MASTER

OF
BUSINESS ADMINISTRATION

SEMESTER-1
ECONOMICS FOR MANAGERS
Unit 2





Prepared by


MANU. K.M.
Assistant Professor
Vimal Jyothi Institute of Management and Research,
Chemperi- Kannur
[email protected]


M.B.A.

Economics for Managers 2




Demand: Introduction
Consumer demand is the basis of all productive activities. Just as necessity is the mother of
invention demand is the mother of production. Increasing demand for a product offers
high business prospects for it in future and decreasing demand for a product diminishes its
business prospect.
Meaning of Demand
Demand is the desire backed by ability to pay and willingness to pay for a commodity.
Mere desire or ability to pay will not form demand.
For e.g. if a man wants to buy a car, but he does not have sufficient money to pay for it,
his want is not his demand for the car.
Similarly a rich miser may have the desire and ability but not willingness to pay. In both
the cases there is no demand.
A want with three attributes-
Desire to buy
Ability to pay
Willingness to pay -becomes effective demand
Basis of the consumer Demand: Utility
Consumers demand a commodity because they derive or expect to derive utility form the
consumption of that commodity.
Meaning of Utility
The concept of utility can be looked up from two angles- from the product angle and from
the consumers angle.
From the product angle, utility is the want satisfying power of a commodity
From the consumers angle, utility is the psychological satisfaction/ pleasure, which a
consumer derives from the consumption, possession or use of the commodity
Utility in the sense of satisfaction is a subjective or relative concept because
a) A commodity need not be useful for all
b) Utility of a commodity varies from person to person and from time to time
c) A commodity need not have the same utility for the same consumer at different points
of time
Quantitative Concepts of Utility
a) Total utility
Total utility is defined as the total psychological satisfaction derived by a consumer from
the consumption of a given amount of a commodity. In other words, it is the sum of utilities
obtained from consumption of different quantities of a commodity.
UNIT- 2
Demand Analysis and Forecasting


M.B.A.

Economics for Managers 3

Suppose a consumer consumes four units of a commodity, X and derives utility from the
successive units of consumption as u1, u2, u3 and u4. His total utility (Ux) from commodity
X can be measured as
TUx= u1+u2+u3+u4
b) Marginal utility
Marginal utility may be defined as the addition to total utility resulting from the
consumption of one additional unit.
MU of n th unit= TUn-TUn-1

Cardinal and ordinal concepts of utility
Cardinal Utility Approach
The cardinal utility approach was developed Classical and neo classical economists
Jermy Bentham, Alfred Marshall, Leon Walras
They believed that Utility is cardinally or quantitatively measurable like height,
weight etc.
They coined the term Utils as a measure/units of utility
Ordinal Utility Approach
The ordinal approach to utility was developed by Modern economists-
J.R. Hicks & R.G.D. Alllen
They believed that utility is not quantitatively measurable
Can be ranked on the basis of their preferability
Assumptions of Cardinal utility approach
Rationality
Utility is cardinally measurable
Limited money income
Maximization of satisfaction
Utility is cardinally measurable
Diminishing marginal utility
Constant marginal utility of money- what ever the level of income
Utility is additive

Law of diminishing marginal utility
The law of diminishing marginal utility is one of the fundamental laws in economics.
I t has been devel oped by Jevon, Karl Menger and Leon Wal ras and was
popularised by Prof. Alfred Marshall
The Law
the additional benefit which a person derives from a given increase in the stock of a
thing diminishes with every increase in the stock that he already has
It means, as a consumer increases the consumption of a product, the utility gained from
successive units goes on decreasing. In other words, the rates of increase of total utility
decreases as more and more units are consumed.


M.B.A.

Economics for Managers 4

Assumptions of the law
1. The unit of the consumer good must be a standard one
2. The consumers taste and preference must remain the same
3. There must be continuity in consumption
4. The mental condition of the consumer must remain normal during the period of
consumption.
To illustrate the law, let us assume that a consumer consumes only one commodity X, and
that utility is measurable in quantitative terms.
Units of
commodity
X
Total
Utility
(Tux)
Marginal
Utility (MUx)
1 30 30
2 50 20
3 60 10
4 65 5
5 60 -5
6 45 -15

As shown in the table, with the increase in the number of units of commodity X consumed
per unit of time, TUx increases but at a diminishing rate. The diminishing MUx is shown in
the last column of the table.

Total Utility/
Marginal Utility
70 M

60
TU
50

40

30

20

10

1 2 3 4 5 6 Quantity
- 10 MUx
The above figure illustrates graphically the law of diminishing marginal utility. The rate of
increase in TUx as a result of increase in the number of units consumed is shown by the
MUx curve. The downward slopping MUx curve shows that marginal utility goes on

M.B.A.

