UNIT II

DEMAND ANALYSIS

INTRODUCTION OF DEMAND:

Demand in common practice / ordinary language means the desire for an

object. Suppose a person desires to have a car. It is called demand in ordinary
usage.

But in economics demand has a separate meaning which is quite distinct

from the above meaning.

A mere desire cannot become demand in Economics.

A desire which is backed up by (i) ability to buy and (ii) willingness to pay
the price, is called demand. Unless the desire is accompanied by ability to buy and
willingness to pay, it cannot be called demand in Economics.

DEFINITIONS OF DEMAND

1. According to Stonier and Hague,

“ Demand in economics means demand backed up by enough money to pay for

the goods demanded”.

This means that the demand becomes effective only if it is backed by

purchasing power in addition to this there must be willingness to buy a commodity.

Thus demand in economics means the desire backed by the willingness to

buy a commodity and the purchasing power to pay.

2. In the words of Benham,

“The demand for anything at a given price is the amount of it which will be
bought per unit of time at that price”. (Thus demand is always at a price for a
definite quantity at a specified time.)

Thus demand has three essentials i.e., price, quantity and time. Without
these three demand has no significance in economics.
Determinants or Factors Affecting Demand:

There are factors on which the demand for a commodity depends. These factors are
economic, social as well as political factors. The effect of all the factors on the
amount demanded for the commodity is called Demand Function.

These factors are as follows:

1. Price of the Commodity:

The most important factor-affecting amount demanded is the price of the

commodity. The amount of a commodity demanded at a particular price is more
properly called price demand. The relation between price and demand is called the
Law of Demand. It is not only the existing price but also the expected changes in
price, which affect demand.

2. Income of the Consumer:

The second most important factor influencing demand is consumer income. In fact,
we can establish a relation between the consumer income and the demand at
different levels of income, price and other things remaining the same. The demand
for a normal commodity goes up when income rises and falls down when income
falls. But in case of Giffen goods the relationship is the opposite.

3. Prices of related goods:

The demand for a commodity is also affected by the changes in prices of the
related goods also. Related goods can be of two types:

(i). Substitutes which can replace each other in use; for example, tea and coffee
are substitutes. The change in price of a substitute has effect on a commodity’s
demand in the same direction in which price changes. The rise in price of coffee
shall raise the demand for tea;

(ii). Complementary foods are those which are jointly demanded, such as pen and
ink. In such cases complementary goods have opposite relationship between price
of one commodity and the amount demanded for the other. If the price of pens
goes up, their demand is less as a result of which the demand for ink is also less.
The price and demand go in opposite direction. The effect of changes in price of a
commodity on amounts demanded of related commodities is called Cross Demand.

4. Tastes of the Consumers:

The amount demanded also depends on consumer’s taste. Tastes include fashion,
habit, customs, etc. A consumer’s taste is also affected by advertisement. If the
taste for a commodity goes up, its amount demanded is more even at the same
price. This is called increase in demand. The opposite is called decrease in
demand.

5. Wealth:

The amount demanded of commodity is also affected by the amount of wealth as

well as its distribution. The wealthier are the people; higher is the demand for
normal commodities. If wealth is more equally distributed, the demand for
necessaries and comforts is more. On the other hand, if some people are rich, while
the majorities are poor, the demand for luxuries is generally higher.

6. Population:

Increase in population increases demand for necessaries of life. The composition of

population also affects demand. Composition of population means the proportion
of young and old and children as well as the ratio of men to women. A change in
composition of population has an effect on the nature of demand for different
commodities.

7. Government Policy:

Government policy affects the demands for commodities through taxation. Taxing
a commodity increases its price and the demand goes down. Similarly, financial
help from the government increases the demand for a commodity while lowering
its price.

8. Expectations regarding the future:

If consumers expect changes in price of commodity in future, they will change the
demand at present even when the present price remains the same. Similarly, if
consumers expect their incomes to rise in the near future they may increase the
demand for a commodity just now.

9. Climate and weather:

The climate of an area and the weather prevailing there has a decisive effect on
consumer’s demand. In cold areas woolen cloth is demanded. During hot summer
days, ice is very much in demand. On a rainy day, ice cream is not so much
demanded.
10. State of business:

The level of demand for different commodities also depends upon the business
conditions in the country. If the country is passing through boom conditions, there
will be a marked increase in demand. On the other hand, the level of demand goes
down during depression.

LAW of Demand:

Law of demand shows the relation between price and quantity demanded of
a commodity in the market. In the words of Marshall, “the amount demand
increases with a fall in price and diminishes with a rise in price”.

A rise in the price of a commodity is followed by a reduction in demand and

a fall in price is followed by an increase in demand, if a condition of demand
remains constant.

The law of demand may be explained with the help of the following demand
schedule.

Demand Schedule.

Price of Appel (In. Rs.) Quantity Demanded

10 1

8 2

6 3

4 4

2 5

When the price falls from Rs. 10 to 8 quantity demand increases from 1 to 2. In the
same way as price falls, quantity demand increases on the basis of the demand
schedule we can draw the demand curve.
 Price

The demand curve DD shows the inverse relation between price and quantity
demand of apple. It is downward sloping.

