CHAPTER -THREE(3)

DEMAND AND DEMAND

FORE-CASTING
Demand and demand forecasting
1. Demand
2. Law of demand
3. Demand Schedule
4. Determinants of Demand
5. Demand Elasticity
 Meaning
 Demand refers to the total or given quantity of a commodity that are
purchased by consumers in the market at a particular price at a
particular time.
 Demand for a commodity implies:
 Desire to acquire it,
 Willingness to pay for it and
 Ability to pay for it.
 The demand for any commodity is the desire for that commodity
backed by willingness as well as ability to pay for it, and is always
defined with reference to a particular time and given values of
variables on which it depends.
 Law of Demand
 In economics, demand is the desire to own anything and the ability to pay
for it.
 The term demand signifies the ability or the willingness to buy a particular
commodity at a given point of time. Demand is also defined elsewhere as a
measure of preferences that is weighted by income.
 Economists record demand on a demand schedule and plot it on a graph as an
inverse (downward sloping) demand curve.
 The inverse curve reflects the relationship between price and demand: as
price decreases, demand increases. The demand curve is equal to the
marginal utility (benefit) curve.
 If there are no externalities, the demand curve is also equal to the social utility
(benefit) curve.
Note:
The demand function is the mathematical expression of the relationship between demand and
those factors that affect the willingness and ability of a consumer to buy goods.
Demand Curve
 In economics, the demand curve can be defined as the
graph depicting the relationship between the price of a
certain commodity, and the amount of it that
consumers are willing and able to purchase at that
given price.
 It is a graphic representation of a demand schedule.
The demand curve for all consumers together follows
from the demand curve of every individual consumer:
the individual demands at each price are added
together.
Demand Curve
 Demand curves are used to estimate behaviour in competitive
markets, and are often combined with supply curves to
estimate the equilibrium price (the price at which sellers
together are willing to sell the same amount as buyers together
are willing to buy, also known as market clearing price) and the
equilibrium quantity (the amount of that good or service that
will be produced and bought without surplus/excess supply or
shortage/excess demand) of that market.
 Demand Curve
 The relationship of price and quantity demanded can be exhibited graphically as the
demand curve.
 The curve is generally negatively sloped.
 The curve depicts the relationship between two variables only; price and quantity
demanded.
 All other factors affecting demand are held constant.
 However, these factors are part of the demand curve and are present in the intercept.
 Economics puts the independent variable on the y-axis and the dependent variable on
the x=axis.
 Consequently, the graphical presentation is of the inverse demand function = P = f (Q).
 Causes of shifts in demand

1. Changes in disposable income

2. Changes in taste and fashion
3. The availability and cost of credit
4. Changes in the prices of related goods (substitutes and complements)
5. Population size and composition
6. Expectations
7. Change in education level.
8. Change in the geographical situation of buyers
9. Change in climate or weather
Changes that increase demand

 Some circumstances which can cause the demand curve to shift out
include:
1. Increase in price of a substitute
2. Decrease in price of complement
3. Increase in income if good is a normal good
4. Decrease in income if good is an inferior good
5. Increase in number of customers
Changes that decrease demand

