Demand Analysis

Dr. Mukta Mukherjee

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Reading
 3.1.4. S_N_Chapter03
 3.1.5. S_N_Chapter04
 3.2.3. P_R_Chapter02
 3.2.4. P_R_Chapter04
 3.3.2. Sal_Elasticity_Numerical
 3.7.1. Misc_Demand_Forecasting

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Demand Curve
 Demand Curve shows the relationship between
quantity demanded and price ceteris paribus

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Law of Demand
“When the price of a commodity is raised (and other things are held constant),
buyers tend to buy less of the commodity; when the price is lowered, other things
being constant, quantity demanded increases”

 Reasons for Law of Demand to hold

◦ Substitution Effect
 Occurs because a good becomes relatively more expensive when its price rises
 When the price of good A rises, I will generally substitute goods B, C, D, . . . for it
 For example, as the price of beef rises, I eat more chicken

◦ Income Effect
 When price of a commodity rises, I find myself somewhat poorer than what I was
 If gasoline prices double, I have in effect less real income, so I will naturally curb my
consumption of gasoline and other goods
 Real income is my ability to purchase from my nominal income

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Determinants of Demand

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Change in Quantity Demand vs Change
in Demand
 Caused by change in price  Caused by change in factors
of the product under other than the price of the
discussion product under discussion

 Movement along the

 Shift of the demand curve
demand curve

Change in Quantity Demanded Change in Demand

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Demand Function
 Demand function is given by the equation below

 Demand curve vs Demand function

◦ Demand Curve: Q is independent and P is dependent
◦ Demand Function: Q is dependent and P is independent
◦ Demand curve is not obtained by plotting demand function
◦ Demand curve is obtained by plotting inverse demand function ceteris paribus

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Types of Goods
 Normal Good: the demand for which increases with increase in income and decreases with decrease in
income ceteris paribus

 Inferior Good: the demand for which decreases with increase in income and increases with decrease in
income ceteris paribus

 Giffen Good: highly inferior, non-luxury good, the quantity demanded of which increases as price rises
and decreases as price falls
◦ Pre-conditions
 Must be an inferior good
 Lack of close substitute

 Veblen Good: luxury good, the demand for which increases as price increases and decreases as price
decreases

 Substitutes: goods X and Y are substitutes if an increase in price of good Y leads to an increase in
demand for good X and vice versa ceteris paribus

 Complements: Goods X and Y are complements if an increase in price of good Y leads to a decrease in
demand for good X.

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Relationship between QD and determinants
 Demand function

Determinant Relationship with Qd

Price Negative: Law of Demand
Income Positive : Normal Goods
Negative: Inferior Goods
Price of Related Positive: Substitute
Goods Negative: Complements

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Demand Function: Example
 Demand for Coffee

 Relationship of Qd (ceteris paribus) with (on )

◦ P: Negative (Law of demand)
◦ I: Positive (Coffee is a normal good for this consumer)
◦ PS: Negative (Sugar and coffee are consumed together and hence are complements)
◦ PT: Positive (Coffee and tea are substitutes as one can be consumed instead of the other)
◦ A: Positive (Increase in advertising will lead to higher consumption of coffee)

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Change in Income: Normal Good

Effect of Income Changes

An increase in income, with the

prices of all goods fixed, causes
consumers to alter their choice of
market baskets.
In part (a), the baskets that
maximize consumer satisfaction for
various incomes (point A, $10; B,
$20; D, $30) trace out the income-
consumption curve.
The shift to the right of the demand
curve in response to the increases in
income is shown in part (b). (Points
E, G, and H correspond to points A,
B, and D, respectively.)

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Change in Income: Inferior Goods

An Inferior Good

An increase in a person’s
income can lead to less
consumption of one of the
two goods being purchased.

Here, hamburger, though a

normal good between A and
B, becomes an inferior good
when the income-
consumption curve bends
backward between B and C.

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Change in Income: Engel Curve
● Engel curve Curve relating the quantity of a good consumed to income.

Engel Curves

Engel curves relate the

quantity of a good consumed
to income.

In (a), food is a normal good

and the Engel curve is
upward sloping.

In (b), however, hamburger

is a normal good for income
less than $20 per month and
an inferior good for income
greater than $20 per month.

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 From Individual to Market Demand
Price A B C Mkt
1 6 10 16 32
● market demand curve Curve relating
2 4 8 13 25
the quantity of a good that all consumers
3 2 6 10 18 in a market will buy to its price.
4 0 4 7 11
5 0 2 4 6

The market demand curve is obtained by

summing our three consumers’ demand curves
DA, DB, and DC.

At each price, the quantity of coffee demanded

by the market is the sum of the quantities
demanded by each consumer.

At a price of $4, for example, the quantity

demanded by the market (11 units) is the sum of
the quantity demanded by A (no units), B (4
units), and C (7 units).