Assumptions:

Law is demand is based on certain assumptions:

1. This is no change in consumers taste and preferences.

2. Income should remain constant.

3. Prices of other goods should not change.

4. There should be no substitute for the commodity

5. The commodity should not confer at any distinction

6. The demand for the commodity should be continuous

7. People should not expect any change in the price of the commodity

Exceptional demand curve or exceptions to the law of demand :

Some times the demand curve slopes upwards from left to right. In this case the
demand curve has a positive slope.
 Price

When price increases from OP to Op1 quantity demanded also increases from to
OQ1 and vice versa. The reasons for exceptional demand curve are as follows.

1. Giffen paradox:

The Giffen good or inferior good is an exception to the law of demand. When the
price of an inferior good falls, the poor will buy less and vice versa. For example,
when the price of maize falls, the poor are willing to spend more on superior goods
than on maize if the price of maize increases, he has to increase the quantity of
money spent on it. Otherwise he will have to face starvation. Thus a fall in price is
followed by reduction in quantity demanded and vice versa. “Giffen” first
explained this and therefore it is called as Giffen’s paradox.

2. Veblen or Demonstration effect:

Veblen has explained the exceptional demand curve through his doctrine of
conspicuous consumption. Rich people buy certain good because it gives social
distinction or prestige for example diamonds are bought by the richer class for the
prestige it possess. It the price of diamonds falls poor also will buy is hence they
will not give prestige. Therefore, rich people may stop buying this commodity.

3. Ignorance:

Sometimes, the quality of the commodity is Judge by its price. Consumers think
that the product is superior if the price is high. As such they buy more at a higher
price.

4.Speculative effect:
If the price of the commodity is increasing the consumers will buy more of it
because of the fear that it increase still further, Thus, an increase in price may not
be accomplished by a decrease in demand.

5. CHANGES IN EXPECTATIONS:

When people expect a further rise in prices, people buy more when prices
rise.

They want avoid paying more in future.

Similarly, when people expect the prices to fall in further, they buy less and
less as prices fall.

They may be expecting a further in prices.

6. Fear of shortage:

During the times of emergency of war People may expect shortage of a

commodity. At that time, they may buy more at a higher price to keep stocks for
the future.

ELASTICITY OF DEMAND:

Elasticity of demand explains the relationship between a change in price and

consequent change in amount demanded. “Marshall” introduced the concept of
elasticity of demand. Elasticity of demand shows the extent of change in quantity
demanded to a change in price.

In the words of “Marshall”, “The elasticity of demand in a market is great or

small according as the amount demanded increases much or little for a given fall in
the price and diminishes much or little for a given rise in Price”

Elasticity of demand

= percentage change in the quantity demanded / percentage change in price

Elastic demand: A small change in price may lead to a great change in quantity
demanded. In this case, demand is elastic.

In-elastic demand: If a big change in price is followed by a small change in

demanded then the demand in “inelastic”.
Types of Elasticity of Demand:

There are three types of elasticity of demand:

1. Price elasticity of demand

2. Income elasticity of demand

3. Cross elasticity of demand

1. Price elasticity of demand:

Marshall was the first economist to define price elasticity of demand. Price
elasticity of demand measures changes in quantity demand to a change in Price. It
is the ratio of percentage change in quantity demanded to a percentage change in
price.

Proportionate change in the quantity demand of commodity

Price elasticity = ------------------------------------------------------------------

Proportionate change in the price of commodity

There are five cases of price elasticity of demand

A. Perfectly elastic demand:

When small change in price leads to an infinitely large change is quantity demand,
it is called perfectly or infinitely elastic demand. In this case E=∞
The demand curve DD1 is horizontal straight line. It shows the at “OP” price any
amount is demand and if price increases, the consumer will not purchase the
commodity.

B. Perfectly Inelastic Demand

In this case, even a large change in price fails to bring about a change in quantity
demanded.

When price increases from ‘OP’ to ‘OP’, the quantity demanded remains the same.
In other words the response of demand to a change in Price is nil. In this case
‘E’=0.

C. Relatively elastic demand:

Demand changes more than proportionately to a change in price. i.e. a small

change in price loads to a very big change in the quantity demanded. In this case

E > 1. This demand curve will be flatter.

When price falls from ‘OP’ to ‘OP’, amount demanded increase from “OQ’ to
“OQ1’ which is larger than the change in price.

D. Relatively in-elastic demand.

Quantity demanded changes less than proportional to a change in price. A large

change in price leads to small change in amount demanded. Here E < 1. Demanded
carve will be steeper.

When price falls from “OP’ to ‘OP1 amount demanded increases from OQ to OQ1,
which is smaller than the change in price.

E. Unit elasticity of demand:

The change in demand is exactly equal to the change in price. When both are equal
E=1 and elasticity if said to be unitary.
When price falls from ‘OP’ to ‘OP1’ quantity demanded increases from ‘OP’ to
‘OP1’, quantity demanded increases from ‘OQ’ to ‘OQ1’. Thus a change in price
has resulted in an equal change in quantity demanded so price elasticity of demand
is equal to unity.

2. Income elasticity of demand:

Income elasticity of demand shows the change in quantity demanded as a result of

a change in income. Income elasticity of demand may be slated in the form of a
formula.

