Chapter 3

Demand analysis
 Unit 3: Demand analysis (CO3)

• Law of Demand, Exceptions to the Law of

Demand, Elasticity of Demand –Classification
of Price, Income & Cross elasticity, Advertising
and promotional elasticity of demand. Uses of
elasticity of demand for Managerial decision
making, Measurement of elasticity of
demand. Law of supply, Elasticity of supply,
Demand Forecasting: Meaning & Significance,
Methods of demand forecasting. (No
problems)
 Demand
• Demand for a commodity is consumers desire
to have it for which he is willing & able to pay.
• Consumers attitude give rise to his action in
purchasing certain units of commodity at
various given price.
• The demand for a commodity is the amount of
it that a consumer will purchase it at various
given prices during a period of time.
Demand :
Demand is, in fact the basis of all production activities. Demand
is the mother of production. Increasing demand for a product
offers a high business prospects in future & decreasing demand
for a product reduces the business prospect.
Example { computers, cars, mobile phones increasing demand in
India }[declining demand for typewriters, black & white T.V
sets.]
 Meaning of Demand

[Desire to buy (+) Willingness to Pay (+) Ability

to pay] = An effective demand for product .
 Factors influencing for demand
• Price
• Income
• Taste, habits and preferences
• Relative prices of other goods (substitute and
complementary products)
• Consumer expectation
• Advertisement effect
Demand contains certain terms:
• The quantity demanded
• The price at which a commodity is demanded.
• The time period over which a commodity is demanded.
• The market area in which a commodity is demanded
 The law of demand:
Statement of the law:
The law of demand states that the demand for a
commodity increases when its price decreases
and falls when its price rises, other things
remaining constant.
It holds only in the short run.
In the long run they tend to change.
 Definition
• According to Robertson, “Other things being equal, the lower the price at
which a thing is offered, the more a man will be prepared to buy it.”
• In the words of Marshall, “The greater the amount to be sold, the smaller
must be the price at which it is offered in order that it may find purchasers;
or in other words, the amount demanded increases with a fall in price and
diminishes with a rise in price.”
• According to Ferguson, “Law of Demand, the quantity demanded varies
inversely with price.”
 Assumptions of law of demand
1. No change in the income.
2. No change in size and composition of the
population.
3. No change in prices of related goods.
4. No change in consumer's taste, preference, etc.
5. No expectation of a price change in future.
6. No change in the climatic conditions.
1. No change in the income
The first assumption regarding the law of demand to operate is that the
income of the consumer must remain same or should not change (i.e.
neither rise nor fall).
• Income is assumed to remain constant, since, its rise may lure the consumer
to buy more goods and raise demand despite an increase in the commodity
prices.
2. No change in size and composition of the population
The second assumption for the law of demand to function is that the size
and composition of the total population of a country should not change. In
other words, the population must neither increase nor decrease.
3. No change in prices of related goods
• The third basic assumption of the law of demand considers that the Prices
of Related Goods (i.e. Substitute Goods and Complementary Goods) don't
change and remains same.
• Here, it is assumed that the Prices of Substitute Goods (like Tea and
Coffee) and Complementary Goods (e.g. Petrol and Cars)
4. No change in consumer's taste, preference, etc.
The fourth assumption of the law of demand considers that the taste,
preference, habit, fashion, etc., of the consumer, should remain unchanged.
That is, there should not arise a newer choice or change in the mood to try
something different.
5. No expectation of a price change in future.
The fifth basic assumption of Demand Law to remain valid is not to expect
any future possibilities regarding a change or fluctuation in the prices of
commodities.
• Here, it is assumed not to keep any expectation of future price change
because it will affect the current demand of goods.
6. No change in the climatic conditions
The sixth assumption of the law of demand is that the weather conditions or
climate of a region or geographical area should remain same and not alter
at all.
 Exceptions to the law of demand
• Giffen paradox
• Fear of shortage
• Change in income
• Veblen effect
• Ignorance of buyers
• Expectation of price rise
• Change in fashion
 Giffen paradox
• Inferior goods are termed as low priced goods or cheaper varieties of goods
like foodstuffs, low priced rice, low priced bread, cheap potatoes; vegetable
ghee etc. are some examples of inferior goods and also termed as Giffen
goods.
• This exception was pointed out by Robert Giffen who observed that when
the price falls, quite often less quantity will be purchased than before
because of the negative income effects and people’s increasing preferences
for a superior commodity with the rise in their real income.
 Veblen effect
The higher the price of the goods the higher the prestige value of it.

