LECTURE NOTES

ON
MANAGERIAL ECONOMICS AND
FINANCIAL ANALYSIS

II B. Tech II semester R19&R20 REGULATIONS

 UNIT-I

INTRODUCTION TO MANAGERIAL ECONOMICS AND DEMAND ANALYSIS

Introduction to Economics:

Economics is a social science. It’s basic function is to study how people- individuals
,households, firms and nations – maximize their gains from their limited resources and opportunities.

Economics can be divided into two broad categories.

Micro Economics & Macro Economics.

Macro Economics studies the economic system as a whole. It includes changes in total output
,total employment, the unemployment rate, exports and imports. The goal of macro economics is to
explain the economic changes that affect many households, firms & markets at once
Micro Economics focuses on the behavior of the individual actors on the economic stage, i e
firms and individuals and their interaction in markets. Economics is thus a social science which studies
human behavior in relation to optimizing allocation of available resources to achieve the given ends.
Definition of Economics :
According to Alfred Marshall -
Economics is a study of man's action in the ordinary
business of life:it enquiries how he gets income and how he uses it.

Meaning of Managerial Economics:

Managerial economics is a part of economics and it is concerned with decision making. It

is a science which deals with the application of economic theories, techniques, principles and concepts
to business management in order to solve business and managerial problems. In short ‘economics
applied in decision making is known as managerial economics’.

Definitions:
Milton H Spencer and Louis Siegel man : defines managerial economics - The
integration of economic theory with business practice for the purpose of facilitating decision making
and forward planning by management.
According to Edwin Mansfield - Managerial Economics is concerned with the
application of economic concepts and economic analysis to the problem of formulating rational
managerial decisions.

 Nature of Managerial Economics:

1. Managerial Economics is Micro Economics in Nature: Managerial economics studies about

the individual firm. It studies how an individual firm can use scarce resources to produce more output
with minimum cost and maximum profit.

2. Managerial Economics is concerned with Normative Economics:Managerial economics tells a

business firm to do certain things which will benefit them and not to do certain things which leads to
losses. Therefore, managerial economics is normative economics because it prescribes.

3. Managerial Economics is Application Oriented:Managerial economics tries to solve some

complicated business problems. Decision making skills can be improved by applying some principles
and concepts.

4. Managerial Economics Takes the Help of Macro Economic Concepts:It takes the help of macro
economics, which is helpful to understand the external environment which is relevant for the business.
5. Managerial Economics Offers Scope to Evaluate Each Alternative:Managerial Economics gives

an opportunity to evaluate each alternative depending on its cost and profit.

6. Interdisciplinary: The contents, tools and techniques of managerial economics are drawn from
different subjects such as economics, management, statistics, accountancy, psychology, mathematics,
etc.

7. Assumptions and limitations: Every concept and theory of managerial economics is based on
certain assumptions. Where there is a change in assumptions, the theory may not hold good at all.

8. Managerial Economics is dynamic in nature:Managerial Economics deals with human-beings (i.e.

human resource, consumers, producers etc.). The nature and attitude differs from person to person.
Thus to cope up with dynamism and vitality managerial economics also changes itself over a period of
time.

 Scope of Managerial Economics:

The main focus in managerial economics is to find an optimal solution to a given

managerial problem. The scope of managerial economics refers to its area of study. It deals with
demand analysis and forecasting, cost analysis, production analysis, pricing policies, profit
management, and capital management etc.

1. Demand Analysis and Forecasting:A business firm convert raw material into finished products and
these products are sold in the market. Hence the firm has to estimate and forecast the demand before
starting production. The firm will prepare production schedule on the basis of demand forecast.

2. Cost Analysis:Every firm wants to reduce cost. A study of economic costs and their estimates are
useful for management decisions. Estimation of cost is essential for decision making.

3. Production Analysis:Production analysis refers to the physical terms while cost analysis refers to
monetary terms. Production analysis deals with different production functions and their managerial
uses.