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MARKET DEMAND
Two points should be noted as a result of this analysis:
1. The market demand curve will shift to the right as more
consumers enter the market.
2. Factors that influence the demands of many consumers will also
affect market demand.
The aggregation of individual demands into market demands becomes
important in practice when market demands are built up from the demands
of different demographic groups or from consumers located in different
areas.
For example, we might obtain information about the demand for home
computers by adding independently obtained information about the
demands of the following groups:
• Households with children
• Households without children
• Single individuals

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 Price Elasticity of Demand
The sensitivity of quantity demanded to price of the commodity
Elastic Demand ∆𝑄
When demand is elastic (ED is
greater than one in absolute
𝐸𝐷=
%∆𝑄
%∆𝑃
=
𝑄
∆𝑃
=
∆𝑄
∆𝑃 ( )( )
𝑃
𝑄
value), total expenditure on 𝑃
the product decreases as the
price goes up. Elasticity Elasticity

Inelastic Demand < -1 Relatively >1 Relatively

Elastic Elastic
When demand is inelastic (i.e.
ED is less than one in absolute = -1 Unit Elastic =1 Unit Elastic
value), the quantity demanded > -1 Relatively <1 Relatively
Inelastic Inelastic
-∞ ∞
is relatively unresponsive to
changes in price. As a result, Perfectly Perfectly
total expenditure on the Elastic Elastic
product increases when the 0 Perfectly 0 Perfectly
price increases. Inelastic Inelastic

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Price Elasticity of Demand

∆𝑄
𝐸𝐷=
%∆𝑄
%∆𝑃
=
𝑄
∆𝑃
= ( )( )
∆𝑄
∆𝑃
𝑃
𝑄
𝑃

𝑄 𝐷 =𝑎1 − 𝑎2 𝑃 +𝑎3 𝐼 +𝑎4 𝑃 𝑅

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Elasticity of Demand: Graphically

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Price Elasticity of Demand Along Linear
Demand Curve

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Price Elasticity of Demand
Isoelastic Demand
● isoelastic demand curve Demand curve with a constant price elasticity.

Unit-Elastic Demand Curve

When the price elasticity of

demand is −1.0 at every
price, the total expenditure
is constant along the
demand curve D.

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Price Elasticity of Demand and
Expenditure

Price Elasticity and Consumer Expenditures

Demand If Price Increases, If Price
Decreases,
Inelastic Expenditures
Increase Expenditures
Decrease
Unit elastic Are unchanged Are unchanged
Elastic Decrease Increase

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Determinants of Price Elasticity of
Demand
 It has more close  It has fewer close
substitutes substitutes

 It is more narrowly  It is more broadly

defined defined

 More time is available

 Less time is available
for buyers to adjust to a for buyers to adjust to a
price change price change
Demand more price elastic Demand less price elastic

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Income Elasticity of Demand
 Sensitivity of Demand to Changes in Income
∆𝑄
𝐸𝐼=
%∆𝑄
%∆𝐼
=
𝑄
∆𝐼
=
∆𝑄
∆𝐼 ( )( )
𝐼
𝑄
𝐼

𝑄 𝐷 =𝑎1 − 𝑎2 𝑃 +𝑎3 𝐼 +𝑎4 𝑃 𝑅

• Good is inferior if income elasticity is negative

• Good is normal if income elasticity is positive
• Good is necessity if income elasticity is less than 1
• Good is luxury if income elasticity is greater than 1

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Cross Price Elasticity of Demand
 Sensitivity of Demand for X to Change in Price of Y
∆𝑄𝑋

𝐸 𝑋𝑌 =
% ∆ 𝑄𝑋
% ∆ 𝑃𝑌
=
𝑄𝑋
∆ 𝑃𝑌
=
(
∆ 𝑄𝑋
∆ 𝑃𝑌 )( )
𝑃𝑌
𝑄𝑋
𝑃𝑌

𝑄 𝐷 =𝑎1 − 𝑎2 𝑃 +𝑎3 𝐼 +𝑎4 𝑃 𝑅

• Good is substitute if cross price elasticity is positive

• Good is complement if cross price elasticity is negative
• Good is independent if cross price elasticity is zero

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Arc Elasticity
 Arc elasticity measures elasticity between two points
on a curve
 Arc measures of elasticity
Price Elasticity:

Income Elasticity:

Cross Price Elasticity:

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Demand Estimation using Elasticities
 Demand function for coffee is given by the equation

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𝑄𝐶=1.5−3𝑃 𝐶 +0.8𝐼+2𝑃 𝑇 −0.6𝑃 𝑆 +1.2 𝐴
 Find elasticities

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𝑄𝐶=1.5−3𝑃 𝐶 +0.8𝐼+2𝑃 𝑇 −0.6𝑃 𝑆 +1.2 𝐴
 Suppose it is expected that next year price of coffee
will increase by 5%, advertising expenditure will
increase by 12%, incomes will increase by 4%, price of
tea will rise by 7% and price of sugar will fall by 8%.
Determine the demand for coffee next year.

