Managerial Economics

Part 2: Demand and Analysis

 DEMAND ANALYSIS

• Demand Theory

• Demand Estimation

• Demand Forecasting
 Demand Analysis: Demand Theory
An Individual’s Demand for a Commodity
This depends on the size of the total market or industry
demand for the commodity, which in turn is the sum of the
demands for the commodity of the individual consumers in the
market. Thus, we begin by examining the theory of consumer
demand in order to learn about the market demand, on which the
demand for the product faced by a particular firm depends. The
analysis is general and refers to almost any type of commodity
(good or service).
 The demand for a commodity arises from the consumers’
willingness and ability (i.e., from their desire or want for the
commodity backed by the income) to purchase the commodity.
Consumer demand theory postulates that the quantity demanded
of a commodity is a function of, or depends on,
 price of the commodity,
 Consumer’s income
 Price of related (i.e., complementary and substitute)
commodities
 Tastes of the consumer
Qdx = f (Px, I, PY , T)
Even the most unsophisticated of managers has probably had
occasion to observe that when the firm increases the price of a
commodity, sales generally decline. He or she also knows that the
firm would probably sell more units of the commodity by
lowering the price. Thus, he or she expects an inverse
relationship between the quantity demand of a commodity and
its price. That is, when the price rises, the quantity purchased
declines, and when the price falls, the quantity sold increases.
When a consumer’s income rises, he
or she usually purchases more of
most commodities. These are
known as normal goods.

Consumer purchases less as income

rises are referreed to as inferior
goods.
The quantity demanded of a commodity by an individual also
depends on the price of related commodities. The individual will
purchase more of a commodity if the price of a substitute
commodity increases or if the price of a complementary
commodity falls.
Consumer demand theory postulates that the
quantity demanded of a commodity per time period
increases with a reduction in its price, with an
increase in the consumer’s income, with an
increase in the price of substitute commodities
and a reduction in the price of complementary
commodities, and with an increased taste for the
commodity. On the other hand, the quantity
demanded of a commodity declines with the
opposite changes.
Assuming, for the moment, that the individual’s income, the price
of related commodities, and tastes are unchanged. The inverse
relationship between the price and the quantity demanded of the
commodity, and the plot of data (with price on the vertical axis
and the quantity on the horizontal axis) gives the corresponding
individual’s demand curve.
The inverse relationship between the price of the commodity and
the quantity demanded per time period is referred to as the law of
demand.
 From Individual to Market Demand

People sometimes demand a commodity because others are

purchasing it and in order to be “fashionable”. The result is
bandwagon effect to “keep up with the Joneses”. This tends to
make the market demand curve flatter than indicated by the
simple horizontal summation of the individual’s demand curves.
At other times, the opposite, or snob effect, occurs as many
consumers seek to be different and exclusive by demanding less
of a commodity as more people consume it. This tends to make
the market demand curve steeper than indicated by the horizontal
summation of the individuals’ demand curves.
 The Demand Faced by a Firm

The demand for a commodity faced by a particular firm

depends on the size of the market or industry demand
for the commodity, the form in which the industry is
organized, and the number of firms in the industry.
If the firm is the sole producer of a commodity for which there
are no goods substitutes (i.e., if the firm is a monopolist), the
firm is or represents the industry and faces the industry or market
demand for the commodity. Monopoly is rare in the real world,
and, when it does occur, it is usually the result of a government
franchise, which is accompanied by government regulation.
Examples: local telephone, electricity, public transportation, and
other public utility companies. At the opposite extreme is the
form of market organization called perfect competition. Here,
are a large number of firms producing a homogenous (identical)
product
The demand for a firm’s product also depends on the type of
product that the firm sells. If the firm sells durable goods (such as
automobiles, washing machines, and refrigerators that provide
services not only during the year when they are purchased but
also in subsequent years, or goods that can be stored), the firm
will generally face a more volatile or unstable demand than a firm
selling nondurable goods.
 Price Elasticity of Demand

Point Price Elasticity of Demand

Price elasticity of demand is a measurement of the change in
consumption of a product in relation to a change in its price.
The price elasticity of demand
(Ep) is given by the percentage
change in the quantity
demanded of the commodity
divided by the percentage
change in its price, holding
constant all the other variables
in the demand function. That is,
Price Elasticity, Total Revenue, and Marginal Revenue