4. Pricing Policies:Pricing is an important area of managerial economics. Price is the basic thing for
the revenue of a firm, and the success of the price decisions taken by it.

5. Profit Management: The primary aim of any firm is to maximize profits. Their existence an
uncertainty in the estimation of profits, because of difference in the costs and revenues, and the effects
of its internal and external factors. Therefore, profit management is the difficult area in managerial
economics.

6. Capital Management:Capital management implies planning, acquisition, disposition and control of

capital. Long term investment decisions need a careful analysis of expected returns, risk and
uncertainty.

 Managerial Economics Relationship with Other Subjects:

Managerial economics is closely linked with many other disciplines such as

economics, accountancy, mathematics, statistics, operation research, psychology and organizational
behavior. The management executive makes use of the concepts and methods form all these
disciplines.
1. Managerial Economics and Micro-Economic Theory: Managerial economics is mainly
microeconomic in nature. Microeconomic theory provides all important concepts and analytical
tools to managerial economics. Managerial economic makes use of such microeconomic concepts
as the elasticity of demand, marginal cost, market structures, and so on in decision making.

2. Managerial Economics and Macro-Economic Theory:Macroeconomic theory has comparatively

less concern with the managerial economics. It is useful to managerial economics mainly in the
area of forecasting.

3. Managerial Economics and Mathematics: Managerial is concerned with estimating and

predicting the relevant economic factors for decision making and forward planning. In this process,
he extensively makes use of the tools and techniques of mathematic such as algebra, exponentials
and such other.

4. Managerial Economics and Statistics: Managerial economics needs the tools of statistics in more
than one way. A successful businessman must correctly estimate the demand for his product. The
statistical tools are used in collecting data and analyzing them to help in the decision making
process.

5. Managerial Economics and Accountancy: The accountant provides accounting information

relating to costs, revenues, receivables, payables, profits/losses etc. and this forms the basis for the
managerial economist to act upon.

6. Managerial Economics and Psychology: Consumer psychology is the basis on which managerial
economist acts upon. How the customer reacts to a given change in price or supply and its
consequential effect on demand or profits is the main focus of study in managerial economics.

7. Managerial Economics and Organizational Behaviour:It enables the managerial economist to

study and develop behavioural models of the manager’s behavior with that of the owner. This
further analyses the economic rationality of the firm in a focused way.

8. Managerial Economics and Operations Research: Decision making is the main focus in
operations research and managerial economics. If managerial economics focuses on ‘problems of
decision making’, operations research focuses on solving the managerial problems.

 Role/Responsibilities of Managerial Economist:

Managerial economist plays a very important role in an organization. He has to gather

economic data, analyze all crucial information. His responsibilities towards his job are:

1. Sales forecasting.
2. Industrial market research.
3. Environmental forecasting.
4. Identify new business opportunities.
5. Economic analysis of competing companies.
6. Investment analysis and forecasting.
7. Production scheduling.
8. Pricing and the related decisions.
9. Advice on trade and Public relations.
 DEMAND ANALYSIS

Meaning and Definition of Demand:

A product is said to have demand when these conditions are satisfied.

Desire

Ability to Pay

Willingness to pay the price of a product.

If these conditions are satisfied, then only we can say the product is having demand in the
market.

n short:
Demand =Desire + Ability to pay (i.e., Money or Purchasing Power) + Will to spend

According to Benham demand means “The quantity of the products the

buyers are willing to purchase at a given price and over a given period of time.”

Factors that influence Demand:

1 .Price of good or service
2 .Income of consumers
3 .Prices of Related Goods
4. Consumers tastes and Preferences
5.Climatic conditions

 Demand Distinctions / Types of Demand / Nature of Demand:

1. Producers’ Goods Demand:Producers’ goods demand means demand for goods, which are used
for the production of other goods such as machines, tools, looms, etc.

2. Consumers’ Goods Demand: Consumers’ goods demand means demand for goods, which are
use for final consumption. Ex: ready- made clothes, prepared food etc.