Economics for Managers 5

decreasing as consumption increases. At 4 units of consumption, TUx reaches its maximum
level, the point of saturation marked by point M. Beyond this point MUx becomes negative
and TUx begins to decline. The downward slopping MUx curve illustrates the law of
diminishing marginal utlity.
Why does MU decrease?
When a person consumes successive units of a commodity, his need is satisfied by degrees
in the process of consumption of the commodity and the intensity of his need goes on
decreasing. Therefore, the utility obtained from each successive units goes on decreasing.
Exceptions of the Law
The law is not applicable under the following situations.
1. The law does not apply to rare collections such as old coins, stamps, rare paintings etc.
2. This law is not (fully) applicable in the case of money. This is because man is not fully
satisfied with money. But it can be said that Marginal utility of money diminishes,
though it will not reach zero or negative.
3. The consumption of liquor is not subject to the law of DMU. The more a person drinks
liquor, the more he likes it.
Law of Equi-marginal utility
(Consumers Equilibrium- cardinal utility approach)
A consumer is said to be in equilibrium when he has
Maximized his satisfaction
Spent his entire income
Attained optimum allocation of expenditure
Consumed optimum quantity of each
The law states that
A consumer is in equilibrium when he spends his income in such a way that utility from
the last one unit of money spend on various commodities is the same
Consumer equilibrium-One Commodity model
Suppose that a consumer with a given money income consumes only one commodity, X.
The utility maximizing consumer reaches his equilibrium where:
MUx = Px( MU m)


MUx
Px
= 1
MUx- Marginal utility of X
Px- Price of x
Mum- Marginal utility of money
Consumer equilibrium- Multiple Commodity Model
Suppose that a consumer consumes only two commodities, X and Y, their prices being Px
and Py respectively.
The consumer equilibrium can be expressed as
MUx
Px
=
MUy
Py
= Mum

M.B.A.

Economics for Managers 6

Criticisms of the laws
1. Cardinal measurability of utility is unrealistic
2. Assumption of constant marginal utility of money is invalid
3. Marshallian demand theorem cannot be derived except in one commodity case.
4. Marshall could not explain Giffen Paradox

The Law of Demand
The relationship between price and quantity demanded is usually referred to as law of
demand.
The law of demand states that,
Other things remaining same, the quantity demanded of a commodity varies inversely
with price.
That is, when price rises demand for the commodity falls and when price falls demand for
the commodity rises.
There exist an inverse relationship between price and quantity demanded.
It is a short run law
Assumptions of the Law
1. Consumers money income remain constant
2. Price of other goods remain the same
3. Taste and preference of consumers remain the same
4. The commodity has no close substitutes
5. The commodity is a normal commodity
The law of demand can be true only when all the assumptions are valid.
The law of demand can be explained with the help of following table and diagram
Demand schedule
A demand schedule is a table which shows the amount of a commodity demanded at a
given period of time at various prices
Price
per cup of tea
No. of cups of tea
consumed per day
Points representing
price quantity
combinations
7 1 i
6 2 j
5 3 k
4 4 l
3 5 m
2 6 n
1 7 o
Demand curve
The law of demand can be presented through a demand curve.
Demand curve is a graphical representation of demand schedule

M.B.A.

Economics for Managers 7

It slopes downwards from left to right
The slope of demand curve
AP
A D

Price D
7 i
6 j
5 k
4 l
3 m
2 n
1 D
0 1 2 3 4 5 6 7
Quantity Demanded
Demand curve shows the quantities of a commodity which a consumer would buy at
different prices per unit of time, under the assumptions of the law of demand. Each point
on the demand curve shows a unique price-quantity combination.
Why does demand curve slope downward to the right?
(Factors behind the law of demand)
The demand curve for a commodity usually slopes downward. The downward slope of the
demand curve depicts the law of demand. The factors that make the law of demand
operate are the following. These factors answer the question why does demand curve
slope downward to the right.
1. Substitution Effect
Substitution effect means the increase in quantity demanded of a commodity as a
consequence of a change in its relative price alone, real income remaining constant
When the price of a commodity falls & prices of its substitutes remaining constant ,
then,
Substitutes become relatively costlier
Commodity whose price has fallen becomes relatively cheaper
Since a utility maximizing consumer substitutes cheaper goods for costlier ones, demand
for cheaper commodity increases. The increase in demand on account of this factor is
known as the substitution effect.


o

M.B.A.