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Demand Forecasting
 Estimate of future demand for a good based on reasonable
judgement of future probabilities of market events

 Not a speculative exercise – uses scientific basis

 Future is uncertain and several variable are affecting the

economy simultaneously and sequentially
◦ Not 100% precise
◦ However, gives reliable approximation regarding possible
outcome with reasonable accuracy – based on laws of probability
and statistical tools

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Demand Forecasting: Levels
 Micro
◦ Demand forecasting by individual business firms for estimating demand for its
product

 Industry
◦ Demand estimate for the product of the industry as a whole.
◦ Undertaken by an industrial or trade association
◦ Relates to market demand as a whole

 Macro
◦ Aggregate demand for output in the economy as a whole
◦ Based on national income or aggregate expenditure of the country
◦ Economies consumption function provides an estimate for demand forecasting

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Demand Forecasting: Significance
 Production planning
◦ Prerequisite for production planning of a business
◦ Output expansion should be based on demand estimates to avoid over- or under-
production

 Sales forecasting
◦ Sales forecasting is based on demand forecasting
◦ Promotional efforts should be based on sales forecasts

 Control of business
◦ Well conceived budgeting of costs and profits is essential for proper control of the
business

 Inventory control
◦ Excess inventory as well as deficit in inventory adversely affects operations and
profitability of the firm

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Demand Forecasting: Significance
 Growth and long-term investment programs
◦ Demand forecasting helps chart growth path and make decisions
regarding long-term investments

 Stability
◦ Forecasts of demand and other business variables provide an insight
into the potential impediments that may adversely affect the business
◦ Help in designing solutions to maintain stability in production and
employment during the turbulent period

 Economic planning and policy making

◦ Required for effective and efficient allocation of resources
◦ Decide the nature of domestic and foreign policy

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Demand Forecasting: Short-Term
 Short-Term Forecasting
◦ Generally relates to a period not exceeding a year
◦ Relate to day-to-day particulars which are concerned with tactical decisions under resource constraints

 Purpose of short-term forecasting

◦ Evolving Sales Policy
 Suitable policy in view of seasonal variation in demand
 Avoid problem of shortage or excess

◦ Determining Pricing Policy

 Suitable policy to clear stocks during off-season and take advantage during peak season

◦ Evolving Purchase Policy

 Purchase policy for buying raw material at lower prices and insulate the business from shocks to input (raw
material) market

◦ Fixation of Sales Targets

 Forecasting helps in setting achievable sales targets

◦ Determining Short-Term Financial Plans

 Cash requirements in the short-run for operating the business cannot be determined without business forecasts

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Demand Forecasting: Long-Term
 Long-Term Forecasting
◦ Generally relates to a period exceeding a year
◦ Permits alteration in scale of production
◦ Relates to information that is vital for undertaking strategic decisions pertaining to
expansion or contraction of the business

 Purpose of long-term forecasts

◦ Business Planning
 Long-term demand potential provides guidelines for determining size of operations
 Required for capital budgeting

◦ Manpower Planning
 Long-term sales determine the quantum of manpower
 Helps avoid over-staffing or under-staffing

◦ Long-term Financial Planning

 Required to understand the quantum of funds that should be raised and the sources

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Demand Forecasting: Approach
Specification of Objectives
Identify and lay down objectives of forecasting,
forecasting horizon and the variable forecasted

Identify Demand Determinants

Identify and collect data for variables that affect demand
for the commodity for which demand is being forecasted

Choice of Forecasting Method

Select suitable method of forecasting in view of the
objectives, availability of data, forecasting horizon, etc.

Interpretation
Judge the implications of the output obtained for
policy making purposes
Demand Forecasting: Primary Data
 Primary Data
◦ Original in character
◦ Collected for the first time keeping in mind the objective of the analysis
◦ Raw data that requires statistical processing

 Sources/Methods
◦ Market survey
 Consumer Survey
 Survey of sales force or collective opinion

◦ Market experiments
 Experimentation in laboratories
 Test Marketing

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Demand Forecasting: Secondary Data
 Secondary Data
◦ Information which was obtained to address other objective and not collected keeping
in mind our purpose of analysis
◦ Already existing in recorded and published forms after undergoing statistical
processing

 Sources
◦ Official publication of Central, State and Local Government and Government
Agencies/Committees, viz. Statistical Abstract of India, Census of India, Economic
Survey, Union and State Budget, Handbook of Statistics on Indian Economy and
Indian States, etc.

◦ Journals, periodicals and reports published by Government and Non-Governmental

Organizations

◦ Official publication of international agencies, viz. IMF, UNO, World Bank, etc.

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Demand Forecasting:
Statistical Methods
 Statistical Methods
◦ More robust and scientific are compared to methods based on
using judgement to estimate future demand
◦ Empirically estimate structural form and parameters of demand
function

 Three types of data

◦ Cross Section – data across units at a given point in time
◦ Time Series – data collected over time for a given unit
◦ Panel/Pooled Data – data that has characteristics of both cross
section and time series

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Demand Forecasting:
Criteria for Good Forecasting Method
 Accuracy
◦ Forecast should be as accurate as possible
◦ Judged by examining past observations and forecasts

 Plausibility
◦ Methods and output should be credible

 Simplicity
◦ A simple robust method that is comprehensible is preferred to complicated one

 Economy
◦ Involve less cost as compared to the benefit

 Quickness
◦ Yield quick results
◦ Time consuming method may delay the decision making process

 Flexibility
◦ Ability to incorporate changes to include the dynamic nature of the economy and business

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