Law of Demand

Demand- Law of Demand

MEANING OF DEMAND

Introduction:Ordinarily, demand means the desire or wants for something. In Economics,

however, demand means much more than that. The Economics meaning of demand refers to
the effective date and, i.e., the quantity the buyers are willing to purchase at a given price
and over a given period of time. This concept of demand may be looked upon as follows:

1. Demand is the desire or want back up money

Demand means effective desire or want for a commodity, which is backed up by the ability
and willingness to pay for it. Demand = Desire+Ability to pay ( money or purchasing power )
+Will to spend.

2. Demand is always related to price and time

Demand is not an absolute term. It is a relative concept. Demand for a commodity should
always have a reference to price and time. Economists always mention the amount of
demand for a commodity with reference to a particular price and specific time period, such
as per day, per week, per month or per year.

Definition of demand: the demand for a product refers to the amount of it which will be
bought per unit of time at a particular price.

3. Demand may be viewed ex-ante or ex-post

Demand for a commodity maybe viewed as ex-ante i.e., intended demand or ex-post i.e.,
what is already purchased. The former denotes potential demand while the latter refers to
the actual amount purchased.

Demand in economics is the consumer's desire and ability to purchase a good or service. It's
the underlying force that drives economic growth and expansion. Without demand, no
business would ever bother producing anything.

THE LAW OF DEMAND

The law of demand describes the general tendency of consumer’s behaviour in demanding a
commodity in relation to the changes in its price. It simply States that demand varies
inversely to changes in price.

STATEMENT OF LAW OF DEMAND

Ceteris Paribus, the higher the price of a commodity, the smaller is the quantity demanded
and lower the price, larger the quantity demanded.

The conventional law of demand relates to the much simplified demand function

D=f(p)

Where D represents demand, p the price and f connotes a functional relationship.

ASSUMPTIONS OF LAW OF DEMAND

1. No change in consumer’s income- If the level of a buyer’s income changes he may buy
more even at a higher price, invalidating the law of demand.

2. No change in consumer’s preferences- The consumer's tastes, habits and preferences

should remain constant.

3. No change in the fashion- If the commodity concerned goes out of the fashion, a buyer
may not buy more of it even at a substantial price of reduction.

4. No change in the price of related goods- Prices of other goods like substitutes and
supportive,i.e, complementary or jointly demanded products remain unchanged.

5. No expectation of future price changes or shortages- The law requires that the given
price change for the commodity is a normal one and has no speculative consideration.

6. No change in size, age composition and sex ratio of the population – It is necessary that
the number of buyers, their preferences, age structure and sex ratio should remain constant,
otherwise, there will be additional buyers in the market, so the total market demand may
contract with a rise in price.

7. No change in the range of goods available to the consumers- This implies that there is
no innovation and arrival of new varieties of product in the market Which may distort
consumer’s preferences.

8. No change in the distribution of income and wealth of the commodity – There is no

redistribution of incomes either, so that the levels of income of the consumers remain the
same.
9. No change in government policy- Changes in taxes may cause changes in consumer’s
income or commodity taxes and may lead to distortion in consumer’s preferences.

10. No change in the weather conditions- It is assumed that the climate and
weather conditions are unchanged in affecting the demand for certain goods like woollen
clothes, umbrella, etc.

EXPLANATION OF THE LAW OF DEMAND

Price of the Quantity A Market demand schedule

commodity X (in demanded (units
Rs.) per week)
5 100
4 200
3 300
2 400
1 500

The table represents a hypothetical demand schedule for commodity x. We can read from
this table that with a fall in price at each stage demand tends to rise. There is an inverse
relationship between price and quantity demanded.
In the above diagram, DD is a downward sloping demand curve indicating an inverse
relationship between price and quantity demanded. From the given market demand curve
one can easily locate the market demand for a product at a given price. Further, the demand
curve geometrically represents the mathematical demand function: Dx=f(Px).

Factors Determining Demand

1. Price of the Product: The price of a product is the most important determinant of
market demand in the long-run and the only determinant in the short-run. As per the law of
demand, the price of a product and its quantity demanded are inversely related, i.e. the
quantity demanded increases when the price falls and decreases when the price rises, other
things remaining the same.

Here, other things imply that the income of the consumer, the price of the substitute and
complementary goods, tastes and preferences and the number of consumers, all remains
constant. The price-demand relationship has more significance in the oligopolistic market
structure in which the result of a price war among the firm and its rival decides the level of
success of the firm.

2. Price of the Related Goods: The market demand for a commodity is also affected by
the changes in the price of the related goods. The related goods may be
the substitute or complementary goods. Two commodities are said to be a substitute for
one another if they satisfy the same want of an individual and the change in the price of
one commodity affects the demand for another in the same direction. Such as, tea
and coffee, Maggi and Yippie, Pepsi and Coca-Cola are close substitutes for each other. The
increase in the price of either commodity the demand for the other also increases and vice-
versa.

A commodity is said to be a complement for another if the use of two goods goes
together such that their demand changes (increases or decreases) simultaneously.
For example, bread and butter, car and petrol, mattress and cot, etc. are complementary
goods. The increase in the price of either commodity the demand for another decreases and
vice-versa.

