Understanding demand

Demand is one of the core concepts in managerial economics. A firm is viable only as long as there exists demand for its product. Unless a manager understands the demand for his product, he is unable to take any decision. For example, without knowing what the level of demand is going to be next quarter, he will be unable to decide how much production capacity to install, how many labor are to be hired, how much loan has to be raised from the market. While studying the dynamics of demand, you will be looking at the following 4 crucial areas. 1. The law of demand 2. The determinants of demand 3. Elasticity of demand 4. Demand forecasting Whereas we will tackle the first three areas of analysis in this module, the fourth one i.e. demand forecasting is interesting and challenging enough to have been treated separately in the next one. The law of demand The law of demand and its applications are a very powerful tool for the business manager. The law of demand tells us that Ceteris paribus (other things remaining constant), the demand for a product rises as the price of the commodity falls and viceversa. It might be fruitful to see this inverse relationship between price and quantity graphically. Price
5500 4500

Demand curve

34,000

98000

Quantity Demanded

Graph 1 The above graph shows the relationship between the price and quantity of Nokia handsets in the market. When the price was Rs.5500 per handset, 34000 Nokia mobile handsets were demanded in the market. Once the price was slashed to Rs. 4500, the demand more than doubled to 98,000 handsets.

Thus, price is a major factor that affects demand. Lower the price, higher will be the demand. Why are Chinese goods flooding markets all over the world? Simple, really. They are the cheapest. However, they remain the best-sellers only so long as other things remain constant. Europeans have been increasingly making a noise about the poorly-paid and exploited Chinese labor because of which Chinese products can be produced so cheaply. If Europeans start advertising their high-cost products to be labor-friendly goods, we may find that despite being the cheapest, Chinese goods may not be the best sellers in the western markets. This only goes to show that while price is indeed important, factors other than the price can have a huge bearing on demand. It is these factors that any successful manager has to take into account for understanding his product better. Determinants of demand You already know that the demand for a commodity changes when the price of the good changes. However, sometimes the demand for a good may fall or rise even when the price remains the same. For example, a manager may find that the introduction of a substitute good in the market reduces the demand for the product of his firm. And this fall in demand happens even when the price of the product is constant. All such factors other than own price of the good (Po) that affect demand are called the determinants of demand. These factors could be Change in the consumers income level With an increase in the income level, the consumer may demand more of a particular product even when its price remains the same. For example, a music lover may buy more CDs each month once her income levels start increasing. Change in income tax rates Income taxes reduce our spending power and hence are delicate issues. An increase in the rate of income tax reduces the disposable income of the consumer i.e. he has lesser amount available for spending. It is obvious that the demand for a commodity will fall with an increase in the income tax rate, even with the price of the commodity remaining constant. Prices of substitute goods available in the market As you must be aware, P&G has drastically slashed the price of the detergent Tide to just Rs.46 per kg. what do you expect must have happened to the demand for its substitute Rin Supreme? Obviously, the demand for Rin (an HLL product) will automatically reduce despite the fact that the own price Po is constant. Prices of complementary goods As the price of petrol increases, the demand for cars reduces, despite the fact that own prices of cars are constant Change in the tastes, preferences of the consumer Think of the recent controversy regarding the pesticide content found in certain cola drinks. Suppose this sparks off a change in preference from colas towards non-aerated

drinks such as say Mangola. This is situation in which the demand for Mangola has increased despite the fact that its price is constant. The demand for colas on the other hand has reduced despite a change in prices again.

Change in the future expectations of a consumer Let us imagine that we are in an unenviable situation such as in Iraq, where a warridden environment rules the day. A consumer who is expecting a war will not be sure whether even basic necessities such as food will be available 2 months down the line. In this situation, the demand for canned food will increase even with the prices remaining the same. Similarly, expectations of a flood or a drought changes the demand with no change in the prices. Change in credit availability Once credit is available on easy terms, the demand for the concerned product tends to shoot up. A case in point in Marutoi Udyog Ltd.s True Value Scheme. Since credit was not available for buying used cars in India, the used cars market never really picked up the way it has done in the US. Maruti Udyog has however introduced a novel scheme to fire the market for used Maruti cars. In a unique tie-up with certain banks, the true value scheme is about offering credit for buying used Maruti cars. This credit availability has increased the demand for used Maruti cars. Marketing Strategies Marketing strategies are a very important determinant of demand. Novel and aggressive marketing strategies attract consumers towards products. These can increase the product demand even when the price remains unchanged. Go back to graph 1 again. The graph shows you that as the price changes, the demand changes as well. In other words, a change in the price of the commodity leads to a movement along the demand curve. On the other hand, a change in the determinants of demand increases or decreses the demand at the ongoing price. Thus, a change in the determinants leads to a shift of the demand curve as shown below in graph 2.

