1 MANAGERIAL ECONOMICS

Module 2: Theory of Demand and Supply [Comprehension]

Demand-law of demand, demand curve, determinants of demand, exceptions to Law of demand. Elasticity of
demand-types and its measurements. Demand Forecasting: definition, methods; Supply-law of supply, supply
curve and determinants of supply. Elasticity of supply-its type, Equilibrium of demand and supply.

Theory of Demand
Theory of Demand is the principle/law that correlates the demand for a product with the price of
the product. The Law of Demand is the basis for price determination in an open market.

Meaning and Determinants of Demand

We have often heard the phrase ‘there is a huge demand for product XYZ in the market’. But what
does this exactly mean? What constitutes the demand for a product in the economy? Let us learn
about the concept of demand and the determinants of demand in a market.

Meaning of Demand
By demand we mean the various quantities of a given commodity or service which consumers
would buy in one market in a given period of time at various prices, or at various incomes, or at
various prices of related goods. —Bober

Therefore, the demand for a good is made up of the following three things:

1. The desires to acquire it

2. The willingness to pay for it, and

3. The ability to pay for it. In other words.

Demand = Desire to acquire + Willingness to pay + Ability to pay

In absence of any of these three characteristics, there is no demand. For example, a teacher may
possess both the willingness to pay as well as the ability to pay for a liquor bottle, yet he does not
have demand for it. This is because he does not desire to have an alcoholic drink. Similarly, a
trader might have the desire to have a TV, he might be rich enough to be able to pay for it, but if
he is not willing to pay for the TV, he does not have demand for this product. Also, a worker might
possess both the desire for a scooter as well as the willingness to pay for it, but if he does not
possess enough money to pay for it, he does not have demand for the scooter. In contrast to these
three situations, a lawyer, who has the desire for a car, as well as both the will and ability to pay
for it, has demand for the car. Thus, demand in economics means effective demand, i.e., one which
meets all its three characteristics—desire, willingness and ability to pay. On the other hand,
demand means desire backed by willingness and ability to pay.

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Besides, demand also signifies a price and a period of time in which the demand is to be fulfilled.
Demand is the quantity of a specific good that people are willing and able to buy during a specific
period, given the choices available.

To sum up. We can say that the demand for a product is the desire for that product backed
by willingness as well as ability to pay for it. It is always defined with reference to a particular
time, place, and price and given values of other variables on which it depends.

Determinants of Demand
The demand for a commodity by a buyer is generally not a fixed quantity. It is affected by many
factors. The factors that influence the demand are called the determinants of demands. The
determinants of demand are also known as demand shifters. The following factors affect an
individual's demand for a commodity:

1. Prices of related commodities

When a change in price of the other commodity leaves the amount demanded of the commodity
under consideration unchanged, we say that the two commodities are unrelated, otherwise these
are related. The related commodities are of two types’ substitutes and complements. When the
price of one commodity and the quantity demanded of the other commodity move in the same
direction (i.e., both increase together and decrease together).

2. Income of the individual

The amount demanded of a commodity also depends upon the income of an individual. With an
increase in income, increased amount of most of the commodities in his consumption bundle,
though the extent of the increase may differ between commodities.

3. Tastes and preferences

It is quite well that the change in tastes and preferences of consumers in favor of a commodity
results in smaller demand for the commodity. Modern business firms, which sell product with
different brand names, rely a great deal on influencing tastes and preferences of households in
favor of their products (with the help of advertisements, etc.) in order to bring about increase in
demand of their products.

4. Tastes of the consumers

The amount demanded also depends on consumer’s taste. Tastes include fashion, habit, customs,
etc. A consumer’s taste is also affected by advertisement. If the taste for a commodity goes up, its
amount demanded is more even at the same price and vice-versa.

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5. Wealth

The amount demanded of a commodity is also affected by the amount of wealth as well as its
distribution. The wealthier are the people, higher is the demand for normal commodities. If wealth
is more equally distributed, the demand for necessaries and comforts is more. On the other hand,
if some people are rich, while the majority is poor, the demand for luxuries is generally less.

6. Expectations regarding the future

If consumers expect changes in price of a commodity in future, they will change the demand at
present even when the present price remains the same. Similarly, if consumers expect their
incomes to rise in the near future, they may increase the demand for a commodity just now.

7. Climate and weather

The climate of an area and the weather prevailing there has a decisive effect on consumer’s
demand. In cold areas, woolen cloth is demanded. During hot summer days, ice is very much in
demand. On a rainy day, ice-cream is not so much demanded.

8. State of business

The level of demand for different commodities also depends upon the business conditions in the
country. If the country is passing through boom conditions, there will be a marked increase in
demand. On the other hand, the level of demand goes down during depression.

DEMAND FUNCTION

A mathematical expression of relationship between quality demanded of the commodity and its
determinants is known as the demand function. Explained below.

