Economics for

Managers

Demand & Supply Analysis

 Agenda

 Demand Analysis

 Elasticity of Demand

 Theory of Consumer
Behavior

 Supply Analysis

20XX SAMPLE FOOTER TEXT 2

Elasticity of
Demand
 Often, we would want to know how sensitive is the demand for a product to its
price; for example, if price increases by 5 percent, how much will the quantities
demanded change?

 Also, how much change in demand will be there if the average income rises by 5
percent?

 What effect will an advertising campaign have on sales?

 Economists use a number of different types of elasticities to answer questions

like these so as to make demand predictions and to recommend changes in
strategies.

 The difference lies in the degree of response of demand. The differences in

responsiveness of demand can be found out by comparing the percentage
changes in prices and quantities demanded.

 Here lies the concept of elasticity

 Elasticity of
Demand

Elasticity of demand is defined as the

responsiveness of the quantity demanded of a
good to changes in one of the variables on
which demand depends.

More precisely, elasticity of demand is the

percentage change in quantity demanded
divided by the percentage change in one of the
variables on which demand depends.
Price Elasticity of Demand
Price elasticity of demand expresses the responsiveness of quantity
demanded of a good to a change in its price, given the consumer’s income,
his tastes and prices of all other goods.

Price elasticity of demand which measures the sensitivity of quantity

demanded to ‘own price’ or the price of the good itself.

The concept of price elasticity of demand is important for a firm for two
reasons.

Knowledge of the nature and degree of price elasticity allows firms to

predict the impact of price changes on its sales.

Price elasticity guides the firm’s profit-maximizing pricing decisions.

 In other words, it is measured as the percentage change in quantity

demanded divided by the percentage change in price, other things remaining
 The percentage change in a variable is just the absolute change in the variable
divided by the original level of the variable.
In symbolic terms
Price Elasticity of Demand
 The greater the value of elasticity, the more sensitive quantity demanded is
to price.

 the value of price elasticity varies from minus infinity to approach zero.

 A negative sign on the elasticity of demand illustrates the law of demand:

less quantity is demanded as the price rises.

 In other words since price and quantity are inversely related (with a few
exceptions) price elasticity is negative.

 For example, let us say that the price of a candy drops from Rs. 10 to Rs.
5 and the demand increases from 10 candies to 15 candies. Here, the
percentage of change in demand is equal to the percentage of change in
price (50% divided by 50%, which is 1).
Illustration 1

 The price of a commodity decreases from Rs 6 to Rs 4 and

quantity demanded of the good increases from 10 units to

15 units. Find the coefficient of price elasticity.

Solution

 Price elasticity = D q / D p × p/q

= 5/2 × 6/10 = 1.5

Illustration 2

The price of a good decreases from ` 100 to ` 60 per unit. If

the price elasticity of demand for it is 1.5 and the original

quantity demanded is 30 units, calculate the new quantity

demanded.
Solution

Price elasticity = (-) D q / D p × p/q

1.5 = D q / 40 x 100/30

= 18

Here Therefore new quantity demanded = 30+18 = 48 units

Illustration 3

 The quantity demanded by a consumer at price Rs 9 per

unit is 800 units. Its price falls by 25% and quantity

demanded rises by 160 units. Calculate its price elasticity of

demand.
Solution

 Change in quantity demanded = 160

 % = change / original demand= 160/800 x 100 = 20%
 Therefore, % change in quantity demanded = = 20%
 % change in price = 25%

Price elasticity = % change in q / % change in p

= 20 / 25

= 0.8
Point Demand
 The point elasticity of demand is the price elasticity of demand at a particular
point on the demand curve.

 The concept of point elasticity is used for measuring price elasticity where the
change in price is infinitesimal (very small).

 Price elasticity is a key element in applying marginal analysis to determine

optimal prices.

 Point elasticity is, therefore, the product of price quantity ratio at a particular
point on the demand curve and the reciprocal of the slope of the demand line
Elasticity at different points on the Demand
Curve
 Ep = 0

The numerical value of elasticity of demand can assume any

value between zero and infinity.

Elasticity is zero, (Ep= 0) if there is no change at all in the

quantity demanded when price changes i.e. when the
quantity demanded does not respond at all to a price
change.