• This exception is associated with the name of the economist, T.Velben and his
doctrine of conspicuous conception. Few goods like diamond can be purchased
only by rich people. The prices of these goods are so high that they are beyond
the capacity of common people. The higher the price of the diamond the higher
the prestige value of it.
• In this case, a consumer will buy less of the diamonds at a low price because
with the fall in price, its prestige value goes down. On the other hand, when
price of diamonds increase, the prestige value goes up and therefore, the
quantity demanded of it will increase.
 Price expectation

• When the consumer expects that the price of the commodity is going to
fall in the near future, they do not buy more even if the price is lower.
• On the other hand, when they expect further rise in price of the
commodity, they will buy more even if the price is higher. Both of these
conditions are against the law of demand.
 Demonstration Effect :

• Demonstration effect is the influence on a person’s behavior by observing the

behavior of others. Fashion is one such incidence. Demand for most of the
items of luxury is governed by demonstration effect.
• In all of these cases price is not a governing parameter and goods are bought
even though prices are rising because these consumers do not want to be
labeled as lagging behind
 Fear of shortage

• When people feel that a commodity is going to be scarce in the near

future, they buy more of it even if there is a current rise in price.

• For example: If the people feel that there will be shortage of L.P.G. gas in
the near future, they will buy more of it, even if the price is high.
 Change in income

• The demand for goods and services is also affected by change in income of
the consumers.
• If the consumers’ income increases, they will demand more goods or
services even at a higher price. On the other hand, they will demand less
quantity of goods or services even at lower price if there is decrease in
their income. It is against the law of demand.
 Change in fashion

• The law of demand is not applicable when the goods are considered to be out
of fashion.
• If the commodity goes out of fashion, people do not buy more even if the price
falls. For example: People do not purchase old fashioned shirts and pants
nowadays even though they've become cheap. Similarly, people buy
fashionable goods in spite of price rise.
 Basic necessities of life or Insignificant proportion of Income
spent

• In case of basic necessities of life such as salt, rice, medicine, etc. the law
of demand is not applicable as the demand for such necessary goods does
not change with the rise or fall in price.
• Things of very low value and limited use like salt and matchbox do not
show any impact of price on their demand. The reason is that the amount
spent on these goods is very small and even a large increase in price has
very negligible impact on money spent.
 Goods with no substitutes
For the goods which have no substitute, such as life saving drugs, petrol
and diesel, people have no option but to buy them, whatever be the price;
hence demand does not show any effect of price change
 Elasticity of Demand:

• Elasticity of demand is a common devise for describing the

shape of the demand function. It is a measurable concept which
measures the response to change in demand.

• While Elasticity of demand refers to the degree of

responsiveness of quantity demanded to a change in price,
income of the consumer, and prices of related goods - Alfred
Marshall developed this concept.
Types of elasticity of demand

Price
elasticity of
demand

Cross Income
elasticity of elasticity of
demand demand
 Elasticity of demand

It refers to degree of correlation between price & demand .

1. Price elasticity of demand
Proportionate change in quantity demanded In response to proportionate
change in price.
Degree of price elasticity
Perfectly E, perfectly inelastic or zero E, relatively E, relatively Inelastic, unit E
% change in quantity demanded
E= --------------------------------------------------------
%change in price