Qx = f (Px,AX,DX,OX,IC,YC,TC,EC,PY,AY,DY,OY,G,N,W)
Where:

1. Qx = Quantity Demanded of product , per period

2. Px = Price of Product
3. Ax = Advertising for Product
4. Dx = Design/style/quality-Cost of product
5. Ox = Outlets, Distribution
6. Ic = Incomes of consumers/customers/clientele
7. Yc = Consumer Expenditures on related goods
8. Tc = Tastes
9. Ec = Expectations of consumers regarding future prices
10. Py = Prices of related goods
11. Ay = Advertising/Promotion of related goods

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12. Dy = Design/Styles of related goods

13. Oy = Outlets of related goods
14. G = Government Policy
15. N = Number of People in the Economy
16. W = Weather Conditions

REASONS FOR CHANGE (INCREASE OR DECREASE) IN DEMAND

 Changes in income
 Changes in tastes, habits and preference.
 Changes in fashions and customs.
 Changes in the distribution of wealth.
 Changes in population.
 Advertisement and publicity.
 Change in the value of money (if money value increases that leads to raise in demand for
goods).

LAW OF DEMAND
Among the many causal factors affecting demand, price is the most significant and the price-
quantity relationship called as the Law of Demand is stated as follows: "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" (Alfred Marshall). In simple words other things being equal, quantity demanded will be
more at a lower price than at higher price. The law assumes that income, taste, fashion, prices of
related goods, etc. remain the same in a given period. The law indicates the inverse relation
between the price of a commodity and its quantity demanded in the market. However, it should be
remembered that the law is only an indicative and not a quantitative statement. This means that it
is not necessary that such variation in demand be proportionate to the change in price.

Definitions Some major definitions of the Law of Demand are as follows:

"Law of Demand states that people will buy more at lower prices and buy less at higher prices, if
other things remaining the same."- Prof. Samuelson.

The Law of Demand states that amount demanded increases with a fall in price and diminishes
when price increases." - Prof. Marshall

"According to the law of demand, the quantity demanded varies inversely with price." –Ferguson

Marshall:-“The greater the amount to be sold the smaller must be the price”

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Benham:-“Usually a larger quantity of commodity will demanded at lower price that a higher
price”

Characteristics of law of demand

 Inverse relationship between price and demand.
 Price is independent variable
 Demand is dependent variable on price of goods.
Demand Curve and Schedule
Table represents the increase in the price of the oranges lead to decrease the demand for oranges.

If the price of the orange is 5/-, people are willing to by 10 oranges. When prices are increased to
8/- where people are willing to buy only 5 oranges. This table shows that the increase in price of
goods causes decreases the quantity demanded for the goods.

Prices of Oranges quantity of oranges demanded at specific prices

10 5

8 8

6 6

5 5

DEMAND CURVE (graphical presentation of law of demand)

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ASSUMPTIONS

Every law will have limitation or exceptions. This law operates when the commodity’s price
changes and all other prices and conditions do not change. The main assumptions are

 Habits, tastes and fashions remain constant

 Money, income of the consumer does not change.
 Prices of other goods remain constant
 The commodity in question has no substitute
 The commodity is a normal good and has no prestige or status value.
 People do not expect changes in the prices.
Exceptions to law of demand
Generally, the amount demanded of good increases with a decrease in price of the good and vice
versa. In some cases, however, this may not be true. Such situations are explained below.

1. Giffen goods: these are those inferior goods on which the consumer spends a large part of his
income and the demand for which falls with a fall in their price. The demand curve for these has a
positive slope. The consumers of such goods are mostly the poor. a rise in their price drains their
resources and the poor have to shift their consumption from the more expensive goods to the giffen
goods, while a fall in the price would spare the household some money for more expensive goods.
which still remain cheaper. These goods have no closely related substitutes; hence income effect
is higher than substitution effect.

2. Commodities which are used as status symbols: Some expensive commodities like diamonds,
air conditioned cars, etc., are used as status symbols to display one’s wealth. The more expensive
these commodities become, the higher their value as a status symbol and hence, the greater the
demand for them. The amount demanded of these commodities increase with an increase in their
price and decrease with a decrease in their price. Also known as a Veblen good. (In economics,
Veblen goods are a group of commodities for which people's preference for buying them increases
as their price increases, as greater price confers greater status, instead of decreasing according to
the law of demand.)

3. Expectations regarding future prices: If the price of a commodity is rising and is expected to
rise in future the demand for the commodity will increase.

4. Emergency: At times of war, famine etc. consumers have an abnormal behaviour. If they expect
shortage in goods they would buy and hoard goods even at higher prices. In depression they will
buy less at even low prices.

5. Quality-price relationship: some people assume that expensive goods are of a higher quality
then the low priced goods. In this case more goods are demanded at higher prices.

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CLASSIFICATION OF DEMAND

1. Individual demand:-

A commodity or good demanded by a single person is called individual demand.