D 5500

D D Quantity Demanded

34000 Graph 2

The curve DD in the above diagram shows that 34000 Nokia mobile handsets were demanded when the price per handset was Rs.5500. However, as Reliance India entered the handsets market, the demand for Nokia handsets reduced. Note that the price of Nokia handsets is still at Rs.5500. Thus, the introduction of a substitute has shifted the demand curve inwards from DD to DD. Elasticity of demand Having understood the different factors that could possibly influence demand, the manager next has to understand how strong the influence of the different factors is. For example, the marketing manager of Emami Talc is interested in trying out non-price strategies for increasing the market share of her product. She has two schemes lined up for the purpose. She could spend additional Rs.25000 either on aggressive advertisement or on jazzier packaging. The market intelligence suggests to her that demand is more responsive to a change in packaging rather than to a change in advertisements. She goes in for a revamped product look with a successful increase in the market share. What you have just learnt from this example is that demand is less responsive or less elastic with respect to advertisements as compared to packaging. What is elasticity of demand? Elasticity of demand is a concept that tells us how much demand will vary as some factor changes. This factor could be own price, other prices, consumer income or advertisement expenditure leading us to different elasticity concepts such as price elasticity, cross-price elasticity, income elasticity and advertisement elasticity of demand. Price elasticity of demand (p) This tells us the extent to which demand changes as a result of a change in price of the good Technically, it is defined to be the percentage change in demand as a result of a 1% change in the price of the commodity. (Insert formula 1 here) p = Percentage change in quantity demanded / Percentage change in price = ( Q/Q) / ( P/P) If the percentage change in demand exactly equals the percentage change in price, then numerator and denominator are equal and price elasticity p equals one. This is referred to as unit price elasticity of demand. If the percentage change in demand exceeds percentage change in price, then demand is highly responsive to price and price elasticity p is greater than one. Demand for goods with p greater than one is called relatively more elastic demand. If the percentage change in demand is lesser than that in price, then demand is not very responsive to price and price elasticity p is lesser than one. Demand for goods with p lesser than one is called relatively less elastic demand.

Solved Example I Pizza Hut reduces the price of a standard pizza from Rs. 100 to Rs. 85 in an attempt to reduce the hold of Dominoes Pizzas in the Indian market. The number of Pizzas ordered from Pizza Hut per month immediately shoots up from 1000 to 1200. Calculate the price elasticity of demand p for pizzas. Also draw the demand curve for the pizzas of Pizza Hut. The price has reduced by 15%. In response, the demand increased by 20%. Thus, the price elasticity of demand is 20/15 = 1.33 Interpretation: Since the price elasticity of demand p is greater than 1 in this case, the demand is highly responsive to price. A reduction in price of 15% has increased demand by more than 15%. When the demand for the good is relatively elastic i.e. greater than 1, it makes business sense to reduce the prices to grab bigger market share. Graphing the pizza elasticity:

Price of Pizzas

100 85 Demand curve for pizzas)

1000

1200

Number of Pizzas demanded

While drawing this graph, we have two data points as reference points. One point is a combination of price Rs. 100 and quantity of 1000 units, whereas the other is a combination of price Rs. 85 and quantity of 1200 units. We plot these two points and join them to draw the demand curve. Note that this curve is slightly flat. This happens because the quantity demanded is extremely responsive to a change in prices. Higher the price elasticity of demand, flatter will be the demand curve. In the limit, even a very small price reduction can bring about an infinite increase in demand. This is the case of a perfectly elastic demand curve. Can you show what the graph of a perfectly elastic demand curve will look like?

Solved Example II

Two companies, Tata Salt and Revlon are thinking of raising the prices of salt and lipsticks respectively by 10%. Since salt is a necessity, its demand is not very responsive to a price rise. In fact, price elasticity of demand for salt is as low as 0.2. On the other hand, the p for lipsticks is as high as 2.5. Calculate the percentage fall in demand for salt and lipsticks following a 10% price hike. Which company according to you should go in for a price hike? Why? Draw the graphs of the demand curves for lipsticks as well as salt. Which graph is flatter? Why? According to the formula, p = Percentage change in quantity demanded / Percentage change in price Thus, for salt, 0.2 = Percentage change in quantity demanded / 10 Percentage change in quantity demanded = 2 So, an increase in price by 10% will reduce the demand by only 2% in the case of salt. For lipsticks, 2.5 = Percentage change in quantity demanded / 10 Percentage change in quantity demanded = 25 So, an increase in price by 10% will reduce the demand by 25% in the case of lipsticks. Interpretation This example is insightful because it tells you that the demand for a necessity will not be very responsive to a change in prices. Items of daily consumption such as salt, milk etc. therefore have relatively less elastic demand. Whenever the p for a good is less than one, the company will have more leeway in increasing the prices of its goods. You already know that the demand curve will be flatter when the price elasticity of demand is higher. Now, for drawing these two demand curves, we have no reference data points that can tell us how to draw the demand curves. Hence, we will simply show two different demand curves with different slopes here.