3. Consumer’s Income: The income is the basic determinant of the quantity demanded
of a product as it decides the purchasing power of the consumers. Thus, people with higher
disposable income spend a larger amount of income on consumer goods and services
as compared to those with lower disposable income. Consumer goods and services can be
grouped under four categories: essential goods, inferior goods, normal goods, and prestige
or luxury goods. The relationship between the consumer’s income and these goods is
explained below:

§ Essential Consumer Goods: The essential goods are the basic necessities of the
life and are consumed by all the persons of the society. Such as food grains, salt, cooking
oil, clothing, housing, etc., the demand for such commodities increases with the increase in
consumer’s income but only up to a certain limit, although the total expenditure may
increase with respect to the quality of goods consumed, other things remaining the same.
§ Inferior Goods: A commodity is deemed to be inferior if its demand decreases with
the increases in the consumer’s income beyond a certain level of income and vice-
versa. For example, Bajra, millet, are the inferior goods.

§ Normal Goods: The normal goods are those goods whose demand increases with the
increase in the consumer’s income, such as clothing, household furniture, automobiles,
etc. It is to be noted that, demand for the normal goods increases rapidly with the increase
in the consumer’s income but slows down with a further increase in the income.

§ Luxury Goods: The luxury goods are those goods which add to the prestige and
pleasure of the consumer without enhancing the earnings. For example, jewelry, stone,
gem, luxury cars, etc. The demand for such goods increases with the increase in the
consumer’s income.

4. Consumers’ tastes and preferences: Consumer’s Tastes and preferences play a

vital role in determining a demand for a product. Tastes and preferences often depend on
the lifestyle, culture, social customs, hobbies, age and sex of the consumers and the
religious sentiments attached to a commodity. The change in any of these factors results in
the change in the consumer’s tastes and preferences, thereby resulting in either increase or
decrease in the demand for a product.

5. Advertisement Expenditure: Advertisement is done to promote sales of a product. It

helps in stimulating demand for a product in four ways; by informing the prospective
consumers about the availability of a product, by showing its superiority over the
competitor’s brand, by influencing the consumer’s choice against the rival product and by
setting new fashion and changing tastes of the consumers. The effect of advertisement is
said to be fruitful if it leads to the upward shift in the demand curve, i.e. the demand
increases with the increase in the advertisement expenditure, other things remaining
constant.

6. Consumers’ Expectations: In the short run, the consumer’s expectation with respect
to the income, future prices of the product and its supply position plays a vital role in
determining the demand for a commodity. If the consumer expects a high rise in the price of
the commodity, shall purchase it today at a high current price so as to avoid the pinch of the
high price in the future. On the contrary, if the prices are expected to fall in the future the
consumer will postpone their purchase with a view to avail benefits of lower prices in the
future, especially in case of nonessential goods.

Likewise, an expected increase in the income increases the demand for a product and vice-
versa. Also, in the case of scarce goods, if its production is expected to fall short in the
future, the consumer will buy it at current higher prices.

7. Demonstration Effect: Often, the new commodities or new models of an existing

product are bought by the rich people. Some people buy goods due to their genuine need for
them or have excess purchasing power. While some others do so because they want to
exhibit their affluence. Once the commodity is in very much fashion, many households buy
them not because they have a genuine need for them but their neighbors have purchased it.
Thus, the purchase made by such people arises out of feelings as jealousy, equality in
society, competition, social inferiority, status consciousness. The purchases made on
the account of these factors results in the demonstration effect, also called as Bandwagon
Effect.
8. Consumer-Credit Facility: The availability of credit to the consumer also determines
the demand for a product. The credit extended by sellers, banks, friends, relatives or from
other sources induces a consumer to buy more than what would have not been possible in
the absence of the credit. Thus, the consumers with more borrowing capacity
consumes more than the ones who borrow less.

9. Population of the Country: The population of the country also determines the total
domestic demand for a product of mass consumption. For a given level of per capita income,
tastes and preferences, price, income, etc., the larger the size of the population the
larger the demand for a product and vice-versa.

10. Distribution of National Income: The national income is one of the basic
determinants of the market demand for a product, such as the higher the national
income, the higher the demand for all the normal goods. Apart from its level,
the distribution pattern of the national income also determines the overall demand for a
product. Such as, if the national income is unevenly distributed, i.e., the majority of the
population falls under the low-income groups, then the market demand for the inferior goods
will be more than the other category goods. Thus, the demand for a commodity can be
estimated or analyzed by studying the determinants of market demand and the nature of
the relationship between the demand and its deterException to the law of Demand:

There are some exceptions to the law of demand. These include the Giffen goods, Veblen
goods, possible price changes, and essential goods.

Giffen Goods: A Giffen good is considered to be an exception to the Law of Demand. The
unique features of a Giffen good results in quantity demanded increasing when there is an
increase in price. As stated earlier, the Law of Demand states that the quantity demanded
should decrease with an increase in price (the inverse relationship).

Sir Robert Giffen observed that when the price of bread increased, the low-paid British
workers in the early 19th century purchased more bread and not less of it. This phenomenon
is a direct contradiction to the Law of Demand.

The reason given for this is that these British workers consumed a diet of mostly bread and
when the price of bread went up they were compelled to spend more on a fixed quantity of
bread. Therefore, they could not afford to purchase as much meat as before. They
substituted bread for meat to maintain their intake of food and calories.

A Giffen good is considered to be a strongly inferior good. There are very few examples of
Giffen goods mostly because it is difficult to prove that they exist. It’s when consumers
consume more of an inferior good when the price of the good rises, which is in direct
violation of the Law of Demand.

Veblen Goods: The second exception to the law of demand is the concept of Veblen goods.
Veblen Goods is a concept that is named after the economist Thorstein Veblen, who
introduced the theory of “conspicuous consumption“. According to Veblen, there are certain
goods that become more valuable as their price increases. If a product is expensive, then its
value and utility are perceived to be more, and hence the demand for that product
increases.