Proportionate change in the quantity demand of commodity

Income Elasticity = ------------------------------------------------------------------

Proportionate change in the income of the people

Income elasticity of demand can be classified in to five types.

A. Zero income elasticity:

Quantity demanded remains the same, even though money income increases.
Symbolically, it can be expressed as Ey=0. It can be depicted in the following way:
As income increases from OY to OY1, quantity demanded never changes.

B. Negative Income elasticity:

When income increases, quantity demanded falls. In this case, income elasticity of
demand is negative. i.e., Ey< 0.

When income increases from OY to OY1, demand falls from OQ to OQ1.

c. Unit income elasticity:

When an increase in income brings about a proportionate increase in quantity

demanded, and then income elasticity of demand is equal to one. Ey = 1
When income increases from OY to OY1, Quantity demanded also increases from
OQ to OQ1.

d. Income elasticity greater than unity:

In this case, an increase in come brings about a more than proportionate increase in
quantity demanded. Symbolically it can be written as Ey> 1.

It shows high-income elasticity of demand. When income increases from OY

to OY1, Quantity demanded increases from OQ to OQ1.

E. Income elasticity leas than unity:

When income increases quantity demanded also increases but less than
proportionately. In this case E < 1.
An increase in income from OY to OY, brings what an increase in quantity
demanded from OQ to OQ1, But the increase in quantity demanded is smaller than
the increase in income. Hence, income elasticity of demand is less than one.

3. Cross elasticity of Demand:

A change in the price of one commodity leads to a change in the quantity

demanded of another commodity. This is called a cross elasticity of demand. The
formula for cross elasticity of demand is:

Proportionate change in the quantity demand of commodity “X”

Cross elasticity = -----------------------------------------------------------------------

Proportionate change in the price of commodity “Y”

a.In case of substitutes, cross elasticity of demand is positive. Eg: Coffee and Tea
When the price of coffee increases, Quantity demanded of tea increases. Both are
substitutes.

b.Incase of compliments, cross elasticity is negative. If increase in the price of

one commodity leads to a decrease in the quantity demanded of another and vice
versa.

When price of car goes up from OP to OP!, the quantity demanded of petrol
decreases from OQ to OQ!. The cross-demanded curve has negative slope.

c.In case of unrelated commodities, cross elasticity of demanded is zero. A

change in the price of one commodity will not affect the quantity demanded of
another.
Quantity demanded of commodity “b” remains unchanged due to a change in the
price of ‘A’, as both are unrelated goods.

4. Advertising elasticity of demand:

It refers to increase in the sales revenue because of change in the advertising

expenditure. 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.

Proportionate change in the quantity demand of product “X”

Advertising elasticity = ---------------------------------------------------------------------

- Proportionate change in advertisement costs.

Factors influencing the elasticity of demand

Elasticity of demand depends on many factors.

1. Nature of commodity:

Elasticity or in-elasticity of demand depends on the nature of the commodity i.e.

whether a commodity is a necessity, comfort or luxury, normally; the demand for
Necessaries like salt, rice etc is inelastic. On the other band, the demand for
comforts and luxuries is elastic.

2. Availability of substitutes:

Elasticity of demand depends on availability or non-availability of substitutes. In

case of commodities, which have substitutes, demand is elastic, but in case of
commodities, which have no substitutes, demand is in elastic.

3. Variety of uses:

If a commodity can be used for several purposes, than it will have elastic demand.
i.e. electricity. On the other hand, demanded is inelastic for commodities, which
can be put to only one use.

4. Postponement of demand:
If the consumption of a commodity can be postponed, than it will have elastic
demand. On the contrary, if the demand for a commodity cannot be postpones,
than demand is in elastic. The demand for rice or medicine cannot be postponed,
while the demand for Cycle or umbrella can be postponed.

5. Amount of money spent:

Elasticity of demand depends on the amount of money spent on the commodity. If

the consumer spends a smaller for example a consumer spends a little amount on
salt and matchboxes. Even when price of salt or matchbox goes up, demanded will
not fall. Therefore, demand is in case of clothing a consumer spends a large
proportion of his income and an increase in price will reduce his demand for
clothing. So the demand is elastic.

6. Time:

Elasticity of demand varies with time. Generally, demand is inelastic during short
period and elastic during the long period. Demand is inelastic during short period
because the consumers do not have enough time to know about the change is price.
Even if they are aware of the price change, they may not immediately switch over
to a new commodity, as they are accustomed to the old commodity.

7. Range of Prices:

Range of prices exerts an important influence on elasticity of demand. At a very

high price, demand is inelastic because a slight fall in price will not induce the
people buy more. Similarly at a low price also demand is inelastic. This is because
at a low price all those who want to buy the commodity would have bought it and a
further fall in price will not increase the demand. Therefore, elasticity is low at
very him and very low prices.

