UNIT 2

Demand, in economics, is the willingness and ability of consumers to purchase a given amount
of a good or service at a given price. Supply is the willingness of sellers to offer a given quantity
of a good or service for a given price.
The demand and supply model is useful in explaining how price and quantity traded are
determined and how external influences affect the values of those variables. Buyers’ behavior is
captured in the demand function and its graphical equivalent, the demand curve. This curve
shows both the highest price buyers are willing to pay for each quantity, and the highest
quantity buyers are willing and able to purchase at each price. Sellers’ behavior is captured in
the supply function and its graphical equivalent, the supply curve. This curve shows
simultaneously the lowest price sellers are willing to accept for each quantity and the highest
quantity sellers are willing to offer at each price.

What is Demand?

A relation showing the quantities of a good that consumers are willing and able to buy at
various prices per period, other things constant.

Demand for commodity implies

• Desire to acquire it
• Willingness to pay for it
• Ability to pay for it

Types of Demand

1.Individual and Market demand

2. Demand for firm’s and industry product
3. Autonomous and derived demand
4. Demand for durable and non-durable goods
5. Short-term and long-term demand

1. Individual and Market demand :

The quantity of a commodity an individual is willing and able to purchase at a
particular price, during a specific time period, given his/her money income, his/her
taste, and prices of other commodities, such as substitutes and complements, is
referred to as the individual demand for the commodity.

The total quantity which all the consumers of the commodity are willing and able to
purchase at a given price per time unit, given their money incomes, their tastes, and
 prices of other commodities, is referred to as the market demand for the
commodity.

2. Demand for firm’s and industry product

The quantity of a firm’s product that can be sold at a given price over time is known
as the demand for the firm’s product.

The sum of demand for the products of all firms in the industry is referred to as the
market demand or industry demand for the product.

3. Autonomous and derived demand

An autonomous demand or direct demand for a commodity is one that arises on its
own out of a natural desire to consume or possess a commodity. This type of
demand is independent of the demand for other commodities

The demand for a commodity which arises from the demand for other commodities,
called ‘parent products’ is called derived demand. Demand for land, fertilizers and
agricultural tools, is a derived demand because these commodities are demanded
due to demand for food.

4. Demand for durable and non-durable goods

Durable goods are those goods for which the total utility or usefulness is not
exhaustible in the short-run use. Such goods can be used repeatedly over a period of
time. The demand for non-durable goods depends largely on their current prices,
consumers’ income, and fashion. It is also subject to frequent changes.

5. Short-term and long-term demand

Short-term demand refers to the demand for goods over a short period.

The long-term demand refers to the demand which exists over a long period of time.

DETERMINANTS OF DEMAND

The demand of a product is influenced by a number of factors. An organization should

properly understand the relationship between the demand and its each determinant to
analyse and estimate the individual and market demand of a product The demand for a
 product is influenced by various factors, such as price, consumer’s income, and growth
of population. For example, the demand for apparel changes with change in fashion and
tastes and preferences of consumers. The extent to which these factors influence
demand depends on the nature of a product. An organization, while analysing the effect
of one particular determinant on demand, needs to assume other determinants to be
constant. This is due to the fact that if all the determinants are allowed to differ
simultaneously, then it would be difficult to estimate the extent of change in demand.
There are six determinants of demand which are given below :

1. Price of product or service

2. Income of the consumers
3. Taste and preference of consumers
4. Price of related goods
5. Consumer’s expectation of future income and price
6. Population of country

1. PRICE OF A PRODUCT OR A SERVICE Affects the demand of a product to a large extent.

There is an inverse relationship between the price of a product and quantity demanded.
The demand for a product decreases with increase in its price, while other factors are
constant, and vice versa. For example, consumers prefer to purchase a product in a
large quantity when the price of the product is less. The price-demand relationship
marks a significant contribution in oligopolistic market where the success of an
organization depends on the result of price war between the organization and its
competitors.

2. INCOME OF THE CONSUMER Constitutes one of the important determinants of

demand. The income of a consumer affects his/her purchasing power, which, in turn,
influences the demand for a product. Increase in the income of a consumer would
automatically increase the demand for products by him/her, while other factors are at
constant, and vice versa. For example, if the salary of Mr. X increases, then he may
increase the pocket money of his children and buy luxury items for his family. This
would increase the demand of different products from a single family. The income-
demand relationship can be analysed by grouping goods into four categories, namely,
essential consumer goods, inferior goods, normal goods, and luxury goods.
The relationship between the income of a consumer and each of these goods is
explained as follows:

a. Essential or Basic Consumer Goods: Refer to goods that are consumed by all the
people in the society. For example, food grains, soaps, oil, cooking fuel, and
clothes. The quantity demanded for basic consumer goods increases with
increase in the income of a consumer, but up to a fixed limit, while other factors
are constant.

b. Normal Goods: Refer to goods whose demand increases with increase in the
consumer’s income. For example, goods, such as clothing, vehicles, and food
items, are demanded in relatively increasing quantity with increase in
 consumer’s income. The demand for normal goods varies due to .different rate
of increase in consumers’ income.

c. Inferior Goods: Refer to goods whose demand decreases with increase in the
income of consumers. For example, a consumer would prefer to purchase wheat
and rice instead of millet and cooking gas instead of kerosene, with increase in
his/her income. In such a case, millet and kerosene are inferior goods for the
consumer. However, these two goods can be normal goods for people having
lower level of income. Therefore, we can say that goods are not always inferior
or normal; it is the level of income of consumers and their perception about the
need of goods.

d. Luxury Goods: Refer to goods whose demand increases with increase in

consumer’s income. Luxury goods are used for the pleasure and esteem of
consumers. For example, expensive jewellery items, luxury cars, antique
paintings and wines, and air travelling.

3. Tastes and Preferences of Consumers Play a major role in influencing the individual
and market demand of a product. The tastes and preferences of consumers are affected
due to various factors, such as life styles, customs, common habits, and change in
fashion, standard of living, religious values, age, and sex. A change in any of these
factors leads to change in the tastes and preferences of consumers. Consequently,
consumers reduce the consumption of old products and add new products for their
consumption. For example, if there is change in fashion, consumers would prefer new
and advanced products over old- fashioned products, provided differences in prices are
proportionate to their income.