And this happens mostly with precious metals and stones such as gold and diamonds and
luxury cars such as Rolls-Royce. As the price of these goods increases, their demand also
increases because these products then become a status symbol.

The expectation of Price Change: There are times when the price of a product increases
and market conditions are such that the product may get more expensive. In such cases,
consumers may buy more of these products before the price increases any further.
Consequently, when the price drops or may be expected to drop further, consumers might
postpone the purchase to avail the benefits of a lower price.

For instance, in recent times, the price of onions had increased to quite an extent.
Consumers started buying and storing more onions fearing further price rise, which resulted
in increased demand.

There are also times when consumers may buy and store commodities due to a fear of
shortage. Therefore, even if the price of a product increases, its associated demand may
also increase as the product may be taken off the shelf or it might cease to exist in the
market.

Highly Essential Good: in case of certain highly essential items such as life- saving drugs,
people buy a fixed quantity at all possible price. Heart patients will buy the same quantity of
‘Sorbitrate’ whether price is high or low. Their response to price change is almost nil. In
cases of such commodities, the demand curve is likely to be a vertical straight line (Fig. 2.4).
At a price OP1, the heart patient consumer demands OD amount of ‘Sorbitrate’. In spite of its
price rise to OP2, the consumer buys the same quantity of it.
Change in Income: Sometimes the demand for a product may change according to the
change in income. If a household’s income increases, they may purchase more products
irrespective of the increase in their price, thereby increasing the demand for the product.
Similarly, they might postpone buying a product even if its price reduces if their income has
reduced. Hence, change in a consumer’s income pattern may also be an exception to
the law of demand.

Using Price as an Index of Quality: Most consumers do not have the capacity or
technical knowledge to examine the physical properties of a product (such as, reliability,
durability, economy, etc.,) as in the case of an item such as a motor car or a VCR. So, in the
absence of other information, price is taken as an index of quality. Thus, a high-priced car is
more valued than a low-priced one.

A costly book is often considered to be more useful by a student than a cheaper title. In such
cases, the demand curve may be upward sloping. This argument is not a new one. This
applies to our previous case where we referred to commodities having snob appeal. So this
point really reinforces the previous one.

Tastes and fads: Consumers are a finicky bunch. Over time, their tastes, preferences,
emotions and desires change. If the change is in favor of a new product, the demand
increases. When preferences go against a certain product, the demand decreases. Because
of these changes in tastes, companies are always seeking ways to increase their brand
favorability through marketing and advertising. Examples include companies with logo
changes or a new slogan to connect with their target market.

TYPES OF DEMAND

1. Price demand:

Price demand refers to the different quantities of the commodity or service which consumers
will purchase at a given time and at given prices, assuming other things remaining the same.
It is the price demand with which people are mostly concerned and as such price demand is
an important notion in economics. Price demand has inverse relation with the price. As the
price of commodity increases its demand falls and as the price decreases, its demand rises.

2. Income demand:

Income demand refers to the different quantities of a commodity or service which consumers
will buy at different levels of income, assuming other things remaining constant. Usually the
demand for a commodity increases as the income of a person increases unless the
commodity happens to be an inferior product. For example, coarse grain is a cheap or
inferior commodity. The demand for such commodities decreases as the income of a person
increases. Thus, the demand for inferior or cheap goods is inversely related with the income.

3. Cross demand:

When the demand for a commodity depends not on its price but on the price of other related
commodities, it is called cross demand. Here we take closely connected or related goods
which are substitutes for one another.

For example, tea and coffee are substitutes for one another. If the price of coffee rises, the
consumer will be induced to buy more of tea and, hence, the demand of tea will increase.
Thus in case of substitutes, when the price of one related commodity rises, the demand of
the other related commodity increases and vice-versa.

But in case of complimentary or joint demand goods, e.g., pen and ink, horses and carriages
etc. when the price of one commodity rises, the demand for it will fall and as a result of it the
demand for the other joint commodity also falls (even though its price remains the same).
For example, if the price of horses increases, their demand will fall and as a result of it the
demand for carriages will also fall even though their price does not change.

4. Direct demand:

Commodities or services which satisfy our wants directly are said to have direct demand.
For example, all consumer goods satisfy our wants directly, so they are said to have direct
demand.

5. Derived demand or indirect demand:

In economics, derived demand is demand for a factor of production or intermediate good

that occurs as a result of the demand for another intermediate or final good. In essence, the
demand for, say, a factor of production by a firm is dependent on the demand by consumers
for the product produced by the firm. The term was first introduced by Alfred Marshall in his
Principles of Economics.

Producers have a derived demand for employees. The employees themselves do not appear
in the employer's utility function; rather, they enable employers to profit by fulfilling the
demand by consumers for their product. Thus the demand for labour is a derived demand
from the demand for goods and services.

For example, if the demand for a good such as wheat increases, then this leads to an
increase in the demand for labour, as well as demand for other factors of production such as
fertilizer.

For another example, demand for steel leads to derived demand for steel workers, as steel
workers are necessary for the production of steel. As the demand for steel increases, so does
its price. The increase in price means manufacturers of steel can gain more in revenue if
they produce more steel, thus leading to a higher demand for the resources involved in
producing steel.

6. Joint demand:

In finished products as in case of bread, there is need for so many things—the services of the
flour mill, oven, fuel, etc. The demand for them is called joint demand. Similarly for the
construction of a house we require land, labor, capital, organization and materials like
cement, bricks, lime, etc. The demand for them is, thus, called a ‘joint demand.’