Significance of Elasticity of Demand :

a. Price of factors of production:

The factors of production are land, labour, capital, organizations and technology.
These have a cost; we have to pay rent, wages, interest, profits and price for these
factors of production.

b. Price fixation:

the manufacturer 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 other words in the
case of a monopoly, the manufacture is free to fix his price as long as it does not
attract the attention of the government, when there are close substitutes, the
product is such that its consumption can be postponed, it cannot be put to
alternative uses and so on, then the price of the product cannot be fixed very
highly.

c. Government policies

1. Tax policies: government extensively depends on this concept to finalize its

policesrelating to taxes and revenues. Where the product is such that the people
cannot postpone its consumptions, the government tends to increase its, price, such
as petrol and diesel, cigarettes, and so on.

2. Raising bank deposits : if the government wants to mobilize larger deposits

fromthe consumer it propose to raise the rates of fixed deposits marginally and vice
versa.

3. Public utilities: government uses the concept of elasticity in fixing charges

for thepublic utilities such as elasticity tariff, water charges, ticket fare in case of
road or rail transport .

d. Forecasting demand:

Income elasticity is used to forecast demand for a particular product or services.

The demand for the products can be forecast at a give income level. The trader can
estimate the quantity of goods to be sold at different income levels to realize the
targeted revenue.

e. 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. In
general, for items whose demand is elastic, it would benefit him to charge
relatively low price. On the other hand, if the demand for the product is inelastic, a
little higher price may be helpful to him to get huge profits without losing sales.
Importance of Elasticity of Demand:

The concept of elasticity of demand is of much practical importance.

1. Price fixation:

Each seller under monopoly and imperfect competition has to take into account
elasticity of demand while fixing the price for his product. If the demand for the
product is inelastic, he can fix a higher price.

2. Production:

Producers generally decide their production level on the basis of demand for the
product. Hence elasticity of demand helps the producers to take correct decision
regarding the level of cut put to be produced.

3. Distribution:

Elasticity of demand also helps in the determination of rewards for factors of

production. For example, if the demand for labour is inelastic, trade unions will be
successful in raising wages. It is applicable to other factors of production.

4. International Trade:

Elasticity of demand helps in finding out the terms of trade between two countries.
Terms of trade refers to the rate at which domestic commodity is exchanged for
foreign commodities. Terms of trade depends upon the elasticity of demand of the
two countries for each other goods.

5. Public Finance:

Elasticity of demand helps the government in formulating tax policies. For

example, for imposing tax on a commodity, the Finance Minister has to take into
account the elasticity of demand.

6. Nationalization:

The concept of elasticity of demand enables the government to decide about

nationalization of industries.

Methods of Measuring Elasticity of Demand :

 There are four methods of measuring elasticity of demand. They are the percentage method,

point method, arc method and expenditure method.

(1) The Percentage Method:

The price elasticity of demand is measured by its coefficient Ep. This coefficient Ep measures the

percentage change in the quantity of a commodity demanded resulting from a given percentage

change in its price: Thus

Where q refers to quantity demanded, p to price and ∆ to change. If Ep> 1, demand is elastic. If

Ep < 1, demand is inelastic, it Ep = 1 demand is unitary elastic.

With this formula, we can compute price elasticities of demand on the basis of a demand

schedule.

Table 11.1: Demand Schedule:

Combination Price (Rs.) per Kg. of X Quantity Kgs. of X

A 6 0

В 5 ————-► 10

С 4 20

D 3 ————-► 30

E 2 40

F 1 ————► 50

G 0 60

Let us first take combinations В and D.

(i) Suppose the price of commodity X falls from Rs. 5 per kg. to Rs. 3 per kg. and its quantity

demanded increases from 10 kgs. to 30 kgs. Then

This shows elastic demand or elasticity of demand greater than unitary.

Note: The formula can be understood like this:

In the formula, p refers to the original price (p,) and q to original quantity (q1). The opposite is

the case in example (ii) below, where Rs. 3 becomes the original price and 30 kgs. as the original

quantity.

(ii) Let us measure elasticity by moving in the reverse direction. Suppose the price of X rises

from Rs. 3 per kg. to Rs. 5 per kg. and the quantity demanded decreases from 30 kgs. to 10 kgs.

Then

This shows unitary elasticity of demand.

Notice that the value of Ep in example (ii) differs from that in example (i) depending on the

direction in which we move. This difference in the elasticities is due to the use of a different base

in computing percentage changes in each case.

Now consider combinations D and F.

(iii) Suppose the price of commodity X falls from Rs. 3 per kg. to Re. 1 per kg. and its quantity

demanded increases from 30 kgs. to 50 kgs. Then

This is again unitary elasticity.

(iv) Take the reverse order when the price rises from Re. 1 per kg. to Rs. 3 per kg. and the

quantity demanded decreases from 50 kgs. to 30 kgs. Then

This shows inelastic demand or less than unitary.

The value of Ep again differs in this example than that given in example (iii) for the reason stated

above.
(2) The Point Method:
Prof. Marshall devised a geometrical method for measuring elasticity at a point on the demand

curve. Let RS be a straight line demand curve in Figure 11.2. If the price falls from PB(=OA) to

MD(=OC). the quantity demanded increases from OB to OD. Elasticity at point P on the RS

demand curve according to the formula is: Ep = ∆q/∆p x p/q

Where ∆ q represents changes in quantity demanded, ∆p changes in price level while p and q are

initial price and quantity levels.