3. Durable Goods Demand:It means demand for goods are those which go on being used over a
period of time. Ex: cars, refrigerators, umbrellas, etc.

4. Non-Durable Goods Demand:It means demand for goods which are cannot be consumed more
than once, for example sweets, bread, milk, etc. They are also called as single usage goods.

5. Derived Demand:When the demand for a product is tied to the purchase of some parent
products, its demand is called as derived demand. Ex: TV-stabilizer, Gun-bullets.

6. Autonomous Demand:If the demand for a product is wholly independent of all others, it is
known as autonomous demand. For example, demand for TV is autonomous but demand for
stabilizer is derived demand.

7. Company Demand:The term company demand denotes the demand for the products of a
particular company. Ex: demand for steel produced by TISCO.

8. Industry Demand: Industrial demand means demand for the products of a particular industry.
Ex: total demand for steel in the country.
 9. Market Segment Demand:Demand for a certain product has to be studied not only in its totality
but also by breaking it into different segment viz., geographical areas, sub-products etc. Demand
for a product in that particular segment is called market segment demand.

10. Total Market Demand: The aggregate demand for a product in all market segments is called as
total market demand.

11. Short-Run Demand:Short-run demand refers to the demand with its immediate reaction to
price changes, income fluctuations etc.

12. Long-Run Demand:Long-run demand is that which will ultimately exist as a result of the
changes in pricing, promotion or product improvement, after enough time has been allowed to let
the market adjust itself to the new situation.

DEMAND FUNCTION

Demand function is a mathematical expression of relation between the quantity demanded

and its determinants. It can be expressed as follows

QD = F( P, I, Psc, T, A)

Where

Qd = quantity demand

F = functional relational between input P

= price of the product

I = income of the consumer

Psc= price of substituted or complementary

T = taste and preference

A = advertisement

LAW OF DEMAND

Introduction:
The relation of price to sales is known in economics as the ‘Law of Demand’. This
law simply expresses the relation between quantity of commodity and its price. This concept was
developed by Alfred Marshall and Samuelson.

Definitions:
According to Prof. Samuelson“Law of Demand states that people will buy more at
lower prices and buy less at higher prices, other things remaining the same”.
According to Alfred Marshall“A rise in the price of a commodity or service
is followed by a decrease in demand, and a fall in the price of a commodity is
followed by an increase in demand, if conditions of demand remains constant”.
 Explanation of the Law of Demand:

A market demand schedule (imaginary data)

Price of Commodity X Quantity Demanded
(In Rs.) (Units per Week)
5 100
4 200
3 300
2 400
1 500

The market demand schedule can be obtained by adding up if all the individual demand
schedules. The table states the relationship between quantity demanded of commodity ‘X’ and its price.
When price of commodity ‘X’ per unit is Rs.5 quantity demanded are 100 units. As price fall to Rs.4
quantity demanded increases to 200 units. This is shown in the following. z

The above diagram represents price of commodity ‘X’ on ‘Y-axis and quantity demanded on the X-
axis. The curve DD shows the mkt. demand for commodity X which slopes downwards from left to
right. When the price is falling, the demand (for commodity X) is increasing. When the price increases,
the demand for it decreases.

 Exceptions to the Law of Demand:

 Giffen paradox: The Giffen goods are inferior goods is an exception to the law of demand.
When the price of inferior good falls, the poor will buy less and vice versa. When the price
of maize falls, the poor will not buy it more but they are willing to spend more on superior
goods than on maize. Thus fall in price will result into reduction in quantity. This paradox
is first explained by Sir Robert Giffen.

 Veblen or Demonstration effect: According to Veblen, rich people buy certain goods
because of its social distinction or prestige. Diamonds and other luxurious article are
purchased by rich people due to its high prestige value. Hence higher the price of these
articles, higher will be the demand.

 Speculation:When people speculate about changes in the price of a commodity in the

future, they may not act according to the law of demand. If the price of a commodity is
increasing and it is expected to still further, the consumer will buy more of them at higher
prices, than they did at lower price.