Economics for Managers 8

2. Income effect
The increase in demand for a commodity as a result of an increase in real income is
known as income effect
When price of a commodity falls, other things remaining the same, then the real income
of the consumer increases
Consequently, his purchasing power increases as he is required to pay less for a given
quantity
The increase in real income encourages the consumer to demand more goods and
services.
The increase in demand on account of this factor is known as income effect
Income effect for a normal goods is +ve
Income effect for an inferior good is -ve
3. Utility maximizing behaviour
When a person buys a commodity, say X , he exchange his money income for the
commodity in order to maximize his satisfaction
When price of a commodity falls, MU x becomes greater than MU of money (Px).
MU x > (MUm=Px)
In order to regain equilibrium he will purchase more of the commodity
The consumer purchases the commodity till
MUx=Px= MUm
This is another reason why demand for a commodity increases when its price decreases.
Exceptions / limitations of the Law of demand
1. Fear of future rise in price: if the price of a commodity is increasing and if it is expected
to increase still further, the consumers will buy more of the commodity at a higher price
than they did at lower price
2. Fear of future fall in price: if the price of the commodity is falling and if it is expected to
fall further, the consumer will buy less of the commodity at low price. The consumer will
hold off their purchase until prices reach the bottom level.
3. Ignorance of the consumer: Due to ignorance, consumers buy in the costly market.
4. Demand for necessaries: the law of demand does not apply in the case of absolute
necessaries of life. Even though prices of necessaries rise, the demand for them remains
more or less the same.
5. Status Goods: the law of demand does not apply to commodities which are used as
status symbols.
E.g. luxury goods: Gold, precious stones, rare paintings, antiques.
Rich people buy such goods mainly because their prices are high and buy more of them
when their prices move up
6. Giffen goods: A giffen good is defined as an inferior good whose demand increases
when its price increases
The demand curve for giffen good will slope upwards to the right
Income effect of a price rise is greater than substitution effect

M.B.A.

Economics for Managers 9

When price of inferior goods increases, income remaining the same, poor people cut the
consumption of superior substitutes so that they are able to buy sufficient quantity of the
inferior good to meet their basic need. So, increase of price brings increase in demand
which is contrary to the law of demand.Thus, this particular phenomenon which was found
by Sir Robert Giffen is known as Giffen Paradox
Determinants of demand
Following are the major factors which determine the demand for a commodity.
1. Price of the commodity
The price of a product is one of the most important determinants of its demand in the
long run and the only determinants in the short-run
Price of the product and its quantity demanded are inversely related
2. Price of related goods
The demand for a commodity is also affected by the changes in the price of its related
goods. Related goods may be substitutes or complementary goods
Substitute goods
If two goods can satisfy the same want ,they are called substitutes
Change in price of one affects the demand for the other in the same direction
E.g. Tea and coffee, petrol and CNG
Increase in the price of a good (tea )causes increase in the demand for its substitute
( coffee)
There is a positive relation between demand for a product and price of its substitute
Complementary goods
Goods which are jointly consumed are known as complementary goods
Demand for complementary goods changes simultaneously
An increase in price of one causes a decrease in demand for the other
Eg: Petrol is a complement to Car
Butter is a complement to Bread
Milk & sugar are complement to Tea
There exists an Inverse relationship between the demand for a good and price of its
complements
3. Consumers income
Income as a determinant of demand is equally important in both short run & long run
There exists a direct relationship between the demand for a normal good and income of
the consumer
Types of consumer goods
Essential consumer goods(ECG)
The goods and services in this category are called basic needs and are consumed by all
persons of a society. E.g. -food grains, salt, vegetable oils, cooking fuel
Demand for ECG increases with increase in income up to a limit


M.B.A.

Economics for Managers 10

Inferior goods (IG)
A commodity is deemed to be inferior if its demand decreases with the increase in
consumers income beyond a certain level
Eg: Millet is inferior to Wheat & rice
Bidi is inferior to cigarette
Kerosene is inferior to cooking gas
Demand for inferior goods rises only up to a certain level of income and declines as income
increases beyond this level
Normal goods (NG)
Normal goods are those goods that are demanded in increasing quantities as consumers
income increases.
Eg: clothing, household furniture, automobiles
Demand for normal goods increases rapidly with increase in income, but slows down with
further increase in income
Luxury and Prestige goods(LG)
Luxury goods
All goods that add to the pleasure and prestige of the consumer without enhancing his
earning fall in the category of luxury goods
Eg. Stone-studded jewellery, costly brands of cosmetics, luxury cars
Prestige goods
A special category of luxury good
Eg. Precious stones, rare paintings, diamond-studded jewellery and watches, prestigious
schools
Demand for such goods arises beyond a certain level of consumers income.
4. Consumers taste and preference
Taste and preference generally depend on
Life-style
Social customs
Religious value attached to a commodity
Habit of the people
General levels of living of the society
Age and sex of consumers
Change in these factors changes the consumers taste and preference and there by the
demand for a commodity
5. Advertisement expenditure
Advertisement helps in increasing demand for a product in 4 ways
I. Informing potential consumers about the availability of the product
II. Showing its superiority over the rival product
III. Influencing consumers choice against the rival products
IV. Setting new fashions and changing tastes


M.B.A.