4. Price of Related Goods Refer to the fact that the demand for a specific product is
influenced by the price of related goods to a greater extent. Related goods can be of
two types, namely, substitutes and complementary goods, which are explained as
follows:

a. Substitutes: Refer to goods that satisfy the same need of consumers but at a different
price. For example, tea and coffee, jowar and bajra, and groundnut oil and sunflower oil
are substitute to each other. The increase in the price of a good results in increase in the
demand of its substitute with low price. Therefore, consumers usually prefer to
purchase a substitute, if the price of a particular good gets increased.
b. Complementary Goods: Refer to goods that are consumed simultaneously or in
combination. In other words, complementary goods are consumed together. For
example, pen and ink, car and petrol, and tea and sugar are used together. Therefore,
the demand for complementary goods changes simultaneously. The complementary
goods are inversely related to each other. For example, increase in the prices of petrol
would decrease the demand of cars.

Example :
a. Substitute goods :If the price of coffee rises, the demand for tea should increase.

b. Complement goods : if the price of ice cream rises, the demand for ice-cream toppings will
decrease.

5. Consumer’s Expectations of future Income and Price

Consumers do not make purchases only on the basis of current price structure. Especially in
case of durables, when demand can be postponed, consumers decide their purchase on the
basis of future price and income. If they expect their income to increase or price to fall in
future, they will postpone their demand on the other hand if they expect price to increase in
future they will hasten the purchase. For example, purchase of cars and other durables
increases before budget is announced if consumers fear that prices may rise after budget. Or,
when people expect pay revisions, they wait for major purchases till pay is revised.

6. Population of the Country

Size of population, age distribution, rural urban distribution and gender distribution affect
aggregate demand. If population of a country is constantly increasing, more food items and
other goods and services will be needed to satisfy the needs of the people. Age distribution of
the population determines what kind of commodities will be demanded. If population mostly
consists of aged people, there will be demand of more medicines and health care services. On
the other hand if major section of population is youth, there will be more demand for
education , employment opportunities and designer apparels.

The Demand Function and the Demand Curve

Demand Curve
Meaning
The demand curve is a graphic presentation of a demand schedule. It relates quantity
demanded of a commodity to its prices. At higher prices less of the commodity is demanded,
and at lower prices more of the commodity is demanded. As we move from higher prices to
lower prices, we move down the demand curve, and as we move from lower prices to higher
prices, we move up the demand curve. In other words, a change in the price of commodity
means a movement along the demand curve.

Definition
The demand curve represents the maximum quantities per unit of time that consumers will
take at various prices.

-Leftwitch

The curve, which shows the relation between the price of a commodity and the amount of the
commodity that the consumer wishes to purchase, is called demand curve.
 -Lipsey

The quantity consumers are willing to buy clearly depends on a number of different factors
called variables. Perhaps the most important of those variables is the item’s own price. In
general, economists believe that as the price of a good rises, buyers will choose to buy less of it,
and as its price falls, they buy more. This is such a ubiquitous observation that it has come to be
called the law of demand, although we shall see that it need not hold in all circumstances.
Although a good’s own price is important in determining consumers’ willingness to purchase
it, other variables also have influence on that decision, such as consumers’ incomes, their tastes
and preferences, the prices of other goods that serve as substitutes or complements, and so on.
Economists attempt to capture all of these influences in a relationship called the demand
function. (In general, a function is a relationship that assigns a unique value to a dependent
variable for any given set of values of a group of independent variables.) We represent such a
demand function as following:

Q = f( Px , I , Py…..)

where Q represents the quantity demanded of some good X (such as per household demand for
gasoline in gallons per week), Px is the price per unit of good X (such as $ per gallon), I is
consumers’ income (as in $1,000s per household annually), and Py is the price of another good,
Y. (There can be many other goods, not just one, and they can be complements or substitutes.)
“Quantity demanded of good X depends on (is a function of) the price of good X, consumers’
income, the price of good Y, and so on.”

DEMAND CURVE In economics, the demand curve is 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.
DEMAND SCHEDULE • It shows the price and output relationship. It is tabular representation of
price and demand.

Shift in Demand Curve

The demand curve plots the relationship between the quantity demanded of a good or
service and its price. The curve depicts in a graphical way the demand schedule, which details
exactly how many units will be bought at each price.

When the demand of a commodity changes due to change in any factor other than the own
price of the commodity, it is known as change in demand. It is expressed as a shift in the
demand curve. The shift of a demand curve takes place when there is a change in any non-price
determinant of demand, resulting in a new demand curve.

Various Reasons for Shift in Demand Curve:

(i) Change in price of substitute goods;
(ii) Change in price of complementary goods;

(iii) Change in income of consumers;

(iv) Change in tastes and preferences;

(v) Expectation of change in price in future;

(vi) Change in population;

(vii) Change in distribution of income;

(viii) Change in season and weather.

For example, suppose income of a consumer increases. Now, the consumer may increase the
demand for the product, even though the price has not changed. Such increase in demand of
any product, whose price has not changed, cannot be represented by the original demand
curve. It will shift the demand curve.

i. Increase in Demand is shown by rightward shift in demand curve from DD to D 1D1. Demand
rises from OQ to OQ1 due to favourable change in other factors at the same price OP
ii. Decrease in Demand is shown by leftward shift in demand curve from DD to D 2D2. Demand
falls from OQ to OQ2 due to unfavourable change in other factors at the same price OP

In the above figure, demand for the commodity is OQ at a price of OP. Change in other factors
leads to a rightward or leftward shift in the demand curve:

i. Rightward Shift:
When demand rises from OQ to OQ1 (known as increase in demand) at the same price of OP, it
leads to a rightward shift in demand curve from DD to D1D1.

ii. Leftward Shift:

On the other hand, fall in demand from OQ to OQ2 (known as decrease in demand) at the same
price of OP, leads to a leftward shift in demand curve from DD to D 2D2.