7. Composite demand:

A commodity is said to have a composite demand when its use is made in more than one
purpose. For example the demand for coal is composite demand as coal has many uses—as
fuel for a boiler of a factory, for domestic fuel, for oven for steam-making in railways engine,
etc.
The extension and contraction in demand are used when the quantity demanded rises or
falls as a result of changes in price and we move along a given demand curve. When the
quantity demanded of a good rises due to the fall in price, it is called extension of demand
and when the quantity demanded falls due to the rise in price, it is called contraction of
demand.

For instance, suppose the price of bananas in the market at any given time is Rs.12 per
dozen and a consumer buys one dozen of them at that price. Now, if other things such as
tastes of the consumer, his income, prices of other goods remain the same and price of
bananas falls to Rs. 8 per dozen and the consumer now buys 2 dozen bananas, then
extension in demand is said to have occurred. On the contrary, if the price of bananas rises
to Rs. 15 per dozen and consequently the consumer now buys half a dozen of the bananas,
then contraction in demand is said to have occurred.

It should be remembered that extension and contraction in the demand takes place as a
result of changes in the price alone when other determinants of demand such as tastes,
income, propensity to consume and prices of the related goods remain constant. These other
factors remaining constant means that the demand curve remains the same, that is, it does
not change its position; only the consumer moves downward or upward on it.

Extension of Demand: If the price decreases from P1 to P2, then the demand increases
(rises) from Q1 to Q. This growth of the demand is called Extension of Demand. For example,
if the prices of Hilsha fish falls in the local markets due to a higher yield or for government
regulation on their exports to other countries, their local demand automatically increases.
Now even poor can afford and enjoy delicious fish also.

Contraction of Demand: If the price increases from P1 to P3, then the demand decreases
from Q1 to Q3. This fall of the demand is called Contraction of Demand. For example, if the
prices of mangoes rise then their demand in the market decreases. It is because, with the
higher prices of mangoes, the ordinary people can’t afford to buy with their limited income.
As a result, the demand for mangoes automatically falls down.

Demand and Quantity Demanded

It is important to understand the distinction between the concepts of demand and quantity
demanded as they are often confused with each other. Demand represents the whole
demand schedule or demand curve and shows how price of a good is related to quantity
which the consumers are willing and able to buy, other factors which determine demand
being held constant.

On the other hand, quantity demanded refers to the quantity which the consumers buy at a
particular price. The quantity demanded of a good varies with changes in its price; it
increases when price falls and decreases when price rises. The changes in demand for a
commodity occur when there is a change in the factors other than price, namely, tastes and
preferences the people, incomes of the consumers, and prices of related goods.

Elasticity of Demand, Degree of Price Elasticity

Elasticity of Demand

The concept of price elasticity of demand has been defined by different economist as under:

According to Alfred Marshall “Elasticity of demand may be defined as the percentage change
in quantity demanded to the percentage change in price”.

Elasticity of demand is the measure of the degree of change in the amount demand of the
commodity in response to a given change in price of the commodity, price of some related
good or changes in consumers’ income. Above definition that elasticity of demand can be
taken to be mainly of three types:

§ Price elasticity is responsiveness of demand to change in price;

§ Income elasticity is the responsiveness of demand to changes in consumers incomes;

§ Cross elasticity is the responsiveness of demand for a commodity A in response to

changes in the price of related commodity B.

Degree of Price Elasticity

i) Perfect elastic Demand:

A perfectly elastic demand curve will be a straight line (horizontal) on a graph, where the x-
axis will be the quantity, and the y-axis will be the price of the product. The market demand
for a product is directly tied to the price of the product.

Perfectly elastic demand is a rare occurrence where the quantity that is demanded change
infinitely when there is a little change in the price of the product. It is represented by a
horizontal demand curve, as seen above.

Perfect elastic demand is considered a theoretical extreme case and there isn’t really any
real-life product that could be considered perfectly elastic. However, the idea is beneficial in
economic analysis.

ii) Perfectly inelastic demand:

Perfectly inelastic is where a small increase or decrease in the price of a product will have no
effect on the quantity that is demanded or supplied of that product. There is no elasticity of
demand or supply for the product. The elasticity of demand in this case will be equal to zero.
This will rarely happen in real life, but it is used as a valuable economic theory.

iv) Relatively Elastic Demand:

Relatively elastic demand refers to a situation in which a small change in price leads to a big
change in quantity demanded. In such a case elasticity of demand is said to be more than
one (ed > 1). This has been shown in figure 4.
n fig. 4, DD is the demand curve which indicates that when price is OP the quantity
demanded is OQ1. Now the price falls from OP to OP1, the quantity demanded increases from
OQ1 to OQ2 i.e. quantity demanded changes more than change in price.’

v). Relatively Inelastic Demand:

Under the relatively inelastic demand, a given percentage change in price produces a
relatively less percentage change in quantity demanded. In such a case elasticity of demand
is said to be less than one (ed < 1). It has been shown in figure 5.

Dd

All the five degrees of elasticity of demand have been shown in figure 6. On OX axis, quantity demanded and
on OY axis price is given.

It shows:

1. AB — Perfectly Inelastic Demand

2. CD — Perfectly Elastic Demand

3. EG — Less than Unitary Elastic Demand

4. EF — Greater Than Unitary Elastic Demand

5. MN — Unitary Elastic Demand.

Mathematical Expression of Price Elasticity of Demand

The price elasticity of demand is defined as the percentage change in quantity demanded due to certain
percentage change in price.
Where, EP= Price elasticity of demand

q= Original quantity demanded

∆q = Change in quantity demanded

p= Original price

∆p = Change in price

Calculation of Price Elasticity of Demand

Suppose that price of a commodity falls down from Rs.10 to Rs.9 per unit and due to this, quantity demanded of
the commodity increased from 100 units to 120 units. What is the price elasticity of demand?