2. Market Demand

A demand for a particular product by all customers and added, is called market demand. (Total all
individual demand is called as the market demand)

Table is the market demand schedule. This schedule, from the angle of simplification, is based on
the assumption that there are two buyers, A and B for X commodity. By adding up their individual
demand, the market demand schedule has been estimated:

Factors affecting market demand

Market or aggregate demand is the summation of individual demand curves. In addition to the
factors which can affect individual demand there are three factors that can affect market demand
(cause the market demand curve to shift):

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 a change in the number of consumers,

 a change in the distribution of tastes among consumers,
 a change in the distribution of income among consumers with different tastes

3. Derived demand

The increase in demand for one particular good causes increase in the demand for other good is
called derived demand. Complementary goods are those goods which are jointly used to satisfy a
want. In other words, complementary goods are those which are incomplete without each other.

These are things that go together, often used simultaneously. For example, pen and ink, Tennis
rackets and tennis balls, cameras and film, etc.

For example, demand for coal leads to derived demand for mining, as coal must be mined for
coal to be consumed.

Examples:

 Increasing demand for use computers in various fields will cause increase in demand for
the operating systems like Microsoft windows products.

 Increase in the demand for automobiles like bikes, cars and large & heavy vehicle will
cause increase in the demand for the fuel like petrol and diesel.

 Increase in the demand for the cellular phone will cause increase in the demand for the
memory cards for the multimedia purpose.

 Increase in the demand for the education will cause increase in the demand for the text
books for the various subjects.

4. Cross Demand:

When the demand of one commodity is related with the price of other commodity is called cross
demand. The commodity may be substitute or complementary. Substitute goods are those goods
which can be used in case of each other. For example, tea and coffee, Coca-cola and Pepsi. In
such case demand and price are positively related. This means if the price of one increased then
the demand for other also increases and vise versa.

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Elasticity of Demand

Elasticity = responsiveness of consumer due to the price change of any commodity Definitions
According to Alfred Marshall: "Elasticity of demand may be defined as the percentage change in
quantity demanded to the percentage change in price."

The law of demand says that consumers will respond to decrease or increase in prices of goods
and services. (other things remaining constant), but law of demand explains only the concept of
change in prices of goods and services effects its demand, but does not explain to what extent
demand changes if prices of goods increase or decrease. The degree of responsiveness or
sensitivity of consumers to a change in price is measured by the concept of price elasticity of
demand If a small change in price is accompanied by a large change in quantity demanded, the
product is said to be elastic (or responsive to price changes). The opposite also applies; a product
is inelastic if a large change in price is accompanied by a small amount of change in demand.

Business know that they face demand curves, but rarely do they know what these curves look like.
Yet sometimes a business needs to have a good idea of what part of a demand curve looks like if
it is to make good decisions. If Rick's Pizza raises its prices by ten percent, what will happen to its
revenues? The answer depends on how consumers will respond. Will they cut back purchases a
little or a lot? This question of how responsive consumers are to price changes involves the
economic concept of elasticity.

 Types of Elasticity of Demand: There are four important kinds of elasticity of demand. These are:

1. Price Elasticity of Demand.

2. Income Elasticity of Demand.

3. Cross Elasticity of Demand.

4. Advertising or Promotional Elasticity of Demand.

1. Price Elasticity of Demand: It can be defined as “the percentage change in quantity demanded
to the percentage change in price.” .To measure the price elasticity of demand the following formula
can be applied.

Percentage change in quantity demanded

Price Elasticity of Demand = --------------------------------------------------------------

Percentage change in price.

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Symbolically:

Where,

Ep = Price elasticity of demand.

Q = the original or old demand (say Q1)
Q2= new demand
P = the original or old price (say P1)
P2 = new price
ΔQ = the change in demand. (i.e., ΔQ = Q2 - Q1.)
ΔP = the change in price. (i.e., ΔP = P2 - P1.)

2. Income Elasticity of Demand: It is defined as “a percentage or proportional change in the quantity

demanded to the percentage or proportional change in income.”

Percentage change in quantity demanded

Income Elasticity of Demand = --------------------------------------------------------------

Percentage change in income

Symbolically:

Where,
Ey =Income elasticity of demand
Q = original demand (Q1)
Q2= new demand
Y = original income (Y1)
Y2= new income
ΔQ = change in demand (Q2-Q1)
ΔY = change in income (Y2-Y1)

3. Cross Elasticity of Demand: The term cross elasticity of demand may be defined as “the
proportionate change in quantity demanded of a commodity to given proportionate change in the price
of the related goods”.

This type of elasticity arise in case of inter related goods such as substitutes and
complementary goods.

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Percentage change in Demand for X

Cross Elasticity of Demand = --------------------------------------------------

Percentage change in Price of Y

Symbolically:

Where,

Exy = cross elasticity of demand.

ΔQx = change in demand of commodity X
ΔPy = change in price of commodity Y
Qx = old demand of commodity X
Py = old price of commodity Y.

