is not available. 2. Turning points in terms of policies or procedures or casual factors cannot be precisely demanded. 3. Sales fluctuations are wide and significant. 4. The reasons of statistical methods are more reliable at the national level rather than firm or industry level, in such cases, the management has to rely more on its judgment to access the validity of such results. Collective methods: Collecting method means after launching of the product in to the market, the organization people gather the needed information about their product i.e quality, price, demand and etc. from the available all sources like customers, retailers, dealers and so on., Economic indicators method: If proper time series data not available and the available data may not show particular trend, the forecaster has to relay upon another source of data. Here they can take the advice from the economic indicators, they are economists of the organization. They collect the detailed information/ data for the demand forecasting. Delphi method: The Delphi technique helps to capture the knowledge of diverse experts while avoiding the disadvantages of other methods. To forecast with Delphi method the manager should recruit 5 to 20 members with suitable data. These members collect the suitable data regarding the demand of the product and they analyses the both collected data and given data by the firm. This process is repeated in 3 rounds/ times for getting better results it is usually sufficient. The third round forecast is the experts final forecast. DEMAND FORECASTING OF NEW PRODUCTS Demand forecasting for a new product is different from those of the established product. This requires thorough understanding of the nature of the product, prevailing competition, and knowledge of consumer psychology etc. The following methods of demand forecasting may be relevant for this purpose. 1. Consumer Opinion Surveys 2. Test Marketing 3. Product lifecycle analysis 4. Growth curve approach 5. Evolutionary approach 6. Vicarious approach 7. Consumer Opinion Surveys: Consumer survey method may be used to forecast the demand for a new product. The consumers should be given free samples and asked to express their views through a questionnaire. The views expressed by consumers should be the guiding force about the future demand. However care should be taken to eliminate consumer bias. Test marketing: It is likely that opinions give in by buyers, sales man or other experts may be at times, misleading. This is the reason why most of the manufacturers favour to test there product or service in a limited matter as test-run before they launch their products nation wide. Advantages: 1. Acceptability of the product can be judged in a limited market. 2. Before its too late, the corrections can be made to product design if necessary, thus major catestrophy, in terms of failure, can be avoided. 3. The customer psychology is more focused in this method and the product and services are aligned or redesigned accordingly to gain more customer acceptance.
26 Disadvantages: 1. It reveals the quality of product to the competitors before it is launched in his wider market. The competitors may bring about a similar product or often misuse the results of the test marketing against the given company. 2. It is not always easy to select a representative audience or market. 3. It may also be difficult to extrapolate the feedback received from such a test market, particularly where the chosen market is not fully representative. Product Lifecycle analysis: Every product has its own life cycle i.e. introduction, growth, maturity, saturation and decline. The producers of new product should first identify in which stage is the product life cycle. If the product is in the introductory or growth stage it is safe to assume that the future sales will be brighter. On the other hand if the product is in the saturation or declination stage the future demand for its product will be very less. Diagram: sales Growth curve approach: Growth curve approach is the method of forecasting the demand based on the pattern of growth of some established substitute product in the market. Evolutionary approach: Evolutionary approach is a method that the demand for a new product can be considered as the outgrowth of an existing product. This method is more appropriate if the new product is an improvement over the existing product and its demand will be a projection of the potential development of the existing product. Vicarious approach: Vicarious approach involves soliciting the views of the dealers who are close to the consumers, about the demand for the new product. But this method has to be used with caution. CRITERIA OF GOOD FORECASTING: Joel Dean suggested that a good forecast should satisfy the following characteristics. 1. Accuracy: A method of forecasting will be considered good if it gives accurate results. This can be judged by its previous projections fitted against the actual achievements. 2. Plausibility: The forecaster should have confident in the method of forecasting that he had selected. Highly mathematical and technical methods of forecasting may lack the quality of plausibility, as they are not easily comprehendible to the business firm.
27 3. Durability: The forecasted results should hold good for a longer period of time. The durability of a forecast depends upon the reasonableness and simplicity of the demand function. 4. Flexibility: The demand forecasting function should be such that the variables used in the function can be easily adjusted from time to time depending upon the change circumstances. 5. Availability: The forecasting technique should be able to produce results quickly. If it takes a long time to obtain the results of the forecast it vitiates the very purpose for which it was undertaken 6. Economy: The techniques or methods used for forecasting should be cheap and economical. They should not be very expensive.
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