Give that,

p= initial price= Rs.10

q= initial quantity demanded= 100 units

∆p=change in price=Rs. (10-9) = Rs.1

∆q=change in quantity demanded= (120-100) units = 20 units

Now,

The quantity demanded increases by 2% due to fall in price by Rs.1.

FACTORS AFFECTING PRICE ELASTICITY OF DEMAND

Ø The number of close substitutes – the more close substitutes there are in the market,
the more elastic is demand because consumers find it easy to switch. E.g. Air travel and
train travel are weak substitutes for inter-continental flights but closer substitutes for
journeys of around 200-400km e.g. between major cities in a large country.

Ø The cost of switching between products – there may be costs involved in switching. In
this case, demand tends to be inelastic. For example, mobile phone service providers may
insist on a12 month contract which has the effect of locking-in some consumers once a
choice has been made
Ø The degree of necessity or whether the good is a luxury – necessities tend to have
an inelastic demand whereas luxuries tend to have a more elastic demand. An example of a
necessity is rare-earth metals which are an essential raw material in the manufacture of
solar cells, batteries. China produces 97% of total output of rare-earth metals – giving them
monopoly power in this market

Ø The proportion of a consumer's income allocated to spending on the good –

products that take up a high % of income will have a more elastic demand

Ø The time period allowed following a price change – demand is more price elastic, the
longer that consumers have to respond to a price change. They have more time to search for
cheaper substitutes and switch their spending.

Ø Whether the good is subject to habitual consumption – consumers become less

sensitive to the price of the good of they buy something out of habit (it has become the
default choice).

Ø Peak and off-peak demand - demand is price inelastic at peak times and more elastic at
off-peak times – this is particularly the case for transport services.

Ø The breadth of definition of a good or service – if a good is broadly defined, i.e. the
demand for petrol or meat, demand is often inelastic. But specific brands of petrol or beef
are likely to be more elastic following a price change.

Market Schedule
Market demand schedule

•A market demand schedule is a tabulation of the quantity of a good that all consumers in a
market will purchase at a given price. At any given price, the corresponding value on the
demand schedule is the sum of all consumers’ quantities demanded at that price.

MEASURING PRICE ELASTICITY OF DEMAND

1. Total Expenditure Method: Dr. Marshall has evolved the total expenditure method to
measure the price elasticity of demand. According to this method, elasticity of demand can
be measured by considering the change in price and the subsequent change in the total
quantity of goods purchased and the total amount of money spent on it.

Total Outlay = Price X Quantity Demanded

There are three possibilities:

(i) If with a fall in price (demand increases) the total expenditure increases or with a rise in
price (demand falls), the total expenditure falls, in that case the elasticity of demand is
greater than one i.e. ED > 1.

(ii) If with a rise or fall in the price (demand falls or rises respectively), the total expenditure
remains the same, the demand will be unitary elastic or ED = 1.

(iii) If with a fall in price (Demand rises), the total expenditure also falls, and with a rise in
price (Demand falls) the total expenditure also rises, the demand is said to be less classic or
elasticity of demand is less than one (ED < 1).

This can be expressed with the help of a Chart.

Leibhafasky has given the following formula to measure elasticity of demand:

In the Table we find three possibilities:

A. More Elastic Demand:

When price is Rs. 10 the quantity demanded is 1 unit and total expenditure is 10.
Now price falls from Rs. 10 to Rs. 6, the quantity demanded increases from 1 to 5
units and correspondingly the total expenditure increases from Rs. 10 to Rs. 30.
Thus it is clear that with the fall in price, the total expenditure increases and vice-
versa. So elasticity of demand is greater than one or ED >1.
B. Unitary Elastic Demand:

If price is Rs. 6, demand is 5 units so the total outlay is Rs. 30. Now price falls to
Rs. 5, the demand increases to 6 units but the total expenditure remains the same
i.e., Rs. 30. Thus it is clear that with the rise or fall in price, the total expenditure
remains the same. The elasticity of demand in this case is equal to one or

ED = 1.

C. Less Elastic Demand:

If price is Rs. 5, demand is 6 and total outlay is Rs. 30. Now price falls from Rs. 5
to Re. 1. The demand increases from 6 units to 10 units and hence the total
expenditure falls from Rs. 30 to Rs. 10. Thus it is clear that with the fall in price,
the total expenditure also falls and vice-versa. In this case, the elasticity of
demand is less than one or ED <1.

Diagrammatic Representation:

ggThe total expenditure can be explained with the help of Fig. 7.

In the fig., there are three phases of the total expenditure curve.

Downward sloping (from A to D), (ii) Vertical (from D to G), (iii) Upward sloping (G
to J).

(i) Downward Sloping Curve:

If the price- total expenditure curve slopes downward from left to right, it means
the elasticity of demand is greater than one. As we see in the diagram that when
price falls from Rs. 10 to Rs. 5 the total expenditure increases from Rs. 10 to Rs.
30. It means, there is opposite relationship between price and total expenditure.
The elasticity of demand in this case is greater than one. Thus the curve from A to
D represents the elasticity greater than one or ED >1.

(ii) Vertical Curve.

If price-total expenditure curve is vertical or parallel to 7-axis, it means that with

fall in price from Rs. 6 to Rs. 5 the total expenditure remains the same. Thus if
total expenditure does not change with the rise or fall in price, the elasticity of
demand will be equal to one. Thus by joining points D and G we get vertical curve
showing elasticity of demand equal to one or Ed =1.
(iii) Upward Sloping Curve:

If price-total expenditure curve rises upward from left to right, it means the
elasticity of demand is less than one. In the diagram, we find that when price falls
from Rs. 5 to Re. 1the total expenditure also falls from Rs. 30 to Rs. 10. It means
by joining G, H, I, J we get an upward sloping curve showing elasticity of demand
less than one or ED < 1. Thus it is clear that the changes in total expenditure due
to changes in price also affect the elasticity of demand.