4. Advertising or Promotional Elasticity of Demand: “The proportionate change in quantity demanded

to the proportionate change advertisement expenditure is known as advertising elasticity of demand”

Percentage change in quantity demanded

Advertising elasticity of demand = --------------------------------------------------------

Percentage change in advertisement expenditure.

Symbolically:

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Where,
Ea= Advertising elasticity of demand
Q = original demand (Q1)
A= original expenditure on advertising (A1)
ΔQ = change in demand (Q2-Q1)
ΔA = change in expenditure (A2-A1)

DEGREES OF PRICE ELASTICITY

Different commodities have different price elasticities. Some commodities have more elastic
demand while others have relative elastic demand. Basically, the price elasticity of demand ranges
from zero to infinity. It can be equal to zero, less than one, greater than one and equal to unity.

According to Dr. Marshall : "The elasticity or responsiveness of demand in a market is great or

small according as the amount demanded increases much or little for a given fall in price and
diminishes much or little for a given rise in price."However, some particular values of elasticity of
demand have been explained as under ;

Types of Price Elasticity of Demand:-

1. Perfectly elastic demand.

2. Perfectly inelastic demand.
3. Relatively elastic demand.
4. Relatively inelastic demand.
5. Unitary inelastic demand.

1. PERFECTLY ELASTIC DEMAND

When the percentage change in quantity demanded is infinite even if the percentage change in
price is zero, the demand is said to be perfectly elastic. Endless demand at given price.

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Observe the graph, price of the goods raised from P to P1 and remained constant. But the demand
curve of the products is increasing from Q1 to Q2 and so on.

Eg:- we can take example as bikes market. In today’s Indian bike market
the demand for bikes and cars is increasing day by day without any effect
of price.

2. PERFECTLY INELASTIC DEMAND

When the percentage change in quantity demanded is zero no matter how price is changed, the
demand is said to be perfectly inelastic

Observe the graph, price of the goods changing or raises from P1 to P2 and P3 but there is no
change in demand at Q.

An example of perfectly inelastic demand would be a lifesaving drug that people will pay any price
to obtain. Even if the price of the drug were to increase dramatically, the quantity demanded would
remain the same.

Example: Emergency services, drugs and essential food item have

perfectly inelastic demand. The price of food item may increase or
decrease; there will be no change in the demand for goods

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3. RELATIVELY ELASTIC DEMAND

When the percentage change in quantity demanded is greater than the percentage change in price,
the demand is said to be elastic.

Or

In other words, relatively small changes in price cause relatively large changes in quantity.

Observe the graph, price of the goods increased from P1 to P2 and eventually the demand for the
goods decreases from Q1 to Q2. But the proportionate change in price is less than the proportionate
change in demand

Example: - there are commodities for which a small

change in price will drastically reduce the amount of
the commodity demanded. For example, air-travel for
vacationers is very sensitive to price. An increase in
the air fare will lead the vacationer to choose another
mode of transportation like car or lead him to
postpone the vacation plan for the time being. Thus
for a rise in air fare for the vacationers we will see a
relatively more drastic reduction in quantity demanded and hence high price elasticity of demand.

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4. RELATIVELY INELASTIC DEMAND

More change in the price of the goods but less change in demand for the goods.

Observe the graph, price of the goods increased from P1

to P2 and eventually the demand for the goods decreases
from Q1 to Q2. The proportionate change in price is more
than the proportionate change in demand.

Example: if we observe the prices of petrol and

comparing its demand change with the change in
price levels of petrol (even though the price
changes to great extent, there will not be much
change in demand)

Facts [+]

WASHINGTON: US motorists drove 1.2 per cent fewer miles in 2011, the lowest level measured
since 2003, while concerns about the high cost of gasoline are rising, the government announced
Tuesday.

According to Federal Highway Administration figures, last year US drivers drove 57.5 billion km
less than they did in 2010.

Since 2008, the distance covered by US drivers, which is calculated by taking into account traffic
volume on the highways, has fallen due to the economic crisis and the high price of gasoline.

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5. UNITARY ELASTIC DEMAND

In case of unitary elastic demand, the proportion of change in demand for goods and services is
equal to proportion of change in its price. Which means the change in the ratio of the price of the
goods and services is equal to the change in demand of the goods and services.

Observe the graph, price of the goods increased

from P1 to P2 in certain proportion then the
demand for the goods decreases from Q1 to Q2
in same proportion to the price change.
Therefore the proportionate change in price of
goods and services is equal the proportionate
change of demand for goods and services in case
of the unitary elastic demand.

Example: The price of digital cameras increases by

10%, the quantity of digital cameras demanded
decreases by 10%. The price elasticity of demand is
(unitary elastic demand).

PROBLEM ON PRICE ELASTICITY OF DEMAND

The most common elasticity measurement is that of price elasticity of demand. It measures how
much consumers respond in their buying decisions to a change in price. The basic formula used to
determine price elasticity is

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Problems:

If price increases by 10% and consumers respond by decreasing purchases by 20%, the equation
computes the elasticity coefficient as -2. The result is negative because an increase in price (a
positive number) leads to a decrease in purchases (a negative number). Because the law of demand
says it will always be negative, many economists ignore the negative sign, as we will in the
following discussion.