LAW OF DEMAND

The law of demand gives the relationship between price of a commodity and its quantity
demanded, when all factors other than price of the commodity remain unchanged.
As discussed earlier, the demand for commodity is affected by many factors such as price of the
commodity, price of related goods, income of the buyer, tastes and preferences etc. So the law
of demand gives effect of change in price of the commodity on the quantity demanded,
assuming that all other factors such as, price of related goods, income of the buyer, tastes and
preferences remain constant.
The law of demand is given as, “If price of a commodity falls, its quantity demanded increases
and if price of the commodity rises, its quantity demanded falls, other things remaining
constant.”
The law of demand means that, other factors determining the demand remaining constant,
price of a commodity and its quantity demanded are inversely related.
Exceptions to the Law of Demand

Definition: There are certain situations where the law of demand does not apply or becomes
ineffective, i.e. with a fall in the price the demand falls and with the rise in price the demand
rises are called as the exceptions to the law of demand. The law of demand does not apply in
every case and situation. The circumstances when the law of demand becomes ineffective are
known as exceptions of the law. Some of these important exceptions are as under.

1. Giffen Goods: Giffen goods are the inferior goods whose demand increases with the increase
in its prices. There are several inferior commodities, much cheaper than the superior
substitutes often consumed by the poor households as an essential commodity. Whenever the
price of the Giffen goods increases its quantity demanded also increases because, with an
increase in the price, and the income remaining the same, the poor people cut the
consumption of superior substitute and buy more quantities of Giffen goods to meet their basic
needs.
For Example, Suppose the minimum monthly consumption of food grains by a poor household
is 20 Kg Bajra (Inferior good) and 10 Kg Rice (superior good). The selling price of Bajra is Rs 5 per
kg, and the rice is Rs 10 per kg, and the household spends its total income of Rs 200 on the
purchase of these items. Suppose, the price of Bajra rose to Rs 6 per kg then the household will
be forced to reduce the consumption of rice by 5 Kg and increase the quantity of Bajra to 25 Kg
in order to meet the minimum monthly requirement of food grains of 30 kg.

2. Conspicuous Consumption:

This exception to the law of demand is associated with the doctrine propounded by Thorsten
Veblen. A few goods like diamonds etc are purchased by the rich and wealthy sections of the
society. The prices of these goods are so high that they are beyond the reach of the common
man. The higher the price of the diamond the higher the prestige value of it. So when price of
these goods falls, the consumers think that the prestige value of these goods comes down. So
quantity demanded of these goods falls with fall in their price. So the law of demand does not
hold good here.

3. Conspicuous necessities:

Certain things become the necessities of modern life. So we have to purchase them despite
their high price. The demand for T.V. sets, automobiles and refrigerators etc. has not gone
down in spite of the increase in their price. These things have become the symbol of status. So
they are purchased despite their rising price. These can be termed as “U” sector goods.

4. Ignorance:

A consumer’s ignorance is another factor that at times induces him to purchase more of the
commodity at a higher price. This is especially so when the consumer is haunted by the phobia
that a high-priced commodity is better in quality than a low-priced one.

5. Emergencies:

Emergencies like war, famine etc. negate the operation of the law of demand. At such times,
households behave in an abnormal way. Households accentuate scarcities and induce further
price rises by making increased purchases even at higher prices during such periods. During
depression, on the other hand, no fall in price is a sufficient inducement for consumers to
demand more.

6. Future changes in prices:

Households also act speculators. When the prices are rising households tend to purchase large
quantities of the commodity out of the apprehension that prices may still go up. When prices
are expected to fall further, they wait to buy goods in future at still lower prices. So quantity
demanded falls when prices are falling.

7. Change in fashion:

A change in fashion and tastes affects the market for a commodity. When a broad toe shoe
replaces a narrow toe, no amount of reduction in the price of the latter is sufficient to clear the
stocks. Broad toe on the other hand, will have more customers even though its price may be
going up. The law of demand becomes ineffective.

Demand Elasticity
Elasticity in general, means the sensitivity or responsiveness of one variable to any change in
another related variable. Demand Elasticity is a concept of judging the responsiveness of
demand.

J.S. Mill and Cournot were the early economists who referred to Elasticity of Demand in
Economics. But this concept was actually developed by Dr. Marshall in his famous book
“Principles of Economics”. Prof. Marshall introduced the concept of elasticity of demand to
measure the change in demand. Thus it is the measurement of the change in demand in
response to a given change in the price of a commodity. It measures how much demand will
change in response to a certain increase or decrease in the price of a commodity.

Definitions

The elasticity of demand measures the responsiveness of the quantity demanded of a good, to
change in its price. Price of other goods and changes in consumer’s income.

– Dooley

Elasticity of demand is a measure of the responsiveness of quantity demanded to a change in

price.

– K Estham

The elasticity of demand at any price or at any output is the proportional change of amount
purchased in response to a small change in price divided by the proportional change in price.

-John Robinson

Elasticity of demand is the capacity of demand to change with least change in price.

-S. K . Rudra

The elasticity of demand for a commodity is the rate at which the quantity bought changes as
the price changes.

-A. Cairncross
Types of Elasticity of Demand
The concept of elasticity of demand can be classified with the respect to a change in its
determinants, like own price, prices of substitutes or complementary commodities and income
of the consumer. The concepts of demand elasticities used in business decisions are :

1. Price elasticity
2. Cross elasticity
3. Income elasticity
4. Advertisement elasticity
5. Arc Elasticity

Price elasticity

The price elasticity of demand is the measure of the responsiveness of quantity demanded of a
good to changes in good’s price, other things being equal. Price elasticity of demand is the ratio
of the percentage change in the quantity demanded of a commodity to a percentage change in
its price. Price elasticity of demand denotes the ratio at which the demand contracts with a rise
in price and extends with a fall in price. There is an inverse relationship between price and
quantity demanded of a good. Accordingly, elasticity of demand is expressed by minus (-) sign .