 Consumer’s Psychological Bias:When the consumer is wrongly biased against the quality
of a commodity with the price change, he may not act according to law of demand.
  Necessaries:In the case of necessaries like rice, vegetables etc, people buy more even at a
higher prices.

 Fear of shortage:During the time of emergency of war people may expect shortage of a
commodity. At that time, they may buy more at a higher price to keep stocks for the future.

 Ignorance: Sometimes customers do not consider the price of the product. Although price
changes they can buy the same quantity of products.

 Brand Loyalty: When consumer is brand loyal to particular product or psychological

attachment to particular product, they will continue to buy such products even at a higher
price

ELASTICITY OF DEMAND

Introduction:

The concept elasticity of demand is developed by Alfred Marshall in his book

“Principles of Economics.”

The concept ‘law of demand’ explains that the demand for a commodity increases when its price falls
and vice versa. But the law does not explain the extent of change in demand. In order to measure the
extent of change in demand Prof. Alfred Marshall developed the concept of elasticity of demand
In measuring the elasticity of demand two variables are considered. There are:
a) Demand
b) The determinants of Demand.
Definition:
“The percentage change in quantity demanded is caused by the
percentage change in demand determinants is known as elasticity of demand.”

Percentage change in quantity demanded

Elasticity of demand = ---------------------------------------------------------
Percentage change in determinant of demand

 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.
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 “the percentage change in the quantity demanded
to the percentage 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 a 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.

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:

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)

 TYPES OF PRICE ELASTICITY OF DEMAND:

Price elasticity of demand 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.

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.)



 Types / Degrees of Price Elasticity of Demand:

Price elasticity of demand is generally classified into five categories. These are:

1. Perfect Elasticity of Demand:Consumers have infinite demand at a particular price and none at all
at an even slightly higher than this given price is known as perfect elasticity of demand. Here the
slope of the curve is horizontal.(E=infinitive)

In the diagram, the quantity demanded increases from OQ to OQ1, from OQ1 to OQ2, even
though there is no change in price. The price is fixed at OP.

2. Perfect Inelasticity of Demand: Where a change in price howsoever large, causes no change in
quantity demanded is called as perfect inelasticity of demand. Here the slope of the curve is
vertical.(E=0)

In the figure, it is shown that there is no change in the quantity demanded even
though the price is changing (increasing). Even though there is an increase in price from OP to OP1,
from OP1 to OP2 there is no change in demand.

3. Relative Elasticity of Demand:The percentage change in quantity demanded is greater than the
percentage change in price is termed as relative elasticity of demand. In this case, the elasticity of
demand is said to be greater than one. (e>1)

The figure shows that the quantity demanded increases from OQ1 to OQ2 as there is a
decrease in price from OP1 to OP2. The amount of the increase in the quantity demanded is greater
than the amount of decrease in the price.

4. Relative Inelasticity of Demand:The percentage change in quantity demanded is less than that of
the percentage change in price is known as relative inelasticity of demand. In this case the
elasticity of demand is said to be less than one. (e<1).
 In the figure, the demand increases from OQ1 to OQ2 as there is a decrease in
price from OP1 to OP2. The amount of increase in the quantity demanded is lesser than the amount
of decrease in the price.

5. Unitary Elasticity of Demand:The percentage change in quantity demanded is equal to the

percentage in price is known as unitary elasticity of demand. (e=1)

The figure shows that the quantity demanded increases from OQ1 to OQ2, as there is a
decrease in price from OP1 to OP2. The amount of increase in the quantity demanded is equal to the
amount of fall in the price.

 INCOME ELASTICITY OF DEMAND:

Income elasticity of demand can be 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)

 Types of Income Elasticity of Demand:Income elasticity of demand mainly of three types:

1) Zero income Elasticity.

2) Negative income Elasticity
3) Positive income Elasticity

1. Zero income elasticity: Where a change in consumer’s income howsoever large causes no change
in quantity demanded is known as zero income elasticity of demand. (Eg. salt, sugar etc). Here income
elasticity (Ey) =0

It shows zero income elasticity of demand. Although an income increases from OY to

OY1, Quantity demanded constant.

