MASTER OF BUSINESS ADMINISTRATION

O01CA504: Business Economics

SEMESTER 1

O01CA504
BUSINESS ECONOMICS
Unit: 2 – Demand Analysis & Demand Forecasting 1
O01CA504: Business Economics

Unit 2
Demand Analysis & Demand Forecasting
TABLE OF CONTENTS
Fig No /
SL SAQ /
Topic Table / Page No
No Activity
Graph
1 Introduction - -
4-5
1.1 Learning Objectives - -
2 Meaning Law of Demand - 1
2.1 Types of demand - -
2.2 Determinants of demand - -
2.3 Demand schedule 1, 1, 2 -
2.4 Demand Function and Demand Curve 3 -
6 - 20
2.5 Significant features of Law of demand - -
2.6 Exception to the Law of Demand 2 -
2.7 Changes In Quantity Demanded, Movement 3 -
Along The Demand Curve
2.8 Changes In Demand, Shifts In Demand Curve 4. 5 -
3 Elasticity of Demand - 2, I
3.1 Kinds of Elasticity 4, 5, 6, 7, 8 -
3.2 Determinants of elasticity - -
21 - 44
3.3 Measurement of elasticity 6 -
3.4 Practical Application Of Price Elasticity Of - -
Demand
4 Demand Forecasting 9 -
4.1 Features of Demand Forecasting - -
4.2 Levels of Demand Forecasting - -
4.3 Criteria For Good Demand Forecasting - -
45 - 68
4.4 Methods or Techniques of Demand - -
Forecasting
4.5 Survey Methods - -
4.6 Statistical Methods 7, 8, 9, 10 -
5 Demand Forecasting for New Products - 3, II 69 – 75
6 Summary - - 76 – 77
7 Glossary - - 78

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8 Terminal Questions - - 79
9 Answers - - 80 – 81
10 Case Study – Economics In Action - - 82 – 84
11 References - - 85

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1. INTRODUCTION

In the previous unit, we learnt about the scope and importance of managerial economics. We
learnt that managerial economics helps managers to arrive at decisions that effectively use the
firm’s resources, and thereby lead the firm to grow profitably. In this unit, we will study demand
analysis. The sustenance and growth of a business firm is greatly influenced by the demand for a
firm’s products (goods or/and services). In this unit, we shall explore the importance of demand
and supply in business decisions/processes like pricing and forecasting. We begin our in-depth
understanding of the subject with a foundation on ‘demand’. Demand and supply are the two main
concepts in economics. Some experts are of the opinion that the entire subject of economics can
be summarized in terms of these two basic concepts.

1.1. Learning Objectives

After studying this unit, you should be able to:
Describe the concept of demand and its features.
Define and interpret the demand schedule, law of demand and price- quantity relationships
and exceptions to the law of demand.
Categorize the various factors which influence the demand for goods and services.
Apply the concept of elasticity of demand and different kinds of elasticity of demand.
Identify the conditions under which the firms develop and use demand forecasts
Distinguish between survey methods and statistical methods of forecasting
Identify and apply suitable methods to forecast demand
Explain the approaches for demand forecasting of new product

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1.2 Case Let

Case Let
Ramesh, a fresh MBA graduate, had recently joined a small firm that was involved in the
manufacture and marketing of traverse rods that were used to suspend window curtains. One
week into his job, Ramesh’s superior asked him to submit a report on the demand for traverse
rods in India. Ramesh was also expected to comment on the factors that influenced

the demand for traverse rods as well as the relative importance of those factors. Ramesh’s report
was expected to guide the marketing/sales team in its activities.

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2. MEANING AND LAW OF DEMAND

In this section, we will discuss the meaning of demand and understand the law of demand. The
term demand is different from desire, want, will or wish. In economics, demand has different
meanings. Any want or desire will not constitute demand.

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

The term ‘Demand’ refers to the total or given quantity of a commodity or a service that is
purchased by the consumer in the market at a particular price and at a particular time.

The following are some of the key features of demand:

• It is backed up by adequate purchasing power.
• It is always at a price.
• It should always be expressed in terms of specific quantity.
• It is related to time.

Consumers create demand. Demand depends on the utility of a product. There is a direct relation
between the two i.e., higher the utility, higher would be demand and lower the utility, lower would
be the demand.

Definitions of Demand:

According to Melvin and Boyes, “Demand is a relationship between two variables, price and
quantity demanded with all other factors that could affect demand being held constant.

According to Ferguson, “Demand refers to the quantities of a commodity that the consumers
are able and willing to buy at each possible price during a given period of time, other things being
equal.”

2.1. Types Of Demand

1. Individual Demand: refers to the quantities of a commodity that an individual consumer is
willing to purchase at various prices during a given period of time. An Individual consumer is
called as a household in economics. For instance, the quantity of milk purchased per day by
a household is the individual demand for milk.

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2. Market Demand: refers to the total quantities of a commodity that all households are willing
to buy at various prices during a given period of time. For instance, the total quantity of milk
which all the buyers are willing to buy at a given price per day or over a week or month is the
market demand for milk.
3. Joint Demand: refers to the demand for two or more products which are jointly demanded
together. For Example, Car and Petrol, Bread and Jam.
4. Derived Demand: The demand for a commodity arises because of the demand for some
other commodity, this is called derived demand. For example, during construction activity
there is a derived demand for bricks, stones, cement, iron rods that are bought together.
During the pandemic there was a derived demand for masks, sanitizers, disinfectants,
thermometers, oximeters that were purchased to use in shops, showrooms, offices and
business units. In Economics, derived demand generally relates to various factors of
production. For instance, Land and labor are derived from the demand for textile production.
5. Composite demand: Demand for goods that have multiple uses is called composite
demand. A commodity is said to have composite demand when it can be put to multiple uses.
For instance, from steel we can manufacture Utensils, cars, auto mobile bodies, grills, spare
parts etc.

2.2. Determinants of demand

The factors that affect or influence demand for a commodity or service are called the ‘Determinants
of demand’.

The demand determinants in brief are as follows:

1. Price of the given commodity.

2. Prices of other substitutes and/or complements,
3. Future expected trend in prices.
4. Level of income and living standards of the people.
5. Tastes, preferences, customs, habits, fashion, and styles.
6. Publicity, propaganda and advertisements.
7. Weather and climatic conditions.
8. Size, rate of growth and composition of population.
9. Government policy.

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Thus, several factors are responsible for bringing changes in the demand for a product onto the
market. A business executive should have the knowledge and information about all these factors
and forces to finalize his own production, marketing, and other business strategies.

Price: Price is the basic factor on the basis of which a consumer usually decides to buy goods or
services. When the prices are low, the quantity demanded is more. Similarly, When the price is
high, the quantity demanded is low and consumers purchase very less quantities. The relationship
is expressed as D=f(P)

In this equation D represents demand which is the dependent variable and P is the price which is
the independent variable.

Income: The purchasing capacity is determined by the buyer’s income. Demand for a commodity
depends on the buyer’s income. With the buyer’s income increases, more goods, products and
commodities are purchased. Demand for luxurious and expensive goods is related to the income
of the buyers.

Taste, habits and preferences: Demand for various goods depends on the consumers' taste and
preferences. For instance, fast food, snacks, ice creams, sweets and beverages completely
depend on individual taste and preference. Whereas the demand for Cigarettes, Alcohol and
Tobacco depends on the habits of the consumers. Vegetarians may have no preference towards
Non veg or meat-based products. Similarly, a Non-Vegetarian will demand for meat-based
products even when the price is very high. Taste, preference and habits change from time to time
and similarly demand for the related products changes too.

Complementary and Substitutes: Complementary goods are goods that are used with other
products to satisfy a particular demand. For example, Petrol is a complementary product used to
ride a bike. Therefore, in order to satisfy the consumer demand for bikes, complementary products
like petrol are needed. As we cannot ride a bike without petrol unless the bike is an electric vehicle.

On the other hand, Substitute are goods that are used as an alternative or instead of the actual
product demanded. For example, if the price of coffee goes up tea can be used instead of coffee.
If the price of coffee increases the demand for coffee will go down. In this case customers will
switch to Tea if the price of Tea is less than Coffee.

Consumer’s Expectations: When a consumer expects a future change in price then the demand
for that product will change. When the consumer expects a decrease in future prices of a product

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the demand decreases. This is because the consumer buys a smaller quantity of the commodity
as the prices may fall in future. Similarly, if the consumer expects an increase in the future price
of a product, then the demand increases. This is because the consumer buys more currently due
to the expectation that the prices may go up and the product may become costly. For instance,
demand for daily commodities in India like tomato and onions. Homemakers with limited income
may buy fewer quantities of onions if they expect a fall in price in future and may buy or demand
large quantities if they expect the price to increase in future.

Advertisements: Consumer preferences can change due to the influence of advertisements,

sales promotions and offers to a certain extent. Consumer preferences for fast moving consumer
goods such as soaps, shampoos toothpaste, cosmetics and detergents are largely influenced by
advertising.

Consumer Credit Facilities: If consumers are able to get loans and credit facilities easily, they
will be tempted to make more purchases of certain commodities thereby increasing the demand
for such commodities.

Government Policy: Economic Policies of the government influence the demand for commodities.
If the government imposes taxes on various commodities in the form of VAT, excise duties etc.
The price of these commodities will increase. When the price increases the demand for these
commodities will decrease. When the government regulates the prices of certain commodities the
price reduces and the demand increases. On the other hand, if the government incurs expenditure
on construction of roads, flyovers or any form of infrastructure then, the demand for goods related
to construction and technology will increase.

Weather and Climatic conditions: Demand for various types of goods depends on the climatic
factors as different goods are needed during different climates. During summer demand for cold
juices, ice cream and cotton clothes increases. During winter there is a great demand for warm
clothes, moisturizers, hot beverages, heaters.

Size and composition of the population: Market demand for a commodity depends on the size
and composition of the population. The population of a country determines the number of
consumers and type of consumers. The larger the population of a country is, the greater the
number of consumers a business can tap. An increase in the size of the population will increase
the demand for a commodity and vice versa. Composition of the population like children,

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teenagers, adults, old people, male and female decide the type of consumers that influence
demand of various commodities that are used by them. For instance, if there are a greater number
of old people demand for medical facilities, health care insurance will be more. If the population of
babies is considerably large then demand for baby products, baby strollers, pediatric facilities will
be high.

2.3. Demand schedule

Individual Demand Schedule
The individual demand schedule is the table which shows various quantities of a commodity that
would be purchased at different prices by a household during a given period. The demand
schedule explains the functional relationship between price and quantity. It is a list of various
amounts of a commodity that a consumer is willing to buy (and so seller to sell) at different prices
at a particular period of time.

Table 1: Individual Demand Schedule for Apples

Price (Rs. Per Kg) Quantity demanded in Units
(Kg per Week)
100 1
90 2
80 4
70 6

Source: Economics by DK Sethi and U Andrews

Table 1, Represents the individual demand schedule for apples. The table shows the quantity
demanded by an individual person per week. When the price falls from Rs100 to Rs.90 the quantity
demanded also increases from 1 kg to 2 kgs and so on.

Market demand schedule

The market demand schedule is a table which shows various quantities of a commodity that all
the buyers or consumers are willing to purchase at different prices during a given period. When
the demand schedules of all buyers are taken together, we get the aggregate or market demand
schedule. In other words, the total quantity of a commodity demanded at different prices in a
market by the whole body of consumers at a particular period of time is called a market demand
schedule. It refers to the aggregate behavior of the entire market rather than mere totaling of

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individual demand schedules. It is the horizontal summation of the individual demand schedule.
The market demand schedule is more continuous and smoother when compared to an individual
demand schedule. Table 2 gives an example of a market demand schedule.

Table 2: Market Demand Schedule for Apples

Price Quantity demanded Quantity demanded by

by person person Total MarketDemand
(A + B)
A B
(Rs. Per Kg) (Kg per week)
(Kg per week) (Kg per week)
100 1 2 1+2= 3
90 2 3 2+3 = 5
80 4 5 4+5 = 9
70 6 7 6+7 = 13

Source: Economics by DK Sethi and U Andrews

Table 2 represents the Market demand schedule for Apples. Let us assume that A and B are the
only individuals buying apples in the market. The total market demand is derived by adding the
individual demand of Person A and Person B. The table shows that as the price falls from Rs100
to 90 the Total market demand increases from 3 to 5 Kgs per week. This shows that the total
quantity demanded falls when there is an increase in price and the total demand increases when
the price falls.

2.4. Demand Function and Demand Curve

The demand for a product or service is affected by its price, the income of the individual, the price
of other substitutes, population, habit, etc. Thus, we can say that demand is a function of the price
of the product and other factors, as mentioned above.

Demand function is a comprehensive formulation which specifies the factors that influence the
demand for a product. Mathematically, a demand function can be represented in the following
manner.

Dx = f (Px, Ps, Pc, Ep, Y, Ey, T, W, A, U… etc.)

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Where,

Dx = Demand for commodity X Ps = Price of the substitutes

Px = Price of the commodity X

Pc = Price of the complements Ep = Expected future price

Y = Income of the consumer Ey = Expected income in future

T = Tastes and preferences W = Wealth of the consumer

A = Advertisement and its impact

U = All other determinants

Demand curve

A demand curve is a locus of points showing various alternative price- quantity combinations. In
short, the graphical presentation of the demand schedule is called a demand curve. Figure 1
depicts the demand curve.

Source: Economics by DK Sethi and U Andrews

The demand curve shown in figure 1 represents ‘DD’, a demand curve or an individual demand
curve. X axis represents quantity demanded and Y axis represents the price. The graph shows
the functional relationship between quantity demanded and prices of a given commodity. The
demand curve has a negative slope or it slopes downwards to the right. The negative slope of
the demand curve clearly indicates that quantity demanded goes on increasing as price
falls and vice versa.