In the words of Lipsey,

“Because of the negative slope of the demand curve, the price and the quantity will always
change in opposite directions. One change will be positive and the other negative, making the
measured elasticity of demand negative.”

However the custom is to ignore the negative sign and discuss only the absolute level of the
price elasticity. In other words price elasticity of demand is expressed as a number eliminating
the need to deal with the negative sign.

Supposing fall in price by 10% is followed by extension in demand by 20 %. Fall in price is

indicated by minus (-) sign. On multiplication these minus sign, turn to plus (+) sign
 Definition
Price elasticity of demand measures the responsiveness of the quantity demanded of a good to
the change in its price.

-Boulding

Question : Quantity demanded is 20 units at a price of Rs.500. When there is a fall in price to
Rs. 400 it results in a rise in demand to 32 units. Therefore the change in quantity demanded
is12 units resulting from the change in price of Rs.100. Calculate price elasticity of demand .

The Price Elasticity of Demand is = 500 / 20 x 12/100 = 3

Values and Meaning of price elasticity

Cross elasticity of demand
Meaning
The Cross elasticity of Demand is the measure of responsiveness of demand for a commodity
to the changes in the price of its substitutes and complementary goods. For example, change in
the price of tea ordinarily causes change in demand for coffee. Likewise, change in the price of
cars causes change in demand for petrol.
Formula of Calculation
The formula for calculating cross elasticity of demand is as follows:

Proportion ate change in quantity demanded of commodity X

ec =
Proportion ate change in price of commodity Y

Definitions
The cross elasticity of demand is the proportional change in the quantity demanded of good X
divided by the proportional change in the price of the related good Y

-Ferguson

The cross elasticity of demand is a measure of the responsiveness of purchases of X to change

in the price of Y

-Leibhafsky

Degree of Cross Elasticity of Demand

When two goods are substitute for one another their demand has positive cross elasticity
because increase in the price of one increases the demand for the other. And, the demand for
complementary goods has negative cross elasticity, because increase in the price of a good
decreases the demand for its complementary goods.

1. Positive
When goods are substitutes of each other, then a given percentage rise in the price of good will
lead to a given percentage increase in the demand for the other good. In other words , cross
elasticity of demand is positive in case of subtitles. For example, rise in the price of coffee will
lead to increase in demand for tea, because the two are close substitutes of each other. It can
be explained with an example. Supposing, when price of coffee 50 paise per cup, then demand
for tea is 50 cups. If price of coffee rises to 70 paise per cup, then demand for tea goes upto 100
cups. Thus, cross elasticity of demand for tea can be calculated by the above formula.
Thus, cross elasticity for tea is greater than unity.

Cross elasticity of demand in case of substitutes e.g. tea and coffee is illustrated in fig. 1. In this
diagram quantity of tea is shown on OX-axis and price of coffee on OY- axis. When price of
coffee is , demand for tea increases to . DCDC curve represents different quantities of tea
demanded as a result of change in price of coffee. This curve slopes upward from left to right. It
means rise in price of coffee will lead to increase in demand for tea and fall in the price of
coffee will lead to decrease in demand for tea.

2. Negative
In case of complementary goods , percentage rise in the price of one leads to percentage fall in
the demand of the other. Consequently, cross elasticity of demand is negative and the same is
indicated by putting a minus ( -) sign before the number of cross elasticity of demand. It is
explained with the help of an example. Supposing, bread and butter are complementary goods.
When price of bread is 80 paise per piece, then demand for butter is 10 kg. With the rise of
price of bread to Rs. 1. 20, demand for bread falls to 5 kg. In this situation, cross elasticity of
demand for butter is calculated as under.
(Here, x stands for butter, and y for bread)

Negative Cross elasticity of demand is explained with the help of following figure. Quantity of
butter is shown on OX- axis and price of bread on OY- axis. DCDC curve represents negative
cross elasticity of demand. It slopes downwards from left to right, signifying that rise in price of
bread will bring down the demand for butter. Points E and indicate that at OP price of bread,
demand for butter is OQ. When price of bread rises to then demand for butter is contracted to

iii. Zero cross elasticity of demand

Cross elasticity of demand is zero when two goods are not related to each other. For example
rise in the price of wheat will have no effect on the demand for shoes. Their cross elasticity of
demand will be called zero.

Income elasticity of Demand

Apart from the price of a product and its substitutes, consumer’s income is another basic
determinant of demand for a product. The relationship between quantity demanded and
income is of positive nature, unlike the negative price demand relationship. The demand for
goods and services increases with increase in consumer’s income and vice-versa. The
responsiveness of demand to the changes in income is known as income elasticity of demand.

Definitions
Income elasticity of demand means the ration of the percentage change in the quantity
demanded to the percentage change in income.

-Watson
 The responsiveness of demand to change in income is termed as income elasticity of demand.

-Richard G. Lipsey

Income elasticity can be measured by the following formula:

Proportion ate change in quantity demanded of commodity X
ey =
Proportion ate change in income of consumer

Advertisement or Promotional Elasticity of Sales

The expansion of demand by means of advertisement and other promotional efforts may be
measured by advertising elasticity of demand also called promotional elasticity. The concept of
advertisement elasticity is useful in determining the optimum level of advertisement
expenditure. The promotional elasticity measures the responsiveness of demand to changes in
advertising or other promotional expenses. The formula for its measurement is as given below:

Here stands for advertising elasticity. ‘S’ stands for sales and ‘A’ stands for advertising outlays.

Factors affecting Advertising Elasticity

1. The level of total sales
In the initial stages of sale of a product, particularly of one which is newly introduced in the
market, the advertisement elasticity is greater than unity. As sales increase, the elasticity
decreases. For instance after the potential market is supplied, the function of advertisement is
to create additional demand by attracting more consumers to the product, particularly those
who are slow in adjusting their consumption expenditure to provide for new commodities.
Therefore, demand decreases at the rate lower than the rate of increase in advertisement
expenditure.