Economics for Managers 11

Sales curve
A sales curve shows the relationship between volume of sales (S) and advertisement
expenditure (AD)
Assumptions
Consumers are fairly sensitive to various modes of advertisements
The rival firm do not react to the advertisement made by a firm
The level of demand has not already reached the saturation point


Volume of Sales curve
sales





Advertisement expenditure
6. Consumers expectations
Consumers expectations about future price, income and supply positions of goods etc.
play an important role in determining the demand for a commodity in the short-run.
If consumers expect a high rise in price of a storable commodity they would buy more of
it at its high current price
If consumers expect a fall in the price of certain goods , they postpone their purchase for
a future date
7. Demonstration effect & Snob effect
Demonstration effect/ bandwagon effect
The tendency of the lower income households to imitate the consumption habits of the
higher income households is known as demonstration effect.
This will raise the consumption expenditure of lower income households whose income is
relatively low.
This particular behaviour of the people was first identified by James Duesenberry.
It has a positive effect on demand
Snob effect
When a commodity becomes the thing of common use, some people, mostly rich, decrease
or give up the consumption of such goods. This is known as snob effect.
It has a negative effect on the demand for the related goods




8. consumer-credit facility
Availability of credit to the consumers from
consumer to buy more than what they would buy in the absence of credit facility.
Credit facility mostly affect
bulk payment at the time of purchase
9. Population of the country
Total domestic demand for a product also depends up on size of the population
Larger the population- the larger the demand for a product
10. Distribution of National
The level of NI is the basic determinant of the market demand for a product
The higher the NI, the higher the demand for all normal goods and services
Distribution of NI : If NI is unequally distributed
If a majority of the population belongs to lower income groups,
essential goods will be the largest
Demand for other goods will be lower
Changes in Demand
Demand for a commodity is determined by many factors. The change in demand may be
due to change in price or due to factors other than price of th

1. Expansion( Extension)
When demand changes due to change in price, it is a case of expansion or contraction of
demand.
a. Expansion of demand
When quantity demanded of a commodity increases due to a fall in its price, it is called
expansion of demand (movement from A to B)
b. Contraction of demand
A fall in demand due to rise in price is called contr
C) . Both Expansion and contraction of demand take place on the same demand curve.


Change in price
Expansion of
demand
M.B.A
Economics for Managers
credit facility
the consumers from sellers, banks, other sources
consumer to buy more than what they would buy in the absence of credit facility.
ostly affects the demand for the durable goods, particularly which require
ime of purchase
9. Population of the country
Total domestic demand for a product also depends up on size of the population
the larger the demand for a product
ational Income
is the basic determinant of the market demand for a product
The higher the NI, the higher the demand for all normal goods and services
If NI is unequally distributed
If a majority of the population belongs to lower income groups, market demand for
essential goods will be the largest
Demand for other goods will be lower

Demand for a commodity is determined by many factors. The change in demand may be
due to change in price or due to factors other than price of the commodity.
( Extension) and Contraction of Demand
When demand changes due to change in price, it is a case of expansion or contraction of
When quantity demanded of a commodity increases due to a fall in its price, it is called
(movement from A to B)
A fall in demand due to rise in price is called contraction of demand. (movement from A to
Both Expansion and contraction of demand take place on the same demand curve.
Changes in
demand
Change in price
Contraction
of demand
Change in assumptions
SHIFT IN DEMAND
Increase in
demand
Decrease in
demand
M.B.A.
12
sellers, banks, other sources induces the
consumer to buy more than what they would buy in the absence of credit facility.
the demand for the durable goods, particularly which require
Total domestic demand for a product also depends up on size of the population
is the basic determinant of the market demand for a product
The higher the NI, the higher the demand for all normal goods and services
market demand for
Demand for a commodity is determined by many factors. The change in demand may be
e commodity.

When demand changes due to change in price, it is a case of expansion or contraction of
When quantity demanded of a commodity increases due to a fall in its price, it is called
action of demand. (movement from A to
Both Expansion and contraction of demand take place on the same demand curve.
Change in assumptions
SHIFT IN DEMAND
Decrease in
demand

M.B.A.

Economics for Managers 13

Price
D
C
A A B -Expansion
A c -Contraction
B

D

Q Q1 Quantity demanded

2. Increase and Decrease in Demand ( Shift in Demand )
Change in demand due to factors other than price is called increase and decrease in
demand. It may be due to change in income, taste and preference etc.
a. Increase in demand: Rise in demand due to changes in factors other than price is called
increase in demand. That means, more is demanded at the same price.
b. Decrease in demand: Fall in demand due to factors other than price is called decrease
in demand. That means, less is demanded at same price.


D
D2 D1
C A B A B -Increase
A c -Decrease

D1
D2 D

Q Q1 Quantity demanded
Expansion, Contraction, Increase and Decrease in a Single Diagram


D1 A B -Expansion
D B A -Contraction
A C A C -Increase
C A -Decrease
B
D1
D

Q Q1 Quantity demanded

P2
P
P1
P2
P
P1
P
P1

M.B.A.