From Figure 11.2

∆ q = BD = QM

∆p = PQ

p = PB
q = OB

Substituting these values in the elasticity formula:

With the help of the point method, it is easy to point out the elasticity at any point along a

demand curve. Suppose that the straight line demand curve DC in Figure 11.3 is 6 centimetres.

Five points L, M, N, P and Q are taken oh this demand curve. The elasticity of demand at each

point can be known with the help of the above method. Let point N be in themiddle of the

demand curve. So elasticity of demand at point.

We arrive at the conclusion that at the mid-point on the demand curve the elasticity of demand is

unity. Moving up the demand curve from the mid-point, elasticity becomes greater. When the

demand curve touches the Y-axis, elasticity is infinity. Ipso facto, any point below the mid-point

towards the X-axis will show elastic demand.

Elasticity becomes zero when the demand curve touches the X-axis.

(3) The Arc Method:

We have studied the measurement of elasticity at a point on a demand curve. But when elasticity

is measured between two points on the same demand curve, it is known as arc elasticity. In the

words of Prof. Baumol, “Arc elasticity is a measure of the average responsiveness to price

change exhibited by a demand curve over some finite stretch of the curve.”

Any two points on a demand curve make an arc. The area between P and M on the DD curve in

Figure 11.4 is an arc which measures elasticity over a certain range of price and quantities. On

any two points of a demand curve the elasticity coefficients are likely to be different depending

upon the method of computation. Consider the price-quantity combinations P and M as given in

Table 11.2.
Table 11.2: Demand Schedule:

Point Price (Rs.) Quantity (Kg)

P 8 10

M 6 12

If we move from P to M, the elasticity of demand is:

If we move in the reverse direction from M to P, then

Thus the point method of measuring elasticity at two points on a demand curve gives different

elasticity coefficients because we used a different base in computing the percentage change in

each case.

(4) The Total Outlay Method:

Marshall evolved the total outlay, total revenue or total expenditure method as a measure of

elasticity. By comparing the total expenditure of a purchaser both before and after the change in
price, it can be known whether his demand for a good is elastic, unity or less elastic. Total outlay

is price multiplied by the quantity of a good purchased: Total Outlay = Price x Quantity

Demanded.
Uses of Price Elasticity of Demand in Business Decision Making :

Elasticity of demand is the sensitivity of quantity demanded of a commodity in

response to the change in factors related to that commodity.

Elasticity of demand may be of different types, depending upon the factor that is
responsible for causing the change in demand. Among them, price elasticity of
demand is one of the most common types and is also the most relevant to business.

Price elasticity of demand can be a useful tool for businessmen to make crucial
decisions like deciding the price of goods and services. It plays vital role in other
business procedures too. These uses are described below in brief.

1. Determination of price
The primary objective of any firm is to earn profit or increase revenue. Therefore,
increasing price of its products to maximize profit is one of the primary concerns
of producers.

However, during the course of increasing price, the producers must not forget that
demand and price share inverse relationship. They must be aware that demand falls
with rise in price. And thus, they must increase price of their commodity to that
level where their desired or optimal profit is still achievable.

From the example, it is clear that producers must always analyze elasticity of
their product and must evaluate the impact of changes in price on the total revenue
and profit of their firm.

2. Monopoly price determination

The situation where a single group or company controls all or almost all of
market for a particular good or service is called monopoly. The monopolistic
market lacks competition. Thus, the goods or services are often charged high prices
in such market.
 A monopolist while fixing the price of the market has to determine whether
its product is of elastic or inelastic nature.

If the product is inelastic (less or no effect on demand with change in price),

the producer can earn profit by setting high price. However, if the product is elastic
(highly affected by even slightest change in price), the producer must set low or at
least reasonable price so that the consumers are attracted to buy the goods.

For example: Fuel is necessity of consumers. Therefore, monopolist who runs the
market of fuel can generate profit even by setting high price of fuel.

On the other hand, tablet (gadget) is a luxury good. If the monopolist who
produces tablet, set high price of its product, he may not be able to sell its products.
But, with a slight drop in the price (setting lowest reasonable price), he can collect
large number of consumers and increase the profit of the company.

3. Price determination under discriminating monopoly

The situation where single group or company charges different prices for the
same commodity at different market is known as discriminating monopoly.

Suppose there is a company that produces air filtering masks. Right now, it
is selling in a competitive market where there are many similar products. In this
market, any increase in the price of the masks will drive the consumers to buy
other substitute products. Thus, the demand in this market is highly elastic.

Now if the same company starts selling the masks in a different country
where there aren’t any competing products, even with a high price, people will be
willing to buy it. Thus, the demand is inelastic and the company can sell its product
at a premium price.

In this way, we saw that the same product can be elastic in one market and
inelastic on the other. So, businesses need to study the elasticity based on the
market and make pricing decisions accordingly.
4. Price determination of joint products
Joint products are various products generated by a single production
procedure at a single time. Sheep and wool, cotton and cotton seeds, wheat and
hay, etc. are some examples of joint products. We cannot separate the cost of
producing wheat and hay, as producing wheat will automatically produce the hay
as well. However, since they are two different products, we cannot sell them at the
same price in the market. Price elasticity of demand plays important role in
determining the prices of these joint products.