2. Cumulative affect of past advertisement

In case expenditure incurred on advertisement in the initial stages is not adequate enough to
be effective, elasticity may be very low. But over time, additional doses of advertisement
expenditure may have a cumulative effect on the promotion of sales and advertising elasticity
may increase.

3. Advertisement by rivals
In the highly competitive market, the effectiveness of advertisement by a firm is also
determined by the relative effectiveness of advertisement by the rival.

4. Other factors
Advertisement elasticity is also affected by other factors affecting the demand for a product,
e.g.

• Change in product’s price

• Consumer’s income
• Growth of substitutes and their prices

Definition of Arc-Elasticity of Demand

Elasticity of demand that is obtained at a point on the demand curve for a good as a
consequence of an extremely small change in its price, is called the point elasticity of demand
for the good.

But if the change in price is not extremely small, if the change is by a considerable amount, then
move to another point on the demand curve which is somewhat away from the initial point. In
this case, the elasticity of demand that is obtained over the arc of the demand curve between
the two points is called the arc-elasticity of demand. This elasticity can be explained with the
help of given figure below:

Arc Elasticity of demand:

In the above given figure , DD is the demand curve for the good. R 1 (p1, q1) and R2 (p2, q2) are
any two p points on DD. Initially, at the point R1, when the price is p1, demand is q1.
Now if the price decreases by a considerable amount from p1 to p2, the demand for the good in-
creases from q1to q2 at the point R2. The elasticity of demand that is obtained in the case of this
price change is called the arc-elasticity of demand—here over the arc R1R2 of the demand curve.
It should be remembered here that if our initial point is R2 (p2, q2) and if, after a rise in price
from p2 to p1, come to the point R1 (p1, q1), then the arc-elasticity of demand—now over the arc
R2R1 is obtained. Since the two arcs, viz., R1R2 and R2R1, over the demand curve are identical,
the arc-elasticities in these two cases would also be the same.

That is why, while measuring the arc-elasticity of demand over the arc R1R2 or R2R1, accept the
average of p1 and p2, i.e., (p1 + p2)/2, as the initial price, and the average of q1 and q2, i.e., (p1 +
p2)/2, as the initial demand.
Therefore, the coefficient of arc-elasticity of demand over the arc R1R2 or R2R1would be:

Uses of Price Elasticity of Demand in Managerial Decision-making

The concept of price elasticity of demand has important practical applications in managerial
decision-making. A business man has often to consider whether a lowering of price will lead to
an increase in the demand for his product, and if so, to what extent and whether his profits
would increase as a result thereof. Here the concept of elasticity of demand becomes crucial.

Knowledge of the nature of the elasticity of demand for his products will help a business to
decide whether he should cut his price in a particular case. Such knowledge would also help a
businessman to determine whether and to what extent the increase in costs could be passed
on to the consumer. In general for items those whose demand is elastic it will pay him to
charge relatively low prices, while on those whose demand is elastic, it would be better off
with a higher price. A monopolist would not be able to increase his price if the demand for his
product is elastic.
The following points highlight the ten main areas of importance of elasticity of demand in
management. Some of the areas are: 1. In the Determination of Output Level 2. In the
Determination of Price 3. In Price Discrimination by Monopolist 4. In Price Determination of
Factors of Production 5. In Demand Forecasting 6. In Dumping 7. In the Determination of
Prices of Joint Products and Other.

Area # 1. In the Determination of Output Level:

For making production profitable, it is essential that the quantity of goods and services should
be produced corresponding to the demand for that product. Since the changes in demand is
due to the change in price, the knowledge of elasticity of demand is necessary for determining
the output level.

Area # 2. In the Determination of Price:

The elasticity of demand for a product is the basis of its price determination. The ratio in which
the demand for a product will fall with the rise in its price and vice versa can be known with
the knowledge of elasticity of demand.

If the demand for a product is inelastic, the producer can charge high price for it, whereas for
an elastic demand product he will charge low price. Thus, the knowledge of elasticity of
demand is essential for management in order to earn maximum profit.

Area # 3. In Price Discrimination by Monopolist:

Under monopoly discrimination the problem of pricing the same commodity in two different
markets also depends on the elasticity of demand in each market. In the market with elastic
demand for his commodity, the discriminating monopolist fixes a low price and in the market
with less elastic demand, he charges a high price.

Area # 4. In Price Determination of Factors of Production:

The concept of elasticity for demand is of great importance for determining prices of various
factors of production. Factors of production are paid according to their elasticity of demand. In
other words, if the demand of a factor is inelastic, its price will be high and if it is elastic, its
price will be low.

Area # 5. In Demand Forecasting:

The elasticity of demand is the basis of demand forecasting. The knowledge of income
elasticity is essential for demand forecasting of producible goods in future. Long- term
production planning and management depend more on the income elasticity because
management can know the effect of changing income levels on the demand for his product.
Area # 6. In Dumping:
A firm enters foreign markets for dumping his product on the basis of elasticity of demand to
face foreign competition.

Area # 7. In the Determination of Prices of Joint Products:

The concept of the elasticity of demand is of much use in the pricing of joint products, like
wool and mutton, wheat and straw, cotton and cotton seeds, etc. In such cases, separate cost
of production of each product is not known.

Therefore, the price of each is fixed on the basis of its elasticity of demand. That is why
products like wool, wheat and cotton having an inelastic demand are priced very high as
compared to their byproducts like mutton, straw and cotton seeds which have an elastic
demand.

Area # 8. In the Determination of Government Policies:

The knowledge of elasticity of demand is also helpful for the government in determining its
policies. Before imposing statutory price control on a product, the government must consider
the elasticity of demand for that product.

The government decision to declare public utilities those industries whose products have
inelastic demand and are in danger of being controlled by monopolist interests depends upon
the elasticity of demand for their products.

Area # 9. Helpful in Adopting the Policy of Protection:

The government considers the elasticity of demand of the products of those industries which
apply for the grant of a subsidy or protection. Subsidy or protection is given to only those
industries whose products have an elastic demand. As a consequence, they are unable to face
foreign competition unless their prices are lowered through subsidy or by raising the prices of
imported goods by imposing heavy duties on them.