Perfectly inelastic demand is as an extreme case of price

insensitivity and is therefore only a theoretical category with
less practical significance.
 For example, insulin is a product that is highly inelastic. For people with diabetes who
need insulin, the demand is so great that price increases have very little effect on the
quantity demanded. Price decreases also do not affect the quantity demanded

 For example, a high-price or a low-price, consumer will need salt in the

same quantity.
 Ep = 1

Elasticity is one, or unitary, (Ep= 1) if the

percentage change in quantity demanded is equal
to the percentage change in price. Figure 8 (b)
shows special case of unit-elastic demand, where
the demand curve is a rectangular hyperbola.
 The price of digital cameras increases by 10%, the quantity of digital
cameras demanded decreases by 10%. The price elasticity of demand
is (unitary elastic demand).

 A typical example of unitary elastic demand is electronic products. As an

example mobile phones, essential electronic products, home appliances.
 Ep > 1

Elasticity is greater than one (Ep > 1) when the

percentage change in quantity demanded is
greater than the percentage change in price. In such
a case, demand is said to be elastic. [Figure8 (d)]. In
other words, the quantity demanded is relatively
sensitive to price changes. When drawn, the
elastic demand line is fairly flat.
 An example of products with an elastic demand is consumer durables.
These are items that are purchased infrequently, like a washing
machine or an automobile, and can be postponed if price rises. For
example, automobile rebates have been very successful in increasing
automobile sales by reducing price
 Ep < 1

Elasticity is less than one (Ep < 1) when the percentage

change in quantity demanded is less than the
percentage change in price. In such a case, demand is
said to be inelastic.[Figure 8 (e)]In this situation, when
price falls the buyers are unable or unwilling to significantly
contract demand. In other words, the quantity demanded
is relatively insensitive to price changes. When drawn,
the inelastic demand line is fairly steep.
 Examples of this are necessities like food and fuel. Consumers will not
reduce their food purchases if food prices rise, although there may be
shifts in the types of food they purchase. Also, consumers will not
greatly change their driving behavior if gasoline prices rise.
 Ep = Infinity

Elasticity is infinite, (Ep= ∞) when a ‘small price reduction raises the

demand from zero to infinity. The demand curve is horizontal at the price
level (where the demand curve touches the vertical axis).As long as the
price stays at one particular level any quantity might be demanded

If there is a slight increase in price, they would not buy anything from the
particular seller. That is, even the smallest price rise would cause quantity
demanded to fall to zero. Roughly speaking, when you divide a number by
zero, you get infinity, denoted by the symbol∞. So a horizontal demand
curve implies an infinite price elasticity of demand. This type of demand
curve is found in a perfectly competitive market.

Examples of such goods are Caribbean cruises and sports vehicles.

 Numerical Verbal description Terminology
measure of
elasticity
Zero Quantity demanded does not Perfectly(or
change as price changes completely) inelastic

Greater than zero, Quantity demanded changes Inelastic

but less than one by a smaller percentage than
does price
One Quantity demanded changes by Unit elasticity
exactly the same percentage as
does price
Greater than one, Quantity demanded changes by Elastic
but less than infinity a larger percentage than does
price
Infinity Purchasers are prepared to buy Perfectly (or infinitely)
all they can obtain at some elastic
price and none at all at an even
slightly higher price
Arc Elasticity
 Arc elasticity is the elasticity of one variable with respect to another between two
given points.

 It is used when there is no general way to define the relationship between the two
variables.

 Arc elasticity is also defined as the elasticity between two points on a curve.

 It is commonly used to measure the changes between the quantity of goods

demanded and their prices.
Illustration 1

 The price of a commodity decreases from Rs 6 to Rs 4 and

quantity demanded of the good increases from 10 units to

15 units. Find the coefficient of price elasticity.