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The market demand curve is a curve that represents different quantities of goods which all the
consumers in the market are willing to buy at different prices during a specified period. The
market demand curve can be drawn by aggregating together all the individual demand curves. It
is the horizontal summation of the demand curves of all the households.

Fig 2 Individual and market demand curve

Source: Economics by DK Sethi and U Andrews

Table 3: Market Demand Schedule for Apples

Total Market Demand
Price Quantity demanded Quantity demanded by
by person person
(A + B)
A B
(Rs. Per
Kg) (Kg per week) (Kg per week) (Kg per week)
100 1 2 1+2= 3
90 2 3 2+3 = 5
80 4 5 4+5 = 9
70 6 7 6 + 7 = 13

Source: Economics by DK Sethi and U Andrews

Figure 2 shows the individual market demand curve on panel (i) and (ii) which is represented as
‘DDA’ and ‘DDB’ respectively. The graphs show the individual demand of Person A and Person
B. The X Axis represents the quantity of apples demanded and Y Axis represents the price per
Kg. The Market demand curve is represented as ‘DDM’, that slopes downwards showing an
inverse relationship between Price and Quantity demanded. We consider the price and Total
market demand (A+B) from table 3 to plot the graph. When the Price is Rs100 per kg the quantity

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of market demand is 3 and when the price goes down to Rs90 per Kg the total quantity demanded
or the total market demand is 5. This shows that the demand increases as the price decreases.

Reasons for the downward slope of the demand curve

1. Law of diminishing marginal utility: The satisfaction derived from the consumption of
successive units goes on falling, because earlier units have partly satisfied our wants. As we
consume every additional unit of the commodity the satisfaction derived is less. A consumer
wants to pay a lower price for additional units and only purchases when the price falls.
Therefore, the demand curve slopes downward.
2. Multiple uses of goods: If the price of the goods falls, consumers use more of those goods
for different purposes and the quantity demanded increases.
3. Substitution effect: When the price of any substitute goods falls, the consumer gives up the
dearer goods or costly goods and buys additional units of the cheaper goods. In the same
way when price falls, the consumers who are consuming the other goods are in turn attracted
to the cheaper goods and this causes the demand curve to slope downward.
4. Income effect: When the price of a commodity falls, the real income of the consumer
increases and the purchasing power of the consumer increases. This enables the consumer
to buy more units and vice versa. This inverse relationship between quantity demanded and
price causes the demand curve to slope negatively or downwards.

2.5. Significant features of Law of demand

The law of demand explains the relationship between price and quantity demanded of a
commodity. It says that demand varies inversely with the price. The law can be explained in the
following manner, “Keeping other factors that affect demand constant, a fall in price of a product
leads to increase in quantity demanded and a rise in price leads to decrease in quantity demanded
for the product”. The law can be expressed in mathematical terms as “Demand is a function of
price”. Thus, symbolically D = F (p) where, D represents Demand, P stands for Price and F
denotes the Functional relationship. The law explains the cause-and-effect relationship between
the independent variable [price] and the dependent variable [demand]. The law explains only the
general tendency of consumers when buying a product. A consumer would buy more when price
falls due to the following reasons:

1. A product becomes cheaper [Price effect]

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2. Purchasing power of a consumer would go up [Income effect]

3. Consumers can save some amount of money
4. Cheaper products are substituted for costly products [substitution effect]

Assumptions of the law of demand

1. There is an inverse relationship between price and quantity demanded.
2. Price is an independent variable and demand is a dependent variable.

The operation of the law is conditioned by the phrase “Other things being equal” or “other things
remain constant”. It indicates that given certain conditions, certain results would follow. The
inverse relationship between price and demand would be valid only when tastes and preferences,
customs and habits of consumers, prices of related goods, and income of consumers would
remain constant.

2.6. Exception to the Law of Demand

Customers would buy more when the price falls in accordance with the law of demand. Exceptions
to the law of demand state that, “with a fall in price, demand also falls, and with a rise in price
demand also rises”. This can be represented by an upward-sloping demand curve. In other words,
the demand curve slopes upwards from left to right.

Figure 3 depicts the exceptional demand curve. It is clear that as price rises from P1 to P2, the
quantity demanded also expands from X1 to X2 units. The curve is an upward or positive sloping
curve. Here, the law of demand does not work and the opposite happens here.

Fig 3: Exceptional Demand Curve

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Some examples that favor the unusual demand curve are as follows:

1. Giffen’s paradox – A paradox is an inconsistency or contrary. Sir Robert Giffen, an Irish

Economist, with the help of example (inferior goods) disproved the law of demand. Giffen’s
paradox holds that “Demand is strengthened with a rise in price or weakened with a fall in
price”. He gave the example of the poor people of Ireland who were using potatoes and meat
as daily food articles. When the price of potatoes declined, customers instead of buying
larger quantities of potatoes started buying more meat (superior goods). Thus, the demand
for potatoes declined in spite of a fall in it’s price.
2. Veblen’s effect – It shows the quality-price relationship as sometimes consumers assume
that high-priced goods are of better or superior quality. Thorstein Veblen, a noted American
economist contends that there are certain commodities that are purchased by rich people
not for their direct satisfaction, but for their ‘snob-appeal’ or ‘ostentation’. Veblen’s effect
states that demand for status symbol goods would go up with a rise in price and vice versa.
In the case of such status symbol commodities, it is not the price which is important but the
prestige conferred by that commodity on a person makes him go for it. More commonly cited
examples of such goods are diamonds and precious stones, Luxury cars, world famous
paintings, commodities used by world famous personalities, etc. Therefore, commodities
having ‘snob-appeal’ are to be considered as exceptions to the law of demand.
3. Fear of shortage – When serious shortages are anticipated by the people, (e.g., during the
war period) they purchase a greater quantity of goods even though the current price is higher.
4. Fear of future rise in price – If people expect a future hike in prices, they buy more even
though they feel that current prices are higher. Otherwise, they have to pay a still high price
for the same product.
5. Speculation – Speculation implies purchase or sale of an asset with the hope that its price
may rise or fall and make speculative profit. Normally, speculation is witnessed in the stock
exchange market. People buy more shares only when their prices show a rising trend. This
is because they make more profit if they sell their shares when the prices actually rise. Thus,
speculation becomes an exception to the law of demand.
6. Conspicuous consumption – when consumers purchase some items although the items’
prices are rising on account of their special uses in the modern style of life. For Example,
Diamonds, Expensive phones and watches.

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7. Emergencies – During emergency periods like war, famine, floods, cyclones, accidents, etc.,
people buy certain articles even though the prices are quite high.
8. Ignorance – Sometimes people may not be aware of the prices prevailing in the market.
Hence, they buy more at higher prices because of sheer ignorance.
9. Necessaries – Necessaries are those items which are purchased by consumers whatever
the price may be. Consumers would buy more necessities in spite of their higher prices.

2.7. Changes In Quantity Demanded, Movement Along The Demand

Curve
When the quantity demanded of a commodity change (rises or falls) as a result of change in its
own price, while other determinants of demand (like income, taste, prices of related goods like
complementary and substitutes) remain constant. It is known as a change in quantity demanded.

1. Expansion of Demand
2. Contraction of Demand
1. Expansion of Demand: When the quantity demanded of a commodity rises due to a fall
in its price, other things remain constant. It is called a Rise in quantity demanded or
Expansion of Demand. In fig 4, When the price falls from P3 to P1 the Quantity increases
from Q3 to Q1 and so on. A movement down a demand curve is called a ‘Rise in the
Quantity demanded or expansion of demand”
2. Contraction of Demand: When the quantity demanded of a commodity falls due to a
rise in its price, other things remain constant. It is called Fall in quantity demanded or
Contraction of Demand. In fig 4, When the price rises from P2 to P3 the Quantity
decreases from Q2 to Q3 and so on. A movement up the demand curve is called a ‘Fall
in the Quantity demanded or Contraction of demand”.

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Expansion and Contraction of Demand

Source: Economics by DK Sethi.

Fig 4 Graph showing Movement along demand Curve,

2.8. Changes In Demand, Shifts in Demand Curve

When the amount purchased of a commodity rises or falls because of changes in factors other
than the own price of the commodity it is called a change in demand.

1. Increase in Demand
2. Decrease in Demand
1. Increase in demand: It refers to a situation when consumers buy larger quantities of a
commodity at the same price due to changes in factors other than the own price of the
commodity. A rightward shift in the demand curve indicates an increase in demand. As per
fig 5 Price is the same but the quantity increases from Q to Q1 due to changes in other
factors. The demand curve shifts towards the right.
2. Decrease in demand: Refers to a situation when consumers buy smaller quantities of a
commodity at the same price due to changes in factors other than the own price of the
commodity. When the demand curve shifts to the left it indicates a decrease in demand. As
per fig 5 Price is the same but the quantity decreases from Q to Q2 due to changes in other
factors. The demand curve shifts towards the left.

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Fig 5 Graph showing increase and decrease in demand

Table 4 showing Change in Quantity demanded - movement along the demand curve
Expansión of Rise in demand Downward Change in
Demand due to fall in movement of demand due to
Price while other curve Price.
things remain
constant.
Contraction of Fall in demand Upward Change in
Demand due to rise in movement of demand due to
Price while other curve Price.
things remain
constant.

Table 5 showing Change in Demand – Shift in demand curve

Increase in Rise in demand Rightward shift of Price remains
Demand due to change in demand curve constant.
other Change in
determinants or demand due to
factors. change in other
factors
Decrease in Fall in demand Left ward shift of Price remains
Demand due to change in demand curve. constant.
other Change in
determinants or demand due to
factors. change in other
factors

Source: Economics by Dk Sethi

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SELF-ASSESSMENT QUESTIONS – 1

1. In a typical demand schedule quantity demanded varies _________ with price.

2. In the case of Giffen’s goods, price and demand go in the _____________
directions.
3. If demand changes as a result of price changes, then it is a case of
____________and ___________ in demand.
4. Law of demand is a__________ statement.
5. Demand function is much more ___________ than law of demand.
6. In the case of Veblen goods, a fall in price leads to a ________ in demand.
True or False
i) If the demand for a good decrease when income falls, the good is called a luxury
good.
ii) When an increase in the price of one good lower the demand for another good,
the two goods are called complements.
iii) If the price of onions increases when the quantity of onions purchased in a
market fall, this could have been caused by a decrease in supply and demand
remaining constant.
iv) A change in a non-price determinant of demand leads to a movement along the
demand curve.
v) A surplus of a good in a market increases its prices while a shortage leads to a
fall in its prices.

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3. ELASTICITY OF DEMAND

Earlier we discussed the law of demand and its determinants. It tells us only the direction of change
in price and quantity demanded. But it does not specify how much more is purchased when price
falls or how much less is bought when price rises. In order to understand the quantitative changes
or rate of changes in price and demand, we have to study the concept of elasticity of demand. In
this section, we will discuss the elasticity of demand.

Meaning and definition

The term elasticity is borrowed from physics. It shows the reaction of one variable with respect to
a change in other variables on which it is dependent. Elasticity is an index of reaction.

In economics the term elasticity refers to a ratio of the relative changes in two quantities. It
measures the responsiveness of one variable to the changes in another variable.

Elasticity of demand is generally defined as the responsiveness or sensitivity of demand to a given

change in the price or determinant of a commodity. It refers to the capacity of demand either to
stretch or shrink to a given change in price or non-price determinant.

Percentage change in quantity demanded

Elasticity of demand =
Percentage change in price

For e.g., The quantity demanded for a good/service changes by some percentage due to change
in consumer income by some percentage, Measurement of these changes can lead to calculation
of elasticity of demand. Elasticity of demand indicates a ratio of relative changes in two quantities,
i.e., price and demand.

According to professor Boulding, ‘Elasticity of demand measures the responsiveness of demand

to changes in price’1.

In the words of Marshall, “The elasticity (or responsiveness) of demand in a market is great or
small, according to the amount demanded much or little for a given fall in price and diminishes
much or little for a given rise in price”2.

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3.1. Kinds of Elasticity

Broadly speaking, there are five kinds of elasticity of demand.

They are price elasticity, income elasticity, cross elasticity, promotional elasticity and substitution
elasticity. We shall discuss each one of them in some detail.

Price elasticity of demand

Price elasticity of demand may be defined as the degree of responsiveness of the quantity
demanded of a commodity in response to a change in its price. Price elasticity of demand refers
to the ratio of the percentage change in the quantity demanded of a commodity to a given
percentage in its price.

Thus

Percentage change in quantity demanded

𝐄𝐩 =
Percentage change in price

Where, Ep is price elasticity of demand

The following are the five degrees of price elasticity of demand:

1. Perfectly elastic demand – In this case, a very small change in price leads to an infinite
change in demand. The demand curve is horizontal

line and parallel to OX axis. The numerical co-efficient of perfectly elastic demand is infinity
(ED= ∞ ). Figure 6 depicts the perfectly elastic demand curve.

Fig 6: Perfectly Elastic Demand

Source: Economics for managers by Geetha M Rajaram

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2. Perfectly inelastic demand – In case of any change in price, the quantity demanded will be
perfectly constant. The demand curve is a vertical straight line and parallel to OY axis. It can
be interpreted from Figure 7 that the movement in price from OP1 to OP2 and OP2 to OP3
does not show any change in the demand of a product (OQ). The demand remains constant
for any value of price Hence, the numerical co-efficient of perfectly inelastic demand is zero.
ED = 0.

Fig 7 depicts perfectly inelastic demand curve.

Source: Economics for managers by Geetha M Rajaram

3. Relatively elastic demand – Here, if there is a small change in price, then it leads to a
greater proportional change in demand. Figure 8 depicts the relatively elastic demand, here
we see that the change in demand is more than that of change in price. Hence, the elasticity
is greater than one. Hence, the numerical co-efficient of demand is greater than one.
Relatively elastic demand is generally called as ‘elastic demand’ or ‘more elastic’ demand,

Fig 8: Relatively Elastic Demand

Source: Economics for managers by Geetha M Rajaram

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4. Relatively inelastic demand – In this case, a large change in price leads to a less
proportionate change in demand, This can be represented by a steeper demand curve.
Hence, elasticity is less than one.