Economics for Managers 14

Factors behind the shift of demand curve
Demand curve for a commodity may shift due to change in any of the determinants of
demand except price. It includes
Change in consumers income
Rise in price of substitutes
Advertisement by the producer
Fall in price of complements
Fashion status, improvement in its quality
Types of demand
1. Individual Demand And Market Demand
Individual Demand
Individual demand refers to the quantity of a product demanded by an individual at a point
of time or a given period of time, given
the price of the product,
income,
price of related goods,
consumers taste and preference,
price expectations and
external influences
Market Demand
The sum of individual demand by all the consumers of a commodity, over a time period and
at a given price, other factors remaining
It is the aggregate of individual demands for a product
If individual demand schedules / individual demand functions are known, the market
demand schedule and curve can be obtained by
A) Adding up individual demand at different prices
B) Summing up individual demand functions
2. Firm Demand And Industry Demand
Firm Demand
Firm demand is the demand for the product of a particular firm. The quantity that a firm
can dispose of at a given price over a time period connotes the demand for a firms product
Eg: demand for parker pen, Colgate etc
Industry demand
The demand for the product of a particular industry is known as industry demand.
Eg: demand for pens, tooth paste
3. Autonomous And Derived Demand
Autonomous demand/ direct demand
Autonomous demand is the demand for a product that can be independently used.
- Demand arises directly from the biological or physical needs of human beings
- Eg: demand for food, cloth, shelter etc.
It may also arise as a result of
Demonstration effect

M.B.A.

Economics for Managers 15

A rise in income
Increase in population
Advertisement of a new product
Derived demand
Demand for a commodity arises because of the demand for some other commodity, called
Parent product is called Derived demand
Eg. Demand for land, fertilizers and agricultural tools and implements- derived from
demand for food
Demand for steel, bricks, cement etc. derived from the demand for housing and
commercial buildings
Demand for tyres- derived from the demand for vehicles
Demand for Petrol -derived from the demand for vehicles
4. Demand For Durable And Non-durable Goods
Durable goods
Durable goods are those whose total utility is not exhausted in a single or short-run use.
Consumer durables: Cloth , shoe, furniture, houses, cars, scooters, TV
Producer goods: Buildings, machinery, office furniture
Demand for durable goods influenced by expected price, income and change in
technology
Non-durable Goods
Goods which can be used or consumed only once and their total utility is exhausted in a
single use.
Consumer goods: All food items, drinks, cooking fuel
Producer goods: Raw materials, fuel and power, finishing materials etc.
Demand for non-durable goods depends largely on their current prices, consumers
income, and fashion
5. Short-term And Long- Term Demand
Short-term demand refers to the demand for goods that are required over a short period
E.g. Demand for Fashion wear
Goods of seasonal use: umbrellas, raincoats, ice creams, new year greeting cards,
crackers
Short term demand depends up on
Price of the product
Price of their substitutes
Current disposable income of the consumer
Ability to adjust their consumption pattern
Long- Term Demand refers to the demand which exists over a long period
E.g. most Generic goods have long term demand
Consumer & Producer goods
Durable & non durable goods
Long term demand depends on
Long term income trends

M.B.A.

Economics for Managers 16

Availability of better substitutes
Sales promotion
Consumer credit facility
Demand Function
A function is a symbolic statement of relationship between the dependent and
independent variables.
A demand function shows the functional relationship between the demand for a product
(dependent variable) and its determinants (the independent variables)
Short-run demand function
Dx= f( Px)
The function reads demand for a commodity X(Dx), is the function of price ( Px)
Dx- dependent variable
Px-independent variable
Linear demand function
A demand function is said to be linear when D/P is constant
Dx= a- bPx
a - constant ( Total demand at zero price)
b = D/P (change in Dx in response to a change in Px
If D/P is constant- demand function is linear
Non linear demand function
A demand function is said to be non linear when the slope of the demand curve P/ D
(slope of the demand curve) changes all along the curve
Dx= a P
x
-h

Multi-variate / Dynamic / long term demand function
The function which describes the relation between the demand and its determinants is
called long term demand function
Dx= f (Px, M, Py, Pc, T, A)

Dx= demand for a commodity x
Px= Price of the commodity
M= income of thee consumer
Py= price of substitutes
Pc= price of complementary goods
T= consumers taste
A= advertisment

Elasticity of Demand
The term elasticity means responsiveness. Elasticity of demand refers to the degree of
responsiveness of quantity demanded of a commodity due to change in its determinants.
In other words, it is the ratio of percentage change in demand to the percentage change in
one of the determinants of demand.
ep=
Pcrccntagc Changc In quantIty dcmandcd
Pcrccntagc Changc In dctcrmInants oI dcmand


M.B.A.