 Q2 = 15

 Q1= 10

 P2= 6

 P1= 4

 Arc Elasticity = {(15-10) /[(15+10)/2]} / {(6-4)/{(6+4)/2]}

= (5/12.5)/(2/10)

= 0.4/0.2 = 2
 Determinants of
Price Elasticity of
Demand

Availability of substitutes

Position of commodity in Time period

consumer’s budget
Consumer habits
Nature of the need that a
Tied demand
commodity satisfies
Price range
No. of uses to which a
Minor complementary items
commodity can be put
 Income Elasticity
of Demand

Income elasticity of demand is the degree of

responsiveness of the quantity demanded of a good
to changes in the income of consumers.

The income elasticity of demand is a measure of how

much the demand for a good is affected by changes
in consumers’ incomes

Estimates of income elasticity of demand are useful

for businesses to predict the possible growth in sales
as the average incomes of consumers grow over time.
In symbolic form

E = Income elasticity of
demand

∆Q = Change in demand

Q = Original Demand

Y = Original money income

∆Y= Change in money income

Income Elasticity of Demand

 If income elasticity is zero, it signifies that the demand for the good is
quite unresponsive to changes in income.

 When income elasticity is greater than zero or positive, then an increase

in income leads to an increase in the demand for the good. This happens in
the case of most of the goods and such goods are called normal goods

 When the income elasticity of demand is negative, the good is an inferior

good. In this case, the quantity demanded at any given price decreases as
income increases. The reason is that when income increases, consumers
choose to consume superior substitutes.
Income Elasticity of Demand

 Another significant value of income elasticity is that of unity. When income

elasticity of demand is equal to one, the proportion of income spent on
goods remains the same as consumer’s income increases.

 If the income elasticity for a good is greater than one, it shows that the
good bulks larger in consumer’s expenditure as he becomes richer.
Such goods are called luxury goods.

 On the other hand, if the income elasticity is less than one, it shows
that the good is either relatively less important in the consumer’s eye
or, it is a good which is a necessity.
Illustration
 A car dealer sells new as well as used cars. Sales during the previous year were
as follows;

Car type Price Quantity

( No)
New 6 .5 lakhs 400
Used 60,000 4000

 During the previous year, other things remaining the same, the real incomes of
the customers rose on average by 10%. During the last year sales of new cars
increased to 500, but sales of used cars declined to 3,850.

 What is the income elasticity of demand for the new as well as used cars? What
inference do you draw from these measures of income elasticity?
Solution
Income Elasticity of demand for new cars

Percentage change in income = 10%, given

Percentage change in quantity of new cars demanded = (∆ Q/Q) X 100)

= (100/400 ) X100 = 25%

Income elasticity of demand = 25%/ 10% = + 2.5

New car is therefore income elastic. Since income elasticity is positive, new car is a normal
good.

Income Elasticity of demand for used cars

Percentage change in income = 10%, given

% change in quantity of used cars demanded = (∆ Q/Q )X 100

=( -1 50/4000 ) x100 = - 3.75%

Income elasticity of demand = – 3.75/ 10= –.375

Since income elasticity is negative, used car is an inferior good.

 Cross Price
Elasticity of
Demand

Cross demand refers to the quantities of a commodity or

service which will be purchased with reference to changes in
price, not of that particular commodity, but of other inter-
related commodities, other things remaining the same.

It may be defined as the quantities of a commodity that

consumers buy per unit of time, at different prices of a
‘related article’, ‘other things remaining the same’.

The demand for a particular commodity may change due to

changes in the prices of related goods. These related goods
may be either complementary goods or substitute goods.
 Substitutes & Complimentary
1. products have the same or similar performance  A Complementary good is a product
characteristics or service that adds value to
2. products have the same or similar occasion for another. In other words, they are
use two goods that the consumer uses
• Coca-Cola and Pepsi together. For example, cereal and
• Butter and margarine milk, or a DVD and a DVD player.

• Physical books and e-books  Examples include: Tennis Balls and

• Petrol vehicles and electric vehicles Tennis Racket; PlayStations and

1. Eyeglasses and contact lenses Games; Movies and Popcorn; and

Mobile Phones and Sim Cards.
2. Laptops and desktops
Substitute goods and Demand

the cross demand curve slopes upwards (i.e. positively)

showing that more quantities of a commodity, will be
demanded whenever there is a rise in the price of a
substitute commodity.

When the price of coffee increases, due to the

operation of the law of demand, the demand for coffee
falls.