 Some circumstances which can cause the demand curve to

shift in include:
1. Decrease in price of a substitute
2. Increase in price of a complement
3. Decrease in income if good is normal good
4. Increase in income if good is inferior good
5. Decrease in number of customers
 Assumptions
 Every law will have limitation or exceptions. While expressing the law of demand, the
assumptions that other conditions of demand were unchanged. If remain constant, the
inverse relation may not hold well. In other words, it is assumed that the income and tastes
of consumers and the prices of other commodities are constant. This law operates when the
commodity’s price changes and all other prices and conditions do not change.
 The main assumptions are:
1. Habits, tastes and fashions remain constant
2. Money, income of the consumer does not change.
3. Prices of other goods remain constant
4. The commodity in question has no substitute
5. The commodity is a normal good and has no prestige or status value.
6. People do not expect changes in the prices.
Reasons for negative slope of demand
1) It has been observed in preceding discussions that both individuals and market
demand curve slopes downward, from left to right. But why? There are, of
course, some reasons:
2) When the price of a commodity falls, new buyers purchase that commodity at
the lower price; the demand, therefore, is greater.
3) When the price of a commodity falls, people demand more of it, perhaps to
put it to alternate uses as well. For an example, when the price per unit of
electricity falls, we are likely to use more electrical appliances, which results
in an increase in the demand for electricity.
4) On the other hand, if the price of a commodity goes up, people go in for
substitutes. This is why the characteristic feature of the demand curve is to
slope downward from left to right.
 Reasons for negative slope of demand
5. When prices fall, old consumers buy more and some of the consumers (who could
purchase earlier due to higher prices) now enter the market.
6. There may be some situations in which the demand curve slopes upward from left to right
instead of sloping downward from left to right. In other words, the demand curve rises
instead of falling. This means that, if prices rise, consumers buy more of that commodity.
This phenomenon is associated with Giffen, and may occur in the following situations:
7. When people anticipate a shortage of a commodity, they buy more of the commodity even
if the price rises;
8. When the commodity attains a distinction, people may buy more despite a rise in the price
of that commodity
Determinants of Demand
1. Price of the product
2. Level of income of the consumers
3. Quality of the product
4. Taste and preference of the consumers
5. Advertisement of the product
6. Credit facility available for the consumer
7. Price of related goods
8. Country’s population
9. Demonstration effect and ‘band –wagon effect’
10. Educational standards of the purchasers
11. New innovations and inventories
Demand determinants...cont’d
12. Future trends in prices
13. Profit margin
14. Living standards and level of income
15. Weather and climatic conditions
16. Consumer’s level of savings and their expenditure pattern
17. Money circulation in the economy
18. Preference of liquidity
19. Trade conditions
20. Institutional factors
 Demand Elasticity
1. In economics, elasticity is the ratio of the percent change in one variable to the
percent change in another variable.
2. It is a tool for measuring the responsiveness of a function to changes in
parameters in a relative way.
3. Commonly analysed are elasticity of substitution, price and wealth.
4. Elasticity is a popular tool among empiricists because it is independent of units
and thus simplifies data analysis.
5. An "elastic" good is one whose price elasticity of demand has a magnitude
greater than one. Similarly, "unit elastic" and "inelastic" describe goods with price
elasticity having a magnitude of one and less than one respectively
Demand Elasticity
1. The degree to which a demand or supply curve reacts to a change in price is
the curve's elasticity.
2. Elasticity varies among products because some products may be more
essential to the consumer.
3. Products that are necessities are more insensitive to price changes
because consumers would continue buying these products despite price
increases.
4. Conversely, a price increase of a good or service that is considered less of
a necessity will deter more consumers because the opportunity cost of
buying the product will become too high.
Elasticity
1. A good or service is considered to be highly elastic if a slight change in
price leads to a sharp change in the quantity demanded or supplied.
2. Usually these kinds of products are readily available in the market and a
person may not necessarily need them in his or her daily life.
3. On the other hand, an inelastic good or service is one in which changes
in price witness only modest changes in the quantity demanded or
supplied, if any at all.
4. These goods tend to be things that are more of a necessity to the
consumer in his or her daily life.
Price elasticity of demand (PED)