Graphs:
Price of Salt Sleep demand curve Ep > 1 Price of lipsticks

Flat demand curve Ep > 1

Quantity of Salt demanded

Number of lipsticks demanded

The 1st panel shows the demand curve for salt. Note that it is steep. This is expected because the change in price is much greater than the change in demand. In fact, lower the price elasticity of demand, steeper is the demand curve. In the limit, the product with zero price elasticity of demand is said to be perfectly inelastic. You could try drawing the graph of a perfectly inelastic curve. The 2nd panel shows the relatively elastic curve for lipsticks and is hence flatter. Price elasticity of demand and Total Revenue of the firm We will now study another application of price elasticity of demand. Any manager is interested in maximizing the revenue earned by her firm. Total revenue TR is defined to be the product of price P and quantity Q. TR = P * Q The sales manager of Parachute Coconut Oil is interested in knowing whether a 5% reduction in its price will help in picking up the sales revenue that has been falling for the past one quarter. You already know that when P falls, Q rises and vice-versa. The question is that when P falls by 5%, by how much will the Q increase. In other words, what this manager really needs to know is the price elasticity of demand for Parachute oil. He carries out a survey that informs him that the price elasticity of demand for Parachute Oil is around 2. Thus, demand is highly responsive to a price change. A price fall of 5% will increase demand by 10%. Now, TR = P*Q. A price cut will drag the TR down, but since the volumes pick up more than the price cut, the overall effect will be a rise in the TR.

Solved Example III The demand for the soap Dove is highly price elastic and equal to 3.5. The company wants to increase the price of the soap to indicate that Dove is associated with high quality. Do you think the scheme will work or backfire? Since the price elasticity is 3.5, it means that a 1% increase in price will reduce the demand or sales by 3.5%. The price rise will pull up the total revenue, but the volumes drag will more than nullify this effect. Under such a situation, a price rise cannot be used to indicate high quality. Dove will have to maintain the same prices but use other strategies such as aggressive advertisement etc. as an indication of quality. Income elasticity of demand y We now go on to examine another elasticity concept that can be of wide use to a firm. The income elasticity of demand for a good tells us the extent to which demand changes when the income of the consumer changes. This concept is especially relevant for sectors such as the Fast Moving Consumer Goods sector, whose product demand directly depends on the income growth of its consumers. Technically, income elasticity of demand y is defined as the percentage change in quantity demanded occurring as a result of a 1% change in consumer income (Income is being denoted by Y). y = Percentage change in quantity demanded / Percentage change in consumer income If the demand is extremely responsive to consumer income, then a 1% change in income will bring about a more than 1% increase in demand. Numerator will be greater than the denominator and the income elasticity will be greater than one. Even as income increases, demand for certain goods may not increase by as much. Think of a family that is already using an LPG cylinder. As the income of this family increases, the demand for cylinders will not increase. Of course, as the income of the population at large increase, some families will switch from kerosene stoves to LPG cylinders. If the percentage of such families is very high, then the income elasticity of demand for LPG cylinders in the population as a whole still may be greater than one. Solved Example IV The income elasticity of demand y for toothpastes in rural India is equal to 2. Colgate Herbal sold 10 lakh toothpastes in rural India in the last fiscal year. It is expected that rural incomes will grow by 5% this year. How much extra stock should Colgate Herbal stock in order to meet toothpaste demand this fiscal? You know that y = Percentage change in quantity demanded / Percentage change in consumer income 2 = Percentage change in quantity demanded / 5