The consumers will substitute tea in the place of

coffee. The price of tea is assumed to be constant.
 Complementary goods

A change in the price of a good will have an opposite

reaction (inverse relationship) on the demand for the other
commodity which is closely related or complementary.

For instance, an increase in demand for solar panels

will necessarily increase the demand for batteries.

Whenever there is a fall in the demand for solar panels

due to a rise in their prices, the demand for batteries
will fall, not because the price of batteries has gone up,
but because the price of solar panels has gone up.
 Complimentary goods

if the price of coffee increases, the quantity demanded for

coffee stir sticks drops as consumers are drinking less coffee
and need to purchase fewer sticks.

In the formula, the numerator (quantity demanded of stir

sticks) is negative and the denominator (the price of coffee) is
positive. This results in a negative cross elasticity.
Cross Price Elasticity of Demand

 Ec = Percentage change in quantity demanded of good X / Percentage change

in price of good Y

 Symbolically,

Ec stands for cross elasticity.

qx stands for original quantity demanded of X.

∆qx stands for change in quantity demanded of X

py stands for the original price of good Y.

∆py stands for a small change in the price of Y.

Illustration

 A shopkeeper sells only two brands of note books Imperial and Royal. It is
observed that when the price of Imperial rises by 10% the demand for Royal
increases by 15%.What is the cross price elasticity for Royal against the price
of Imperial?
Solution
 Ec = 15% / 10% = +1.5

 The two brands of note book Imperial and Royal are substitutes with
significant substitutability
Advertisement Elasticity
 Advertisement elasticity of sales or promotional elasticity of demand is the
responsiveness of a good’s demand to changes in the firm’s spending on
advertising.

 The advertising elasticity of demand measures the percentage change in

demand that occurs given a one percent change in advertising expenditure.

 Advertising elasticity measures the effectiveness of an advertisement

campaign in bringing about new sales.

 Advertising elasticity of demand is typically positive.

 Higher the value of advertising elasticity greater will be the responsiveness of

demand to change in advertisement.

 Advertisement elasticity varies between zero and infinity.

 A good example of this is when a specific beer company advertises its product, which
compels a consumer to buy beer, but not simply the specific brand they saw
advertised. Beer has an industry-wide elasticity of 0.0, which means that advertising
has little influence on profits.
Advertisement Elasticity

 Ea= % Change in quantity demanded / % change in spending on

advertising

 Ea = DQd/Qd / DA/A
∆Qd denotes increase in demand

∆A denotes additional expenditure on advertisement

Qd denotes initial demand

A denotes initial expenditure on advertisement

Advertisement Elasticity

Elasticity Interpretation

Ea = 0 Demand does not respond at all to increase

in advertisement expenditure
Ea >0 but < Increase in demand is less than
1 proportionate to the increase in
advertisement expenditure
Ea = 1 Demand increase in the same proportion in
which advertisement expenditure increase
Ea> 1 Demand increase at a higher rate than
increase in advertisement expenditure
 Demand
Forecasting

Forecasting of demand is the art and science of

predicting the probable demand for a product or a
service at some future date on the basis of certain past
behavior patterns of some related events and the
prevailing trends at present.

It should be kept in mind that demand forecasting is

not simple guessing, but it refers to estimating
demand scientifically and objectively on the basis
of certain facts and events relevant to forecasting.
 Demand Distinctions

Producers’ goods vs. Consumers’ goods

Industry Demand vs. Firm Demand

Consumer durable vs. non durable

Derived demand and Autonomous

demand
 CONSUMER GOODS PRODUCER GOODS

 Consumer goods are those  Producer goods are those goods,

goods, which satisfy the want which satisfy the want of
of consumer directly. They consumers indirectly. As they
are goods, which are used for help in producing other goods,
consumption. For example they are known as producer
bread, fruits, milk, clothes goods. For example machinery,
etc. tools, raw materials, seeds,
manure and tractor etc are all
example of producer goods.
 Demand for
consumer’s goods

Goods that yield direct satisfactions to consumers are said to

have direct demand. They consist of clothes, food, house,
etc. Hence, the demand for consumer goods is direct

While overall demand for food is not likely to fluctuate wildly although
the specific foods consumers purchase can vary significantly under
different economic conditions the level of consumer spending on more
optional purchases, such as automobiles and electronics, varies greatly
depending on a number of economic factors.
 Demand for
Producer’s goods

Demand for all producer’s goods are derived demands because they
are needs in order to produce consumer’s or producer’s goods.