Area # 10. In the Determination of Gains from International Trade:

The gains from international trade depend, among others, on the elasticity of demand. A
country will gain from international trade if it exports goods with less elasticity of demand and
import those goods for which its demand is elastic.

DEMAND FORECASTING
Every manager would like to know exact nature of future events to accordingly take action or
plan his action when sufficient time is in hand to implement the plan. The effectiveness of his
plan depends upon the level of accuracy with which future events are known to him. But every
manager plans for future irrespective of the fact whether future events are exactly known or
not. That implies, he does try to forecast future to the best of his Ability, Judgment and
Experience. Virtually all management decisions depend on forecasts. Managers study sales
forecasts, for example, to take decisions on working capital needs, the size of the work force,
inventory levels, the scheduling of production runs, the location of facilities, the amount of
advertising and sales promotion, the need to change prices, and many other problems.

Forecasting is a process of estimating a future event by casting forward past data. The past data
are systematically combined in a predetermined way to obtain the estimate of the future.
Prediction is a process of estimating a future event based on subjective considerations other
than just past data; these subjective considerations need not be combined in a predetermined
way. Thus forecast is an estimate of future values of certain specified indicators relating to a
decisional/planning situation, In some situations forecast regarding single indicator is sufficient,
where as, in some other situations forecast regarding several indicators is necessary. The
number of indicators and the degree of detail required in the forecast depends on the intended
use of the forecast. There are two basic reasons for the need for forecast in any field.

1. Purpose – Any action devised in the PRESENT to take care of some contingency accruing out
of a situation or set of conditions set in future. These future conditions offer a purpose / target
to be achieved so as to take advantage of or to minimize the impact of (if the foreseen
conditions are adverse in nature) these future conditions.

2. Time – To prepare plan, to organize resources for its implementation, to implement; and
complete the plan; all these need time as a resource. Some situations need very little time,
some other situations need several years of time. Therefore, if future forecast is available in
advance, appropriate actions can be planned and implemented ‘intime’.

The industry forecast is based on surveys of consumers’ intention and analysis of statistical
trends is made available by trade associations or chamber of commerce. It can give indication
to a firm regarding tine direction in which the whole industry will be moving. The company
derives its sales forecast by assuming that it will win a certain market share.

In the words of Cundiff and Still, “Demand forecasting is an estimate of sales during a specified
future period which is tied to a proposed marketing plan and which assumes a particular set of
uncontrollable and competitive forces”. Therefore, demand forecasting is a projection of firm’s
expected level of sales based on a chosen marketing plan and environment.
 Definition: Demand Forecasting is a systematic process of predicting the future demand for a
firm’s product. Simply, estimating the potential demand for a product in the future is called as
demand forecasting.

Steps in Demand forecasting

1. Specifying the Objective: The objective for which the demand forecasting is to be done must be
clearly specified. The objective may be defined in terms of; long-term or short-term demand,
the whole or only the segment of a market for a firm’s product, overall demand for a product or
only for a firm’s own product, firm’s overall market share in the industry, etc. The objective of
the demand must be determined before the process of demand forecasting begins as it will give
direction to the whole research.
2. Determining the Time Perspective: On the basis of the objective set, the demand forecast can
either be for a short-period, say for the next 2-3 year or a long period. While forecasting
demand for a short period (2-3 years), many determinants of demand can be assumed to
remain constant or do not change significantly. While in the long run, the determinants of
demand may change significantly. Thus, it is essential to define the time perspective, i.e., the
time duration for which the demand is to be forecasted.
3. Making a Choice of Method for Demand Forecasting: Once the objective is set and the time
perspective has been specified the method for performing the forecast is selected. There are
several methods of demand forecasting falling under two categories; survey
methods and statistical methods.

The Survey method includes consumer survey and opinion poll methods, and the statistical
methods include trend projection, barometric and econometric methods. Each method varies
from one another in terms of the purpose of forecasting, type of data required, availability of
data and time frame within which the demand is to be forecasted. Thus, the forecaster must
select the method that best suits his requirement.

4. Collection of Data and Data Adjustment: Once the method is decided upon, the next step is to
collect the required data either primary or secondary or both. The primary data are the first-
hand data which has never been collected before. While the secondary data are the data
already available. Often, data required is not available and hence the data are to be adjusted,
even manipulated, if necessary with a purpose to build a data consistent with the data
required.
5. Estimation and Interpretation of Results: Once the required data are collected and the
demand forecasting method is finalized, the final step is to estimate the demand for the
predefined years of the period. Usually, the estimates appear in the form of equations, and the
result is interpreted and presented in the easy and usable form.

Thus, the objective of demand forecasting can only be achieved only if these steps are followed
systematically.

Why Forecast ?
․ To plan for the future by reducing uncertainty.

․ To anticipate and manage change.

․ To increase communication and integration of planning teams.

․ To anticipate inventory and capacity demands and manage lead times.

․ To project costs of operations into budgeting processes.

․ To improve competitiveness and productivity through decreased costs and improved delivery
and responsiveness to customer needs.

At different levels forecasting may be classified into:

(i) Macro-level forecasting,

(ii) Industry- level forecasting,

(iii) Firm- level forecasting and

(iv) Product-line forecasting.

Macro-level forecasting is concerned with business conditions over the whole economy. It is
measured by an appropriate index of industrial production, national income or expenditure.
Industry-level forecasting is prepared by different trade associations.

This is based on survey of consumers’ intention and analysis of statistical trends. Firm-level
forecasting is related to an individual firm. It is most important from managerial view point.
Product-line forecasting helps the firm to decide which of the product or products should have
priority in the allocation of firm’s limited resources.

USEFUL FORECASTING TERMS

Forecast accuracy a measurement of forecast usefulness, often defined as the average
difference between the forecast value to the actual value.
Forecast bias Tendency of a forecast to systematically miss the actual demand (consistently
either high or low).

Forecast error the difference between actual demand and forecast demand, stated as an
absolute value or as a percentage.