Economics for Managers 17

Types of Elasticity of Demand
Following are the important types of elasticity of demand
1. Price elasticity
2. Cross elasticity
3. Income elasticity
4. Advertisement elasticity
5. Elasticity of price expectations
I.Price Elasticity Of Demand
Price elasticity of demand is the degree of responsiveness of quantity demanded of a
commodity due to change in its price.
In other words, price elasticity of demand is the ratio of percentage change in quantity
demanded to percentage change in price. It is denoted by ep.
ep =
Pcrccntagc Changc In quantIty dcmandcd Ior a commodIty
Pcrccntagc Changc In PrIcc oI thc commodIty

=
changc In quanIty dcmandcd (q)
InItIaI quantIty dcmandcd (q)
x100
changc In prIcc ( p)
InItIaI prIcc (p)
x100
=
q
q
x100
p
p
x1uu =
q
q
x
p
p

ep =
q
p
x
p
q

The law of demand does not explain at what rate, demand changes in response to a given
change in its price.
Price elasticity of demand tells us exactly how much the quantity demanded would
increase or decrease as a result of a given fall or rise in price.
Price elasticity of demand is always negative
Types / Degrees of Price Elasticity of Demand
On the basis of the degree of responsiveness of demand to the change in price, elasticity of
demand is generally classified in to five categories.
1. Perfectly elastic demand (ep=)
2. Perfectly inelastic demand (ep=0)
3. Unitary elastic demand (ep=1)
4. Elastic demand (ep>1)
5. Inelastic demand (ep<1)
1. Perfectly Elastic Demand (ep=)
Demand for a commodity is said to be perfectly elastic when a slight change in price causes
infinite change in quantity demanded.
The Demand curve will be a straight line parallel to X axis (horizontal line). Here price
elasticity of demand is infinity ()


M.B.A.

Economics for Managers 18

Price


D D
ep=



O Quantity demanded

2. Perfectly Inelastic Demand (ep=0)
Demand for a commodity is said to be perfectly inelastic if quantity demanded does not
change at all in response to a change in its price. The demand curve is thus a straight line
parallel to y axis (vertical line).
Price D
ep=0






O Q Quantity demanded
Here the price elasticity of demand is zero.
3. Unitary Elastic Demand (ep= 1)
Demand for a commodity is unitary elastic if a given change in price causes an equal and
proportionate change in quantity demanded.
Price

D

ep=1



D

Q Q1 Quantity demanded
In the diagram when price falls from OP to OP1 quantity demanded expands from OQ to
OQ1. The change is equal and proportional

P
P1
P
P
P1

M.B.A.

Economics for Managers 19

4. More/Relatively Elastic Demand ( ep>1)
Demand for a commodity more elastic if a given change in price leads to a more than
proportionate change in quantity demanded.

D

ep >1

D



Q Q1 Quantity demanded
This is otherwise called elastic demand. In the figure when price falls from OP to OP1,
quantity demanded expands from OQ to OQ1. The change in demand is more than the
change in price (QQ1>PP1).
5. Less Elastic Demand/ Relatively Inelastic Demand ( ep <1)
Demand for a commodity is less elastic when a given change in price leads to a less than
proportionate change in quantity demanded. This is also called inelastic demand.
D


ep <1



D

Q Q1 Quantity demanded
In the diagram when price falls from OP to OP1 quantity demanded expands from OQ to
OQ1. The change in demand is less than the change in price. ( i.e. QQ1< PP1)
Measurement of Price Elasticity of Demand
1. Arc elasticity
2. Point elasticity
a) Arc elasticity
The measure of elasticity of demand between any two finite points on a demand curve is
known as arc elasticity. The formula for calculating price elasticity using arc method is
ep =
q
p
x
p
q

P
P1
P
P1

M.B.A.

Economics for Managers 20

b) Point elasticity
The concept of point elasticity is used for measuring price elasticity where change in price
is infinitesimally small.
Point elasticity is the elasticity of demand at a finite point on a demand curve.
The price elasticity of demand at any point on a linear demand curve is equal to the ration
of lower segment to the upper segments of the line.
ep=
Luwer segment
Upper segement


M ep=
ep>1


ep=1 P

ep <1


N ep=0
At point P elasticity is unity, since the lengths of both lower and upper segment of
MN are equal.
At point M ep = , since the length of the upper segment is zero
A =
L
U
=
MN
0
=
At point N ep= 0, since the length of the lower portion is zero
At any point on MN above P , ep > 1
At any point on MN below P, ep < 1.
Determinants of price elasticity of demand
1. Availability of substitutes
The higher the degree of closeness of substitutes , the greater the elasticity of demand
e.g. Tea and coffee
Wider the range of substitutes, the greater the elasticity
Soap, toothpastes, cigarettes- more elastic
Sugar and Salt- less elastic
2. Nature of commodity
o Demand for luxury goods- more elastic
Consumption of them can be postponed when their prices rise
o Demand for necessary goods- less elastic
Consumption of them cannot be postponed when their prices rise
o Comforts- more elastic demand than necessities and less elastic than luxuries
o Demand for durable goods- more elastic
Demand for non durable goods less elastic

M.B.A.