There is important relationship between price elasticity

of demand and the firm's total revenue and marginal
revenue. Total Revenue (TR) is equal to (P) times
Quantity (Q), while Marginal Revenue (MR) is the
change in total revenue per unit change in output or
sales (quantity demanded). That is,
TR = P · Q
MR = ∆TR / ∆Q
 Factors Affecting the Price Elasticity of Demand

The price elasticity of demand for a commodity depends

primarily on the availability of substitutes for the commodity
but also on the length of time over which the quantity
response to the price change is measured. The size of the price
elasticity of demand is larger the closer and the greater is the
number of available substitutes for the commodity.
 INCOME ELASTICITY OF DEMAND
We can measure the responsiveness in the
demand for a commodity to a change in
consumers’ income by the income elasticity of
demand (EI). This is given by the percentage
change in the demand for the commodity
divided by the percentage change in income,
holding constant all the other variables in the
demand function, including price. As with price
elasticity, we have point and arc income
elasticity. Point income elasticity of demand is
given by
 CROSS-PRICE ELASTICITY OF DEMAND
The demand for a commodity also depends on the price of related (i.e.,
substitute and complementary) commodities.For example, if the price of
tea rises, the demand for coffee increases (i.e., shifts to the right, and
more coffee is demanded at each coffee price) as consumers substitute
coffee for tea in consumption. On the other hand, if the price of sugar (a
complement of coffee) rises, the demand for coffee declines (shifts to the
left so that less coffee is demanded at each coffee price) because the
price of a cup of coffee with sugar is now higher.
We can measure the responsiveness in the demand for commodity X
to a change in the price of commodity Y with the cross-price elasticity
of demand (EXY).
EXY = ∆QX / QX = ∆QX · PY
∆PY / PY ∆PY · QX
USING ELASTICITIES IN MANAGERIAL DECISION MAKING
The analysis of the forces or variables that affect demand and reliable
estimates of their quantitative effect on sales are essential for the firm to
make the best operating decisions and to plan for its growth. Some
of the forces that affect demand are under the control of the firm, while
other are not. A firm can usually set the price of the commodity it sells
and decide on the level of its expenditures on advertising, product quality,
and customer service, but it has no control over the level and growth of
consumers’ incomes, consumers’ price expectations, competitors’ pricing
decisions, and competitors’ expenditures on advertising, product quality,
and customer service. The firm can estimate the elasticity of demand with
respect to all the forces or variables that affect the demand for the
commodity that the firm sells. The firm needs these elasticity estimates in
order to determine the optimal operational policies and the most effective
way to respond to the policies of competing firms.
 ELECTRONIC COMMERCE
E-commerce refers to the production, advertising, sale, and distribution of
products and services from business to business and from business to
consumers through the Internet. This has sharply reduced time and distance
barriers between buyers and sellers. In e-commerce, there is no traveling to
a traditional “brick-and-mortar” store, no salesperson, no order book, and
no cash register – only the Web site. This offers tremendous advantages to
buyers and sellers interact in the marketplace.
The biggest lures for consumers are the convenience of
having round-the-clock access to the virtual store and
being able to engage in comparative shopping at minimal
cost and effort.
Behind the Market Demand Curve – The Theory of Consumer Choice

• The Consumer’s Tastes: Indifference Curves- If we assume, for

simplicity, that a consumer spends all of his or her income on
commodities X and Y, we can represent the tastes of the consumer
with indifference curves. An indifference curve shows the various
combinations of commodity X and commodity Y that yield equal
utility or satisfaction to the consumer.
• The Consumer’s Constraints: The Budget Line- The constraints
that a consumer faces can be shown graphically by the budget line.
The budget line shows the various combinations of commodities X
and Y that a consumer can purchase, given his or her money income
and the prices of the two commodities.
• The Consumer’s Equilibrium- A consumer is in equilibrium
when, given his or her income and commodity prices, the
consumer maximizes the utility or satisfaction from his or her
expenditures. In other words, a consumer is in equilibrium
when he or she reaches the highest indifference curve possible
with his or her budget line.
2 - 2 DEMAND ESTIMATION
 Part 2: Demand Analysis- Demand Estimation