1. PED is a measure of the sensitivity of the quantity

variable, Q, to changes in the price variable, P.
2. Elasticity answers the question of how much the quantity
will change in percentage terms for a 1% change in the
price.
3. The formula for calculating PED is : ( ∂Q/∂P).
 Determinants of PED
 Availability of substitutes: If the price of Pepsi goes up by 20%, one can
always purchase Coke, 7-Up and so forth
 Necessity: Insulin is the ultimate necessity.
 Proportion of income spent on a good: A consumer will give more
time and thought to the purchase of a $3000 television than a $1 candy
bar.
 Duration
 Breadth of definition: How specifically the good is defined. For example, the
demand for automobiles is more elastic than the demand for Toyotas which is in
turn greater than the demand for Red Toyota Priuses
 Availability of Information Concerning Substitute Goods
Income elasticity of demand (YED)
1. In economics, the income elasticity of demand measures the
responsiveness of the demand of a good to the change in the
income of the people demanding the good.
2. It is calculated as the ratio of the percent change in demand
to the percent change in income.
3. For ex: if, in response to a 10% increase in income, the
demand of a good increased by 20%, the income elasticity
of demand would be 20%/10% = 2.
Income Elasticity of Demand
1. A negative income elasticity of demand is associated with inferior goods;
an increase in income will lead to a fall in the demand and may lead to
changes to more luxurious substitutes.
2. A positive income elasticity of demand is associated with normal goods;
an increase in income will lead to a rise in demand. If income elasticity of
demand of a commodity is less than 1, it is a necessity good. If the
elasticity of demand is greater than 1, it is a luxury good or a superior
good.
3. A zero income elasticity (or inelastic) demand occurs when an increase in
income is not associated with a change in the demand of a good. These
would be sticky goods.
Factors that make demand for good elastic
1. There are many substitutes.
2. The substitutes are readily obtainable.
3. The good is a necessity - it is something you have to have.
4. The good is important in terms of proportion of income spent of
the goods.
5. The consumer had plenty of time to search for the substitutes.
Factors that make demand for a good inelastic
1. There are few substitutes.
2. Substitutes are difficult to obtain.
3. The good is a luxury - it is something you can do
without.
4. The good is unimportant.
5. The consumer has little time or inclination to
search for substitute.
Interpreting price Elasticity of demand
1. The coefficient of elasticity indicates how sensitive the demand for a good is to a price
change.
2. If the PED is between zero and 1 demand is said to be inelastic,
3. if PED equals 1, the demand is unitary elastic and
4. if the PED is greater than 1 demand is elastic
Income elasticity of demand
1. The income elasticity of demand measures the demand response to a change
in income all other determinants of demand being held constant.
2. Income is a non-price determinant of demand.
3. Therefore a change in income will cause a shift in the demand curve.
4. If income increases the demand curve will shift out (for normal goods).
Income decreases will induce a decrease in demand - the curve shifts inward.
5. PED measures the magnitude of this shift in relative terms. If the coefficient
of elasticity is greater than one the response is elastic.
6. If the coefficient is less than one the response is inelastic
 Types of Elasticity of demand
1. Price elasticity of demand (PED)
2. This is one of the important concepts, which is very useful for producers, farmers,
Government and workers.
3. In the words of Prof. Stonier and Hague, “Price elasticity of demand is a technical
term used by economists to describe the degree of responsiveness of the demand for
a commodity to a change in its price”.
4. The price elasticity of demand is a ratio of two pure numbers, the numerator is the
percentage change in quantity demanded and the denominator is the percentage change
in price of the commodity.
5. It is measured by the following formula:
PED= Percentage change in quantity demanded
Percentage change in price
Income Elasticity of Demand
1. This may be defined as the ratio or proportionate change in the quantity
demanded of a commodity to a given proportionate change in the income.
2. In short, it indicates the extent to which demand changes with a variation in
consumer’s income.
3. The formula, which helps to measure, this is given as follows:

4. Income Elasticity of Demand = Percentage change in demand

Percentage change in income
Cross Elasticity of Demand

1. This may be defined as the proportionate change in the quantity

demanded of a particular commodity in response to a change in the
price of another related commodity.
2. The formula for calculating cross elasticity of demand is as follows:

3. CED =Percentage change in quantity demanded of commodity A

Percentage change in the price of commodity B
Advertising or Promotional Elasticity of demand

1. This refers to the proportionate change in demand or sales to a

given change in advertising outlay.
2. The formula to calculate the advertising elasticity is as follows:

3. AED = Percentage change in demand or sales

Percentage change in Advertisement expenditure
Substitution Elasticity of Demand
1. It may be defined as the proportionate change in the ratio of two
substitute goods A and B to the proportionate change in their price ratio.
2. The formula for calculating this is as follows:

SED= Percentage change in the demand ratio of two goods A & B

Percentage change in the price ratios of two goods A &B
Determinants of elasticity of demand
1. Nature of the commodity ( Salt Vs Car)
2. Substitutes (Coffee Vs Tea)
3. Deferred consumption (When the price of motorcycle comes down I may buy
it)
4. Variety of uses(coal, milk, electricity )
5. Level of prices
6. Time factor
7. Income group
8. Proportion of income spent
9. Joint demand (The elasticity of demand for ink depends directly on the nature of
elasticity of demand for pens)
10. Habits (Liquor, cigarettes)
11. Reparable commodities (Fans, furniture Vs Cheap electronic )
Forecasting methods are classified into two groups:
Qualitative Methods
Type Characteristics Strengths Weaknesses
Executive A group of managers Good for strategic or One person's opinion
opinion meet & come up with new-product can dominate the
a forecast forecasting forecast

Market Uses surveys & Good determinant of It can be difficult to

research interviews to identify customer preferences develop a good
customer preferences questionnaire