Economics for Managers 21

3. Weightage in the total consumption
If proportion of income spent on a commodity is large, its demand will be more elastic
If proportion of income spent on a commodity is small, its demand is less price elastic
E.g. salt, match boxes, pen, etc.
Demand for these goods is generally inelastic because increase in the price of such goods
does not substantially affect consumers budget
4. Time factor in adjustment of consumption pattern
The Longer the time available for the consumer to adjust the consumption pattern to a
new price, the greater the price elasticity
5. Range of commodity use
The wider the range of the uses of a product, the higher the elasticity of demand for the
decrease in price.
E.g. Milk can be taken in the form of curd, cheese, ghee and buttermilk. The demand for
milk will therefore be highly elastic for decrease in price.
Demand for electricity--- highly elastic for a reduction in price
6. Proportion of market supplied
If less than half of the market is supplied at the ruling price, ep>1
If more than half of the market is supplied, ep<1

II. Cross Elasticity Of Demand
Cross elasticity is the measure of responsiveness of demanded of a commodity to the
change in price of its substitutes and complementary goods
In other words, it shows the degree of responsiveness of quantity demanded of
commodity X due to change in price of commodity Y.
E.g., cross elasticity of demand for tea is the percentage change in its quantity
demanded with respect to change in price of its substitute, coffee.
ec =
Pcrccntagc Changc In quantIty dcmandcd oI tca
Pcrccntagc Changc In prIcc oI coIIcc


ec =
Qt
Pc
x
Pc
Qt

where: Qt= quantity demanded of tea Pc = Price of coffee
Qt= change in demand of tea (Q-Q1) Pc = change in price of coffee (Pc-Pc1)
Uses of cross elasticity
1. Define substitute goods: if cross elasticity is positive, two goods may be considered as
substitutes
2. Define complementary goods: if cross elasticity between two goods is negative they may be
considered as complementary to each other.
3. Changing the prices of the product: if cross elasticity in response to the price of substitutes is
greater than one, it would be inadvisable to increase price, rather, reducing the price is may prove
beneficial.



M.B.A.

Economics for Managers 22

III. Income Elasticity Of Demand
Income elasticity of demand shows the degree of responsiveness of quantity demanded of a
commodity to a change in the income of the consumer.
Income elasticity (ey) =
Pcrccntagc Changc In quantIty dcmandcd
Pcrccntagc Changc In Incomc


ey =
Q
Y
x
Y
Q

where: Q= quantity demanded Y = income of the consumer
Q= change in demand (Q-Q1) Y = change in income (Y-Y1)
Uses of income elasticity in business
In production planning and management
Estimate the future demand
Define normal good: goods whose income elasticity is positive for all levels of income
Define inferior good: goods whose income elasticity is negative beyond a certain level of
income
IV. Advertisement elasticity of demand (Promotional elasticity of sales)
The measure of response in sales to a change in advertisement expenditure.
c
A
=
S
A
x
A
S


where: S= sales A = initial advertisement cost
S= increase in sales (S-S1) A = Additional expenditure on advertisement
(A-A1)
Determinants of advertisement elasticity
i.The level of total sales
ii.Advertisement by rival firms
iii.Cumulative effect of past advertisement
iv.Other factors affecting demand; change in price, consumers income etc.
V.Elasticity of price expectations
The elasticity of price expectations refers to the expected change in future price as a result
of change in current prices of a product.
c
x
=
PI
Pc
x
Pc
PI

Where, Pc and Pf are current and future price respectively.
If c
x
>1, it indicates that future change in price will be greater than the present
change in price and vice versa.
Use
If c
x
>1 it indicates that sellers will be able to sell more in the future at higher prices


M.B.A.

Economics for Managers 23

Uses/ importance of elasticity of demand in business
The concept of elasticity of demand plays a crucial role in business decision regarding
manoeuvring of prices with a view to making larger profits
For instance, when cost of production is increasing, the firm would want to pass the
rising cost on to the consumer by raising the price. Firms may decide to change the price
without any change in the cost of production. But whether raising price following the rising
cost or other ways proves beneficial depends on
A) the price elasticity of demand for the product: i.e., how high or low is the
proportionate change in its demand in response to a certain percentage change in its
price
B) price elasticity of demand for its substitutes: because when the price of a product
increases, the demand for its substitutes increases automatically even if the their
prices remain unchanged.
Raising the price will be beneficial only if
Demand for the product is less elastic
Demand for its substitute is much less elastic
Although most businessmen are intuitively aware of the elasticity of demand of the goods
they make, the use of precise estimates of elasticity of demand will add precision to their
business decision.

Demand Forecasting
Demand forecasting is the activity of estimating the quantity of a product or service that
consumers will purchase. Demand forecasting may be used in making pricing decisions, in
assessing future capacity requirements, or in making decisions on whether to enter a new
market.