Formula : ∆Q P
----- X -----
Q ∆P
Price elasticity can be precisely defined as proportionate change in
quantity demanded in response to proportionate change in price.
P(e) = Percentage change in quantity demanded /percentage change in
price
Factors determining price elasticity of demand
• Nature of the commodity
• Extent of use
• Substitutes
• Durability
• Income spent
• Income group
• Habits & conventions
• Postponement
• time
 1. Perfectly Elastic Demand:
• When a small change in price of a product causes a major change in its
demand, it is said to be perfectly elastic demand. In perfectly elastic
demand, a small rise in price results in fall in demand to zero, while a small
fall in price causes increase in demand to infinity. In such a case, the
demand is perfectly elastic or ep = ∞
 2. Perfectly Inelastic Demand:
• A perfectly inelastic demand is one when there is no change produced in
the demand of a product with change in its price. The numerical value for
perfectly inelastic demand is zero (ep=0).
• In case of perfectly inelastic demand, demand curve is represented as a
straight vertical line
 3. Relatively Elastic Demand
Relatively elastic demand refers to the demand when the proportionate
change produced in demand is greater than the proportionate change in
price of a product. The numerical value of relatively elastic demand ranges
between one to infinity.
• Mathematically, relatively elastic demand is known as more than unit
elastic demand (ep>1). For example, if the price of a product increases by
20% and the demand of the product decreases by 25%, then the demand
would be relatively elastic.
 4. Relatively Inelastic Demand:
• Relatively inelastic demand is one when the percentage change produced in
demand is less than the percentage change in the price of a product. For
example, if the price of a product increases by 30% and the demand for the
product decreases only by 10%, then the demand would be called relatively
inelastic. The numerical value of relatively elastic demand ranges between
zero to one (ep<1). Marshall has termed relatively inelastic demand as
elasticity being less than unity.
 5. Unitary Elastic Demand
When the proportionate change in demand produces the same change in the
price of the product, the demand is referred as unitary elastic demand. The
numerical value for unitary elastic demand is equal to one (ep=1).
 Income elasticity of demand

It’s the ratio of proportionate change in the purchase of goods to

the proportionate change in income
The income elasticity of demand is defined as the ratio of
proportionate change. In the purchase of goods to the
proportionate change in income of a consumer.
Income elasticity of demand = Percentage change in quantity
demanded /percentage change in income of a consumer.
 Income elasticity of Demand
• The responsiveness of demand to the change in
income is known as income elasticity of
demand.
∆x y
• E= ------- × ------
x ∆y
X = Quantity demanded
Y = disposable income
 Types of income elasticity

Negative income E, zero income E, income E <

than 1,income E equal to 1,income E >1,
 Types of income elasticity of demand
• Zero Income Elasticity: The increase in income of the individual does not
make any difference in the demand for that commodity. ( Ei = 0)
• Negative Income Elasticity: The increase in the income of consumers
leads to less purchase of those goods. ( Ei < 0).
• Unitary Income Elasticity: The change in income leads to the same
percentage of change in the demand for the good. ( Ei = 1).
• Income Elasticity is Greater than 1: The change in income increases the
demand for that commodity more than the change in the income. ( Ei > 1).
• Income Elasticity is Less than 1: The change in income increases the
demand for the commodity but at a lesser percentage than the change in
the Income. ( Ei < 1).
 Cross elasticity of demand

• It is the ratio of the percentage change in demand for one

good to the percentage change in the price of other goods
• It explains how the demand for a good say coffee depends
upon the price of a substitute tea
• Pepsi & coke are substitutes
• Cross elasticity can be precisely defined as proportionate
change in quantity demanded in response to proportionate
change in price of other goods .Like substitutes and
compliments.
• Cross elasticity of demand = percentage change in quantity
demanded /percentage change in the price of other goods.
 Cross elasticity of Demand
• A change in the demand for one good in
response to the change in price of another good
represents cross elasticity of demand of the
former goods for the later good.
% change in quantity demanded for x
• E = ------------------------------------------------------
% change in price of the product y
 Advertising & Promotional Elasticity of Demand

• Advertising elasticity can be precisely defined as proportionate

change in quantity demanded in response to proportionate
change in advertising and promotional activities of a seller.
• It is useful in determining the optimum level of advertising
expenditure
Factors that determine ad elasticity are :
• Levels of total sales
• advertisement by rival firms
• cumulative effect of past advertisement
• other factors
 Advertising elasticity of demand
• Measure of the responsiveness of demand for a
commodity to the change in outlay on
advertisements and other promotional efforts.
% change in demand
• E = --------------------------------------------------------
% change in expenditure on advertisement
∆D A
E = ----- X ------
D ∆A
 Uses of elasticity of demand