Delphi Seeks to develop a Excellent for Time consuming to

method consensus among a forecasting long-term develop
group of experts product demand,
technological
changes, and
Quantitative Methods
 Time Series Models:
 Assumes information needed to generate a forecast is contained
in a time series of data
 Assumes the future will follow same patterns as the past
 Causal Models or Associative Models
 Explores cause-and-effect relationships
 Uses leading indicators to predict the future
 Housing starts and appliance sales
Time Series Models

 Forecaster looks for data patterns as

 Data = historic pattern + random variation

 Historic pattern to be forecasted:

 Level (long-term average) – data fluctuates around a constant mean
 Trend – data exhibits an increasing or decreasing pattern
 Seasonality – any pattern that regularly repeats itself and is of a constant length
 Cycle – patterns created by economic fluctuations

 Random Variation cannot be predicted

Time Series Patterns
 Time Series Models
 Naive: Ft 1  At
 The forecast is equal to the actual value observed during the last period –
good for level patterns
 Simple Mean: Ft 1   A t / n

 The average of all available data - good for level patterns

 Moving Average: Ft 1   A t / n

 The average value over a set time period

(e.g.: the last four weeks)
 Each new forecast drops the oldest data point & adds a new observation
 More responsive to a trend but still lags behind actual data
Time Series Models con’t
 Weighted Moving Average: Ft 1   Ct A t

 All weights must add to 100% or 1.00

e.g. Ct .5, Ct-1 .3, Ct-2 .2 (weights add to 1.0)
 Allows emphasizing one period over others; above indicates more
weight on recent data (Ct=.5)
 Differs from the simple moving average that weighs all periods
equally - more responsive to trends
 Time Series Models con’t
 Exponential Smoothing: Ft 1  αA t  1  α Ft
Most frequently used time series method because of ease of use and
minimal amount of data needed
 Need just three pieces of data to start:
 Last period’s forecast (Ft) 

 Last periods actual value (At)

 Select value of smoothing coefficient, ,between 0 and 1.0
 If no last period forecast is available, average the last few periods or
use naive method
 Higher values (e.g. 0.7 or 0.8) may place too much weight on last
period’s random variation
 Time Series Problem
Period Actual
 Determine forecast for periods 7 & 8
1 300
 2-period moving average
2 315
 4-period moving average
3 290
 2-period weighted moving average with t-1 weighted 0.6
4 345
and t-2 weighted 0.4
5 320
 Exponential smoothing with alpha=0.2 and the period 6
forecast being 375 6 360
7 375
8
 Time Series Problem Solution

Period Actual 2-Period 4-Period 2-Per.Wgted. Exponential Smooth.

1 300
2 315
3 290
4 345
5 320
6 360
7 375 340.0 328.8 344.0 372.0
8 367.5 350.0 369.0 372.6
Forecasting trend problem: a company uses exponential smoothing with trend to
forecast usage of its lawn care products. At the end of July the company wishes to
forecast sales for August. July demand was 62. The trend through June has been 15
additional gallons of product sold per month. Average sales have been 57 gallons
per month. The company uses alpha+0.2 and beta +0.10. Forecast for August.

 Smooth the level of the series:

S July  αA t  (1  α)(St 1  Tt 1 )  0.262  0.857  15  70

 Smooth the trend:

TJuly  β(St  St 1 )  (1  β)Tt 1  0.170  57   0.9 15  14.8
 Forecast including trend:

FITAugust  S t  Tt  70  14.8  84.8 gallons

Linear Trend Line
A time series technique that computes a forecast with trend by drawing a straight
line through a set of data using this formula:
Y = a + bx where
Y = forecast for period X
X = the number of time periods from X = 0
A = value of y at X = 0 (Y intercept)
B = slope of the line
 Forecasting Trend
 Basic forecasting models for trends compensate for the lagging that would otherwise
occur
 One model, trend-adjusted exponential smoothing uses a three step process
 Step 1 - Smoothing the level of the series

S t  αA t  (1  α)(S t 1  Tt 1 )
 Step 2 – Smoothing the trend

Tt  β(S t  S t 1 )  (1  β)Tt 1
 Forecast including the trend

FITt 1  S t  Tt
Forecasting Seasonality

 Calculate the average demand per season

 E.g.: average quarterly demand
 Calculate a seasonal index for each season of each year:
 Divide the actual demand of each season by the average demand per
season for that year
 Average the indexes by season
 E.g.:take the average of all Spring indexes, then of all Summer
indexes, ...
Seasonality con’t
 Forecast
demand for the next year & divide by the
number of seasons
 Use regular forecasting method & divide by four for
average quarterly demand
 Multiplynext year’s average seasonal demand by
each average seasonal index
 Result is a forecast of demand for each season of next
year
Seasonality problem: a university must develop forecasts for the next year’s quarterly
enrollments. It has collected quarterly enrollments for the past two years. It has also
forecast total enrollment for next year to be 90,000 students. What is the forecast for
each quarter of next year?