Fig 9: Relatively Inelastic Demand

Source: Economics for managers by Geetha M Rajaram

Figure 9 depicts the relatively inelastic demand curve. It can be interpreted that the proportionate
change in demand from OQ1 to OQ2 is relatively smaller than the proportionate change in price
from OP1 to OP2. Relatively inelastic demand is popularly known as ‘inelastic demand’ or ‘less
elastic demand’.

5. Unitary elastic demand – Here, there is a proportionate change in price which leads to
equal proportional change in demand. For e.g., 5 % fall in price leads to exactly 5 % increase
in demand. Hence, elasticity is equal to unity. It is possible to come across unitary elastic
demand but it is a rare phenomenon.

Fig 10 depicts the unitary elastic demand curve.

Source: Economics for managers by Geetha M Rajaram

From figure 10, it can be interpreted that change in price OP1 to OP2 produces the same change
in demand from OQ1 to OQ2. Therefore, the demand is unitary elastic.

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Out of five different degrees, the first two are theoretical and the last one is a rare possibility.
Hence, in all our general discussions, we make reference only to two terms: relatively elastic
demand and relatively inelastic demand.

3.2. Determinants of Price Elasticity of Demand

You may observe that the elasticity of demand depends on several factors of which the following
are some of the important ones:

1. Nature of the commodity – Commodities coming under the category of necessities and
essentials tend to be inelastic, because people buy them whatever the price may be. For
example, rice, wheat, sugar, milk, vegetables, etc.; on the other hand, for comforts and
luxuries, demand tends to be elastic, e.g., TV sets, refrigerators, etc.
2. Existence of substitutes – Substitute goods are those that are considered to be economically
interchangeable by buyers. If a commodity has no substitutes in the market, demand tends
to be inelastic because people have to pay a higher price for such articles. For example, salt,
onions, garlic, ginger, etc. In the case of commodities having different substitutes, demand
tends to be elastic. For example, blades, toothpaste, soaps, etc.
3. Number of uses for the commodity – Single-use goods are those which can be used for only
one purpose and multiple-use goods can be used for a variety of purposes. If a commodity
has only one use (singe use product), demand tends to be inelastic because people have to
pay more prices if they have to use that product for only one use, for example, all kinds of
eatables, seeds, fertilizers, pesticides, etc. On the contrary, for commodities having several
uses, [multiple-use-products] demand tends to be elastic, for example, coal, electricity, steel,
etc.
4. Possibility of postponing the use of a commodity – In case there is no possibility of postponing
the use of a commodity, demand tends to be inelastic because people have to buy them
irrespective of their prices, e.g., medicines. If there is a possibility of postponing the use of a
commodity, demand tends to be elastic, e.g., buying a TV set, motor cycle, washing machine,
car, etc.
5. Level of income of the people – Generally speaking, demand will be relatively inelastic in the
case of rich people, because any change in market price will not alter and affect their
purchase plans. On the contrary, demand tends to be elastic in case of poor.

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6. Durability and reparability of a commodity – Durable goods are those which can be used for a
long period of time. Demand tends to be elastic in case of durable and repairable goods,
because people do not buy them frequently, e.g., table, chair, vessels etc. On the other hand,
for perishable and non-repairable goods, demand tends to be inelastic e.g., milk, vegetables,
electronic watches, etc.
7. Range of prices – There are certain goods or products like imported cars, computers,
refrigerators, TV, etc. which are costly in nature. Similarly, a few other goods like nails, needles,
etc. are low priced goods. In all these cases, a small fall or rise in prices will have an
insignificant effect on their demand. Hence, demand for them is inelastic in nature. However,
commodities having normal prices are elastic in nature.
8. Range of prices – There are certain goods or products like imported cars, computers,
refrigerators, TV, etc. which are costly in nature. Similarly, a few other goods like nails, needles,
etc. are low priced goods. In all these cases, a small fall or rise in prices will have an
insignificant effect on their demand. Hence, demand for them is inelastic in nature. However,
commodities having normal prices are elastic in nature.
9. Proportion of the expenditure on a commodity – When the amount of money spent on buying
a product is either too small or too big, demand tends to be inelastic. For example, salt,
newspapers or a site or house. On the other hand, if the amount of money spent is moderate,
demand tends to be elastic. For example, vegetables and fruits, clothes, provision items etc.
10. Habits – When people are used to a commodity or addicted, they do not care for price changes
over a certain range e.g., in the case of smoking, drinking, use of tobacco, etc. In that case,
demand tends to be inelastic. If people are not used to the product, then demand generally
tends to be elastic.
11. Period of time – Price elasticity of demand varies with the length of the time period. Generally
speaking, in a short period, demand is inelastic because consumption habits of the people,
customs and traditions, etc. do not change. On the contrary, demand tends to be elastic in the
long period where there is the possibility of all kinds of changes.
12. Level of knowledge – Demand in case of customers who are aware would be elastic and in
case of ignorant customers, it would be inelastic.
13. Existence of complementary goods – Goods or services whose demands are interrelated such
that an increase in the price of one of the products results in a fall in the demand for the other
are known as complementary goods. Goods that are jointly demanded are inelastic in nature.

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For example, pen and ink, vehicles and petrol, shoes and socks, etc. have inelastic demand
for this reason. If a product does not have complementary goods, in that case demand tends
to be elastic. For example, biscuits, chocolates, ice creams, etc. In this case, the use of a
product is not linked to any other product.
14. Purchase frequency of a product – If the frequency of purchase is very high, the demand tends
to be inelastic, e.g., coffee, tea, milk, match-box, etc. On the other hand, if people buy a
product occasionally, demand tends to be elastic, e.g., durable goods like radio, tape
recorders, refrigerators, etc.

Thus, the demand for a product being elastic or inelastic will depend on a number of factors.

3.3. Measurement of elasticity

There are different methods to measure the price elasticity of demand and among them, the three
most important methods are: total expenditure method, point method and arc method.

Let us discuss these methods in detail.

Total expenditure method

Elasticity of demand can be measured by considering the change in total expenditure incurred on
a commodity as a result of change in the price of the commodity. Total expenditure incurred on a
commodity before and after the price change is compared to understand the elasticity in demand.

The expenditure incurred by households on the purchase of a commodity.

The product of the price of a commodity and the quantity demanded at that price.

TE=P XQ

P is the price and Q is the quantity.

Or Total expenditure = Price per unit x Total quantity purchased

For example, if 10 units of a commodity are demanded when its price is Rs 6, the total expenditure
will be Rs.60 (10 X 6 = 60)

Under this method, the price elasticity is measured by comparing the total expenditure of the
consumers (or total revenue i.e., total sales values from the point of view of the seller) before and
after variations in price. Table 2.3 shows the total expenditure of consumers with variations in

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price and quantity demanded. We measure price elasticity by examining the change in total
expenditure as a result of a change in the price and quantity demanded for a commodity.

Total expenditure = Price per unit x Total quantity purchased

Table 6: Total Expenditure of Consumers

Price in(Rs.) Qty. Total Nature ofPED
Demanded Expenditure
I Case 5.00 2000 10000
4.00 3000 12000 >1
2.00 7000 14000
II Case 5.00 2000 10000
4.00 2500 10000 =1
2.00 5000 10000
III Case 5.00 2000 10000
4.00 2200 8000 <1
2.00 4200 8400

Note:
Variation in the value of ED can be summarized as:
1. When a new outlay is greater than the original outlay, then ED > 1.
2. When new outlay is equal to the original outlay then ED = 1.
3. When new outlay is less than the original outlay then ED < 1.

Fig 11: Graphical Representation of Total Expenditure Method

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Total Expenditure

From the diagram it is clear that:

1. From A to B, price elasticity is greater than one.

2. From B to C, price elasticity is equal to one.
3. From C to D, price elasticity is less than one.

Note:
The following points should be noted from the total expenditure method:
▪ When total expenditure increases with the fall in price and decreases with a rise in price, then
the PED is greater than one.
▪ When the total expenditure remains the same either due to a rise or fall in price, the PED is
equal to one.
▪ When total expenditure decreases with a fall in price and increases with a rise in price, PED
is less than one.

As per the graph when the new outlay (expenditure) is more than the original outlay, then price
elasticity is greater than. I.e., Pe > 1

Graph 1 - Relatively Elastic Demand - Total outlay method

Graph 2 – Unitary Elastic - Total outlay method

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As per the graph when the new outlay (expenditure) remains the same like the original outlay then
the price elasticity is equal to one, I.e., Pe = 1

Graph 3 – Inelastic demand – Total outlay method

As per the graph, when the new outlay (expenditure) is less than the original outlay, then price
elasticity is less than one. Pe< 1.

Point method

Prof. Marshall advocated this method. The point method measures price elasticity of demand at
different points on a demand curve. This method is used when there is an insignificant change in
quantity due to a very small change in price. Hence, in this case, an attempt is made to measure
small changes in both price and demand. It can be explained either with the help of mathematical
calculation or with the help of a diagram or graphical representation. Elasticity of demand is
different on different points on the same demand curve. The price elasticity of demand at any point
on the demand curve can be measured by:

𝐿𝑜𝑤𝑒𝑟 𝑠𝑒𝑔𝑚𝑒𝑛𝑡
e𝑝 =
Upper segment

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1. On a straight-line demand curve:

To measure price elasticity of demand at point R on a linear or straight-line demand

curve AB, which is intercepted by both axes. (Curve touches both Y and X axis). The
lower line segment below point R is called RB and the upper line segment is RA

𝐿𝑜𝑤𝑒𝑟 𝑠𝑒𝑔𝑚𝑒𝑛𝑡
e𝑝 at point R =
Upper segment

𝑅𝐵
= RA

Hence e e𝑝 _p > 1(Since RB > RA)

Similarly, if elasticity has to be measured at any other point on the demand curve. Say at point K
𝐾𝐵
e𝑝 at K = 𝐾𝐴

Hence e𝑝 < 1 (Since KB < KA)

Therefore, this proves that price elasticity at different points on the demand curve is different.

Graph 4 Ep on straight line demand curve - Point method Graph

Source: Economics by DK Sethi.

Similarly, we can calculate the elasticity on various points:

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Graph 5 showing Ep at different points on the demand curve

Source: DK Sethi Economics

AB is a straight-line demand curve, with A as its intercept on Y axis and B as X axis intercept and
D as its mid-point. The point method of measuring elasticity

as the ratio of line segment below the point and line segment above the points are used to
illustrate elasticity at various points.

1. At point A = demand curve touches the vertical axis

Line segment below A
𝑒𝑝 at point R =
Line segment above A
𝐴𝐵
= = infinity
O

2. At point above the midpoint but below A, say E

BE
𝑒𝑝 at E = EA >1

As the lower segment is greater than the upper segment.

3. At the mid-point D
BD
𝑒𝑝 𝑎𝑡 𝐷 = =1
DA

As the lower segment equals the upper segment.

4. At any point below mid-point but above B say at C

BC
𝑒𝑝 𝑎𝑡 𝐶 = < 1
CA

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As the lower segment is smaller than the upper segment

5. At point B where the demand curve touches the horizontal axis

0
𝑒𝑝 𝑎𝑡 𝐵 = −=0
𝐴𝐵

Therefore, as we travel downwards from left to right on a straight-line demand curve, price
elasticity of demand steadily varies from infinity at Y intercept to zero at X intercept being greater
than unity (elastic demand) at any point above the midpoint, equal to the unitary at the mid-point
and less than unity or inelastic demand at any point below the mid-point. From this we analyze
that the curve is elastic towards the left-hand end and less elastic towards the right-hand end.

2. On a Non-Linear demand curve: Price elasticity of demand can be measured on a curve

which is not a straight line by using point method. We draw a tangent to the demand curve
through the chosen point and measure the elasticity of the tangent at this point as the ratio
of the lower line segment to the upper line segment.

Graph 6 showing PE on no-linear demand curve

Source: Economics DK Sethi

If we want to measure price elasticity at point R on the demand curve DD as shown in the graph.
We draw a line AB tangent to the demand curve DD at point R. Since the slope of the demand
curve at R equals the slope of the tangent at that point, the price elasticity of the demand curve
DD at R will be equal to the elasticity of the tangent AN=B at point R.

Lower Line segment

𝑒𝑝 𝑎𝑡 𝑝𝑜𝑖𝑛𝑡 𝑅 =
Upper Line segment

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BR
=
RA

Arc method

This method is suggested to measure large changes in both price and demand. When the price
elasticity is to be found between the two prices, the question arises which price and quantity should
be considered as the base. As elasticities found by using original price and quantity figures that
serve as the base will be different from the one derived by using new price and quantity figures.
Therefore, to avoid confusion generally the average of the two prices and quantities are taken as
the base. When elasticity is measured over an interval of a demand curve, the elasticity is called
as an interval or arc elasticity. It is the average elasticity over a segment or range of the demand
curve. Hence, it is also called average elasticity of demand.

Formula:

= ΔQ X (P1+P2)

ΔP (Q1+Q2)

P1 = Original price

P2 = New price

Q1 = Original quantity

Q2 = New quantity

ΔQ = change in quantity

ΔP = change in price

For instance: A health and well-being store has a special offer on Hair wash bottles. It reduces
their prices from Rs150 to Rs100. Suppose the store manager observes that the quantity
demanded has increased from 700 bottles to 1300 bottles. Calculate the price elasticity of demand
on the hair wash bottles

Formula:

= ΔQ X (P1+P2) =

ΔP (Q1+Q2)

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ΔQ = 1300 – 700 = 600 (increased quantity – Original quantity)

ΔP = 150-100 = 50 (Old price – new price)

P1 = 150 , P2 = 100

Q1 = 700, Q2 = 1300

= 600 X (150-100)

50 (700+1300)
600 250 3
= 𝑋 =2
50 2000

= 1.5 hence the hair wash bottle elasticity is 1.5

Proportionate or Percentage Method: Here elasticity is measured by the ratio between the
proportionate or percentage change in the quantity demanded and percentage change in price.