For example if there is a demand for mobile phones with radio,

internet and camera, the machinery require to produce such phones
will also be demanded.

So demand of phones is an example of direct demand, while

machinery is an example of derived demand.
 N O N - D U RA B L E G O O D S D U RA B L E G O O D S
 Single use goods are those goods,  Durable use goods are those goods,

which can be used only once. which can be used again and again for
a long period of time.
 For example bread, butter, egg, milk
 Durable use consumer goods are cloth,
etc are the single use consumer
furniture, television, scooter etc. that can
goods as they are consumed be used by consumer again and again.
immediately and once for all.
 Durable use producer goods are used in
 Similarly single use producer goods production again and again for example,

are exhausted in one production machines, tools, tractors and implements

process. etc.

 In fact the value of these goods gets

 For example coal, raw material,
depreciated after continuous use.
seeds, manure etc.
 Demand for Non-
durable goods

The demand for non durable goods remains constant

throughout economic growth and setback.
Consumers normally purchase the same amount of non
durable goods as durable goods, during both recession and
growth.

The demand for non-durable goods depends largely on their

current prices, consumers' income and fashion whereas the
expected price, income and change in technology influence
the demand for the durable goods.
 Demand for
Durable goods

Demand for durable goods is more volatile than the demand for
non-durable goods.

Increase in demand for them may not show up in more

production of such goods for quite some time because the
greater demand for them can be met by drawing upon their
inventories.

Analysis of demand for durable goods must consider not only

new consumers’ demand for them but also consider the need for
building up their inventories by distributors and producers and
replacement demand for them which may be deferred
FREE GOODS ECONOMIC GOODS

Free goods are free gifts of nature. Economic goods are those goods
They are available in abundance (manmade or free gifts of nature)
i.e. in unlimited quantity and the whose demand is more than
supply is much more than the supply. They command a price and
demand. You don’t have to pay they can be bought in the market.
anything to get them. That is why Clean water, purified air, solar
they are called free goods. panels etc.
Air, water, sunlight etc
 Firm’s demand vs.
Industry’s demand

Goods are produced by more than one firm and so

there is a difference between the demand facing an
individual firm and that facing an industry.

For e.g., cars are manufactured in India by Maruthi,

Hindustan motors, and several companies.

Demand for Maruthi alone is firm’s demand whereas

demand for all kinds of cars is industry’s demand
 Short-run Demand

Short run demand refers to demand with

its immediate reaction to changes in
product price and prices of related
commodities, income fluctuations, ability
of the consumer to adjust their
consumption pattern, their susceptibility
to advertisement of new products etc
 Long run Demand

Long-run demand refers to demand

which exists over a long period. Most
generic goods have long term demand.

Long term demand depends on long

term income trends, availability of
substitutes, credit facilities etc.
Methods of Demand Forecasting
Survey’s of Buyers Intentions
 The most direct method of estimating demand in the short run is to ask customers
what they are planning to buy during the forthcoming time period, usually a year.

 This method involves direct interview of potential customers.

Expert Opinion method

 Professional market experts and consultants have specialized knowledge about the
numerous variables that affect demand.

 This, coupled with their varied experience, enables them to provide reasonably reliable
estimates of probable demand in future.

 Information is elicited from them through appropriately structured unbiased tools of

data collection such as interview schedules and questionnaires.
Methods of Demand Forecasting
Statistical methods:

 statistical methods have proved to be very useful in forecasting demand.

 Forecasts using statistical methods are considered as superior methods

because they are more scientific, reliable and free from subjectivity.

 Trend projection method, Graphical method, Fitting trend method

Regression analysis:

 This is the most popular method of forecasting demand.

 Under this method, a relationship is established between the quantity

demanded (dependent variable) and the independent variables (explanatory
variables) such as income, price of the good, prices of related goods etc.