Let us suppose, there has been bumper production of cotton this season. As a
result, huge amount of cotton as well as cotton seeds have been produced.

Cotton has wide scope in the market as it can be used for different purposes.
The producers of cotton can gain maximum profit by setting high price of cotton,
as demand of cotton in market is not easily altered. But cotton seeds have limited
scope, so it is an elastic product. If the business does not decrease the price, then
demand will be less.

By setting a high price for cotton (inelastic product) and low price for cotton seeds
(elastic product), the business can maximize its revenue.

This way, two or more products which are produced from single
manufacturing process may also have different nature of elasticity. And, producers
must evaluate the degree of elasticity of each product in order to extract maximum
profit from all products.

5. Wage determination
Labour is one of the major factors of production, and wage is the fixed
regular payment made to the labour in return of their input. Degree of elasticity of
commodity has potential to affect the wage to be paid to the labour.

If a commodity is of inelastic nature, the labour can force the employer to

increase their wage through extreme ways like strike. As a result, the company will
have to consider the demands of labour in order to meet the demand of consumers
for the inelastic goods.

However, if the commodity is of elastic nature, labour unions and other

associations cannot force the employers to raise wage as the producers can alter the
demand of their products.

6. International trade
We have already known that change in price cannot bring drastic change in
demand of the product in case of inelastic commodity. But even a slight change in
price can cause huge effect on demand of elastic commodity.

We have also known that higher price can be charged for inelastic goods and
lowest possible price must be set for elastic goods.

Taking into account the above information, a country may fix higher prices
for goods of inelastic nature. However, if the country wants to export its products,
the nature (elasticity/inelasticity) of the commodity in the importing country
should also be considered.

For example: Rice maybe an inelastic product for China and thus exports around
the world at the price “x”. But, if rice is price elastic in the US, China will be
forced to decrease the price from the initial value of “x” to be able to sell the
product in American market.

7. Importance to finance minister

Price elasticity of demand can also be used in the taxation policy in order to
gain high tax revenue from the citizens. One of the ways would be for the
government to raise tax revenue in commodities which are price inelastic.

For example: Government could increase the tax amount in goods like cigarettes
and alcohol. Given how these are the commodities people choose to purchase
regardless of the price tag, the tax revenue would significantly rise.
Demand Distinctions: Demand may be defined as the quantity of goods or
services desired by an individual, backed by the ability and willingness to pay.
Types of Demand:
1.Direct and indirect demand: demand for goods that are directly used for
consumption by the ultimate consumer is known as direct demand (example:
Demand for T shirts). On the other hand demand for goods that are used by
producers for producing goods and services. (example: Demand for cotton by
atextile mill)
2.Derived demand and autonomous demand: when a produce derives its usage
from the use of some primary product it is known as derived demand. (example:
demand for tyres derived from demand for car) Autonomous demand is the
demand for a product that can be independently used. (example: demand for a
washing machine)
3.Durable and nondurable goods demand: durable goods are those that can be
used more than once, over a period of time (example: Microwave oven)
Nondurable goods can be used only once (example: Band-aid)
4.Firm and industry demand: firm demand is the demand for the product of a
particular firm. (example: Dove soap) The demand for the product of a particular
industry is industry demand (example: demand for steel inIndia)
5.Total market and market segment demand: a particular segment of the
markets demand is called as segment demand (example: demand for laptops by
engineering students) the sum total of the demand for laptops by various segments
in India is the total market demand. (example: demand for laptops in India)
6.Short run and long run demand: short run demand refers to demand with its
immediate reaction to price changes and income fluctuations. Long run demand is
that which will ultimately exist as a result of the changes inpricing, promotion or
product improvement after market adjustment with sufficient time.
7.Joint demand and Composite demand: when two goods are demanded in
conjunction with one another at the same time to satisfy a single want, it is called
as joint or complementary demand. (example: demand for petrol and two wheelers)
A composite demand is one in which a good is wanted for several different uses.
(example: demand for iron rods for various purposes)
8.Price Demand: The ability and willingness to buy specific quantities of agood at
the prevailing price in a given time period.
9.Income Demand: The ability and willingness to buy a commodity at the
available income in a given period of time.
10.Market Demand: The total quantity of a good or service that people are
willing and able to buy at prevailing prices in a given time period. It is the sum of
individual demands.
11.Cross Demand: The ability and willingness to buy a commodity or service at
the prevailing price of the related commodity i.e. substitutes or complementary
products. For example, people buy more of wheat when the price of rice increases.

DEMAND FORECASTING :

Demand forecasting refers to an estimate of future demand for the product. It

is an objective assessment of the future course of demand, in recent times,
forecasting plays an important role in business decision – making. The survival and
prosperity of a business firm depend on its ability to meet the consumer’s needs
efficiently and adequately. Demand forecasting has an important influence on
production planning. It is essential for a firm to produce the required quantities at
the right time.

It is also essential to distinguish between forecasting of demand and forecast

of sales, sales forecasts are important for estimating revenue, cash requirements
and expenses whereas, demand forecasting relate to production, inventory control,
timing, reliability of forecast etc. however, there is not much difference between
these terms.