Percentage change in demand

𝐸𝑝 =
Percentage change in price

In order to find out percentage change in demand, the formula is –

Change in quantity demand

X 100
Original quantity demanded

Percentage or Proporttionate Method

In this method, price elasticity of demand is measured by the ratio of percentage change in
the quantity demanded to a percentage change in the price of the commodity. Thus.
percentage change in quantity demanded
𝑒𝑝=
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒

𝑐ℎ𝑎𝑟𝑔𝑒 𝑖𝑛 𝑄𝑢𝑎𝑙𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑

× 100
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦
=
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒
× 100
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑃𝑟𝑖𝑐𝑒

∆𝑄
𝑄 × 100 ∆𝑄 ∆𝑃
= = +
∆𝑃 𝑄 𝑃
𝑃 × 100

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∆𝑄 𝑃 ∆𝑄 𝑃
= × = ×
𝑄 ∆𝑃 ∆𝑃 𝑄
Thus:
∆𝑄 𝑃
𝑒𝑃 = ×
∆𝑃 𝑄
Where 𝑒𝑝 stands for price elasticity of demand

Q Stands for initial quantity

P stands for initial quantity

∆Q stands for initial prince

∆P stands for change in prince

Figure showing formula expansion.

Source Economics DK Sethi

For example
Price of A Quantity
(Rs) demanded of A
(units)
5 10
4 15
When price of A is Rs 5 quantity demanded is 10 units and When Price falls to Rs.4 quantity
demanded rises to 15 units.

ΔP = Rs 5 – Rs 4 = Rs 1

ΔQ = 15 – 10 = 5 units

Initial Price = Rs5

Initial Quantity = 10 units

𝑃 𝛥𝑞 5 5 25
= Q X Δp= 10X1= = 2.5
10

Since price elasticity greater than one is Relatively elastic then the Elasticity of Product A is More
than one which is 2.5 therefore this is Relatively elastic.

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3.4. Practical Application of Price Elasticity Of Demand

A few examples of the practical application of price elasticity of demand are as follows:
1. Production planning – It helps a producer to decide about the volume of production. If the
demand for his products is inelastic, specific quantities can be produced while he has to
produce different quantities, if the demand is elastic.
2. Helps in fixing the prices of different goods – It helps a producer to fix the price of his
product. If the demand for the product is inelastic, a higher price is fixed and if the demand
is elastic, a lower price is charged. Thus, a price-increase policy is followed if the demand is
inelastic in the market and a price-decrease policy is followed if the demand is elastic.

Similarly, it helps a monopolist to practice price discrimination on the basis of elasticity of

demand.

3. Helps in fixing the rewards for factor inputs – Factor rewards refer to the price paid for
their services in the production process. It helps the producer to determine the rewards for
factors of production. If the demand for any factor unit is inelastic, the producer has to pay a
higher reward for it and vice versa.
4. Helps in determining the foreign exchange rates – Exchange rate refers to the rate at
which currency of one country is converted in to the currency of another country. It helps in
the determination of the rate of exchange between the currencies of two different nations.
For e.g., if the demand for US dollar to an Indian rupee is inelastic, in that case, an Indian
has to pay more Indian currency to get one unit of US dollar and vice-versa.
5. Helps in determining the terms of trade – it is the basis for deciding the ‘terms of trade’
between two nations. The terms of trade imply the rate at which the domestic goods are
exchanged for foreign goods. For e.g., if the demand for Japan’s products in India is inelastic,
we have to pay more in terms of our commodities to get one unit of a commodity from Japan
and vice-versa.
6. Helps in fixing the rate of taxes – Taxes refer to the compulsory payment made by a citizen
to the government periodically without expecting any direct return benefit from it. The finance
minister can formulate a sound taxation policy of the country and impose more taxes on those
goods for which the demand is inelastic and lower taxes if the demand is elastic in the market.
7. Helps in declaration of public utilities – Public utilities are those institutions which provide
certain essential goods to the general public at economical prices. The government may

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declare a particular industry as ‘public utility’ or nationalize it, if the demand for its products
is inelastic.
8. Poverty in the midst of plenty – The concept explains the paradox of poverty in the midst
of plenty. A bumper crop of rice or wheat, instead of bringing prosperity to farmers, may
actually bring poverty to them because the demand for rice and wheat is inelastic.

Thus, the concept of price elasticity of demand has great practical application in economic theory.

Income elasticity of demand

Income elasticity of demand may be defined as the ratio or percentage change in the quantity
demanded of a commodity to a given percentage change in the income. In short, it indicates the
extent to which demand changes with a variation in consumer income. The following formula helps
to measure Ey.

Percentage change in demand

Ey =
Percentage change in income

Symbolically

∆𝐷 𝑌
Ey = ×
∆𝑌 𝐷

300 4000
× = 1.5
2000 400

Original demand = 400 units Original Income = 4000-00 New demand = 700 units New Income =
6000-00

Generally speaking, Ey is positive. This is because there is a direct relationship between income
and demand, i.e., the higher the income; higher would be the demand and vice versa. On the
basis of the numerical value of the co-efficient, Ey is classified as greater than one, less than one,
equal to one, equal to zero, and negative. The concept of Ey helps us in classifying commodities
into different categories. Based on the value of Ey, the commodities can be classified as:

1. When Ey is positive, the commodity is normal [used in day-to-day life]

2. When Ey is negative, the commodity is inferior, e.g., Jowar, beedi, etc.
3. When Ey is positive and greater than one, the commodity is luxury.
4. When Ey is positive, but less than one, the commodity is essential.

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5. When Ey is zero, the commodity is neutral, e.g. salt, match-box, etc.

Practical application of income elasticity of demand

A few examples of the practical application of income elasticity of demand are as follows:
1. Helps in determining the rate of growth of the firm – If the growth rate of the economy
and income growth of the people is reasonably forecasted, in that case, it is possible to
predict an expected increase in the sales of a firm and vice versa.
2. Helps with the demand forecasting of a firm – It can be used in estimating future demand
provided that the rate of increase in income and the Ey for the products are known. Thus, it
helps in demand forecasting activities of a firm.
3. Helps in production planning and marketing – Knowledge of Ey is essential for production
planning, formulating marketing strategy, deciding advertising expenditure and nature of
distribution channel, etc. in the long run.
4. Helps in ensuring stability in production – Proper estimation of different degrees of
income elasticity of demand for different types of products helps in avoiding over-production
or under production in a firm. One should also know whether the rise or fall in income is
permanent or temporary.
5. Helps in estimating construction of houses – The rate of growth in incomes of the people
also helps in housing program in a country. Thus, it helps a lot with managerial decisions of
a firm.

Cross elasticity of demand

Cross elasticity demand may be defined as the percentage change in the quantity demanded of a
particular commodity in response to a change in the price of another related commodity. In the
words of Prof. Watson, cross elasticity of demand is the percentage change in quantity associated
with a percentage change in the price of related goods. Generally, it arises in the case of
substitutes and complements. The formula for calculating cross elasticity of demand is as follows:

Percentage change in quantity demanded of commodity X

Ec = Percentage change in the price of commodity Y

∆(∆Qx X Py)
=
(∆𝑄𝑥 ∆𝑃𝑦)

ec stands for cross elasticity of demand of X for Y

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Qx stands for the original quantity demanded of X

ΔQx stands for change in quantity demanded of good X

Py stands for the original price of good Y

ΔPy stands for a small change in the price of good Y

It should be noted that:

1. Cross elasticity of demand is positive in case of good substitutes,

e.g., coffee and tea.

2. High cross elasticity of demand exists for those commodities which are close substitutes. In
other words, if commodities are perfect substitutes, for e.g., Bata or Corona shoes, Close-
up or Pepsodent toothpaste, beans and ladies' finger, Pepsi and Coca-Cola, etc.
3. The cross elasticity is zero when commodities are independent of each other, for e.g.,
stainless steel, aluminum vessels, etc.
4. Cross elasticity between two goods is negative when they are complements. In these cases,
a rise in the price of one will lead to a fall in the quantity demanded of another commodity,
for example, car and petrol, pen and ink, etc.

Practical application of cross elasticity of demand

A few examples of the practical application of cross elasticity of demand are as follows:
1. Help at the firm level – Knowledge of cross elasticity of demand is essential to study the
impact of change in the price of a commodity which includes either substitutes or
complements. If accurate measures of cross elasticity are available, a firm can forecast the
demand for its product and it can adopt necessary safeguards against fluctuating prices of
substitutes and complements. The pricing and marketing strategy of a firm would depend on
the extent of cross elasticity between different alternative goods.
2. Helps at the industry level – Knowledge of cross elasticity would help the industry to know
whether an industry has any substitutes or complements in the market. This helps in
formulating various alternative business strategies to promote different items in the market.

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Advertising or promotional elasticity of demand

Most of the firms, in the present marketing conditions, spend considerable amounts of money on
advertising and other such sales promotional activities with the object of promoting their sales.
Advertising elasticity refers to the responsiveness of demand or sales to change in advertising or
other promotional expenses. The formula to calculate the advertising elasticity is as follows:
Percentage change in demand or sales
Ea = Percentage change in Advertisement expenditure

Symbolically,

∆𝐷 or Sales
Ea = A X A Demand or sales

40,000
= 2.67
1200 X 800 / 10,000

Original sales = 10,000 units original advertisement expenditure = 800-00

New sales = 50,000 units new advertisement expenditure = 2000-00

In the above example, advertising elasticity of demand is 2.67. It implies that for every one-time
increase in advertising expenditure, the sales would go up 2.67 times. Thus, Ea is more than one.

Practical application of advertising elasticity of demand

The study of advertising elasticity of demand has been of paramount importance to a firm in recent
years because of fierce competition. A few examples of the practical application of advertising
elasticity of demand are as follows:
1. Helps in determining the level of prices – The level of prices fixed by one firm for its
product would depend on the amount of advertising expenditure incurred by it in the market.
2. Helps in formulating appropriate sales promotional strategy – The volume of advertising
expenditure also throws light on the sales promotional strategies adopted by a firm to
increase its total sales in the market. Thus, it helps a firm to stimulate its total sales in the
market.
3. Help in manipulating sales – It is useful in determining the optimum level of sales in the
market. This is because the sales made by one firm would also depend on the total amount
of money spent on sales promotion of other firms in the market.

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Substitution elasticity of demand

Substitution elasticity demand measures the effects of the substitution of one commodity for
another. It may be defined as the percentage change in the demand ratios of two substitute goods
X and Y to the percentage change in the price ratio of two goods X and Y. The following formula
is used to measure substitution elasticity of demand.

Percentage change in the ratio of 2 goods X and Y

Es=Percentage change in the price ratio of 2 goods X and Y

∆[𝐷𝑥 / 𝐷𝑦]
Symbolically Es = [𝐷𝑥 / 𝐷𝑦]
÷ ∆[𝑃𝑥 / 𝑃𝑦]Px / Py

Where, Dx / Dy is ratio of quantity demanded of two goods X & Y.

Delta DX / Dy is the change in the quantity ratio of two goods X & Y.

PX / Py is the price ratio of two goods X & Y.

Delta PX / PY is change in price ratio of two goods X & Y.

The coefficient of substitution elasticity is equal to one when the percentage change in demand
ratios of two goods X and Y are exactly equal to the percentage change in price ratios of two
goods X and Y. It is greater than one when the changes in the demand ratios of X and Y is more
than proportionate to change in their price ratios.

Practical application of substitution elasticity of demand

The concept of substitution elasticity is of great importance to a firm in the context of availability
of various kinds of substitutes for one factor inputs to another. For example, let us assume one
computer can do the job of 10 laborers and if the cost of a computer becomes cheaper than
employing workers, in that case, a firm would certainly go for substituting workers for computers.
An employer would always compare the cost of different alternative inputs and employ those
inputs which are much cheaper than others to cut down the cost of operations. Thus, the concept
of substitution elasticity of demand has great theoretical as well as practical application in
economic theory.

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Activity – 1
- From a local grocery shop find out the price changes during the last two
months on a set of ten products of common consumption and enquire about
the changes in quantity demanded for the products. On this basis, find out
the elasticity of demand.
Hint: Use the theoretical concept and apply the same in the given scenario

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SELF-ASSESSMENT QUESTIONS – 2

Fill in the blanks:

7. Law of demand explains the _________________change in demand and
elasticity of demand explains___________ change in demand.
8. According to Marshall, is the degree of responsiveness of demand to the
change in price of that commodity.
9. The relatively elastic demand curve is ___________ .
10. When the quantity demanded increases with the increase in income, we say
that income elasticity of demand will be. When quantity demanded decreases
with an increase in income, we say that the income elasticity of demand is.
11. ______________helps the manager to decide the advertisement expense.
12. Point method helps to measure _____________quantity of change in
demand and arc methods helps to measure changes in demand.
True or False
vi) A good faces inelastic demand if the quantity demanded increases
significantly when the price decreases slightly.
vii) Goods that have close substitutes have more elastic demand than goods that
do not have close substitutes
viii)The demand curve is vertical and elasticity is 0 when demand is perfectly
inelastic.
ix) Cross-price elasticity can be used to determine if goods are inferior or normal
goods.
x) The elasticity of a linear, downward-sloping demand curve is constant while
its slope is not constant.

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4. DEMAND FORECASTING

Introduction
While our understanding of demand is clear from the previous unit, we need to go further and see
how we can use this understanding. In the previous unit, we learnt about how demand for a good
or service is influenced by various determinants of demand. We also learnt about measuring the
responsiveness of demand to changes in the determinants of demand. Business firms are also
expected to forecast demand in the short term, medium term and long term so as to develop
suitable business strategies.