2. Negative income elasticity: Where an increase in come leads to decrease in demand is termed as
negative income elasticity of demand. Eg, Inferior Goods. Here Ey< 0

It shows negative income elasticity of demand. When income increases from OY to

OY1, Quantity demanded decreases from OQ to OQ1.

3. Positive income Elasticity: In this case, an increase in income may lead to an increase in the
quantity demanded. i.e., when income rises, demand also rises. (Ey =>0) This can be further classified
in to three types:

a) Unitary Income Elasticity of Demand: The percentage change in quantity demanded of a

commodity is equal to the percentage in consumer’s income is known as unitary income
elasticity of demand. Unitary income elasticity is equal to one i.e., (Ey) = 1
 It shows unitary income elasticity of demand. When income increases from OY to OY1, Quantity
demanded also increases from OQ to OQ1. But the increase in quantity demanded is exactly equal to
the increase in income.

b) High-Income Elasticity of Demand: High income elasticity of demand means the

percentage change in quantity demanded of a commodity is greater than the percentage
change in the consumer’s income. High income elasticity of demand is greater than one i.e.,
Ey> 1.

It shows high-income elasticity of demand. When income increases from OY to OY1, Quantity
demanded also increases from OQ to OQ1. But the increase in quantity demanded is greater than the
increase in income.

c) Low-Income Elasticity of Demand: Low income elasticity of demand means the percentage
change in quantity demanded of a commodity is less than the percentage change in the
consumer’s income. Low income elasticity of demand is less than one i.e., Ey< 1.

It shows low-income elasticity of demand. When income increases from OY to OY1, Quantity
demanded also increases from OQ to OQ1. But the increase in quantity demanded is smaller than the
increase in income.

Difference between Income Elasticity and Price Elasticity of Demand:

Price Elasticity of Demand Income Elasticity of Demand

1 In this elasticity of demand, when price of 1 In this elasticity of demand, the demand
product is less then, quantity demanded is changes for a product with the change in
high and if the price increases the quantity consumer’s income.
demand decreases.
2 Elasticity of demand completely relies on 2 Elasticity of demand completely relies on
price of the product income of the consumer
3 Price of the product and quantity demanded 3 Income of the consumer and quantity
are inversely related. demanded are directly related to each other
 4 For Giffen goods, as price of product 4 For inferior goods, as income of the
increases, quantity demanded also increases consumer increases, quantity demanded
decreases.
5 While defining law of demand, price of the 5 While defining law of demand, consumer’s
product is considered. income is kept constant.

MEASUREMENTS OF ‘ELASTICITY OF DEMAND’

Price elasticity of demand 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.

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.)

 Measurements of Price Elasticity of Demand:To measure price elasticity of demand broadly

three methods are there. They are:

1. Total Outlay Method

2. Point Method
3. Arc Method

1. Total Outlay Method: Under this method, the change in the price of a product and their
resultant change in the outlay (or expenditure) on the purchase of the product are taken into
account to measure the price elasticity of demand.

 When the price falls and total outlay increases, the elasticity of demand is greater than one
(e > 1).
 When the price falls and total outlay decreases, the elasticity of demand is less than one (e <
1).
 When the price falls and the total outlay remains the same, the elasticity of demand is equal
to one (e =1).
These three relations illustrated in the following table:

Price of Product and Change in Outlay

Price (Rs.) Quantity Demanded Total Outlay (Rs.) Elasticity of demand
(units)
10 1000 10,000
8 1500 12,000 (e > 1)

10 1000 10,000
8 1100 8,800 (e < 1)

10 1000 10,000
8 1250 10,000 (e = 1)

This is clearly shown in following Figure:

2. Point Method:When elasticity is measured at a point on a straight line demand curve, it is known as
‘point elasticity of demand’. Elasticity at any one point is ‘the ratio of the lower part of the straight line
demand curve to the upper part of the straight line demand curve. In symbol,
Where,

Ed = Lower Segment
Upper Segment

Where
Ed = Price elasticity of demand
L = Lower part of the straight line demand curve
U = Upper part of the straight line demand curve.