Therefore, the demand will change by 10%. Remember that this is a very simplistic example whereby other factors that affect demand have simply been ignored. Normally, a firm has to look at a host of factors that may increase or reduce demand for its product regionally. However, the example gives you an insight into how and when the concept of income elasticity becomes relevant. Cross price elasticity of demand c This concept tells us the extent to which the demand for a good changes when the price of a related product changes. For example, an increase in the price of petrol may affect the number of new cars sold on the market. Or a decrease in the price of Sunsilk shampoo may reduce the demand for its toughest competitor Pantene. Firms have to take into account the fact that presence of substitutes and complements in the markets affect the demand for their goods indirectly. Technically, cross price elasticity c is defined to be the percentage change in the quantity demanded of good X occurring due to a 1% change in the price of a related commodity Y. c = Percentage change in quantity demanded / Percentage change in price of related commodity So far, we have not had to deal with the sign on the elasticity. We have simply spoken about percentage change without really delving into whether the percentage change is positive or negative. Whenever the price increases, we say that the percentage change in price is positive. Whenever it reduces or the quantity demanded reduces, the percentage change is said to be negative. With this new concept introduced to you, it might occur to you that the price elasticity of demand is always negative. This is because a positive percentage change in prices leads to a negative percentage change in demand. However, we have ignored the elasticity sign and focused instead on the number. Normally, income elasticity tends to be positive, because a positive change in the income normally leads to a positive change in demand. Goods for which this general rule holds are called normal goods. There are also goods, however, for which a positive change in income leads to a negative change in demand. This implies that the consumer actually reduces the consumption of these goods once he is better off. Good examples could be smokers switching from bidis to cigarettes once their income increases. Or people switching from bajra rotis to flour after becoming better off. Goods for which the demand reduces in response to an increase in income are called inferior goods. Before going ahead into the concepts of cross-price elasticity for substitutes and complements, note that in the following section, the sign of the elasticity is going to be much more important that the number. Cross price elasticity c of substitutes

Let us assume that Sunsilk and Pantene are perfect substitutes for each other. If the price of Sunsilk is increased (a positive percentage change), then the demand for Pantene will also increase (a positive percentage change). In other words, the price of Sunsilk and the demand for its substitute Pantene both move in the same direction. Cross price elasticity is calculated using the formula c = Percentage change in quantity demanded / Percentage change in price of related commodity In this case, c = Percentage change in quantity demanded of Pantene / Percentage change in price of the substitute Sunsilk Since both the numerator as well as the denominator are positive, the cross price elasticity in the case of substitutes will be positive. Solved Example V Many consumers use Surf Excel and Ariel interchangeably i.e. these two detergents can be treated to be close substitutes of each other. As the prices of Ariel fell by nearly 20%, the sales of Surf Excel were hit by 35%. Calculate the cross price elasticity between Surf Excel and Ariel. You know that c = Percentage change in quantity demanded (of Surf Excel) / Percentage change in price of related commodity (i.e. Ariel, its substitute) So, c = +35/+20 = 1.75 As expected, the cross price elasticity between these two substitute products is positive. Cross price elasticity c of complements Complementary goods are those that are used jointly for consumption. Typical examples would be pen and ink, tea and sugar, cars and petrol etc. If the price of petrol were to rise, it may affect the demand for cars adversely. In other words, a positive change in the price of petrol brings about a negative change in the demand for cars. Thus, the cross price elasticity for complements is seen to be negative. Solved Example VI Reynolds pen became a rage only within a few days of hitting the market. As Reynolds refills became costlier, the popularity of the pen however started reducing. A 5% increase in the refill prices gave a rude shock to the company and reduced its sales by nearly 8%. Calculate the cross-price elasticity of demand between Reynolds pens and refills. A positive percentage increase in the price of refills has resulted in a negative percentage change in the quantity of pens sold or demanded in the market. You already know that

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c = Percentage change in quantity demanded (of pens) / Percentage change in price of related commodity of its complement (of refills) In this case, c = -8/+5 = -1.6 Thus, the cross-price elasticity of complements is indeed negative as was expected. Application of cross price elasticity In a unique case filed against Du Pont, the packaging company, the concept of cross price elasticity was used to win an anti-trust case. It was alleged that the cellophane market was being monopolized by the packaging company Du Pont. Du Pont showed that the cross price elasticity between different packaging materials such as cellophane, waxed paper, aluminum foils etc was positive indicating the fact that all these were close substitutes belonging to the same industry i.e. packaging. Thus, Du Pont countered that the correct industry to be considered was not in fact the cellophane industry but the packaging industry in which it had less than 20% of the market share and hence was not a monopoly. The argument won them the case. Conclusion You have studied the law of demand, the determinants of demand as well as elasticity concepts in this module. We have also seen through concrete examples how elasticity concepts can be of practical relevance to the firms. Price elasticity of demand has to be taken into account before a firm decides to increase or reduce the product prices. Similarly, income elasticity is very relevant to firms such as an FMCG firm whose sales depend upon income growth. Of course, the firm cannot just calculate these simple elasticities for taking final decisions. A host of other factors apart from elasticities have to be considered before the firm can estimate the demand for its product or change the product prices. What we have studied in this module is the relevance of demand analysis for firm managers. However, you also need to understand a few fundamentals of demand that are not directly applicable to the firm. These fundamentals tell you how the demand curve is derived, how the consumer receives a consumer surplusetc. These are issues that are not directly relevant to a manager when she takes decisions for her firm; however they would improve your understanding vastly. These issues are included in the appendix that follows this module. After understanding these fundamentals, we will then move to the most challenging area of demand analysis i.e. demand forecasting.

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