An important aspect of demand analysis from the management point of view is concerned with
forecasting demand for products, either existing or new. In this unit, we will discuss demand
forecasting. Demand forecasting refers to an estimate of the most likely future demand for a
product, under the given conditions. Such forecasts are of immense use in making decisions with
regard to production, sales, investment, expansion, employment of manpower etc., both in the
short run as well as in the long run. Forecasts are made at micro level and macro level. There are
different methods of forecasts like survey methods and statistical methods which are generally
applied for the existing products. For new products, depending on their nature, a number of
methods like evolutionary approach, substitute approach, growth curve approach, etc. can be
applied..

Case Let

(continued from Unit 2)

After about 2 months, Ramesh used his knowledge of demand theory and submitted a report on
the demand for traverse rods in India. He found that the demand for traverse rods was influenced
by factors such as consumer income, number of new houses / offices constructed, price of
traverse rods, etc. Impressed with his efforts, his superior asked him to forecast the demand for
traverse rods during the next year, the next three years and for the next ten years. Ramesh’s
superior also informed him that the forecasts would be tabled in the next meeting of the board of
management during which capital investments during the next few years were to be decided.

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4.1. Features of Demand Forecasting

In this section, we will discuss the meaning and the features of demand forecasting. Demand
forecasting seeks to investigate and measure the forces that determine sales for existing and new
products. Generally, companies plan their business - production or sales in anticipation of future
demand. Hence, forecasting future demand becomes important. The art of successful business
lies in avoiding or minimizing the risks involved as far as possible and facing uncertainties in a
most befitting manner. Thus, demand forecasting refers to an estimation of the most likely future
demand for a product, under given conditions.

Important features of demand forecasting

The important features of demand forecasting are as follows:

• It is informed and well thought out guesswork.
• It is in terms of specific quantities.
• A forecast is made for a specific period of time which would be sufficient to take a decision
and put it into action.
• It is based on historical information and past data.

Demand forecasting is needed to know whether the demand is subject to cyclical fluctuations or
not, so that the production and inventory policies, etc., can be suitably formulated.

Demand forecasting is generally associated with forecasting sales. A firm can make use of the
sales forecasts made by the industry as a powerful tool for formulating sales policy and sales
strategy. They can become action guides to select the course of action which will maximize the
firm’s earnings. To use demand forecasting in an active rather than a passive way, management
must recognize the degree to which sales are a result not only of external economic environment
but also of the action of the company itself.

Managerial uses of demand forecasting

Demand forecasting refers to an estimate of the most likely future demand for a product, under
the given conditions. Such forecasts are of immense managerial use, both in the short run as well
as in the long run.

Now, we will discuss the managerial uses of demand forecasting in the short run and the long run.

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In the short run

Demand forecasts for short periods are made on the assumption that the company has a given
production capacity, and the period is too short to change the existing production capacity.
Generally, it would be a one-year period. The impact of demand forecasting in the short run can
be summarized as:
• Production planning – It helps in determining the level of output at various periods, avoiding
under or over production.
• Helps to formulate right purchase policy – It helps in better material management of buying
inputs and controlling inventory level, which cuts down costs of operations.
• Helps to frame realistic pricing policy – A rational pricing policy can be formulated to suit
short run and seasonal variations in demand.
• Sales forecasting – It helps the company to set realistic sales targets for each individual
salesman and for the company as a whole.
• Helps in estimating short–term financial requirements – It helps the company to plan the
finances required for achieving the production and sales targets. The company will be able
to raise the required finance well in advance at reasonable rates of interest.
• Reduce the dependence on chances – The firm would be able to plan its production properly
and face the challenges of competition efficiently.
• Helps to evolve a suitable labor policy – Proper sales and production policies help to
determine the exact number of laborers to be employed in the short run.

In the long run

Long run forecasting of probable demand for a product of a company is generally for a period of
3 to 5 or 10 years.
• Business planning – It helps to plan expansion of the existing unit or a new production unit.
Capital budgeting of a firm is based on long-run demand forecasting.
• Financial planning – It helps to plan long run financial requirements and investment by
floating shares and debentures in the open market.
• Manpower planning – It helps in preparing long term planning for imparting training to the
existing staff and recruit skilled and efficient labor force for its long run growth.
• Business control – Effective control over total costs and revenues of a company helps to
determine the value and volume of business. This, in turn, helps to estimate the total profits

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of the firm. Thus, it is possible to regulate business effectively to meet the challenges of the
market.
• Determination of the growth rate of the firm – A steady and well-conceived demand
forecasting determines the speed at which the company can grow.
• Establishment of stability in the working of the firm – Fluctuations in production cause
ups and downs in business, which retards smooth functioning of the firm. Demand
forecasting reduces production uncertainties and helps in stabilizing the activities of the firm.
• Indicates interdependence of different industries – Demand forecasts of particular
products become the basis for demand forecasts of other related industries, e.g., demand
forecast for cotton textile industry, supply information to the most likely demand for textile
machinery, color, dye-stuff industry, etc.
• More useful in case of developed nations – It is of great use in industrially advanced
countries where demand conditions fluctuate much more than supply conditions.

The above analysis clearly indicates the significance of demand forecasting in the modern
business setup.

4.2. Levels of Demand Forecasting

In this section, we will discuss the levels of demand forecasting. Demand forecasting may be
undertaken at three levels, viz., micro level or firm level, industry level and macro level.

Micro level or firm level

This refers to the demand forecast by a firm for its product. The management of a firm is really
interested in such forecasting. Generally speaking, demand forecasting refers to the forecasting
of demand of a firm.

Industry level
Demand forecasting for the product of an industry as a whole is generally undertaken by the trade
associations and the results are made available to the members. By using such data and
information, a member firm may determine its market share.

Macro-level
Estimating industry demand for the economy as a whole will be based on macro-economic
variables like national income, national expenditure, consumption function, index of industrial
production, aggregate demand, aggregate supply etc. Generally, it is undertaken by national

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institutes, govt. agencies, etc. Such forecasts are helpful to the government in determining the
volume of exports and imports, control of prices, etc.

The managerial economist has to take into consideration the estimates of aggregate demand and
also industry demand, while making the demand forecast for the product of a particular firm.

4.3. Criteria For Good Demand Forecasting

In this section, we will discuss the criteria for good demand forecasting. Apart from being
technically efficient and economically ideal, a good method of demand forecasting should satisfy
a few broad economic criteria. They are as follows:
• Accuracy – Accuracy is the most important criterion of a demand forecast, even though cent
percent accuracy about the future demand cannot be assured. Generally, it is measured in
terms of the past forecasts on the present sales and by the number of times it is correct.
• Plausibility – The techniques used and the assumptions made should be intelligible to the
management. It is essential for correct interpretation of the results.
• Simplicity – It should be simple, reasonable and consistent with the existing knowledge. A
simple method is always more comprehensive than the complicated one.
• Durability – Durability of demand forecast depends on the relationships of the variables
considered and the stability underlying such relationships, as for instance, the relation
between price and demand, between advertisement and sales, between the level of income
and the volume of sales, etc.
• Flexibility – There should be scope for adjustments to meet the changing conditions. This
imparts durability to the technique.
• Availability of data – Immediate availability of required data is of vital importance to
business. It should be made available on an up-to-date basis. There should be scope for
making changes in the demand relationships, as they occur.
• Economy – It should involve lesser costs as far as possible. Its costs must be compared
against the benefits of forecasts.
• Quickness – It should be capable of yielding quick and useful results. This helps the
management to take quick and effective decisions.

Thus, an ideal forecasting method should be accurate, plausible, durable, flexible, make the data
available readily, economical and quick in yielding results.

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4.4. Methods or Techniques Of Demand Forecasting

In this section, we will discuss the methods and techniques of demand forecasting. Demand
forecasting is a highly complicated process as it deals with the estimation of future demand. It
requires the assistance and opinion of experts in the field of sales management. While estimating
future demand, one should not give too much importance to either statistical information, past data
or experience, intelligence and judgment of the experts. To become more realistic, demand
forecasting should consider the two aspects in a balanced manner. Application of common-sense
is needed to follow a pragmatic approach in demand forecasting.

Broadly speaking, there are two methods of demand forecasting, namely, survey methods and
statistical methods. Figure 3.1 depicts the methods of demand forecasting.

Figure 3.1: Methods of Demand Forecasting

4.5. Survey Methods

In this section, we will discuss the survey methods. Survey methods help us in obtaining data
about the future purchase plans of potential buyers through collecting the opinions of experts or
by interviewing the consumers. These methods are extensively used in the short run and for
estimating the demand for new products. There are different approaches under survey methods.
Let us discuss them in detail.

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1. Consumers’ interview method

Under this method, efforts are made to collect the relevant information directly from the
consumers with regard to their future purchase plans. In order to gather information from
consumers, a number of alternative techniques are developed from time to time. Among
them, the following are some of the important ones:

a) Survey of buyer’s intentions or preferences

It is one of the oldest methods of demand forecasting. It is also called “Opinion surveys”.

Under this method, consumer-buyers are requested to indicate their preferences and
willingness about particular products. They are asked to reveal their future purchase
plans with respect to specific items. They are expected to give answers to questions like
what items they intend to buy, how much quantity, why, where, when, what quality they
expect, how much money are they planning to spend, etc. Generally, the field survey is
conducted by the marketing research department of the company or by hiring the
services of outside research organizations consisting of learned and highly qualified
professionals.

The heart of a survey is the questionnaire. It is a comprehensive one, covering almost all questions
either directly or indirectly in a most intelligent manner. It is prepared by an expert body who are
specialists in the field of marketing.

The questionnaire is distributed among the consumer buyers either through mail or in person by
the company. Consumers are requested to furnish all relevant and correct information.

The next step is to collect the questionnaire from the consumers for the purpose of evaluation.
The material collected is classified, edited and analyzed. If any bias, prejudices, exaggerations,
artificial or excess demand creation, etc., are found at the time of answering, they are eliminated.

The information collected is consolidated and reviewed by the top executives with a lot of
experience. It is examined thoroughly. Inferences are drawn and conclusions are arrived at. Finally,
a report is prepared and submitted to management for taking final decisions.

The success of the survey method depends on many factors including:

1. The nature of the questions asked

2. The ability of the surveyed

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3. The representative of the samples

4. Nature of the product
5. Characteristics of the market
6. Consumer-buyers’ behavior, intentions and thoughts.
7. Techniques of analysis
8. Conclusions drawn

The management should not entirely depend on the results of the survey reports to project future
demand. Consumer buyers may not express their honest and real views and they may give only
the broad trends in the market. In order to arrive at the right conclusions, field surveys should be
regularly checked and supervised.

This method is simple and useful to the producers who produce goods in bulk. Here, the burden
of forecasting is put on customers.

However, this method is not very useful in estimating the future demand of the households, as
they run in large numbers and do not express their future demand requirements freely. It is
expensive and difficult. Preparation of a questionnaire is not an easy task. At best, it can be used
for short term forecasting.

b) Direct interview method

Generally, many customers do not respond to questionnaires addressed to them whether the
questions are simple or short due to lack of time and interest. Hence, an alternative method
is developed. Under this method, customers are directly contacted and interviewed. The
questions asked in the interview are direct and simple. They are requested to answer
specifically about their household budget, expenditure plans, particular items to be selected,
the quality and quantity of products, relative price preferences, etc. for a particular period of
time. There are two different methods of conducting direct personal interviews. They are as
follows:

i) Complete enumeration method

Under this method, all potential customers are interviewed in a particular city or a region.
The answers elicited are consolidated and carefully studied to obtain the most probable
demand for a product. The management can safely project the future demand for its

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products. This method is free from all types of prejudices. The result mainly depends on
the nature of questions asked and answers received from the customers.
However, this method cannot be used successfully by all sellers in all conditions. This
method can be employed only those products whose customers are concentrated in a
small region or locality.
In case consumers are widely dispersed, this method may not be practical and may prove
to be costly both in terms of time and money. Hence, this method is highly cumbersome
in nature.
ii) Sample survey method or the consumer panel method
As it is practically not possible to approach all customers, careful sampling of
representative customers is essential. Hence, another variant of complete enumeration
method has been developed, which is popularly known as sample survey method. Under
this method, different cross sections of customers that make up the bulk of the market are
carefully chosen. Only such consumers, who are selected from the relevant market
through some sampling method, are interviewed or surveyed. In other words, a group of
consumers are chosen and asked about their preferences in concrete situations. The
selection of a few customers is known as sampling. The selected consumers form a panel.
This method uses either random sampling or the stratified sampling technique. The
method of survey may be direct interview or mailed questionnaire to the selected
consumers. On the basis of the views expressed by these selected consumers, the most
likely demand may be estimated. The advantage of a panel lies in the fact that the same
panel is continued, and a new expensive panel does not have to be formulated, every
time a new product is investigated.
As compared to the complete enumeration method, the sample survey method is less
tedious, less expensive, much simpler and less time consuming. This method is generally
used to estimate short run demand by government departments and business firms.
The success of this method depends upon the sincere co-operation and honest views of
the selected customers. Hence, selection of suitable consumers for a specific purpose is
of great importance.
Despite the careful selection of customers and truthful information about their buying
intention, the results of the survey can only be of limited use. A sudden price change,

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inconsistency in consumer buying pattern and increase in consumers who dropouts from
the panel put a serious limitation on the practical usefulness of the panel method.
c) Collective opinion method or opinion survey method
This is a variant of the survey method. This method is also known as “Sales- force polling”
or “Opinion poll method”. Under this method, sales representatives, professional experts,
market consultants and others are asked to express their opinion about the volume of sales
expected in the future. The logic and reasoning behind the method is that the salesmen
and other experts connected with the sales department are directly involved in the
marketing and selling of the products in different regions. Salesmen, work very close to the
customers, will be in a position to know and feel the customers’ reactions towards the
product. They can study the consumer pulse and identify specific views of the customers.
The people involved in sales are quite capable of estimating the likely demand for the
product through their friendly relations with the customers and frame personal judgments
based on past experience. Thus, they provide approximate, if not accurate estimates. The
views of all salesmen are aggregated to get the overall probable demand for a product.