Problem 1:

If the price of certain goods falls from 20/- to 10/-, that causes increase in the demand from43 units
to 75 units. Calculate the price elasticity of demand.

Solution:

I f the values are given separately and not in the percentages, we should apply the following
formula model 1

 ∆Q =change in the demand.(difference in demand) =43- 75= 32

 ∆P=change in the price.(difference in the price) =20-10 = 10
 P=initial price. (first price/ old price) =20
 Q=initial demand. (first demand/ old demand)= 43

Hence Price Elasticity of Demand =1.48

We should compare the above value with the price which is 1%. And its general always.

Hence 1% of the price change causes the 1.48% change in demand

Easy way to remember:

Elastic means that a change in price leads to a bigger Change in quantity demanded. Think of a
rubber band, or elastic, that stretches to a bigger size than its original size. Inelastic means that a

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change in price leads to a smaller Change in quantity demanded. Unlike a rubber band, it does not
stretch bigger.

Unit Elastic means that a change in price leads to a one-for-One change in quantity demanded. For
example, a doubling of the price leads to a halving of the quantity demanded. Remember by unit,
meaning single or one.

DEMAND FORECASTING

The activity of estimating the quantity of a product or service that consumers will purchase.
Demand forecasting involves techniques including both informal methods, such as educated
guesses, and quantitative methods, such as the use of historical sales data or current data from test
markets. 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.

— according to Cundiff and Still, "Demand Forecasting is an estimate of Demand during a

specified period. Which estimate is tied to a proposed marketing plan and which assumes a
particular set of uncontrollable and competitive forces."

— In the words of Prof. Philip Kotler. The company (sales) forecast is the expected level of
company sales based on a chosen marketing plan and assumed marketing environment"

— According to Evan J. Douglas, "Demand forecasting may be defined as the process of finding
values for demand in future time periods."

Demand Forecasting
The cost should be controlled by producing correct level of goods in the firm and also according
to the demand for those goods in the market. For the estimation of demand, demand forecasting is
to be done by the firm.

 Forecasting = estimation of future situations.

 Forecasting reduces or minimizes the uncertainty.
 By forecasting effective decisions can be taken for tomorrow.
 Demand forecasting is based on the determinants of the demand.
 Demand for goods increases and gives sales.
 Sales are the primary source of the income for a firm.

STEPS INVOLVED IN DEMAND FORECASTING

1. Identification of business objectives:

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In the first stage we should know what is the aim of forecasting? What we get or know from the
forecasting? Estimation of factors like quantity and composition of demand for goods, price to be
quoted, sales planning and inventory control etc., are done in the first stage.
2. Determining the nature of goods under consideration:
Different category of goods has their own distinctive demand. Example capital goods, consumer
durables and non-durables goods in which category our goods fall we should estimate.
3. Selecting a proper method of forecasting:
There are different methods for demand forecasting. Which is best suited method that we should
select for doing demand forecasting?
4. Interpretation of results:
The forecasting which is done by the managerial economist should be interpreted in detailed
manner. That means it should be easy to understand by the top management.

Demand Forecasting Techniques

To invest money and others factors in business; we require a reasonable accurate forecast of
demand. Starting with qualitative methods like survey of collective opinions, buyers' intention,
Delphi approach and its variant, a number of quantitative methods are used for computing demand
forecasts as detailed below:

Demand Forecasting Methods / Techniques for Existing Product:

In the sales forecasting two types of forecasting techniques are there:

Survey of Buyer’s Intention

Survey methods Collective Opinion Survey

Delphi Method

Naive Method

Demand forecasting Moving Average Method

Statistical methods
methods
Regression Method

Test Marketing Method

Controlled experiments
Other methods
Expert Opinion Method

Judgmental Approach

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1) Survey of Buyer’s intentions: In this method, almost all the potential users of the product are
contacted and are asked about the future plan of purchasing the product in question. The quantities
indicated by the consumers are added together to obtain the probable demand for the product.

2) Collective Opinion Survey: In this method sales forecast is done by sales force. The territory-
wise forecasts are consolidated at branch, area or regional level and the aggregate is taken.

3) Delphi Method: In this method, a group of experts and a Delphi coordinator will be selected.
The experts give their written opinion / forecasts individually to the coordinator. The coordinator
processes, compiles and refers them back to the panel members for vision, if any.

4) Naive Method: In this approach, the sales of the future period are forecasted as the value of the
sales for the previous period. This method ignores the irregular components, and assumes that
seasonality and cyclicality do not exist and the trend is flat.

This Year’s Sales

Next Year’s Sales = This Year’s Sales ×----------------------
Last Year’s Sales
5) Moving Average method: In this method, the forecaster estimates sales based on an average
of previous time period.. The period for moving averages, such as 3-yearly, 5-yearly, etc., will
depend usually on the length of the cycle.