2. Proportionate Method:

This method is also associated with the name of Dr. Marshall. According to this
method, “price elasticity of demand is the ratio of percentage change in the
amount demanded to the percentage change in price of the commodity.”

It is also known as the Percentage Method, Flux Method, Ratio Method, and
Arithmetic Method. Its formula is as under:

Implications:

(a) This method should be used when there is a very small change in price and
quantity demanded.

(b) The coefficient of price elasticity of demand is always negative. It is because

when price changes, demand changes in the opposite direction. But by
convention, we ignore negative sign.

(c) The elasticity of demand is relative. It is not expressed in any unit rather
expressed in percentage or infractions.

3. Point Method:

This method was also suggested by Marshall and it takes into consideration a
straight line demand curve and measures elasticity at different points on the
curve. This method has now become very popular method of measuring elasticity.
In this we take a straight line demand curve, which connects the demand curve
with both the axes OX and OY. In the diagram OX axis represents the quantity
demanded and OY axis represents the price.

Case (i) Linear Demand Curve:

In Fig. 8 RS is a straight line demand curve. Initially, price is OP or QA and OQ or

PA is the initial demand. At OP’ new price the demand is OQ’. At point R elasticity
of demand can be measured with the following formula.
Case (ii) Non-Liner Demand Curve:

It is possible that the demand curve is not a straight line but a curve. Even then
the above technique shall be applicable. The only change to be made is that a
tangent is drawn on the demand curve at a point at which we want to measure
elasticity of demand.

In Fig 10 DD1 is the demand curve and we raw a line RS to measure the elasticity of
demand. At point A demand curve DD1 and RS line touches each other. Therefore,
both have same slope. Therefore, a point A, elasticity of demand is Ed = AS/AR
4. Arc Elasticity of Demand:

“Arc elasticity is a measure of the average responsiveness to price change

exhibited by a demand curve over some finite stretch of the curve” Prof. Baumol

“Arc elasticity is the elasticity at the mid-point of an arc of a demanded curve”

Watson

“When elasticity is computed between two separate points on a demand curve,

the concept is called Arc elasticity” Leftwitch
5. Revenue Method:

Mrs. Joan Robinson has given this method. She says that elasticity of demand can
be measured with the help of average revenue and marginal revenue. Therefore,
sale proceeds that a firm obtains by selling its products are called its revenue.
However, when total revenue is divided by the number of units sold, we get
average revenue.

On the contrary, when addition is made to the total revenue by the sale of one
more unit of the commodity is called marginal revenue. Therefore, the formula to
measure elasticity of demand can be written as,

EA = A/ A-M

Where Ed represents elasticity of demand, A = average revenue and M = marginal

revenue. This method can be explained with the help of a diagram 12.

In this diagram 12, revenue has been shown on OY- axis while quantity of goods
on OX-axis. AB is the average revenue or demand curve and AN is the marginal
revenue curve. At point P on demand curve, elasticity of demand is calculated
with the formula,
In this way, value of Ep is one which means that price elasticity of demand is
unitary. Similarly, if it is more than one, price elasticity of demand is greater than
one and if it is less than one, price elasticity of demand is less than unity.

THE SIGNIFICANCE OF DEMAND FORECASTING IS SHOWN IN THE FOLLOWING

POINTS:

i. Fulfilling objectives:

Implies that every business unit starts with certain pre-decided objectives. Demand
forecasting helps in fulfilling these objectives. An organization estimates the current demand
for its products and services in the market and move forward to achieve the set goals.

For example, an organization has set a target of selling 50, 000 units of its products. In such
a case, the organization would perform demand forecasting for its products. If the demand
for the organization’s products is low, the organization would take corrective actions, so that
the set objective can be achieved.

ii. Preparing the budget:

Plays a crucial role in making budget by estimating costs and expected revenues. For
instance, an organization has forecasted that the demand for its product, which is priced at
Rs. 10, would be 10, 00, 00 units. In such a case, the total expected revenue would be 10*
100000 = Rs. 10, 00, 000. In this way, demand forecasting enables organizations to prepare
their budget.

iii. Stabilizing employment and production:

Helps an organization to control its production and recruitment activities. Producing

according to the forecasted demand of products helps in avoiding the wastage of the
resources of an organization. This further helps an organization to hire human resource
according to requirement. For example, if an organization expects a rise in the demand for
its products, it may opt for extra labor to fulfill the increased demand.

iv. Expanding organizations:

Implies that demand forecasting helps in deciding about the expansion of the business of the
organization. If the expected demand for products is higher, then the organization may plan
to expand further. On the other hand, if the demand for products is expected to fall, the
organization may cut down the investment in the business.

v. Taking Management Decisions:

Helps in making critical decisions, such as deciding the plant capacity, determining the
requirement of raw material, and ensuring the availability of labor and capital.

vi. Evaluating Performance:

Helps in making corrections. For example, if the demand for an organization’s products is
less, it may take corrective actions and improve the level of demand by enhancing the
quality of its products or spending more on advertisements.
vii. Helping Government:

Enables the government to coordinate import and export activities and plan international
trade.

Objectives of Demand Forecasting:

Demand forecasting constitutes an important part in making crucial business decisions.