Further, the opinions or estimates collected from various experts are considered,
consolidated and reviewed by the top executives to eliminate bias, optimism or pessimism
of different salesmen. These revised estimates are further examined to identify and propose
changes in selling prices, product designs, advertising campaigns and combat competition.
The final sales forecast would emerge after these factors have been taken into account.
This method heavily depends on the collective wisdom of salesmen, departmental heads
and the top executives.

It is simple, less expensive and useful for short-run forecasting, particularly in the case of
new products.

The main drawback is that it is subjective and depends on the intelligence and awareness
of the salesmen. It cannot be relied upon for long term business planning.

d) Delphi method or experts' opinion method

This method was originally developed at Rand Corporation in the late 1940’s by Olaf Helmer,
Dalkey and Gordon. This method was used to predict future technological changes. This
method is more useful and popular in forecasting

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non-economic rather than economic variables. It is a variant of opinion poll and survey
method of demand forecasting. Under this method, external experts are appointed. They are
supplied with all kinds of information and statistical data. The management requests the
experts to express their considered opinions and views about the expected future sales of
the company. Their views are generally regarded as the most objective ones. Their views
generally avoid or reduce the “Halo – Effects” and “Ego – Involvement” of the views of the
others. Since experts’ opinions are more valuable, a firm gives a lot of importance to them
and prepares their future plan on the basis of the forecasts made by the experts.

e) End use or input – output method

Under this method, the demand forecast of the product is conducted on the basis of demand
survey opinion provided by the industries that actually use the product as an intermediate
product. As per this method the demand for the intermediate product depends on the final
product. For instance, the demand for pure chocolates is the same as the demand for cocoa
powder which is an intermediate product actually used to make pure chocolates. Therefore,
in order to know the future demand for cocoa the end use method conducts a demand survey
on industries that use cocoa for their production such as chocolate or chocolate-based
product manufacturers. In the end the demand survey is targeted at the chocolate producers
to predict the demand for Cocoa powder. An intermediate product may have many end-users,
for e.g., steel can be used for making various types of agricultural and industrial machinery,
for construction, for transportation, etc. It may have demand both in the domestic market as
well as the international market. Thus, end– use demand estimation of an intermediate
product may involve many final goods’ industries using this product, at home and abroad.
After we know the demand for final consumption of goods including their exports, we can
estimate the demand for the product which is used as intermediate goods in the production
of these final goods with the help of input–output coefficients. The input–output table
containing input–output coefficients for particular periods is made available in every country
either by the Government or by research organizations.

This method is used to forecast the demand for intermediate products, only. It is quite useful
for industries which are large producers of goods, like aluminum, steel, etc. The main
limitation is that this method becomes inconvenient to use if the number of end-users of a
product increase.

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4.6. Statistical Methods

In this section, we will discuss the statistical method. It is the second most popular method of
demand forecasting. It is the best available technique and most commonly used method in recent
years. Under this method, statistical, mathematical models, equations, etc. are extensively used
in order to estimate future demand for a particular product. This method is highly complex and
meant for estimating long-term demand. Some of them require considerable mathematical
background and competence.

This method uses historical data in estimating future demand which means that the past demand
analysis acts as the basis for present trends. Here, both past and present demand analysis data
act as the basis for calculating the future demand of a commodity. Here we need to note that the
possible changes that may occur in future are taken into account.

There are several statistical methods and their application should be done by someone who is
reasonably well versed in the methods of statistical analysis and in the interpretation of the results
of such analysis.

1. Trend projection method

An old firm operating in the market for a long period will have accumulated previous data on
either production or sales pertaining to different years. If we arrange them in chronological
order, we get a ‘time series. It is an ordered sequence of events over a period of time
pertaining to certain variables. It shows a series of values of a dependent variable e.g., sales,
as it changes from one point of time to another. In short, a time series is a set of observations
taken at specified time, generally at equal intervals. It depicts the historical pattern under
normal conditions. This method is not based on any particular theory, which explains the
causes for the variables to change; it merely assumes that whatever forces contributed to
the change in the recent past will continue to have the same effect. On the basis of time
series, it is possible to project the future sales of a company.

In addition, the statistics and information with regards to the sales call for further analysis.
When we represent the time series in the form of a graph, we get a curve called the sales
curve. It shows the trend in sales at different periods of time. Also, it indicates fluctuations
and turning points in demand. If the turning points are few and their intervals are also widely
spread, they yield acceptable results. Here, the time series shows a persistent tendency to

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move in the same direction. Frequency in turning points indicates uncertain demand
conditions and in this case, the trend projection breaks down.

The major task of a firm while estimating the future demand lies in the prediction of turning
points in the business rather than in the projection of trends. When turning points occur more
frequently, the firm has to make radical changes in its basic policy with respect to future
demand. It is for this reason that the experts give importance to the identification of turning
points while projecting the future demand for a product.

The heart of this method lies in the use of time series. Changes in the time series arise on
account of the following reasons:

1. Secular or long run movements – Secular movements indicate the general conditions
and direction in which graph of a time series moves in relatively a long period of time.
2. Seasonal movements – Time series also undergoes changes during seasonal sales of a
company. During festival season, sales clearance season, etc., we come across the most
unexpected changes.
3. Cyclical Movements – It implies change in time series or fluctuations in the demand for a
product during different phases of a business cycle like recession, depression, revival and
boom.
4. Random movements – When changes take place at random, we call them irregular or
random movements. These movements imply sporadic changes in time series occurring
due to unforeseen events such as floods, strikes, elections, earthquakes, droughts and
similar natural calamities. Although such changes take place only in the short run the impact
will still prevail on the sales of a company.

An important question in this connection is how to ascertain the trend in time series? A statistician,
in order to find out the pattern of change in time series, may make use of the following methods.

a) The least squares method

b) The free hand method
c) The moving average method
d) The method of semi-averages

The least squares method is scientific, popular and thus, more commonly used when compared
to the other methods. It uses the straight-line equation Y= a + bx, to fit the trend to the data.

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Illustration
Under this method, the past data of the company is considered to understand the current demand
and project the future demand. For example, a businessman collects the data pertaining to the
business sales over the last 5 years. The statistics regarding the past sales of the company are
given below.

Table 3.1 indicates that the sales fluctuate over a period of 5 years. However, there is an uptrend
in the business. The same can be represented in a diagram.

Diagrammatic representation
Table 3.1 shows the sales fluctuation over 5 years and figure 3.2 depicts the sales curve based
on that fluctuation.

a) Deriving sales Curve

Table 3.1: Sales Fluctuation

Sales
Year (Rs)
1990 30
1991 40
1992 35
1993 50
1994 45

sWe can find out the trend values for each of the 5 years and also for the subsequent years making
use of a statistical equation, the method of least squares. In a time, series, x denotes time and y
denotes variable. With the passage of time, we need to find out the value of the variable.

To calculate the trend values i.e., Yc, the regression equation used is –

Yc = a+ bx.

As the values of ‘a’ and ‘b’ are unknown, we can solve the following two normal equations,
simultaneously.

i) ∑Y = Na + b∑x
ii) ∑XY = a∑x + b∑x2

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Where,

∑Y = Total of the original value of sales (y)

N = Number of years,

∑X = Total of the deviations of the years taken from a central period.

∑XY = Total of the products of the deviations of years and corresponding sales (y)

∑X2 = total of the squared deviations of X values.

When the total values of X. i.e., ∑X = 0

Table 3.2 gives the values of x and y over a period of five years, in order to compute the trend
value, Yc.

Table 3.2: Trend Values Computation

Deviation Square of Product sales
Sales in Computed
from assumed Deviation and time
Year = n Lakhs Rs. trend valuesYc
year X
Y X2 Deviation XY

1990 30 -2 +4 -60 32
1991 40 -1 +1 -40 36
1992 35 0 0 0 40
1993 50 +1 +1 +50 44
1994 45 +2 +4 +90 48
N =5 ∑ Y=200 ∑X=0 ∑X 2 =10 ∑XY = 40

Regression equation = Yc = a + bx

To find the value of a =∑Y/N = 200/5 = 40

To find out the value of b = ∑XY/ ∑X 2 = 40/10 = 4

For 1990 Y = 40 + (4 x –2)

Y = 40 – 8 = 32

For 1991 Y = 40 + (4 x –1)

Y = 40 – 4 = 36

For 1992 Y = 40 + (40 x 0)

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Y = 40 + 0 = 40

For 1993 Y = 40 + (4 × 1)

Y = 40 + 4 = 44

For 1994 Y = 40 + (4×2)

Y = 40 + 8 = 48

For the next two years, the estimated sales would be:

For 1995 Y = 40 + (4 × 3)

Y = 40 + 12 = 52

For 1996 Y = 40 + (4 × 4)

Y = 40 + 16 = 56

Finding trend values when even years are given

Table 3.3 gives the values of x and y over a period of four (even) years, in order to compute the
trend value, Yc.

Table 3.3: Computation of Trend Values over Even No. of Years

DeviationFrom
Sales in Square of Product sales Computed
Assumed year
Year = N Rs. Lakhs = =X
Deviation = and time trend
Y X2 deviation = XY values Yc

1990 55 -3 9 -165 44

1991 25 -1 1 -25 48

1992 65 +1 1 +65 52

1993 55 +3 9 +165 56

N=4 ∑Y=200 ∑X=0 ∑X2=20 ∑XY=40

Note:

When even years are given, the base year would be in between the two middle years. In this
example, in between the two middle years is 1991.5 (one year = 1 whereas 6 months = .5).

For the purpose of simple calculation, we assume the value for each.6 months i.e., 0.5 = 1

To find out the value of a = 200/4 = 50

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To find out the value of b = 40/20 = 2

a=50, b=2.

Calculation for each year

Finding trend values:

1991.5 = Base Year For1990 Y = 50 + 2 × – 3
Y = 50 – 6 = 44
90 = –3
90.5 = –2 For1991 Y = 50 + 2 × –1
91 = –1 Y = 50 – 2 = 48
91.5 = 0
92 = +1 For 1992 Y = 50 + 2 × 1
92.5 = +2 Y = 50 + 2 = 52
93 = +3
For 1993 Y = 50 + 2 × 3

Y = 50 + 6 = 56

Deriving trend line:

Table 3.3: Computation of Trend Values over Even No. of Years

Deviation
Sales in Square of Product Computed
From
Year = Rs. Lakhs Deviation sales and trend
Assumed
N = = X2 time values Yc
year = X
Y deviation =
XY
1990 55 -3 9 -165 44

1991 25 -1 1 -25 48

1992 65 +1 1 +65 52

1993 55 +3 9 +165 56

N=4 ∑Y=200 ∑X=0 ∑X2=20 ∑XY=40

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Fig 3.3 depicts the trend projection for estimating future demand.

The above trend projection is derived by considering Year on the X axis N= 4 even years and
Sales trend value from column C of Computed trend values Y on the Y axis. Trend projection
method requires simple working knowledge of statistics, which is quite inexpensive and yields
fairly reliable estimates of future course of demand.

Practice Exercises 1
A cement factory reports the following sales of cement as shown against various years. Estimate
the sales for the next two years I.e., for 2013 and 2014 with the help of least squares method.
Sales is in Tonnes (in 000’s)
Year 2008 2009 2010 2011 2012
Sale
s 90 80 70 80 60

Solution 1
Year Sales (in Deviation Square Product sales Computed trend values Yc
X Rs.) x of and time
Y Deviatio deviation = XY Y= a+bx
n = X2
2008 90 -2 4 -180 76+(-6x-2) =88
2009 80 -1 1 -80 76+(-6x-1) =82
2010 70 0 0 0 76+(-6x0) =76
2011 80 1 1 80 76+(-6x1) =70
2012 60 2 4 120 76+(-6x2) =64
N=5 ∑Y=380 ∑X=0 ∑X2=10 ∑XY= -60

Regression equation = Yc = a + bx

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To find the value of a = ∑Y/N = 380/5 = 76

To find out the value of b = ∑XY/ ∑X 2 = -60/10 = -6

For the next two years, the estimated sales would be:

For 2013 Y = 76 + (-6 × 3)

Y = 76 + -18 = 58

For 2014 Y = 76 + (-6×4)

Y = 76 + -24 = 52

The Sales trend graph for Solution 1 shows a downward trend. This graph includes the trend
projection for the next two years, 2013 and 2014.

Practice Exercises 2

Use the method of Least squares and compute the trend value for each of the years and forecast
the amount of sale for 2013 from the figures given.
Year 2008 2009 2010 2011 2012
Sale
s 90 80 70 80 60

Year Sales Deviation Square Product sales Computed trend values Y c

X (in x of and time
Rs.) Deviatio deviation = Y= a+bx
Y n = X2 XY

2008 50 -2 4 -100 62.4+3.4(-2) =55.6

2009 62 -1 1 -62 62.4+3.4(-1) =60
2010 78 0 0 0 62.4+3.4(0) =62.4
2011 48 1 1 48 62.4+3.4(1) =65.8
2012 74 2 4 148 62.4+3.4(2) =69.2
N=5 ∑Y=3 ∑X=0 ∑X2=10 ∑XY= 34
12

Regression equation = Yc = a + bx

To find the value of a = ∑Y/N = 312/5 = 76s

To find out the value of b = ∑XY/ ∑X 2 = 34/10 = 3.4

For the next two years, the estimated sales would be:

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For 2013 Y = 62.4+ 3.4(3)

Y = 62.4 + 10.2 = 72.6

Moving Averages Method:

A moving average is a technique that calculates the overall trend in a data set. In demand
forecasting, the data set is the sales volume from historical data of the company. This technique
is very useful for forecasting short-term trends. It is simply the average of a select set of time
periods.