The formula for computing the 3-yearly moving average will be:

(a +b + c ) /3, ( b + c + d)/3,........

6) Regression Analysis: It reveals the average relationship between two variables and this make
estimate or prediction possible. Two or more variables are used to estimate the tendency of sales
to vary. One variable required is the dependent.
7) Test Marketing: In this method companies select a limited number of cities population which
are representative of the target customers in terms of demographic factors that include age, income,
lifestyle and shopping behaviour. A product is made available at the retail outlets without any
promotional campaign.

7) Controlled Experiments: In this method an effort is made to vary separatly certain

determinants of demand which can be manipulated, e.g., price, advertising, etc.

8) Expert’s Opinion: An approach to demand forecasting is to ask experts in the field to provide
their own estimates of likely sales. Experts may include executives directly involved in the market,
such as dealers, distributers and suppliers.

10) Judgmental Approach: Management may have to use its own judgement when other methods
are not fiesble to apply.

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SIVA KRISHNA.G | Assistant Professor
21 MANAGERIAL ECONOMICS

SUPPLY ANALYSIS

Unlike a demand curve, a supply curve has a positive slope, reflecting the law of supply. The law
of supply states that quantity supplied is positively related to price; i.e., firms offer larger amounts
at higher prices and smaller amounts at lower prices. In this case, price is the reward for production
so that higher market prices bring forth larger quantities. Higher prices provide firms with extra
funds to purchase more resources or inputs to increase production. Higher prices also act as a signal
to producers that consumers value their goods highly and desire more of them.

Definition of Supply

According to Prof. Benam, “Supply may mean the amount offered for sale per unit of time."
According to Prof. Thomas, “The supply of goods is the quantity offered for sale in a given market
at a given time at various prices.”

Producer or manufacturer of the goods always thinks to supply more goods at high price for the
consumer to get more income .Like demand, supply is not a given quantity—that is called quantity
supplied. It is a relationship between price and quantity. As the price of a good rises, producers are
generally wants to sell in larger quantity. The reverse is equally true: as price decreases, so the
supplier don’t like to sell or supply in large quantity. Like demand, supply can also be described
in a table or a graph.

LAW OF SUPPLY

Like law of demand which states a relation between the price and the quantity demanded for a
good or service, law of supply states a relation between price and quantity supplied. Supply, like
demand, is a flow concept. As Lipsey has put it: "Supply is a desired flow: how much firms are
willing to sell per (unit) period of time not how much they actually sell." Law of supply refers to
the amount of a goods or services that producers are willing and able to offer for sale at each
possible price per unit. The law of supply simply states that, as the price of a good or service rises,
the quantity supplied (i.e., offered for sale) also rises.

Definitions

— In the words of Dooley. "The law of supply states that other things being equal the higher the
price, the greater the quantity supplied or the lower the price, the smaller the quantity supplied."

— According to Lipsey, "The law of supply states that other things being equal, the quantity of
any commodity that firms will produce and offer for sale is positively related to the commodity's
own price, rising when price rises and falling when price falls."

As the price of good increases, suppliers will attempt to maximize profits by increasing the quantity
of the product sold.

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SIVA KRISHNA.G | Assistant Professor
22 MANAGERIAL ECONOMICS

Table of supply schedule

The relationship between price and quantity supplied is usually a direct and positive relationship.
A rise in price is associated with a rise in quantity supplied by the seller in the market.

WHY DOES PRICE INCREASES WHEN THERE IS A SHORTAGE OF GOODS?

In below table , there is a shortage of goods (150-50 =100 units) at a price of $5 and Quantity
demanded (Qd) (150 units) is greater than quantity supplied (Qs) (50 units), buyers will not be
able to buy all they had hoped to buy at $5. Some buyers will bid up the price to get sellers to sell
to them instead of selling goods to other buyers. Some sellers, seeing buyers more demand for the
goods, sellers will realize that they can raise the price of the goods that they have for sale. Hence
the higher prices will also make the sellers to add (production) output. Thus, there is a tendency
for price and output to rise until equilibrium is achieved.

SCHOOL OF COMMERCE
SIVA KRISHNA.G | Assistant Professor
23 MANAGERIAL ECONOMICS

DETERMINANTS OF SUPPLY

Innumerable factors and circumstances could affect a seller’s willingness or ability to produce
and sell a good. Some of the more common factors are:

1. Cost factor of production

Cost of production depends on the factors like

 price of raw materials
 rents and interest on capital
 cost of machinery
 payments to human resources (wages and salaries)
 transportation charges
If cost of production is high, in general supply will be low.
2. State of technology

Use of latest technology decreases the cost of production and increases the production capacity
which increases supply of goods.

3. Factors outside the economic sphere

Supply depends upon the below said factors. These factors should not arise if they arise; they
affect the supply directly or indirectly.