Forecast horizon the period of time into the future for which a forecast is prepared.
Objectives of Demand Forecasting

The objectives of demand forecasting can be divided into two categories, namely short-term
objectives and long-term objectives.
Short-term Objectives
1. Formulation of Production Policy
Demand forecast helps in formulating suitable production policy so that there may not be any
gap between demand and supply of product. This can further ensure:

Regular supply of material: By the determination of desired volume of production on the basis
of sales forecasts, one can evaluate the necessary raw material requirements in future so as to
ensure regular and continuous supply of the materials as well as controlling the size of
inventory at economic level.
Maximum utilisation of machines: The operations can be so planned that the machines are
utilised to their maximum capacity.
Regular availability of labour: Skilled and unskilled workers can be properly arranged to meet
the production schedule requirement.
2. Price Policy Formulation
Demand forecast enables the management to formulate some appropriate pricing mechanism,
so that the level of price does not fluctuate too much during the period of depression or
inflation.

3. Proper Control of Sales

Demand forecasts are calculated region-wise and then the sales targets for various territories
are fixed accordingly. This later on becomes the basis to evaluate the sales performance.

4. Arrangement of Finance
On the basis of sales forecast, one can determine the financial requirements of the organization
for the product of the desired output. This can lead to minimize the cost of obtaining finance.

Long-term Objectives of Demand Forecasting

1. To decide about the Production Capacity
The size of the plant should be such that the output conforms to sales requirements. Too small
or too large size of the plant may not be in the economic interest of the firm. By studying the
demand pattern for the product and the forecasts for future, the firm can plan for plant/output
of desired capacity.
2. Labour Requirements
Expenditure on labour is one of the most important components in cost of production. Reliable
and accurate sales forecasts can help the management to assess the appropriate labour
requirements.

3. Capital Restructuring/Resourcing
Long term production planning can help the management to arrange for long term finance on
reasonable terms and conditions from different sources, internal as well as external sources,
and sometimes from global sources
Forecasting Techniques:

Demand forecasting is a difficult exercise. Making estimates for future under the changing con-
ditions is a Herculean task. Consumers’ behaviour is the most unpredictable one because it is
motivated and influenced by a multiplicity of forces. There is no easy method or a simple
formula which enables the manager to predict the future.

Economists and statisticians have developed several methods of demand forecasting. Each of
these methods has its relative advantages and disadvantages. Selection of the right method is
essential to make demand forecasting accurate. In demand forecasting, a judicious combination
of statistical skill and rational judgement is needed. There are two types of techniques used for
demand forecasting.

1. Qualitative Technique

2. Quantitative technique

Qualitative Technique

(a) Consumer’s Survey Method or Survey of Buyer’s Intentions:

In this method, the consumers are directly approached to disclose their future purchase plans.
This is done by interviewing all consumers or a selected group of consumers out of the relevant
population. This is the direct method of estimating demand in the short run. Here the burden of
forecasting is shifted to the buyer. The firm may go in for complete enumeration or for sample
surveys. If the commodity under consideration is an intermediate product then the industries
using it as an end product are surveyed.

(b) Sales Force Opinion Method:

This is also known as collective opinion method. In this method, instead of consumers, the
opinion of the salesmen is sought. It is sometimes referred as the “grass roots approach” as it is
a bottom-up method that requires each sales person in the company to make an individual
forecast for his or her particular sales territory.
These individual forecasts are discussed and agreed with the sales manager. The composite of
all forecasts then constitutes the sales forecast for the organisation. The advantages of this
method are that it is easy and cheap. It does not involve any elaborate statistical treatment.
The main merit of this method lies in the collective wisdom of salesmen. This method is more
useful in forecasting sales of new products.

(c) Experts Opinion Method:

This method is also known as “Delphi Technique” of investigation. The Delphi method requires
a panel of experts, who are interrogated through a sequence of questionnaires in which the
responses to one questionnaire are used to produce the next questionnaire. Thus any
information available to some experts and not to others is passed on, enabling all the experts to
have access to all the information for forecasting.

The method is used for long term forecasting to estimate potential sales for new products. This
method presumes two conditions: Firstly, the panellists must be rich in their expertise, possess
wide range of knowledge and experience. Secondly, its conductors are objective in their job.
This method has some exclusive advantages of saving time and other resources.

Quantitative Techniques ( Statistical Method )

(i) Trend Projection Method:

A firm existing for a long time will have its own data regarding sales for past years. Such data
when arranged chronologically yield what is referred to as ‘time series’. Time series shows the
past sales with effective demand for a particular product under normal conditions. Such data
can be given in a tabular or graphic form for further analysis. This is the most popular method
among business firms, partly because it is simple and inexpensive and partly because time
series data often exhibit a persistent growth trend.

The trend can be estimated by using any one of the following methods:
(a) The Graphical Method

(b) The Least Square Method.

a) Graphical Method:
This is the most simple technique to determine the trend. All values of output or sale for
different years are plotted on a graph and a smooth free hand curve is drawn passing through
as many points as possible. The direction of this free hand curve—upward or downward—
shows the trend. A simple illustration of this method is given in Table.

Sales of Firm

Year es (Rs. in Crore)

1995 40

1996 50

1997 44

1998 60

1999 54

2000 62

In the given figure, AB is the trend line which has been drawn as free hand curve passing
through the various points representing actual sale values.

(b) Least Square Method:

Under the least square method, a trend line can be fitted to the time series data with the help
of statistical techniques such as least square regression. When the trend in sales over time is
given by straight line, the equation of this line is of the form: y = a + bx. Where ‘a’ is the
intercept and ‘b’ shows the impact of the independent variable. We have two variables—the
independent variable x and the dependent variable y. The line of best fit establishes a kind of
mathematical relationship between the two variables .v and y. This is expressed by the
regression у on x.

In order to solve the equation v = a + bx, we have to make use of the following normal
equations:
Σ y = na + b ΣX
Σ xy =a Σ x+b Σ x2

(ii) Regression Analysis:

It attempts to assess the relationship between at least two variables (one or more independent
and one dependent), the purpose being to predict the value of the dependent variable from the
specific value of the independent variable. The basis of this prediction generally is historical
data. This method starts from the assumption that a basic relationship exists between two
variables. An interactive statistical analysis computer package is used to formulate the
mathematical relationship which exists.