Illustration

Using a three yearly moving average determine the trend values. Sales in 000’ units
Year 2005 2006 2007 2008 2009 2010 2011 2012
Sales 21 22 23 24 25 26 27 26
Solution
3 yearly moving 3 yearly moving
Year Sales Total average
2005 21 - -
2006 22 21+22+23 = 66 66/3 = 22
2007 23 22+23+24= 69 69/3 = 23
2008 24 23+24+25 = 72 72/3 = 24
2009 25 24+25+26 = 75 75/3 = 25
2010 26 25+26+27= 78 78/3 = 26
2011 27 26+27+26=79 79 /3 = 26.33
2012 26 - -

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Practice Exercises: Calculate 5 yearly moving average trend value

Year Consumption
1986 20
1987 28
1988 36
1989 48
1990 44
1991 40
1992 32
1993 48
1994 52
1995 68
1996 76
1997 56
1998 52
1999 48
2000 60

5 years Moving 5 yearly Moving Calculation of 5 yearly moving

Year Consumption total Average average
1986 20 - -
1987 28 - -
1988 36 176 35.2 176+196+200/5 = 35.5
1989 48 196 39.2 176+196+200+212 / 5 = 39.2
1990 44 200 40 176+196+200+212+216 / 5 = 40
1991 40 212 42.4 196+200+212+216 +240/ 5 = 42.4
1992 32 216 43.2 200+212+216 +240+276/ 5 = 43.2
1993 48 240 48 212+216 +240+276+300/ 5 = 48
1994 52 276 55.2 216+240+276+300+304/ 5 = 55.2
1995 68 300 60 240+276+300+304+300/ 5 = 60
1996 76 304 60.8 276+300+304+300+292/ 5 = 60.8
1997 56 300 60 300+304+300+292/ 5 = 60
1998 52 292 58.4 304+300+292/5=58.4
1999 48 - - -

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2000 60 - - -

Method of semi averages:

This method is very simple and relatively objective. In this method, we classify the time series data
into two equal parts and then calculate averages for each half. If the data is for even number of
years, it is easily divided into two. If the data is for an odd number of years, then the year at the
middle of the time series is left and the two halves are constituted with the period on each side of
the mid-year. Let us discuss the Method of Semi Averages in detail.

In this method we divide the data into two equal parts with respect to time and plot the arithmetic
mean of the two sets of values against the center of the relative time span. When the number of
observations is even then it can be easily divided into two halves but if the number of observations
is an odd number, then the value in the middle will be skipped i.e., n+12 th term. We need to join
these two points together through a straight line which shows the trend. The trend values can then
be read from the graph corresponding to each time period. To find the solution to a secular trend
we have to show our time series on a graph. The x axis shows the sales and the y axis shows the
data of production. After plotting original data, we can calculate the trend line. For calculating the
trend line, we will calculate semi-average. If there is an extreme deviation in the values the graph
will appear with distorted plots.

When the data is even: In this case, the time series will be into two parts and then we calculate
the average of each part. Suppose if we have 6 years data then we divide it into 3 -3 years and
then we will calculate the first three-year average and the next three-year average. We then plot
this on the graph paper.

When data is odd: In this case, we just leave the middle data and we will follow the above-said
procedure for the rest. Which involves taking the two halves and calculating the average. Below
table shows calculation of Semi average.
Semi
Year Production
averages
1971 40
1972 45 40+45+40+42/
1973 40 4 = 41.75
1974 42
1975 46 46+52+56+61/
1976 52 4 = 53.75

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1977 56
1978 61

Thus, we get the two points 41.75 and 53.75 which we shall plot corresponding to their middle
years i.e., 1972.5 and 1976.5. By joining these points, we will obtain the required trend line.

Conclusion: While estimating future demand, we assume that the past rate of change in the
dependent variable will continue to remain the same in future as well. Hence, the method yields
result only for that period where we assume there are no changes. It does not explain the vital
upturns and downturns in sales; thus, it is not very useful in formulating business policies.

2. Economic indicators
Economic indicators as a method of demand forecasting have developed recently. Under this
method, a few economic indicators become the basis for forecasting the sales of a company.
An economic indicator indicates a change in the magnitude of an economic variable. It gives
the signal about the direction of change in an economic variable. This helps in the decision-
making process of a company. We can mention a few economic indicators in this context, as
follows:
1. Construction contracts sanctioned for demand towards building materials like cement.
2. Personal income towards demand for consumer goods.
3. Agriculture income towards the demand for agricultural inputs, instruments, fertilizers,
manure, etc.
4. Automobile registration towards demand for car spare-parts, petrol etc.
5. Personal income, consumer price index, money supply, etc., towards demand for
consumption goods.

The above-mentioned and other types of economic indicators are published by specialist
organizations like the Central Statistical Office. The analyst should establish a relationship
between the sales of the product and the economic indicators to project the correct sales and to
measure the extent to which these indicators affect sales. The job of establishing relationships is
a highly difficult task, particularly in the case of new products where there are no past records.

Under this method, demand forecasting involves the following steps:

a. The forecaster has to ensure whether a relationship exists between the demand for a product
and certain specified economic indicators.

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b. The forecaster has to establish the relationship through the method of least square and
derive the regression equation. Assuming the relationship to be linear, the equation will be y
= a + bx.
c. After the regression equation is obtained by forecasting the value of x, an economic indicator
can be applied to forecast the values of Y, i.e., demand.
d. Past relationships between different factors may not be repeated. Therefore, the value
judgment is required to forecast the value of future demand. In addition to it, many other new
factors may also have to be taken into consideration.

When economic indicators are used to forecast the demand, a firm should know whether the
forecasting is undertaken for a short period or long period. It should collect adequate and
appropriate data and select the ideal method of demand forecasting. The next stage is to
determine the most likely relationship between the dependent variables and finally interpret the
results of the forecasting.

However, it is difficult to find an appropriate economic indicator. This method is not useful in
forecasting demand for new products.

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5. DEMAND FORECASTING FOR NEW PRODUCTS

In this section, we will discuss the demand forecasting for new products. Demand forecasting for
new products means the demand forecasting for a different kind of product, which is totally
different established products. There is no past data or past experience available for any of the
firms. An intensive study of the economic and competitive characteristics of the product should be
made to make efficient forecasts.

Professor Joel Dean, however, has suggested a few guidelines for forecasting the demand for
new products, as follows:

a) Evolutionary approach – The demand for the new product may be considered as an
outgrowth of an existing product. For e.g., demand for new Tata Indica, which is a modified
version of old Indica can most effectively be projected based on the sales of the old Indica,
the demand for new Pulsar can be forecasted based on the sales of the old Pulsar. Thus,
when a new product evolves from the old product, the demand conditions of the old product
can be taken as a basis for forecasting the demand for the new product.
b) Substitute approach – If the new product developed serves as a substitute for the existing
product, the demand for the new product may be worked out on the basis of ‘market share’.
The growth of demand for all the products has to be worked out on the basis of intelligent
forecasts for independent variables that influence the demand for the substitutes. After that,
a portion of the market can be sliced out for the new product, for e.g., a moped as a substitute
for a scooter, a cell phone as a substitute for a landline. In some cases, price plays an
important role in shaping future demand for the product.
c) Opinion poll approach – Under this approach, the potential buyers are directly contacted,
or through the use of samples of the new product, their responses are found out. Finally,
these are extrapolated to forecast the demand for the new product.
d) Sales experience approach – Offer the new product for sale in a sample market; say
supermarkets or big bazaars in big cities, which are also big marketing centers. The product
may be offered for sale through one supermarket and the estimate of sales obtained may be
extrapolated to arrive at estimated demand for the product.

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e) Growth curve approach – According to this, the rate of growth and the ultimate level of
demand for the new product are estimated on the basis of the pattern of growth of established
products. For e.g., an Automobile Co., while introducing a new version of a car will study the
level of demand for the existing car.
f) Vicarious approach – A firm will survey consumers’ reactions to a new product indirectly by
getting in touch with some specialized and informed dealers who have good knowledge about
the market, about the different varieties of the product already available in the market, the
consumers’ preferences, etc. This helps in making a more efficient estimation of future
demand.

These methods are not mutually exclusive. The management can use a combination of several of
them, supplement and cross check each other.

Activity – 2
- The construction industry registers changes in the demand for various
products required in the industry more visibly. Identify changes in
demand for housing and trace the changes in demand for steel, cement,
etc. during the same period.

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SELF-ASSESSMENT QUESTIONS – 3

Fill in the blanks:

13. Demand forecasting refers to an estimate of ____________ for the product under
given conditions.
14. The heart of the survey method is ___________ .
15. Collective opinion method is also known as ___________ .
16. Sample survey method of Demand forecasting is also called __________ .
17. An economic indicator indicates changes in the magnitude of an___________ .
18. On the basis of ______________ it is possible to project the future sales of a
company.
True or False
xi) It is difficult to forecast the precise demand for a product in the medium term
or long term.
xii) As forecasts are not precise, management should not consider them in
decision making.
xiii) Respondents to a survey may be biased in their responses and this issue
should be considered while designing a survey.
xiv) The complete enumeration method is inexpensive and easy to implement
xv) Time series methods assume that the conditions that influenced demand in
the previous time periods would continue to influence future demand in the
same manner.

Theory of Consumer Choice

The theory of consumer choice, a fundamental aspect of microeconomics, explains how

individuals decide to spend their limited income on various goods and services to maximize their
satisfaction or utility. This theory is underpinned by several key concepts: utility, the subjective
satisfaction derived from consumption; preferences, the way consumers rank different

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combinations of goods; and the budget constraint, which represents the limited resources
available for spending, dictated by income and prices.

At the heart of this theory is the principle of utility maximisation. Consumers aim to achieve the
highest possible level of satisfaction given their budget constraints. This involves making trade-
offs between different goods and services based on their preferences and the prices of these
items. For instance, a consumer deciding between spending on coffee or tea will evaluate which
option brings greater satisfaction within their spending ability. The concept of marginal utility, which
refers to the additional satisfaction gained from consuming one more unit of a good, plays a crucial
role here. This utility typically diminishes with each additional unit consumed, a principle known
as diminishing marginal utility. For example, the enjoyment a consumer derives from each
successive cup of coffee may decrease, influencing their decision on how many cups to purchase.
The principle of utility maximization is a fundamental concept in economics, particularly in the
study of consumer behavior. It posits that individuals seek to maximize their overall satisfaction,
or utility, when they make choices about what goods and services to consume. This principle
operates under the assumption that consumers are rational and have well-defined preferences.

Key Aspects of Utility Maximization:

• Utility: Refers to the satisfaction or benefit a consumer derives from consuming goods and
services.
• Rationality: Consumers are assumed to make rational choices that maximize their utility.
• Budget Constraint: Consumers have a limited budget to spend on goods and services.
• Marginal Utility: The additional satisfaction from consuming an additional unit of a good or
service. Utility maximization often involves equating the marginal utility per unit of cost across
all goods.

Example:

Let's consider a consumer with a budget of INR 50, choosing between books and movies. Assume
a book costs INR 10 and a movie ticket costs INR 5. The consumer derives different levels of
satisfaction (utility) from each book and movie. Initially, the utility gained from each unit might be
high, but as they consume more of one item, the additional satisfaction (marginal utility) they gain
decreases - a concept known as diminishing marginal utility.

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In utility maximization, the consumer will allocate their INR 50 in such a way that the last dollar
spent on books yields the same level of additional satisfaction as the last dollar spent on movies.
Suppose the consumer initially buys two books for INR 20. The satisfaction from reading a third
book might be less than watching a new movie. If the additional satisfaction (marginal utility) from
spending the next INR 5 on a movie is higher than buying another book, the consumer will choose
the movie. This process continues until the budget is exhausted, with the consumer balancing
their spending to maximize total satisfaction.

This optimal consumption point can be technically described as the point where the ratio of the
marginal utility of each good to its price is equal across all goods. In mathematical terms, this is
where:

MUbooks/ P books = MUmovies/ P Movies

Here, MU books, MUbooks and MUmoviesMUmovies are the marginal utilities of books and
movies, respectively, and PbooksPbooks and PmoviesPmovies are their prices.

In real-world scenarios, consumers' choices are influenced by various factors including personal
preferences, income levels, prices of goods, and the utility derived from different products. The
principle of utility maximization provides a framework to understand and predict how consumers
allocate their budget in pursuit of maximum satisfaction.

The concept of an indifference curve is a fundamental tool in microeconomics, particularly in the

study of consumer behavior. It represents a graphical depiction of consumer preferences,
illustrating the different combinations of two goods that provide the same level of satisfaction or
utility to a consumer. Indifference curves graphically represent these choices, showing
combinations of goods that provide the same level of utility to the consumer. The consumer's goal
is to reach the highest possible indifference curve while staying within their budget constraint. The
optimal point of consumption, where the budget line is tangent to the highest indifference curve,
indicates the most preferred combination of goods a consumer can afford.

Key Characteristics of Indifference Curves:

• Downward Sloping: An indifference curve slopes downwards from left to right. This slope
indicates that if the quantity of one good increases, the quantity of the other must decrease
for the consumer to maintain the same level of utility.

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• Convex to the Origin: Indifference curves are generally convex to the origin. This shape
reflects the principle of diminishing marginal rate of substitution, which states that as a
consumer has more of one good, they are willing to give up less of another good to get one
more unit of the first good.
• No Two Indifference Curves Can Intersect: Each curve represents a different level of utility,
so no two curves can intersect, as this would imply contradictory preferences.
• Higher Curves Represent Higher Utility: A curve that lies further from the origin represents a
higher level of utility. Moving to a higher indifference curve signifies an increase in
satisfaction.

Example:

Consider a consumer choosing between coffee and tea. An indifference curve can show various
combinations of coffee and tea that give the consumer the same level of satisfaction. For instance,
one such curve might indicate that the consumer is equally satisfied with either 3 cups of coffee
and 2 cups of tea, or 4 cups of coffee and 1 cup of tea. The consumer has no preference between
these two combinations as they provide the same level of utility.