 If the businessmen know the elasticity for their commodities,

they can determine the prices accordingly.
 the concept of income elasticity is determining demand ,sales
forecasting and planning business expansion deli taxation &
subsidy policy
 Importance in determination of factor prices , pricing of joint
supply products
• Production decision
• Demand Forecasting
• Pricing decision
 Measuring Elasticity Of Demand
Elasticity of demand is known as price-elasticity of
demand. Because elasticity of demand is the degree of
change in amount demanded of a commodity in response
to a change in price. Price elasticity of demand can be
measured through three popular methods.
The methods are:-
1. The Percentage Method
2. The Point Method
3. The Arc Method
4. Total Outlay Method
 1. The Percentage Method:
• The price elasticity of demand is measured by its coefficient
(Ep). This coefficient (Ep) measures the percentage change in
the quantity of a commodity demanded resulting from a given
percentage change in its price.
 2. The Point Method:
• Prof. Marshall devised a geometrical method for measuring elasticity at a
point on the demand curve. Let RS be a straight line demand curve in
Figure. 2. If the price falls from PB ( = OA) to MD ( = OC), the quantity
demanded increases from OB to OD.
• Elasticity at point P on the RS demand curve according to the formula
is:
• EP = Δq/Δp x p/q
 The Arc Method:
• We have studied the measurement of elasticity at a point on a demand
curve. But when elasticity is measured between two points on the same de-
mand curve, it is known as arc elasticity. In the words of Prof. Baumol,
“Arc elasticity is a measure of the average responsiveness to price
change exhibited by a demand curve over some finite stretch of the
curve.”
 4. The Total Outlay Method:

• Marshall evolved the total outlay, or total revenue or total expenditure

method as a measure of elasticity. By comparing the total expenditure of a
purchaser both before and after the change in price, it can be known
whether his demand for a good is elastic, unity or less elastic.
• Total outlay is price multiplied by the quantity of a good purchased
• Total Outlay = Price x Quantity Demanded.
 Law Of Supply

• Definition: Law of supply states that other factors remaining constant,

price and quantity supplied of a good are directly related to each other. In
other words, when the price paid by buyers for a good rises, then suppliers
increase the supply of that good in the market.
•
Description: Law of supply depicts the producer behavior at the time of
changes in the prices of goods and services. When the price of a good rises,
the supplier increases the supply in order to earn a profit because of higher
prices.
 Market Supply Schedule:
Market Supply Schedule of a Commodity:
Px Q xS
4 100
3 80
2 60
1 40
In the table above, the produce are able and willing to offer for
sale 100 units of a commodity at price of $4. As the price falls, the
quantity offered for sale decreases. At price of $1, the quantity
offered for sale is only 40 units.
 Demand forecasting

Predicting future marked demand magnitude on the basis of

statistical data & empirical measurement of functional
relationship between demand & its determinants
Demand forecasting is predicting the future demand for the
firms product.
The knowledge about the future demand for the product helps in
• Planning & scheduling production
• Acquiring inputs
• Making provision for finances
• Formulating pricing strategy
• Planning advertisement
 Demand Forecasting types
• Passive Demand Forecasting: Passive Demand Forecasting is carried out
for stable businesses with very conservative growth plans. Simple
extrapolations of historical data is carried out with minimal assumptions.
• Active Demand Forecasting: Active Demand Forecasting is carried out
for scaling and diversifying businesses with aggressive growth plans in
terms of marketing activities, product portfolio expansion and
consideration of competitor activities and external economic environment.
• Short-term Demand Forecasting: Short-term Demand Forecasting is
carried out for a shorter term period of 3 months to 12 months
• Medium to long-term Demand Forecasting: Medium to long-term
Demand Forecasting is typically carried out for more than 12 months to 24
months in advance (36-48 months in certain businesses).
• External macro level Demand Forecasting: This type of Forecasting
deals with the broader market movements which depend on the
macroeconomic environment.
• Internal business level Demand Forecasting: As the name suggests, this
type of Forecasting deals with internal operations of the business such as
product category, sales division, financial division, and manufacturing
group
 Significance of demand forecasting
Fulfilling objectives:
• Implies that every business unit starts with certain pre-decided objectives.
Demand forecasting helps in fulfilling these objectives. An organization
estimates the current demand for its products and services in the market and
move forward to achieve the set goals.
Preparing the budget:
• Plays a crucial role in making budget by estimating costs and expected
revenues. For instance, an organization has forecasted that the demand for
its product, which is priced at Rs. 10, would be 1,00,000 units. In such a
case, the total expected revenue would be 10* 100000 = Rs. 10, 00, 000. In
this way, demand forecasting enables organizations to prepare their budget.
Stabilizing employment and production:
• Helps an organization to control its production and recruitment activities.
Producing according to the forecasted demand of products helps in
avoiding the wastage of the resources of an organization. This further helps
an organization to hire human resource according to requirement. For
example, if an organization expects a rise in the demand for its products, it
may opt for extra labor to fulfill the increased demand.
Expanding organizations:
• Implies that demand forecasting helps in deciding about the expansion of
the business of the organization. If the expected demand for products is
higher, then the organization may plan to expand further. On the other
hand, if the demand for products is expected to fall, the organization may
cut down the investment in the business.
Taking Management Decisions:
• Helps in making critical decisions, such as deciding the plant capacity,
determining the requirement of raw material, and ensuring the availability
of labor and capital.
Evaluating Performance:
• Helps in making corrections. For example, if the demand for an
organization’s products is less, it may take corrective actions and improve
the level of demand by enhancing the quality of its products or spending
more on advertisements.
Helping Government:
• Enables the government to coordinate import and export activities and plan
international trade
Steps in demand forecasting :
• Identification of objectives
• Nature of product and market
• Determinants of demand
• Analysis of factors
• Choice of technology
• Testing the accuracy
 Demand Forecasting methods