The objectives of demand forecasting are divided into short and long-term
objectives, which are shown in Figure-1:

The objectives of demand forecasting (as shown in Figure-1) are discussed as

follows:

i. Short-term Objectives:

Include the following:

a. Formulating production policy:

Helps in covering the gap between the demand and supply of the product. The demand
forecasting helps in estimating the requirement of raw material in future, so that the regular
supply of raw material can be maintained. It further helps in maximum utilization of
resources as operations are planned according to forecasts. Similarly, human resource
requirements are easily met with the help of demand forecasting.

b. Formulating price policy:

Refers to one of the most important objectives of demand forecasting. An organization sets
prices of its products according to their demand. For example, if an economy enters into
depression or recession phase, the demand for products falls. In such a case, the
organization sets low prices of its products.

c. Controlling sales:

Helps in setting sales targets, which act as a basis for evaluating sales performance. An
organization make demand forecasts for different regions and fix sales targets for each
region accordingly.

d. Arranging finance:

Implies that the financial requirements of the enterprise are estimated with the help
of demand forecasting. This helps in ensuring proper liquidity within the organization.

ii. Long-term Objectives:

Include the following:

a. Deciding the production capacity:

Implies that with the help of demand forecasting, an organization can determine the size of
the plant required for production. The size of the plant should conform to the sales
requirement of the organization.

b. Planning long-term activities:

Implies that demand forecasting helps in planning for long term. For example, if the
forecasted demand for the organization’s products is high, then it may plan to invest in
various expansion and development projects in the long term.

http://cdn.economicsdiscussion.net/wp-content/uploads/2015/01/clip_image00217.jpg

Demand Forecasting, Influencing Factors and its types:

Demand Forecasting:

Demand forecasting is a combination of two words; the first one is Demand and another
forecasting. Demand means outside requirements of a product or service. In general,
forecasting means making estimation in the present for a future occurring event.

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

 Forecasting = estimation of future situations.

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

Demand forecasting enables an organization to take various business decisions, such as

planning the production process, purchasing raw materials, managing funds, and deciding
the price of the product. An organization can forecast demand by making own estimates
called guess estimate or taking the help of specialized consultants or market research
agencies. Let us discuss the significance of demand forecasting in the next section.

Factors influencing demand forecasting:

Demand forecasting is a proactive process that helps in determining what products are
needed where, when, and in what quantities. There are a number of factors that
affect demand forecasting.

Some of the factors that influence demand forecasting are shown in Figure-2:

The various factors that influence demand forecasting (“as shown in Figure-2) are
explained as follows:

i. Types of Goods:
Affect the demand forecasting process to a larger extent. Goods can be producer’s goods,
consumer goods, or services. Apart from this, goods can be established and new goods.
Established goods are those goods which already exist in the market, whereas new goods
are those which are yet to be introduced in the market.

ii. Competition Level:

Influence the process of demand forecasting. In a highly competitive market, demand for
products also depend on the number of competitors existing in the market. Moreover, in a
highly competitive market, there is always a risk of new entrants. In such a case, demand
forecasting becomes difficult and challenging.

iii. Price of Goods:

Acts as a major factor that influences the demand forecasting process. The demand
forecasts of organizations are highly affected by change in their pricing policies. In such a
scenario, it is difficult to estimate the exact demand of products.

iv. Level of Technology:

Constitutes an important factor in obtaining reliable demand forecasts. If there is a rapid

change in technology, the existing technology or products may become obsolete.
For example, there is a high decline in the demand of floppy disks with the introduction of
compact disks (CDs) and pen drives for saving data in computer. In such a case, it is difficult
to forecast demand for existing products in future.

v. Economic Viewpoint:

Play a crucial role in obtaining demand forecasts. For example, if there is a positive
development in an economy, such as globalization and high level of investment, the demand
forecasts of organizations would also be positive.

Apart from aforementioned factors, following are some of the other important factors that
influence demand forecasting:

a. Time Period of Forecasts:

Act as a crucial factor that affect demand forecasting. The accuracy of demand
forecasting depends on its time period.

Forecasts can be of three types, which are explained as follows:

1. Short Period Forecasts:

Refer to the forecasts that are generally for one year and based upon the judgment of the
experienced staff. Short period forecasts are important for deciding the production policy,
price policy, credit policy, and distribution policy of the organization.

2. Long Period Forecasts:

Refer to the forecasts that are for a period of 5-10 years and based on scientific analysis and
statistical methods. The forecasts help in deciding about the introduction of a new product,
expansion of the business, or requirement of extra funds.
3. Very Long Period Forecasts:

Refer to the forecasts that are for a period of more than 10 years. These forecasts are
carried to determine the growth of population, development of the economy, political
situation in a country, and changes in international trade in future.

Among the aforementioned forecasts, short period forecast deals with deviation in long
period forecast. Therefore, short period forecasts are more accurate than long period
forecasts.

4. Level of Forecasts:

Influences demand forecasting to a larger extent. A demand forecast can be carried at three
levels, namely, macro level, industry level, and firm level. At macro level, forecasts are
undertaken for general economic conditions, such as industrial production and allocation of
national income. At the industry level, forecasts are prepared by trade associations and
based on the statistical data.

5. Nature of Forecasts:

Constitutes an important factor that affects demand forecasting. A forecast can be specific
or general. A general forecast provides a global picture of business environment, while a
specific forecast provides an insight into the business environment in which an organization
operates. Generally, organizations opt for both the forecasts together because over-
generalization restricts accurate estimation of demand and too specific information provides
an inadequate basis for planning and execution.