Types of demand Forecasting:

Based on the time span and planning requirements of business firms, demand
forecasting can be classified in to

1. Short-term demand forecasting and

2. Long – term demand forecasting.

1. Short-term demand forecasting:

Short-term demand forecasting is limited to short periods, usually for one year. It
relates to policies regarding sales, purchase, price and finances. It refers to existing
production capacity of the firm. Short-term forecasting is essential for formulating
is essential for formulating a suitable price policy. If the business people expect of
rise in the prices of raw materials of shortages, they may buy early. This price
forecasting helps in sale policy formulation. Production may be undertaken based
on expected sales and not on actual sales. Further, demand forecasting assists in
financial forecasting also. Prior information about production and sales is essential
to provide additional funds on reasonable terms.

2. Long – term forecasting:

In long-term forecasting, the businessmen should now about the long-term demand
for the product. Planning of a new plant or expansion of an existing unit depends
on long-term demand. Similarly a multi product firm must take into account the
demand for different items. When forecast are mode covering long periods, the
probability of error is high. It is vary difficult to forecast the production, the trend
of prices and the nature of competition. Hence quality and competent forecasts are
essential.

Features for good demand forecasting :

1. It is in terms of specific quantities

2. It is undertaken in an uncertain atmosphere.
3. A forecast is made for a specific period of time which would be sufficient to
take a decision and put it into action.
4 . It is based on historical information and the past data.
5. It tells us only the approximate demand for a product in the
future.
6. It is based on certain assumptions.
7. It cannot be 100% precise as it deals with future expected demand

Demand forecasting is the activity of estimating the quantity of a product or

service that consumers will purchase. Demand forecasting involves techniques
including both informal methods, such as educated guesses, and quantitative
methods, such as the use of historical sales data or current data from test markets.
Demand forecasting may be used in making pricing decisions, in assessing
future capacity requirements, or in making decisions on whether to enter a new
market

Objectives of Demand Forecasting:

Demand forecasting constitutes an important part in making crucial business
decisions.

The objectives of demand forecasting are divided into short and long-term
objectives, which are shown in Figure-1:

The objectives of demand forecasting (as shown in Figure-1) are discussed as

follows:

i. Short-term Objectives:

a. Formulating production policy:

Helps in covering the gap between the demand and supply of the product. The
demand forecasting helps in estimating the requirement of raw material in future,
so that the regular supply of raw material can be maintained. It further helps in
maximum utilization of resources as operations are planned according to forecasts.
Similarly, human resource requirements are easily met with the help of demand
forecasting.

b. Formulating price policy:

Refers to one of the most important objectives of demand forecasting. An

organization sets prices of its products according to their demand. For example, if
an economy enters into depression or recession phase, the demand for products
falls. In such a case, the organization sets low prices of its products.

c. Controlling sales:

Helps in setting sales targets, which act as a basis for evaluating sales performance.
An organization make demand forecasts for different regions and fix sales targets
for each region accordingly.

d. Arranging finance:

Implies that the financial requirements of the enterprise are estimated with the help
of demand forecasting. This helps in ensuring proper liquidity within the
organization.

ii. Long-term Objectives:

a. Deciding the production capacity:

Implies that with the help of demand forecasting, an organization can determine
the size of the plant required for production. The size of the plant should conform
to the sales requirement of the organization.

b. Planning long-term activities:

Implies that demand forecasting helps in planning for long term. For example, if
the forecasted demand for the organization’s products is high, then it may plan to
invest in various expansion and development projects in the long term
Methods of forecasting:

Several methods are employed for forecasting demand. All these methods can be grouped
under survey method and statistical method. Survey methods and statistical methods are
further subdivided in to different categories.

1. Survey Method:

Under this method, information about the desires of the consumer and opinion of exports are
collected by interviewing them. Survey method can be divided into four types viz., Opinion
survey method; expert opinion; Delphi method and consumers interview methods.

a. Opinion survey method:

This method is also known as sales-force composite method (or) collective opinion method.
Under this method, the company asks its salesman to submit estimate of future sales in their
respective territories. Since the forecasts of the salesmen are biased due to their optimistic or
pessimistic attitude ignorance about economic developments etc. these estimates are
consolidated, reviewed and adjusted by the top executives. In case of wide differences, an
average is struck to make the forecasts realistic.

B. Expert opinion method:

Apart from salesmen and consumers, distributors or outside experts may also e used for
forecasting. In the United States of America, the automobile companies get sales estimates
directly from their dealers. Firms in advanced countries make use of outside experts for
estimating future demand. Various public and private agencies all periodic forecasts of short
or long term business conditions.

C. Delphi Method:

A variant of the survey method is Delphi method. It is a sophisticated method to arrive at a

consensus. Under this method, a panel is selected to give suggestions to solve the problems
in hand. Both internal and external experts can be the members of the panel. Panel members
one kept apart from each other and express their views in an anonymous manner. There is
also a coordinator who acts as an intermediary among the panelists. He prepares the
questionnaire and sends it to the panelist. At the end of each round, he prepares a summary
report.
 D. Consumers interview method:

In this method the consumers are contacted personally to know about their plans
and preference regarding the consumption of the product. A list of all potential
buyers would be drawn and each buyer will be approached and asked how much he
plans to buy the listed product in future. He would be asked the proportion in
which he intends to buy. This method seems to be the most ideal method for
forecasting demand.