• One of the most important steps of the Demand

Forecasting process is the selection of the appropriate
method for Demand Forecasting. Demand can be
forecasted using
(A) Qualitative methods
(B) Quantitative methods
 1. Opinion Polling Method:

• In this method, the opinion of the buyers, sales force and

experts could be gathered to determine the emerging trend in
the market.
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. I his 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.
(i) Complete Enumeration Survey:
Under the Complete Enumeration Survey, the firm has to go for a door to
door survey for the forecast period by contacting all the households in the
area

(ii) Sample Survey and Test Marketing:

• Under this method some representative households are selected on random
basis as samples and their opinion is taken as the generalised opinion. This
method is based on the basic assumption that the sample truly represents
the population
(iii) End Use Method or Input-Output Method:
• This method is quite useful for industries which are mainly producer’s
goods. In this method, the sale of the product under consideration is
projected as the basis of demand survey of the industries using this product
as an intermediate product, that is, the demand for the final product is the
end user demand of the intermediate product used in the production of this
final product.
 (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.
 (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.
 2. Statistical Method:
• Statistical methods have proved to be immensely useful in demand
forecasting. In order to maintain objectivity, that is, by consideration
of all implications and viewing the problem from an external point
of view, the statistical methods are used.
(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
 The trend can be estimated by using any one of the following methods:

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.
(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 inde-
pendent 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.
 (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.
(a) The Leading Series:
• The leading series comprise those factors which move up or down before
the recession or recovery starts. They tend to reflect future market changes.
For example, baby powder sales can be forecasted by examining the birth
rate pattern five years earlier, because there is a correlation between the
baby powder sales and children of five years of age and since baby powder
sales today are correlated with birth rate five years earlier, it is called
lagged correlation. Thus we can say that births lead to baby soaps sales.
(b) Coincident or Concurrent Series:
• The coincident or concurrent series are those which move up or down
simultaneously with the level of the economy. They are used in confirming
or refuting the validity of the leading indicator used a few months
afterwards. Common examples of coinciding indicators are G.N.P itself,
industrial production, trading and the retail sector.
(c) The Lagging Series:
• The lagging series are those which take place after some time lag with
respect to the business cycle. Examples of lagging series are, labour cost
per unit of the manufacturing output, loans outstanding, leading rate of
short term loans, etc.
 (iii) 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.
 (iv) Econometric Models:

• Econometric models are an extension of the regression technique whereby

a system of independent regression equation is solved. The requirement for
satisfactory use of the econometric model in forecasting is under three
heads: variables, equations and data.
• The appropriate procedure in forecasting by econometric methods is model
building. Econometrics attempts to express economic theories in
mathematical terms in such a way that they can be verified by statistical
methods and to measure the impact of one economic variable upon another
so as to be able to predict future events.