As the consumer moves to a different curve, say one that is farther from the origin, it indicates a
higher level of satisfaction. On this new curve, combinations like 5 cups of coffee and 2 cups of
tea, or 6 cups of coffee and 1 cup of tea, could represent equal satisfaction at a higher utility level
than the previous curve.

The concept of the marginal rate of substitution (MRS) is also integral to indifference curves. MRS
is the rate at which a consumer is willing to give up one good in exchange for an additional unit of
another good, while keeping the same level of utility. On the indifference curve, this is reflected in
the slope at any point. As one moves along the curve, the MRS changes, indicating that the
consumer's willingness to trade one good for the other varies depending on the quantities of goods
they already possess.

Thus an indifference curves are a visual representation of a consumer's preferences, showing the
trade-offs they are willing to make between two goods to maintain the same level of satisfaction.
These curves are a cornerstone of consumer theory, helping to analyze and predict consumer
behavior in various market scenarios.

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Changes in prices lead to two effects: the income effect, where a change in price alters the
consumer's purchasing power, and the substitution effect, where consumers replace more
expensive goods with cheaper alternatives. For example, if the price of coffee decreases, a
consumer might buy more coffee due to its lower price (substitution effect) and use the saved
money to purchase other goods (income effect), thus altering their overall consumption pattern.
Moreover, the theory considers consumer surplus, the additional benefit consumers receive when
they purchase goods at prices lower than what they are willing to pay. For instance, if a consumer
values a coffee at INR 5 but buys it for INR 3, they gain a consumer surplus of INR 2. While
traditional consumer choice theory assumes rational decision-making, behavioral economics
suggests that psychological factors, cognitive biases, and emotions often influence consumer
choices, introducing the concept of bounded rationality. This notion acknowledges that consumers'
decisions are often limited by available information, cognitive limitations, and the time available
for making decisions. For example, brand loyalty or habits may lead a consumer to make choices
that do not align with the rational maximization of utility. In practical terms, understanding
consumer choice theory is crucial for both policymakers and marketers. It helps in designing
policies like taxes and subsidies, considering their impact on consumer behavior. Similarly,
marketers leverage this theory to anticipate how changes in pricing, product features, or
advertising strategies might influence consumer preferences and buying patterns.

The theory of consumer choice provides a framework for analyzing how individuals make
decisions about purchasing goods and services. It combines economic principles with
psychological insights to understand the complex process of decision-making in the marketplace.
This theory not only helps in predicting consumer behavior but also in shaping strategies in
business and public policy to influence and accommodate these choices.

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6. SUMMARY

Let us recapitulate the important concepts discussed in this unit:

• Demand is created by consumers. Consumers can create demand only when they have
adequate purchasing power and willingness to buy different goods and services. There is a
direct relationship between utility and demand. The law of demand tells us that there is an
inverse relationship between price and demand in general. Sometimes, customers buy more
in spite of a rise in the prices of some commodities.
• Thus, the law of demand has certain exceptions. Demand for a product not only depends on
price but also on a number of other factors. In order to know the quantitative changes in both
price and demand, one has to study elasticity of demand.
• Price elasticity of demand indicates the percentage changes in demand as a consequence
of changes in prices. The response of demand to price changes is different. Hence, we have
elastic and inelastic demand. One can measure exactly the extent of price elasticity of
demand with the help of different methods like point and arc methods. Income elasticity
measures the quantum of changes in demand in response to changes in income of the
customers.
• Cross elasticity tells us the extent of a change in the price of one commodity and
corresponding changes in the demand for another related commodity. Substitution elasticity
measures the amount of changes in demand ratio of two substitute goods to changes in price
ratio of two substitute goods in the market. The concept of elasticity of demand has great
theoretical and practical application in all aspects of business life.
• An important aspect of demand analysis from the management point of view is forecasting
demand, either for existing products or for new products.
• Demand forecasting refers to the estimation of future demand under given conditions. Such
forecasts have immense managerial uses in the short run like production planning,
formulating right purchase policy, pricing policy, sales forecasting, estimating short run
financial requirements, reducing the dependence on chances, evolving suitable labor policy,
control on stocks, etc.
• In the long run they help in efficient business planning, financial planning, regulating business
efficiently, determination of growth rate of firm, stabilizing the activities of the firm and help in

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the growth of industries dependent on each other providing required information particularly
in the developed nations.
• Demand forecasts are done at micro level, industry level and macro level. A good demand
forecasting method must be accurate, plausible, economical, durable, flexible, simple, quick
yielding and it must permit changes in the demand relationships on an up-to-date basis.
• Broadly speaking there are two methods of demand forecasting: survey methods and
statistical methods. Under the survey methods there are a number of variants like consumers’
interview method, collective opinion method, experts’ opinion method and end-use method.
Under the consumers’ interview method, demand forecasting is done either by conducting a
survey of buyers’ intentions through a questionnaire or by directly interviewing all the
consumers residing in a region or by forming a panel of consumers.
• Under the collective opinion method forecasts are made on the basis of the information
gathered from the sales men and market experts regarding the future demand for the product.
Under the Expert opinion method, assistance from outside experts is taken to forecast future
demand. The end use method is adopted to forecast the demand for the intermediate
products making use of the input-output coefficients for particular periods.
• Statistical methods like trend projection and economic indicators are generally used to make
long-run demand forecasts. Under the trend projection method, based on the past data, by
adopting a regression analysis, the demand forecasts are made. Sometimes, changes in the
magnitude of the economic variables too serves as a basis for demand forecasting. A rise in
personal income indicates a rise in the demand for consumption goods.
• In the case of new products, as the firm will not have any past experience or past sales data,
it will have to follow a few guidelines while making demand forecasts. Depending upon the
nature of the development of the product, different approaches like evolutionary approach,
substitute, growth-curve, opinion poll, sales-experience, vicarious etc., are adopted.
• Thus, a number of methods are being adopted to estimate the future demand for the products,
which is of very great importance in the efficient management of the business.

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7. GLOSSARY

It is the total or given quantity of a commodity or a service that is

Demand - purchased by the consumer in the market at a particular price and at a
particular time.

A locus of points showing various alternative price-quantity

Demand curve -
combinations

A comprehensive formulation which specifies the factors that influence

Demand function -
the demand for a product.

Elasticity of Responsiveness or sensitivity of demand to a given change in the price

-
demand or non-price determinant of a commodity.

Keeping other factors that affect demand constant, a fall in price of a

Law of Demand - product leads to an increase in quantity demanded and a rise in price
leads to decrease in quantity demanded for the product..

Necessaries - Items which are purchased by consumers whatever the price may be.

Purchase or sale of an asset with the hope that its price may rise or fall
Speculation -
and make speculative profit.

Demand for status symbol goods would go up with a rise in price and
Veblen’s effect -
vice versa.

Vicarious It is a survey done to know the customers Reactions to the new

-
approach products indirectly..

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8. TERMINAL QUESTIONS
1. State and explain the law of demand.
2. Discuss the various exceptions to the law of demand.
3. Explain the concepts of shifts in demand.
4. Explain the different degrees of price elasticity with suitable diagrams.
5. Discuss the determinants of price elasticity of demand.
6. What is Demand Forecasting?
7. Explain in brief various methods of forecasting demand.
8. Explain trend projection method of demand forecasting with illustration.
9. Explain the guidelines for demand forecasting for a new product.

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9. ANSWERS

Self-Assessment Questions
1. Inversely
2. Same / upward
3. Expansion, contraction
4. Qualitative
5. Comprehensive / wider
6. Fall
7. Direction percentage
8. Price Elasticity of Demand
9. Flatter
10. Positive; negative
11. Advertisement Elasticity of Demand
12. Small, large
13. Most likely future demand
14. Questionnaire
15. Sales-force polling
16. Consumer panel
17. Economic variable
18. Time series

True or False
i) False
ii) True
iii) True
iv) False
v) False
vi) False
vii) True
viii) True
ix) False

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x) False
xi) True
xii) False
xiii) True
xiv) True
xv) False

Terminal Questions
Answer 1: The term demand refers to total or given quantity of a commodity or a service that is
purchased by the consumer in the market at a particular price and at a particular time.

Answer 2: Exceptions to the law of demand state that with a fall in price, demand also falls and
with a rise in price demand also rises.

Answer 3: If demand increases, there will be a forward shift in the demand curve to the right and
if demand decreases, then there will be a backward shift in the demand cure.

Answer 4: Elasticity of demand shows the reaction of one variable with respect to a change in
other variables on which it is dependent.

Answer 5: The elasticity of demand depends on several factors.

Answer 6: Demand forecasting seeks to investigate and measure the forces that determine sales
for existing and new products.

Answer 7: Broadly speaking, there are two methods of demand forecasting, namely, survey
methods and statistical methods.

Answer 8: Trend projection or time series method is a set of observations taken at specified time,
generally at equal intervals. It depicts the historical pattern under normal conditions.

Answer 9: Some of the guidelines for forecasting the demand of new products- Evolutionary
approach, Substitute approach, Opinion poll approach, Sales experience approach etc.

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10. CASE STUDY: ECONOMICS IN ACTION

Maruti Suzuki, which specialises in small models, sold 1.27 million cars in the fiscal year that
ended in March, with an increase of 25 percent. "So, it might even be slightly less than last year.
There are still four months to go. Let's see how it goes but I doubt if we'll have any growth this
year," he said. Bhargava had said in August that he expected Maruti, 54.2 percent-owned by
Japan's Suzuki Motor Corp, to post single-digit sales growth this fiscal year.

He said on Monday he expects the Indian automobile industry to grow 2- 3 percent this fiscal year,
compared with the record 30 percent growth it had clocked a year ago. Slowing economic growth,
rising interest rates and fuel prices, as well as falling stock markets have dampened sentiment in
the Indian auto market.

"While first-time car buyers...have continued to buy cars, the people who used to replace cars or
buy a second or a third car in their family, those people have deferred buying decisions this year,"
Bhargava said. He remained optimistic for a demand revival, but said it was difficult to give a time
frame.

Maruti, which until last year sold nearly every other car in India, faces a tough competition from
the global car makers such as: Hyundai Motor Co, Ford Motor Co, General Motors Co and Honda
Motor Co; and it has seen its market share slide to just over 40 percent.

Bhargava said it was "a little bit unfair" to calculate this year's market share as Maruti has been
hit by one-off factors such as labour unrest and inadequate capacity to meet a surge in demand
for cars that run on less- expensive diesel fuel. "Realistically, we would expect to keep around 42-
43 percent of the market," said Bhargava.

Maruti was hit by a labour strike at a key plant in the northern state of Haryana, where workers
wanted to leave their existing union to form one of their own. The unrest led to a production loss
of about 83,000 cars, or almost half a billion dollars in output, while buyers were made to wait
longer for the cars they ordered.

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Bhargava said recent rises in petrol prices have boosted demand for diesel cars, but Maruti did
not have the capacity to meet the demand. "We have a waiting list of diesel cars and we have
surplus capacity of petrol cars," he said. Maruti is in advanced talks with Italian automaker Fiat
SpA to source diesel engines to boost its production and expects to receive supplies starting in
January, he said.

Europe has traditionally been the biggest export market for Maruti, but the company is now trying
to build the export market beyond the debt crisis-racked continent, focusing on Southeast Asia,
Africa and Latin America, Bhargava said.

Discussion Questions:
1. How do macroeconomic conditions (such as slowing economic growth) affect the demand
for products such as cars?
2. What are the various segments that contribute to demand for cars?
3. What could be the relationship between petrol cars and diesel cars?
4. How can international economic conditions impact the export markets for cars?
5. What steps could Maruti Suzuki take to increase its market share?

(Source: The Economic Times, Nov 21, 2011)

Hint: With the help of the theoretical concepts build your views in this case study.

India steel demand, output to surge by 2020: JSW Reuters

MILAN: Indian steel consumption is seen rising to about 130 million tonnes in 2020 from about 67
million tonnes this year, as growing incomes and urbanisation drive demand, a senior executive
at India's leading steel producer JSW Steel Ltd said on Thursday.

India's steel output is expected to rise to more than 150 million tonnes in 2020 from close to 70
million tonnes this year and about 80 million tonnes in 2012, JSW Steel senior vice president in
charge of sales, Sharad Mahendra, told at a steel conference organised by Metal Bulletin.

JSW Steel has cut its 2020 steel consumption forecast from an earlier expectation of an about
200 million tonnes, in line with the government forecast reduction, due to delays in some projects
to boost production capacity, Mahendra told Reuters on the sidelines of the conference.

JSW Steel total annual production capacity is expected to rise to 35.3 million tonnes in 2020 from
14.3 million tonnes this year, thanks to the new green field projects in India, he said.

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India's total production of coated and galvanised steel, which is used in environments requiring
corrosion resistance, is expected to rise to more than 6 million tonnes in 2013 from 4.7 million
tonnes this year, Mahendra said. India's current coated steel production capacity stands at 6.2
million tonnes, he said. The construction sector, which accounts for about 50 per cent of
galvanised steel consumption, will be the main demand-growth driver, with demand from white
goods and automobile industries rising too, he said.

Discussion Questions:
1. If you owned a steel production unit that is currently producing 2 million tonnes per annum,
how would you use the above forecasts?
2. What are the factors that would affect the demand for steel in future?
3. If you were a producer of coated and galvanised steel, which sectors would be your main
sources of demand?

(Source: The Economic Times, 15th Sept 2011)

Hint: With the help of the theoretical concepts build your views in this case study.

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11. REFERENCES

• Veblen, T. B. (1899), The Theory of the Leisure Class. An Economic Study of Institutions.
London: Macmillan Publishers
• Boulding, Kenneth E. (1966), Economic Analysis, Microeconomics. Vol. I, 4th Ed. New York:
Harper & Row, Publishers.
• Marshall, Alfred. (1920), Principles of Economics., 8th edition.
• Stonier, Alfred William, Douglas, Chalmers Hague, (1980), A Textbook of Economic Theory,
Edition 5, Longman.

E-Reference:
• www.Economictimes.com – retrieved on 21st November 2011

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