Narsee Monjee Institute of Management Studies

NMIMS University

Demand Analysis

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scfDipankar De
Mumbai, July 2007
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 Demand Analysis

• “What is market potential for any new product?”

• “How much quantity the product would be demanded or sold?”

• “What are the factors that influence its quantity demanded?”

• Hence, the importance of demand analysis for the managers can be

briefly stated in two points:
– It provides insights necessary to effectively manipulate demand

– It helps forecast sales and revenues

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 Concept of Demand

• The quantity demanded is the number of units of a good that

consumers are willing and can afford to buy over a (specified) period of
time.

• A crucial assumption of “ceteris paribus” i.e. “other things being equal”

is made at the outset.

• The quantity demanded of any product normally depends on its price.

• It also depends on a number of other determinants, including

population size, consumer incomes, tastes & preferences, prices of
other products, etc.
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 Concept of Demand

• Law of Demand: There exists inverse relation between price and

quantity demanded, all other things held constant

• Demand Schedule: It is a table showing how quantity demanded of

some product during a specified period of time changes as the price of
that product changes, holding all other determinants of quantity
demanded constant.
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 Demand Curve

• A demand curve is a graphical representation of a demand schedule.

• It shows how the quantity demanded of a product will change as the price of that
product changes during a specified period of time, holding all other determinants of
quantity demanded constant.

• The curve shows the highest quantity of a good at each price the consumer is
willing to buy, ceteris paribus.

Price The demand curve slopes

downward: as the price of the
commodity decreases more people
Demand Curve would be willing to purchase the
commodity at larger quantities.

Willing Unwilling
to buy to buy

Quantity demanded 5
Demand Function

• It is a mathematical function that shows the relationship

between the quantity demanded and all variables that
influence the quantity demanded. It can be expressed as:

Where Qxis the quantity of good X, Pxis the price of price of good X, Ps & Pcare
prices of substitute & complementary goods, respectively, Y is income, W is wealth,
E is expectations, T is tastes & preferences, A is advertisement expenditure.

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 Movement along the demand curve

• A movement along the demand curve happens if there is change in price

of the good that results in change in the quantity demanded. E.g. if price of
good X falls from Rs. 9 to Rs. 8, there will be increase in quantity
demanded from 60 units to 70 units.

Price

Quantity demanded
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 Shift in the demand curve

• A shift in demand curve occurs when demand determinants other than

price change. If income level increases demand curve will shift to the
right, indicating more is demanded at the existing prices as consumers
are now better off.

Price

Quantity demanded
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Concepts of Elasticity

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 Concepts of Elasticity of Demand

• Knowing the direction of change in demand is not enough for a manager. It is

important to know to what extent the demand for his product is going to change
with the change in any of the determinants.

• An elasticity is a measure of the sensitivity of one variable to another.

• Specifically, it is a number that tells us the percentage change that will occur in
one variable in response to a 1 percent change in another variable. It measures
the responsiveness of a variable to the changes in its causal factors.

• Various elasticity measures are:

– Price elasticity
– Income elasticity
– Cross elasticity, etc.
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 Price Elasticity

• Price elasticity of demand measures the sensitivity of quantity

demanded to price changes.

• It tells us what the percentage change in quantity demanded for a

good will be following a 1 per cent increase in the price of that
good.

• Two different types of price elasticity can be calculated:

– Point elasticity of demand
– Arc elasticity of demand

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 Price Elasticity

• Point elasticity of demand is defined as:

Q 2 − Q1 P2 − P1 ∆Q P1
ep = ( ) /( )=
Q1 P1 ∆P Q1

• Since the demand curve is downward sloping, and quantity demanded increases
with the fall in price, the measure has a negative sign. However, as a matter of
convention in economics, we show price elasticity by a positive number.

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 Price Elasticity

• For appreciable change in prices, arc elasticity is more appropriate.