THE IDENTIFICATION PROBLEM

The demand curve for a commodity is generally estimated from
market data on the quantity purchased of the commodity at
various prices over time (i.e., using time-series data) or for
various consuming units or markets at one point in time (i.e.,
using cross-sectional data). However, simply joining the price-
quantity observations on a graph does not generate the demand
curve for the commodity. The reason is that each price-quantity
observation is given by the intersection of a different (but
unobserved) demand and supply curve of the commodity.
The intersection (equilibrium) of the different but unknown
demand and supply curves generates the different price-quantity
points observed. (If the demand and supply curves did not shift or
differ, the commodity price would remain the same.) Therefore,
by simply joining the different price-quantity observations, we do
not generate the demand curve for the commodity. The demand
curve cannot be identified so simply. This is referred to as the
identification problem.
MARKETING RESEARCH APPROACHES TO DEMAND ESTIMATION

While regression analysis (to be discussed next) is by far the most

useful used method of estimating demand, marketing research
approaches are also used. The most important of these are
consumer surveys, consumer clinics, and market experiments.
These approaches to demand estimation are discussed in detail in
marketing courses.
 Consumer Surveys and Observational Research
Consumer surveys involve questioning a sample of consumers about
how they would respond to particular changes in the price of the
commodity, incomes, the price of related commodities, advertising
expenditures, credit incentives, and other determinants of demand. These
surveys can be conducted by simply stopping and questioning people at
a shopping center or by administering sophisticated questionnaires to a
carefully constructed representative sample of consumers by trained
interviewers.
In theory, consumer questionnaires can provide a great deal of useful
information to the firm. In fact, they are often biased because consumers
are either unable or unwilling to provide accurate answers.
 Consumer Clinics
Another approach to demand estimation is consumer clinics. These are
laboratory experiments in which the participants are given a sum of money
and asked to spend it in a simulated store to see how they react to changes
in the commodity price, product packaging, displays, price of competing
products, and other factors affecting demand. Participants in the
experiments can be selected so as to closely represent the socioeconomic
characteristics of the market of interest. Participants have an incentive to
purchase the commodities they want the most because they are usually
allowed to keep the goods purchased. Thus, consumer clinics are more
realistic than consumer surveys. By being able to control the
environment, consumer clinics also avoid the pitfall of actual market
experiments, which can be ruined by extraneous events.
 Market Experiments
Unlike consumer clinics, which are conducted under strict laboratory
conditions, market experiments are conducted in the actual
marketplace. There are many ways of performing market experiments.
 Select several markets with similar socioeconomic characteristics and
change the commodity price in some markets or stores,
 Packaging in other markets or stores
 Change in the amount and type of promotion in still other markets or
stores, then record the responses (purchases) of consumers in the
different markets.
The advantages of market experiments are that they can be conducted
on a large scale to ensure the validity of the results and that consumers are
not aware that they are part of an experiment.
INTRODUCTION TO REGRESSION ANALYSIS
Figure 4-2 is known as scattered diagram since its shows the
spread of the points X-Y plane. From there, we can see that there
is a positive relationship between the level of the firm's
advertising expenditures and its sales revenue and that this
relationship is approximately linear.
 DEMAND ESTIMATION BY REGRESSION ANALYSIS

While consumer surveys, consumer clinics, market experiments,

and other marketing research approaches to demand estimation
may be useful, by far the most common method of estimating
demand in managerial economics is regression analysis. This
method is usually more objective, provides more complete
information, and is generally less expensive than properly
conducted marketing approaches to demand estimation.
2 - 3 DEMAND FORECASTING
 Part 2: Demand Analysis- Demand Forecasting
QUALITATIVE FORECASTS
Surveys and opinion polls are often used to make short-term
forecasts when quantitative data are not available. These
qualitative techniques can also be useful for supplementing
quantitative forecasts that anticipate changes in consumer
tastes or business expectations about future economic
conditions. They can also be invaluable in forecasting the demand
for a product that the firm intends to introduce. In this section we
briefly examine forecasting based on surveys, opinion polling,
and soliciting a foreign perspective.
 Survey Techniques

Best-known surveys are:

1.Surveys of business executives’
plant and equipment expenditure
plans.
2.Surveys of plans for inventory
changes and sales expectations.
3.Surveys of consumers’
expenditure plans.
 Opinion Polls

While the results of published surveys of expenditure plans of

businesses, consumers, and governments are useful, the firm
usually needs specific forecasts of its own sales. The firm’s sales
are strongly dependent on the general level of economic activity
and sales for the industry as a whole, but they also depend on the
policies adopted by the firm. The firm can forecast its sales by
polling experts within and outside the firm. There are several
such polling techniques:
 1-Executive polling.