Quarter Year 1 Seasonal Year 2 Seasonal Avg. Year3

Index Index Index
Fall 24000 1.2 26000 1.238 1.22 27450

Winter 23000 22000

Spring 19000 19000

Summer 14000 17000

Total 80000 84000 90000

Average 20000 21000 22500

 Causal Models
 Often, leading indicators can help to predict changes in future demand
e.g. housing starts
 Causal models establish a cause-and-effect relationship between
independent and dependent variables
 A common tool of causal modeling is linear regression:
 Additional related variables may require multiple regression modeling

Y  a  bx
Linear Regression

 Identify dependent (y) and independent (x)

variables
 XY  X  Y 
b
 X 2  X  X   Solve for the slope of the line

b
 XY  n XY

 X  nX
2 2

 Solve for the y intercept

a  Y  bX
 Develop your equation for the trend line
Y=a + bX
Linear Regression Problem: A maker of golf shirts has been tracking the relationship
between sales and advertising dollars. Use linear regression to find out what sales might
be if the company invested $53,000 in advertising next year.

Sales $ Adv.$ XY X^2 Y^2 b

 XY  n XY

 X  nX
2
(Y) (X) 2

1 130 32 4160 2304 16,900

28202  447.25147.25
2 151 52 7852 2704 22,801 b  1.15
9253  447.25
2

3 150 50 7500 2500 22,500

a  Y  b X  147.25  1.1547.25
4 158 55 8690 3025 24964
a  92.9
5 153.85 53 Y  a  bX  92.9  1.15X
Tot 589 189 28202 9253 87165 Y  92.9  1.1553  153.85
Avg 147.25 47.25
Correlation Coefficient How Good is the Fit?
 Correlation coefficient (r) measures the direction and strength of the linear relationship
between two variables. The closer the r value is to 1.0 the better the regression line fits the data
points.
n XY    X  Y 
r
 X    X  Y   Y 
2 2
2 2
n * n
428,202  189589
r  .982
4(9253)- (189) * 487,165  589
2 2

r 2  .982  .964
2

 Coefficient of determination ( r 2 ) measures the amount of variation in the dependent variable

about its mean that is explained by the regression line. Values of (r 2 ) close to 1.0 are desirable.
 Measuring Forecast Error
 Forecasts are never perfect
 Need to know how much we should rely on our chosen forecasting
method
 Measuring forecast error:

E t  A t  Ft
 Note that over-forecasts = negative errors and under-forecasts =
positive errors
Measuring Forecasting Accuracy
 Mean Absolute Deviation (MAD)
 measures the total error in a forecast without regard MAD 
 actual  forecast
to sign n
 Cumulative Forecast Error (CFE)
 Measures any bias in the forecast CFE   actual  forecast
 Mean Square Error (MSE)
 Penalizes larger errors
 actual - forecast2

 Tracking Signal MSE 

 Measures if your model is working n
CFE
TS 
MAD
Accuracy & Tracking Signal Problem: A company is comparing the accuracy of two
forecasting methods. Forecasts using both methods are shown below along with the actual
values for January through May. The company also uses a tracking signal with ±4 limits to
decide when a forecast should be reviewed. Which forecasting method is best?

Method A Method B
Month Actual F’cast Error Cum. Tracking F’cast Error Cum. Tracking
sales Error Signal Error Signal

Jan. 30 28 2 2 2 27 2 2 1

Feb. 26 25 1 3 3 25 1 3 1.5
March 32 32 0 3 3 29 3 6 3
April 29 30 -1 2 2 27 2 8 4
May 31 30 1 3 3 29 2 10 5

MAD 1 2
MSE 1.4 4.4
Selecting the Right Forecasting Model

1. The amount & type of available data

 Some methods require more data than others
2. Degree of accuracy required
 Increasing accuracy means more data
3. Length of forecast horizon
 Different models for 3 month vs. 10 years
4. Presence of data patterns
 Lagging will occur when a forecasting model meant for a level
pattern is applied with a trend