Importance/ Objectives of demand forecasting
Formulation of production policy
Formulation of price policy
Proper control of sales
Arrangement of finance
Acquiring inputs ( labour, raw materials and capital)
Planning advertisement
Criteria for a good demand forecasting method
1.Accuracy
2.Simplicity and Ease of comprehension
3.Economical
4.Durability
Activity of estimating future demand for a firms product
It is a projection of a firms expected future demands
It assumes greater significance in large scale production


M.B.A.

Economics for Managers 24

5.Effective
6.Flexibility
7.Maintenance of timeliness:- It must be in up to date basis
Steps in demand forecasting
Specifying the objective
Determining the time perspective- short period or long period
Making the choice of method for demand forecasting
Collection of data and data adjustment
Estimation and interpretation of result
Methods/ techniques of Demand Forecasting
There are mainly two approaches to forecast demand.
1. Survey methods
2. Statistical methods
I. Survey Methods
In order to forecast the demand for existing product survey methods are often employed.
Survey methods are generally used where the purpose is to make short-run forecast of
demand. It includes the following techniques.
Survey Methods


Consumer survey method Opinion poll methods

A. Consumer survey method
This method involves direct interview of potential consumers. Consumers are interviewed
by the following methods
1. Complete Enumeration method
In this method, almost all potential users of the product are contacted and are asked about
their future plan of purchasing the product in question.
The probable demand may be calculated as
B
P
= q
1
+q
2
+q
3
+...+ q
n

Where, Dp- total probable demand
q
1
, q
2
, q
3
,- demand by individual households 1,2,3 e.t.c.
This method can be used successfully only in case of those products whose consumers
are concentrated in a certain region
2. Sample survey method
This method is used when population of the target market is very high.
3. End-use method
This method focuses on forecasting the demand for intermediary goods
A commodity that is used for the production of some other finally consumable
goods is known as intermediary goods

M.B.A.

Economics for Managers 25

E.g. Milk- an intermediary good for the production of ice cream, paneer and other
diary products.
B. Opinion poll method
This method aims at collecting opinions of those who are supposed to possess knowledge
of the market. E.g. sales representatives, sales executives, professional marketing expert
and consultants. It includes
1. Experts Opinion Poll
In this method the experts on a particular product whose demand is under study are
requested to give their opinion about the product.
These experts, dealing in the same or similar product are able to predict the likely sales of a
given product in the future periods under different conditions based on their experience.
2. Delphi Method
This is a variant of the opinion poll method.
Under this method opinion of experts is collected through mail survey.
Steps in Delphi method
a. Prepare the questionnaire
b. Send the questionnaire to experts through mail
c. Collect the filled in questionnaire back
d. Summarise the response
e. Send back again to experts to express their reasons
f. Repeat the process for one or more rounds
Advantages
a. Intelligible to users
b. More accurate
c. Less expensive
3. Market studies and experiments
Under this method, firms first select some areas of market, then carryout market
experiment b changing price, advertisement expenditure, in demand function and record
the consequent changes in demand.
II. Statistical Methods
Statistical methods are considered to be superior techniques of demand estimation for the
following reasons.
a) In the statistical methods, the element of subjectivity is minimum
b) Scientific estimation
c) More reliable
d) Smaller cost
Statistical methods



Trend projection methods Barometric methods Econometric methods

M.B.A.

Economics for Managers 26

1. Trend projection methods
This method is used to forecast demand for a product whose past sales records are
available for a number of years. Under this method, the time series data of the under
forecast are used to fit a trend line or curve either graphically or through statistical method
of least squares.
It includes,
Graphical method`
Least square method
a. Graphical method
Under this method trend line is fitted on a graph using time series data of sales/demand.
This method is very simple and least expensive.
b. Ordinary Least Square (OLS) method
Under this method trend line is fitted using statistical methods of ordinary least squares.
OLS method is used to minimize the errors while fitting a trend line. Error term refers to
the deviation of the plotted points from the straight line
In OLS method Squares of the error terms are used to minimize errors
Linear trend
Y= a+ b X
Y- dependent variable
X- independent variable
A and B are constants
Coefficients of a and b can be estimated by solving the following equations based on the
principle of least squares

2. Barometric methods
Under this method certain economic indicators are used as barometers to forecast trends
in business
Indicators used
leading indicators-index of business investment
coincidental indicators- Rate of unemployment
Lagging indicators- labour cost per unit of output
3. Econometric methods
It includes, a) regression method, b) simultaneous equation method
a) Regression method
Regression analysis is the most popular method of demand estimation. This method
combines economic theory and statistical techniques of estimation.
Demand dependent variable
Determinants of demand- independent variable

M.B.A.

Economics for Managers 27

The regression technique is similar to trend fitting. An importance difference between the
two
in trend fitting- independent variable is time
in regression independent variable is any of the determinants of demand
b) Simultaneous equation model
This is a complex method. Here instead of one regression equation showing the demand
for the commodity, a set of equations is to be specified and estimated in a model frame
work.