For example, one may build up the sales model as:

Quantum of Sales = a. price + b. advertising + c. price of the rival products + d. personal
disposable income +u

Where a, b, c, d are the constants which show the effect of corresponding variables as sales.
The constant u represents the effect of all the variables which have been left out in the
equation but having effect on sales. In the above equation, quantum of sales is the dependent
variable and the variables on the right hand side of the equation are independent variables. If
the expected values of the independent variables are substituted in the equation, the quantum
of sales will then be forecasted.

(ii) Barometric Technique:

A barometer is an instrument of measuring change. This method is based on the notion that
“the future can be predicted from certain happenings in the present.” In other words,
barometric techniques are based on the idea that certain events of the present can be used to
predict the directions of change in the future. This is accomplished by the use of economic and
statistical indicators which serve as barometers of economic change.

Law of supply
Law of supply expresses a relationship between the supply and price of a product. It states a
direct relationship between the price of a product and its supply, while other factors are kept
constant.

For example, in case the price of a product increases, sellers would prefer to increase the
production of the product to earn high profits, which would automatically lead to increase in
supply.

Similarly, if the price of the product decreases, the supplier would decrease the supply of the
product in market as he/she would wait for rise in the price of the product in future.

Supply Schedule:
Supply schedule shows a tabular representation of law of supply. It presents the different
quantities of a product that a seller is willing to sell at different price levels of that product.

Supply Curve:
The graphical representation of supply schedule is called supply curve. In a graph, price of a
product is represented on Y-axis and quantity supplied is represented on X-axis.

Supply Function:

Supply function is the mathematical expression of law of supply. In other words, supply
function quantifies the relationship between quantity supplied and price of a product, while
keeping the other factors at constant.

The supply function can be expressed as:

Sx = f (Px)

Where: Sx = Quantity supplied for product X , Px = Price of product X

f = Constant representing change produced in Sx with one unit change in Px

Elasticity of Supply

Meaning of Elasticity of Supply:

The law of supply indicates the direction of change—if price goes up, supply will increase. But
how much supply will rise in response to an increase in price cannot be known from the law of
supply. To quantify such change we require the concept of elasticity of supply that measures
the extent of quantities supplied in response to a change in price.

Elasticity of supply measures the degree of responsiveness of quantity supplied to a change in

own price of the commodity. It is also defined as the percentage change in quantity supplied
divided by percentage change in price.

It can be calculated by using the following formula:

ES = % change in quantity supplied/% change in price
Symbolically,

ES = ∆Q/Q ÷ ∆P/P = ∆Q/∆P × P/Q

Types of Elasticity of Supply:

For all the commodities, the value of Es cannot be uniform. For some commodities, the value
may be greater than or less than one.
Like elasticity of demand, there are five cases of ES:

(a) Elastic Supply (ES>1):

Supply is said to be elastic when a given percentage change in price leads to a larger change in
quantity supplied. Under this situation, the numerical value of E s will be greater than one but
less than infinity.

(b) Inelastic Supply (ES< 1):

Supply is said to be inelastic when a given percentage change in price causes a smaller change
in quantity supplied. Here the numerical value of elasticity of supply is greater than zero but
less than one.

(c) Unit Elasticity of Supply (ES = 1):

If price and quantity supplied change by the same magnitude, then we have unit elasticity of
supply.
(d) Perfectly Elastic Supply (ES = ∞):
The numerical value of elasticity of supply, in exceptional cases, may reach up to infinity. If
price slightly drops down , nothing will be supplied.

(e) Perfectly Inelastic Supply (ES = 0):

Another extreme is the completely or perfectly inelastic supply or zero elasticity which means
whatever the price of the commodity, it may even be zero, quantity supplied remains
unchanged .

Factors Influencing Elasticity Of Supply

1. Nature of the commodity: If the commodity is perishable in nature then the elasticity of
supply will be less. Durable goods have high elasticity of supply.

2. Time period: If the operational time period is short then supply is inelastic. When the the
production process period is longer the elasticity of supply will be relatively elastic.

3. Scale of production: Small scale producer’s supply is inelastic in nature compared to the
large producers.

4. Size of the firm and number of products: If the firm is a large scale industry and has more
variety of products then it can easily transfer the resources. Therefore supply of such products
is highly elastic.

5. Natural factors: Natural calamities can affect the production of agricultural products so they
are relatively inelastic.

6. Nature of production: If the commodities need more workmanship, or for artistic goods the
elasticity of supply will be high.

Uses of Price Elasticity of Supply in Managerial Decision-making

1. Financial decisions
2. Production decisions
3. Inventory decisions

Price of Product under demand and supply forces

The operation of the market depends on the interaction between buyers and sellers. Market
equilibrium refers to the stage where the quantity demanded for a product is equal to the
quantity supplied for the product. The price when the quantity demanded is equal to the
quantity supplied for the product is known as equilibrium price. Equilibrium price is also termed
as market clearing price, which is referred to a price when there is neither an unsold stock nor
an unsupplied demand. An equilibrium is the condition that exists when quantity supplied and
quantity demanded are equal. At equilibrium, there is no tendency for the market price to
change. The market price refers to a current price at which a product is sold in the market. It is
determined by the collaboration of two functions, namely, demand and supply. According to
economic theory, the market price of a product is determined at a point where the forces of
supply and demand meet. The point where the forces of demand and supply meet is called
equilibrium point. Conceptually, equilibrium means state of rest. It is the stage where the
balance between two opposite functions, demand and supply is achieved.

At any price level other than P0, the wishes of buyers and sellers do not coincide.

Higher demand leads to higher equilibrium price and higher equilibrium quantity.
 Higher supply leads to lower equilibrium price and higher equilibrium quantity.

Lower demand leads to lower price and lower quantity exchanged.

Lower supply leads to higher price and lower quantity exchanged.