Suppose the demand line length is 2mts. By the help of demand curve. We find out the Elasticity.

It can be explained in the following figure.

By applying this formula, we can come to the following conclusions:

At Point “M :-

The Ed = MB/MA = 1/1 = 1. ( Where Ed = 1)

At Point “N” :-

The Ed = NB/NA = 1.5/0.5 = 3. (where Ed > 1)

At Point “L” :-

The Ed = LB/LA = 0.5/1.5 = 0.3 (Where Ed < 1)

At point “A” :-

The Ed = AB/A = 2/0 ( Where Ed = ∞)

At point “B” ;

The Ed = B/AB = 0/2 = 0 (Where Ed = 0)

2. Arc Method: We have studied the measurement of elasticity at a point on a demand curve,
when elasticity is measured between two finite (countable) points on a same demand curve, it
is known as ‘arc elasticity of demand.’
The formula used for measuring arc elasticity of demand is thus:

Where,
Ep = Arc elasticity of demand
Q = Initial quantity of demand
Q1 = New quantity of demand

= Change in quantity demanded

P = Initial price
P1 = New price
= Change in price
Note : Example is explained in running notes

 FACTORS AFFECTING THE ELASTICITY OF DEMAND:

Introduction:

The concept elasticity of demand is developed by Alfred Marshall in his book

“Principles of Economics.”

The concept ‘law of demand’ explains that the demand for a commodity increases when
its price falls and vice versa. But the law does not explain the extent of change in demand. In order to
measure the extent of change in demand Prof. Alfred Marshall developed the concept of elasticity of
demand in his book principles of economics.

In measuring the elasticity of demand two variables are considered. There are:

a) Demand
b) The determinants of Demand.
Definition:

“The percentage change in quantity demand is caused by the

percentage change in demand determinants is known as elasticity of demand.”

Proportionate change in quantity demanded

Elasticity of demand = -----------------------------------------------------------
Proportionate change in determinant of demand


Factors Influencing the Elasticity of Demand:

1. Nature of Goods: Goods can be classified into three categories. These are: Essentials,
Comforts, and Luxuries. The demand for essentials goods is generally inelastic as the
consumption of a necessary good does not change much with the change in price. Ex: Salt
or Rice. The demand for comfort and luxuries changes much due to a price change and is
therefore elastic. Ex: Luxury cars or Silk saris.

2. Availability of Substitutes: A commodity having different substitutes will have elastic

demand, because if its price rises its consumption can be diverted to its substitutes. On the
other hand c commodity with weak substitutes will have relatively inelastic demand.

3. Extent of Use: A commodity having variety of uses will have elastic demand.

Ex: Steel (it is used for many purposes). A commodity having limited use will have inelastic
demand.

4. Consumer’s Income: People with high income are less affected by price changes than people
with low income.
 5. Amount of money spend: Items that constitute a smaller amount of expenditure in a
consumer’s family budget tend to have relatively inelastic demand. Ex: Match box, Salt etc.
Thus, cheap or small, expensive or large expenditure items tend to have more demand
inelasticity than expensive or large expenditure items.

6. Range of Prices: Range of prices exerts an important influence on elasticity of demand. At a

very high price, demand is inelastic because a slight fall in price will not induce the people buy
more.

7. Influence of Habit and Customs: There are certain articles which have demand on account of
conventions, customs or habit and in their cases, elasticity is less.

8. Time: Elasticity of demand varies with time. Generally demand is inelastic during short period
and elastic during the long period.

 DEMAND FORECASTING FOR EXISTING PRODUCT:

Demand Forecasting refers to an estimate of future demand for the product. Accurate
demand forecasting is essential for a firm to enable it to produce the required quantities at the right
time and to arrange well in advance for the various factors of production.