 Whether conditions
 Floods
 Wars
 Epidemics (unexpected situations)
4. Tax and subsidy

If tax subsidy (charge less tax) is given by the government the production cost decreased. If that
is not there production cost raises. Finally the production will be low and effects to decrease in
supply.

SCHOOL OF COMMERCE
SIVA KRISHNA.G | Assistant Professor
24 MANAGERIAL ECONOMICS

SUPPLY FUNCTION

The supply function is the mathematical expression of the relationship between supply and those
factors that affect the willingness and ability of a supplier to offer goods for sale

SX = Supply of goods
PX = Price
PF = Factor input employed (used) for production.
 Raw material
 Human resources
 Machinery
O = Factors outside economic sphere.
T = Technology.
t = Taxes.
S = Subsidies
There is a functional (direct) relationship between price and supply.

ELASTICITY OF SUPPLY

The Price Elasticity of Supply measures the rate of response of quantity demand due to a price
change. If you've already read Elasticity of Demand and understand it, you may want to just
skim this section, as the calculations are similar.

Definitions

— According to Lipsey, "Elasticity of supply is the ratio of percentage change in quantity

supplied over the percentage change in price."

— In the words of Prof. Bilas, "Elasticity of supply is defined as the percentage change in
quantity supplied divided by percentage change in price."

Price elasticity of supply measures the relationship between change in quantity supplied and a
change in price. The formula for price elasticity of supply is:

SCHOOL OF COMMERCE
SIVA KRISHNA.G | Assistant Professor
25 MANAGERIAL ECONOMICS

 ∆Q =change in the demand.(difference in demand)

 ∆P=change in the price.(difference in the price)
 P1=initial price. (first price/ old price)
 Q1=initial demand. (first demand/ old demand)
The value of elasticity of supply is positive, because an increase in price is likely to increase the
quantity supplied to the market and vice versa.

Calculating the Price Elasticity of Supply

You may be asked "Given the following data, calculate the price elasticity of supply when the
price changes from $9.00 to $10.00" Using the chart on the bottom of the page, I'll walk you
through answering this question.

First we need to find the data we need. We know that the original price is $9 and the new price is
$10, so we have Price(OLD)=$9 and Price(NEW)=$10. From the chart we see that the quantity
supplied (make sure to look at the supply data, not the demand data) when the price is $9 is 150
and when the price is $10 is 110. Since we're going from $9 to $10, we have Q Supply(OLD)=150
and Q Supply(NEW)=210, where "Q Supply" is short for "Quantity Supplied". So we have:

 Price(OLD)=9
 Price(NEW)=10
 QSupply(OLD)=150
 QSupply(NEW)=210
To calculate the price elasticity, we need to know what the percentage change in quantity supply
is and what the percentage change in price is. It's best to calculate these one at a time.

Calculating the Percentage Change in Quantity Supply

The formula used to calculate the percentage change in quantity supplied is:

[QSupply(NEW) - QSupply(OLD)] / QSupply(OLD)

By filling in the values we wrote down, we get:

[210 - 150] / 150 = (60/150) = 0.4

So we note that % Change in Quantity Supplied = 0.4 (This is in decimal terms. In percentage
terms it would be 40%). Now we need to calculate the percentage change in price.

Calculating the Percentage Change in Price

Similar to before, the formula used to calculate the percentage change in price is:

[Price (NEW) - Price (OLD)] / Price (OLD)

SCHOOL OF COMMERCE
SIVA KRISHNA.G | Assistant Professor
26 MANAGERIAL ECONOMICS

By filling in the values we wrote down, we get:

[10 - 9] / 9 = (1/9) = 0.1111

We have both the percentage change in quantity supplied and the percentage change in price, so
we can calculate the price elasticity of supply.

Final Step of Calculating the Price Elasticity of Supply

We go back to our formula of:

PEoS = (% Change in Quantity Supplied)/(% Change in Price)

We now fill in the two percentages in this equation using the figures we calculated.

PEoD = (0.4)/(0.1111) = 3.6

When we analyze price elasticities we're concerned with the absolute value, but here that is not an
issue since we have a positive value. We conclude that the price elasticity of supply when the price
increases from $9 to $10 is 3.6.

Five Types of Elasticities of Supply:

1. Unit Elastic Supply: When change in price of X brings about exactly proportionate change in
its quantity supplied then supply is unit elastic i.e. elasticity of supply is equal to one, e.g. if price
rises by 10% and supply expands by 10% then, change in the quantity supplied the supply is
relatively inelastic or elasticity of supply is less than one.

Es = % change in Quantity Supplied of X

% change in price of X
2. Relatively Elastic Supply: When change in price brings about more than proportionate change
in the quantity supplied, then supply is relatively elastic or elasticity of supply is greater than one.

3. Perfectly Inelastic Supply: When a change in price has no effect on the quantity supplied then
supply is perfectly inelastic or the elasticity of supply is zero.

4. Perfectly Elastic Supply: When a negligible change in price brings about an infinite change in
the quantity supplied, then supply is said to be perfectly elastic or elasticity of supply is infinity.