The firm can poll its top management from its sales, production,
finance, and personnel departments on their views on the sales
outlook for the firm during the next quarter or year. While these
personal insights are to a large extent subjective, by averaging the
opinions of the experts who are most knowledgeable about the
firm and is products, the firm hopes to arrive at a better forecast
than would be provided by these experts individually.
 2-Sales force polling

This is a forecast of the firm’s sales in each region and for each
product line; it is based on the opinion of the firm’s sales force in
the field. These are the people closest to the market, and their
opinion of future sales can provide valuable information to the
firm’s top management.
 3-Consumer intentions polling.

Companies selling automobiles, furniture, household appliances,

and other durable goods sometimes poll a sample of potential
buyers on their purchasing intentions. Using the results of the
poll, the firm can forecast its national sales for different levels of
consumers’ future disposable income.
 Soliciting a Foreign Perspective

Many U.S. firms sell an increasing share of their output abroad and face
rising competition at home and abroad from foreign firms. Thus, it
becomes increasingly important for them to forecast changes in
markets and products abroad because these affect not only the firm’s
exports but also its competitiveness at home. To get such an
international perspective, an increasing number of U.S. firms are
forming councils of distinguished foreign dignitaries and
businesspeople, especially in Europe. The purpose is to get a global
perspective on evolving events resulting from economic unification in
Western Europe, restructuring in Eastern Europe, and economic
liberalization in emerging markets or developing countries.
 Reasons for Fluctuations in Time-Series Data

If we plot most economic time-series data, we discover that

they fluctuate or vary over time. This variation is usually
caused by:
• secular trends
• cyclical fluctuations
• seasonal variations- because of the holidays
• and irregular or random influences -resulting from
wars, natural disasters, strikes, or other unique events.

193
 Smoothing Techniques

Other methods of naive forecasting are smoothing

techniques. These predict values of a time series on the
basis of some average of its past values only. Smoothing
techniques are useful when the time series exhibit little
trend or seasonal variations but a great deal of irregular or
random variation. Two smoothing techniques are:
• Moving Averages- simplest smoothing technique.
Forecasted value of a time series in a given period
(month, quarter, year, etc.) is equal to the average value
of a time series in a number of previous periods.
In order to decide which of these moving average forecasts is
better, we calculate the root-mean-square error (RMSE) of
each forecast and use the moving average results in the smallest
RMSE (weighted average error in the forecast) The formula
for the root-mean-square error (RMSE) is

RMSE = Σ (At - Ft)2

n
RMSE = 78.3534 = 2.95
9

RMSE = 62. 48 = 2.99

7
 Smoothing Techniques
• Exponential Smoothing - A serious criticism of using simple
moving averages in forecasting is that they give equal weight to
all observations in computing the average, eventhough
intuitively we might expect more recent observations to be
more important. Exponential smoothing overcomes this
objection and is used more frequently than simple moving
averages in forecasting.
 Exponential Smoothing

Ft+1 = wAt + ( 1 - w) F1
Forecast to period t+1 . That is, Ft+1 is the weighted average of the
actual and forecasted values of time series in period t.
We must decide on the value of w (the weight to assign to A)
Ft+1 = wAt + ( 1 - w) F1
 Barometric Methods

One way to forecast or anticipate short-term changes in

economic activity or turning points in business cycles is to use
the index of leading economic indicators. These are time series
that tend to precede (lead) changes in the level of general
economic activity, much as changes in the mercury in the
barometer precede changes in weather conditions (hence the
name “barometric methods”). Barometric forecasting, as
conducted today, is primarily the result of the work conducted at
the National Bureau of Economic Research (NBER) and
Conference Board.
 Econometric Models

The firm’s demand and sales of a commodity as well as

many other economic variables are increasingly being
forecasted with econometric models. The characteristics
that distinguishes econometric models from other
forecasting methods is that they seek to identify and
measure the relative importance (elasticity) of the various
determinants of demand or other economic variables to
be forecasted.
• Single-Equation Models- The simplest form of econometric
forecasting is with a single-equation model.

• Multiple-Equation Models -Although single-equation models

are often used by firms to forecast demand or sales, economic
relationships may be so complex that a multiple-equation
model may be required. This is particularly the case in
forecasting macrovariables such as gross national product
(GNP) or the demand and sales of major sectors or industries.
Multiple-equation models may include only a few equations or
hundreds of them.