2. Statistical Methods:

Statistical method is used for long run forecasting. In this method, statistical and
mathematical techniques are used to forecast demand. This method relies on post
data.

a. Time series analysis or trend projection methods:

A well-established firm would have accumulated data. These data are analyzed to
determine the nature of existing trend. Then, this trend is projected in to the future
and the results are used as the basis for forecast. This is called as time series
analysis. This data can be presented either in a tabular form or a graph. In the time
series post data of sales are used to forecast future.

b. Barometric Technique:

Simple trend projections are not capable of forecasting turning paints. Under
Barometric method, present events are used to predict the directions of change in
future. This is done with the help of economics and statistical indicators. Those are
(1) Construction Contracts awarded for building materials (2) Personal income(3)
Agricultural Income.(4) Employment (5) Gross national income (6) Industrial
Production (7) Bank Deposits etc.

c. Regression and correlation method:

Regression and correlation are used for forecasting demand. Based on post data the
future data trend is forecasted. If the functional relationship is analyzed with the
independent variable it is simple correction. When there are several independent
variables it is multiple correlation. In correlation we analyze the nature of relation
between the variables while in regression; the extent of relation between the
variables is analyzed. The results are expressed in mathematical form.

Steps of Demand Forecasting:

The Demand forecasting process of an organization can be effective only when it is
conducted systematically and scientifically.

It involves a number of steps, which are shown in Figure-3:

The steps involved in demand forecasting (as shown in Figure-3) are explained
as follows:

1. Setting the Objective:

Refers to first and foremost step of the demand forecasting process. An

organization needs to clearly state the purpose of demand forecasting before
initiating it.

Setting objective of demand forecasting involves the following:

a. Deciding the time period of forecasting whether an organization should opt for
short-term forecasting or long-term forecasting

b. Deciding whether to forecast the overall demand for a product in the market or
only- for the organizations own products

c. Deciding whether to forecast the demand for the whole market or for the
segment of the market

d. Deciding whether to forecast the market share of the organization

2. Determining Time Period:

Involves deciding the time perspective for demand forecasting. Demand can be
forecasted for a long period or short period. In the short run, determinants of
demand may not change significantly or may remain constant, whereas in the long
run, there is a significant change in the determinants of demand. Therefore, an
organization determines the time period on the basis of its set objectives.

3. Selecting a Method for Demand Forecasting:

Constitutes one of the most important steps of the demand forecasting process
Demand can be forecasted by using various methods. The method of demand
forecasting differs from organization to organization depending on the purpose of
forecasting, time frame, and data requirement and its availability. Selecting the
suitable method is necessary for saving time and cost and ensuring the reliability of
the data.

4. Collecting Data:

Requires gathering primary or secondary data. Primary data refers to the data that
is collected by researchers through observation, interviews, and questionnaires for
a particular research. On the other hand, secondary data refers to the data that is
collected in the past; but can be utilized in the present scenario/research work.

5. Estimating Results:

Involves making an estimate of the forecasted demand for predetermined years.

The results should be easily interpreted and presented in a usable form. The results
should be easy to understand by the readers or management of the organization.

SUPPLY ANALYSIS

SUPPLY
 When price changes, quantity supplied will change. That is a movement along
the same supply curve. When factors other than price changes, supply curve will
shift. Here are some determinants of the supply curve.

Determinants of supply :

1. Production cost:

Since most private companies’ goal is profit maximization. Higher production cost
will lower profit, thus hinder supply. Factors affecting production cost are: input
prices, wage rate, government regulation and taxes, etc.

2. Technology:

Technological improvements help reduce production cost and increase profit, thus
stimulate higher supply.

3. Number of sellers:

More sellers in the market increase the market supply.

4. Expectation for future prices:

If producers expect future price to be higher, they will try to hold on to their
inventories and offer the products to the buyers in the future, thus they can capture
the higher price.

Definition of 'Law Of Supply'

Definition: Law of supply states that other factors remaining constant, price and
quantity supplied of a good are directly related to each other. In other words, when
the price paid by buyers for a good rises, then suppliers increase the supply of that
good in the market.

Description: Law of supply depicts the producer behavior at the time of changes in
the prices of goods and services. When the price of a good rises, the supplier
increases the supply in order to earn a profit because of higher prices.
The above diagram shows the supply curve that is upward sloping (positive
relation between the price and the quantity supplied). When the price of the good
was at P3, suppliers were supplying Q3 quantity. As the price starts rising, the
quantity supplied also starts rising.

The supply curve is a graphical representation of the relationship between the

price of a good or service and the quantity supplied for a given period of time. In a
typical representation, the price will appear on the left vertical axis, the quantity
supplied on the horizontal axis.

Supply Function

The supply function is the mathematical expression of the relationship between

supply and those factors that affect the willingness and ability of a supplier to offer
goods for sale

SX = Supply of goods

PX = Price

PF = Factor input employed (used) for production.

• Raw material
 • Human resources

• Machinery

O = Factors outside economic sphere.

T = Technology. t = Taxes.

S = Subsidies

There is a functional (direct) relationship between price and supply.