All the five types of Elasticities of supply can be shown by different slopes of the supply curve.
Fig. (1) Shows the supply is unit elastic because change in price from OP to OP1 brings about
exactly proportionate change in the quantity supplied of commodity X viz., from OM to OM1. In
this case Es = 1.

SCHOOL OF COMMERCE
SIVA KRISHNA.G | Assistant Professor
27 MANAGERIAL ECONOMICS

Fig (2) shows that supply is relatively inelastic because change in price of from OP to OP1 brings
about less than proportionate change in quantity supplied of X. in this case Es < 1.

Fig (3) shows that supply is relatively elastic because change in price of X from OP to OP1 brings
about more than proportionate change in quantity supplied of X. in this case Es > 1.

Fig (4) shows that supply is perfectly inelastic because change in price of X from OP to OP1 has
absolutely no effect on quantity supplied of X. in this case Es = 0. Thus, if the supply curve is
vertical, i.e. parallel to Y-axis it represents perfectly inelastic supply.

SCHOOL OF COMMERCE
SIVA KRISHNA.G | Assistant Professor
28 MANAGERIAL ECONOMICS

Fig (5) shows that supply is perfectly elastic because a small change in price of X brings about infinite
change in supply. Thus, if the supply curve is horizontal or parallel to X- axis it represents perfectly
elastic supply.

Hence, the five different types of elasticities of supply can be shown by five different slopes of supply
curve.

THE MODEL OF SUPPLY AND DEMAND (EQUILIBRIUM)

Equilibrium is defined to the price-quantity pair where the quantity demanded is equal to the
quantity supplied, represented by the intersection of the demand and supply curves.

In words, equilibrium exists if the amount sellers are willing to sell is equal to the amount buyers
are willing to buy.

The market price of goods are determined by both the supply and demand for it. In 1890, English
economist Alfred Marshall published his work, Principles of Economics, which was one of the
earlier writings on how both supply and demand interacted to determine price. Today, the supply-
demand model is one of the fundamental concepts of economics. The price level of a good
essentially is determined by the point at which quantity supplied equals quantity demanded. To
illustrate, consider the following case in which the supply and demand curves are plotted on the
same graph.

Equilibrium: What Happens to Price When There Is a Surplus or a Shortage?

What did the middlemen do when the price was $ 5.00 and there was a surplus of apples? He
lowered the price of apple. What did the middlemen do when the price was $2.5 and there was a
shortage of apple? He raised the price. The behavior of the middlemen can be summarized this
way: If a surplus exists, middlemen lower the price of apple ; if a shortage exists, middlemen raise
the price of apple. This is how the middlemen moved the apple market into equilibrium.

SCHOOL OF COMMERCE
SIVA KRISHNA.G | Assistant Professor
29 MANAGERIAL ECONOMICS

Not all markets have middlemen. (When was the last time you saw an middlemen in the grocery
store?) But many markets act as if an middle men were calling out higher and lower prices until
equilibrium price is reached. In many real-world middlemen-less markets, prices fall when there
is a surplus and rise when there is a shortage. Why?

WHY DOES PRICE OF GOODS FALL WHEN THERE IS A SURPLUS?

In the below table , there is a surplus of (150 Qs -50 Qd = 100) at a price of $15 and the Quantity
supplied (150 units) is greater than quantity demanded (50 units). Suppliers will not be able to sell
all they had hoped to sell at $15. As a result, their inventories will grow beyond the level they hold
in preparation for demand changes. Then the sellers want to reduce their inventories by lowering
prices to clear-off their inventories, some will cut back on production and others will do a little of
both by reducing price and cutting back production . As shown in the picture, there is a tendency
for price and output to fall until equilibrium is achieved.

WHY DOES PRICE OF GOODS INCREASES WHEN THERE IS A SHORTAGE?

In below table , there is a shortage of goods (150-50 =100 units) at a price of $5 and Quantity
demanded (Qd) (150 units) is greater than quantity supplied (Qs) (50 units), buyers will not be
able to buy all they had hoped to buy at $5. Some buyers will bid up the price to get sellers to sell
to them instead of selling goods to other buyers. Some sellers, seeing buyers more demand for the
goods, sellers will realize that they can raise the price of the goods that they have for sale. Hence
the higher prices will also make the sellers to add (production) output. Thus, there is a tendency
for price and output to rise until equilibrium is achieved.

SCHOOL OF COMMERCE
SIVA KRISHNA.G | Assistant Professor
30 MANAGERIAL ECONOMICS

By observing the below table it can be understood that the price of $3.00 is the equilibrium price
and the quantity of 70 is the equilibrium quantity. At any other price, sellers would want to sell a
different quantity than buyers want to buy.

The same information can be shown with a graph. On the graph, the equilibrium price and
quantity are indicated by the intersection of the supply and demand curves.

*****

SCHOOL OF COMMERCE
SIVA KRISHNA.G | Assistant Professor