 Demand Forecasting Methods for Existing Product: In the demand forecasting the following
types of forecasting techniques are there:
Survey of Buyer’s Intention

Survey methods Collective Opinion Survey

Delphi Method

Naive Method

Demand forecasting Statistical methods Moving Average Method

methods

Regression Method

Test Marketing Method

Controlled experiments
Other methods
Expert’s Opinion Method

Judgmental Approach

1) Survey of Buyer’s intentions:It involves the selection of a sample of potential buyers and then
getting information on their likely purchase of the production in future. It is more suited to industrial
products.

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) Naïve 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.

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 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 populations 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.

8) Controlled Experiments: In this method an effort is made to vary separately certain determinants of
demand which can be manipulated, e.g., price, advertising, etc.

9) 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, distributors and suppliers.

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

 DEMAND FORECASTING NEW PRODUCT:

Demand Forecasting refers to an estimate of future demand for the product. Accurate
demand forecasting is essential for a firm to enable it to produce the required quantities at the right
time and to arrange well in advance for the various factors of production.

 Demand Forecasting Methods for New Product:

Evolutionary Approach

Substitute Approach

Growth Curve Approach

Demand forecasting methods
Opinion Poll Approach

Vicarious/ Indirect Approach

Sales Experience
 1. Evolutionary Approach:In this approach the demand conditions of the existing product in the
company should be taken into account while assessing the demand for the new product. E.g.
3D-TV from colour TV.

2. Substitute Approach: In this approach the demand conditions of the existing product of
competing companies should be taken into account while assessing the demand for the new
product.

3. Growth Curve Approach: By this approach the demand for the new product will be
established on the basis of some growth patterns of an already established product. Ex: the
average sales of Ponds powder will give an idea as to how a new cosmetic will be received in
the market.

4. Opinion Poll Approach:Under this method, demand will be estimated by making direct
enquires from the ultimate consumers.

5. Vicarious/indirect Approach:By this method, the consumer’s reactions for a new product are
found out indirectly through the specialized dealers who are able to judge the consumer’s
needs tastes and preferences.

6. Sales Experience Approach: According to this method the demand for the new product is
estimated by offering the new product for sale in a sample market.

 DEMAND FUNCTION:

The functional relationship between the demand for the product and its various
demand determinants expressed in mathematical terms is called as ‘demand function’. Thus, the
demand function for commodity X can, symbolically, is stated as follow:

Dx = f (I, Px, Ps, Pc, T, u)

Where,
Dx = demand for commodity X
f = depends on
I = consumer’s Income
Px = price of commodity X
Ps = prices of substitutes of X
Pc = prices of complements of X
T = consumers’ tastes
u = other determinants of demand for X (like population, future expectations
etc.)

 DEMAND SCHEDULED:

A tabular representation (statement) of price and quantity relationship is called as ‘the

demand scheduled’. There are, two types of demand scheduled:

1. The Individual Demand Scheduled.

2. The Market Demand Scheduled.

 The Individual Demand Scheduled: It shows the quantities of a commodity that will be
purchased by an individual at each alternative conceivable price in a given period of time.
 Individual demand scheduled.
Price Demand per week

80 2
70 4
60 6
50 10
40 16

 The Market Demand Scheduled: It is tabular statement narrating the quantities of a commodity
demanded in aggregate by all the buyers in the market at different prices over a given period of
time.

A Market Demand Scheduled (Hypothetical data)

Units of commodity X demanded per day

Price by individuals Total market
A B C demand
4 1 1 3 5
3 2 2 5 9
2 3 5 7 15
1 5 9 10 24

 DEMAND CURVE:

A graphical representation of price and quantity relationship is called as ‘the demand

curve’. By using the following demand schedule, graphically we can represent the relation between
price of a commodity and its demand.

Price of Commodity X Quantity Demanded

(In Rs.) (Units per Week)
5 100
4 200
3 300
2 400
1 500

The demand curve shows the negative relationship between price and quantity demanded. It
means if the price falls, the demand will increase and vice versa.