In arc elasticity, average price and quantity is considered because
when there is appreciable change in price, the value of elasticity
calculated on the basis of two points on the arc.

Q2 − Q1 ( P + P1 ) / 2 ∆Q P1 + P2
e pArc = ( )* 2 =
P2 − P1 (Q1 + Q2 ) / 2 ∆P Q1 + Q2

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 Price Elasticity

• For a linear demand curve, the price elasticity depends not only on the slope of

the demand curve, but also on the price and quantity. The elasticity, therefore,

varies along the demand curve.

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Price Elasticity

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 Determinants of Price Elasticity

• Greater the number of close substitutes, more will be the price-elasticity since
whenever there is a change in the price of the commodity, it will be substituted by
and for the substitutes depending on the increase and decrease of the price
respectively.

• The nature of the commodity used whether luxury or necessity. For

necessities, like food, medicines, etc. the elasticity will be low enough. Changes
in their prices are not going to change quantities demanded appreciably. For
luxuries, one can postpone the consumption.

• The durability of goods particularly HH goods like TV, car, washing machines,
etc. also affects the elasticity. These goods are used for longer periods. If prices
fall, there may be considerable replacement activities causing an increase in the
quantity demanded, making elasticity higher.

• The proportion of income spent on the commodity. If it is extremely low, the

consumer may not feel the impact of price changes on the consumption of the
commodity. It is low in such cases, e.g. match boxes, newspapers, etc. 16
 Uses of Price Elasticity

• Price elasticity has important applications in business decision-making.

• The most common use of price elasticity is in “pricing policy”

formulation. How much increase in total revenue a firm can get by
reducing the price of its product depends upon price elasticity of
demand.
• The price elasticity is an important determinant to find the impact of
taxes.
• There are substantial uses of price elasticity in adaptation of a new
technology.

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 Income Elasticity

• The income elasticity shows the percentage change in quantity

demanded when income of the consumer changes by one percent, that
is
Q − Q1 Y 2 − Y1 ∆Q Y 1
ey = ( 2 ) /( )=
Q1 Y1 ∆P Q1

• Generally, per capita disposable income is taken as a measure of income in

practice.
• For most of the goods (normal goods) the income elasticity of demand will be
positive.
• For inferior goods, income elasticity turns out to be negative. For luxury goods, it is
greater than one.
• For necessities and semi-luxury goods, it may vary between zero and one. 18
 Uses of Income Elasticity

• The knowledge of income elasticity is a vital piece of information for the

firm.

• A firm whose demand functions show high income elasticity will have
good opportunities for business particularly for expansion. For certain
goods, there may be consumption limit from the consumers’ point of
view. A firm supplying such goods will be stagnant if it continues to
produce them. The firm in such situation can grow only through
diversification of its business.

• The income elasticity helps in making such decisions. Even for future
assessment of demand, the firm will take income elasticity into account.
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 Cross-Price Elasticity

• The cross-elasticity is used to measure the responsiveness of quantity demanded

of goods, say X, when there is a change in the price of some other goods, say Y.
The two goods X and Y, may be either substitute or complementary to each other.

Qx2 − Qx1 py − py
2 1 1
∆ Q x py
ex .y =( ) /( )=
Qx1 1
py ∆ Py Qx1

• Examples of substitutes: teas & coffee, coal & gas, petrol & diesel, etc.
• Examples of complements: tea & sugar, petrol & car, pen & ink, etc.

• For substitute goods, cross-elasticity will be positive and for complementary goods it
will be negative. It will be positive in case of derived demand also, i.e. when X is
used for production of Y.
• If cross-elasticity is zero, then the two goods are unrelated. 20
 Uses of Cross-Price Elasticity

• The knowledge of cross-elasticity is very essential when the goods are

competing with each other or when they are required in some combination
with others

• In case of different brands competing with each other, it is used to find the
effect of prices of other brands of commodities supplied by the competitors
on its own

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