Steps in demand forecasting:

1. Specifying the Objective: The objective for which the demand forecasting is to be
done must be clearly specified. The objective may be defined in terms of; long-term or
short-term demand, the whole or only the segment of a market for a firm’s product,
overall demand for a product or only for a firm’s own product, firm’s overall market
share in the industry, etc. The objective of the demand must be determined before the
process of demand forecasting begins as it will give direction to the whole research.
2. Determining the Time Perspective: On the basis of the objective set, the demand
forecast can either be for a short-period, say for the next 2-3 year or a long period.
While forecasting demand for a short period (2-3 years), many determinants of
demand can be assumed to remain constant or do not change significantly. While in
the long run, the determinants of demand may change significantly. Thus, it is
essential to define the time perspective, i.e., the time duration for which the demand
is to be forecasted.
3. Making a Choice of Method for Demand Forecasting: Once the objective is set
and the time perspective has been specified the method for performing the forecast is
selected. There are several methods of demand forecasting falling under two
categories; survey methods and statistical methods.

The Survey method includes consumer survey and opinion poll methods, and the
statistical methods include trend projection, barometric and econometric methods.
Each method varies from one another in terms of the purpose of forecasting, type of
data required, availability of data and time frame within which the demand is to be
forecasted. Thus, the forecaster must select the method that best suits his
requirement.
 4. Collection of Data and Data Adjustment: Once the method is decided upon, the
next step is to collect the required data either primary or secondary or both. The
primary data are the first-hand data which has never been collected before. While the
secondary data are the data already available. Often, data required is not available
and hence the data are to be adjusted, even manipulated, if necessary with a purpose
to build a data consistent with the data required.
5. Estimation and Interpretation of Results: Once the required data are collected
and the demand forecasting method is finalized, the final step is to estimate the
demand for the predefined years of the period. Usually, the estimates appear in the
form of equations, and the result is interpreted and presented in the easy and usable
form.

Thus, the objective of demand forecasting can only be achieved only if these steps are
followed systematically

I. Survey

1. Opinion polling method or Survey

Aim at collecting opinions of those who are supposed to possess knowledge of the market,
etc., sales representatives, sales executives, professional marketing experts and
consultants. The opinion poll method consists:

 Expert-opinion methods – By professional consultants and sales representative

Least costly method.
 Delphi method –experts are provided information on estimates of forecasts of other
experts along with underlying assumption. The consensus of experts above the
forecast constitutes of final forecast.
 Market studies and experiments –under this method, firms first select some areas
of the representative markets-three or four cities having similar features, viz.,
population, income levels, cultural and social background, occupational distribution,
choices and preferences of consumers. Then, they carry out market experiments by
 changing prices, advertisement expenditure, and other controllable variables in the
demand function under the assumption that other things remain the same.

· Nominal Group Technique -This technique was originally developed by Delbecq and
VandeVen. This is a further modification of Delphi method of forecasting. A panel of 3-4
groups of up to 10 experts are formed and allowed to interact, discuss 'and rank all the
suggestions in descending (highest to lowest). Finally deciding it.

II. Statistical Methods

 Trend projection method - This technique assumes that whatever past years
demand pattern will be continued in the future also. Basing on the historical data that
means previous year’s data is used to predict the demand for the future. In this trend
projection method, previous year’s data is presented on the graph and future demand
is estimated.

 Regression Analysis: Past data is used to establish a functional relationship

between two variables. For Example, demand for consumer goods has a relationship
with income of Individuals and family; demand for tractors is linked to the agriculture
income and demand for cement, bricks etc. are dependent upon value of construction
contracts at any time. Forecasters collect data and build relationship through co-
relation and regression analysis of variables.

 Econometric Models - Econometric models are more complex and comprehensive as

this model uses mathematical and statistical tools to forecast demand. This model
takes various factors which affect the demand. For example, demand for passenger
transport is not only dependent upon the population of the city, geographical area,
industrial units, their location etc.It is not easy to locate one single economic indicator
for determining the demand forecast of a product. Invariably, a multi-factor situation
applies Econometric Models, although complex, are being increasingly used for market
analysis and demand forecasts.

 Simple Average Method - Among the quantitative techniques for demand analysis,
simple Average Method is the first one that comes to one's mind. Herein, we take
simple average of all past periods - simple monthly average of all consumption figures
collected every month for the last twelve months or simple quarterly average of
 consumption figures collected for several quarters in the immediate past. Thus,
Sum of Demands of all periods =simple average
 No of periods

Least square methods - Under the least square method, a trend line can be fitted to the
time series data with the help of statistical techniques such as least square regression. When
the trend in sales over time is given by straight line, the equation of this line is of the form: y
= a + bx. Where ‘a’ is the intercept and ‘b’ shows the impact of the independent variable.
We have two variables—the independent variable x and the dependent variable y. The line
of best fit establishes a kind of mathematical relationship between the two variables .v and
y.

 Moving average: A moving average is a technique to get an overall idea of the

trends in a data set; it is an average of any subset of numbers. The moving average is
extremely useful for forecasting long-term trends. You can calculate it for any period
of time. For example, if you have sales data for a twenty-year period, you can
calculate a five-year moving average, a four-year moving average, a three-year
moving average and so on. Stock market analysts will often use a 50 or 200 day
moving average to help them see trends in the stock market and (hopefully) forecast
where the stocks are headed.An average represents the “middling” value of a set of
numbers. The moving average is exactly the same, but the average is calculated
several times for several subsets of data. For example, if you want a two-year moving
average for a data set from 2000, 2001, 2002 and 2003 you would find averages for
the subsets 2000/2001, 2001/2002 and 2002/2003. Moving averages are usually
plotted and are best visualized.
