MANAGERIAL ECONOMICS

CHAPTER – II

Presented By
Dr. G.VIJAYAKRISHNA
MBA,MHRM, PG D(IR&PM), Ph.D
Associate Professor
Department of Management
Bule Hora University
 DEMAND ANALYSIS AND FORECASTING
DEMAND DETERMINANTS
The demand for a product and its sales depend upon a
number of factors. These include –
• Price
• Buyer’s Income
• Availability and price of substitute
• Advertising and Sales promotion
• Population
• Weather
• One’s status
• Geographic location of buyers
• Expected future trends in prices
• Changes in consumer tastes, needs and preferences etc.
Meaning of Demand
• Demand in economics means desire to buy backed by
adequate purchasing power. The demand for goods,
therefore, denotes that someone is able and willing to buy
the goods. For example, everyone desires to possess Toyota
Car but only a few have the ability to buy it. So everybody
cannot be said to have a demand for the car.
• Further, the demand for goods refers to the various
quantities that consumer will take off the market during a
time unit at different prices. Thus, we can say that, at a price
of Br. 5, the demand is 80 units, at price Br. 4, the demand is
100 units, and so on.
• The relation of price to sales has been a major interest of
economists for a long time. A better knowledge of such
relationship is also of concern to management.
Law of Demand
• The relation of price to sales is known in economics
as the ‘Law of Demand’. The Law of Demand states
that “higher the price, lower the demand, and vice
versa, other things remaining the same”.
• Demand Schedule, Demand Curve, and Demand
Function
• In elementary economics, the relationship of price to
sales or demand, or alternatively, the Price-Quantity
Relation, as it is often called, is shown arithmetically
in the form of a table showing prices and
corresponding quantities. This table is known as
‘Demand Schedule’. We give below an illustration of
the ‘Demand Schedule’.
 Demand Schedule

Price Quantity Demanded

Br. 5 80 units
Br. 4 100 units
Br. 3 150 units
Br. 2 200 units

The ‘Law of Demand’ or the ‘Price-Quantity Relationship’ is also portrayed

graphically in the form of a chart which is called the ‘Demand Curve’.
An example of the ‘Demand Curve’ is given in the following figure.

Price

D1

Quantity

The price-quantity relation is also expressed algebraically in the form of the following equation:
Q = f (P)
Which means that quantity demanded is a function of price.
Chief Characteristics
The chief characteristics of the Law of Demand are
as follows:
• Inverse Relationship. The relationship between price and
quantity demanded is inverse. That is, if the price rises
demand falls, and if the price falls, the demand goes up.
• Price, and independent variable, and demand, a
dependent variable. Under the Law of Demand, it is the
effect of price on demand which is examined, and not the
effect of demand on price. When demand rises, the prices
would rise, and when demand falls, the price would fall.
But the law of demand does not concern with this kind of
behavior. In other words, in the law of demand prices is
regarded as an independent variable and demand a
dependent variable.
• Other things remain the same. The Law of
Demand assumes that other things remain the
same. In other words, there should be no change
in the other factors influencing demand except
price. If, however, any one or more of the other
factors, say, income, substitute’s price, consumers’
tastes and preferences, advertising outlays, etc.,
vary the demand may rise, in spite of a rise in
price, or alternatively, the demand may fall in
spite of a fall in price.
• Reasons underlying the Law of Demand. The inverse relation
between price and demand as stated by the Law of Demand can be
explained in terms of two reasons. Viz. (a) Income Effect, and (b)
Substitution Effect.
• Income Effect. The fall in the price of a commodity leads to and,
therefore, is equivalent to an increase in the income of the consumer
because now he has to spend less for purchasing the same quantity as
before. A part of the money so gained can be used for purchasing some
more units of the commodity. When price rises, the consumer’s
income is, in effect, reduced and he has to curtail his expenditure on
all commodities including the commodity whose price has risen.
• Substitution Effect. When the price of the commodity falls, the
consumer tends to substitute that commodity for other commodities
which have not become relatively dear. If the price of one product
falls, it will be used by some people in place of other products to some
extent. Conversely, when the price of a commodity rises, other
commodities will be used in its place, at least to some extent.
Therefore, a fall in the price of a commodity increases demand and a
rise in its price reduces demand.
Individual Demand and Market Demand
• The quantity demanded by an individual
purchaser at a given price is known as individual
demand whereas the total quantity demanded by
all the purchasers together is known as market
demand.
• The market demand, that is, the total demand for a
commodity, can be calculated by adding the
quantities demanded by all the purchasers.
Suppose five persons viz, A, B, C, D and E
purchase eggs in the market. The market demand
will then be calculated as follows:
 Market Demand for Eggs

Price
per
Dozen Quantity Demanded in Dozens by Total
Br.
A B C D E
10 1 3 0 0 0 4
9 2 4 1 0 0 7
8 3 5 3 1 0 12
7 4 6 5 2 1 18
6 5 7 6 3 2 23
5 6 8 7 4 3 28
4 7 9 8 5 4 33

The last column gives the total demand for eggs at different prices.
Price Elasticity of Demand
• The Law of Demand tells us that as the price of a
commodity falls, the quantity demanded increases and
vice versa. But it does not state by bow much the quantity
demanded increased, as a result of a certain fall in the
price or how much quantity demanded decreases as a
result of a rise the price.
• The Law of Demand tells only the direction of change
but not the rate at which the change takes place. That is
known as “Price Elasticity of Demand”.
• Elasticity of demand refers to that “the degree of
responsiveness of quantity demanded to a change in
price”.
• It thus, represents the rate of change in the quantity
demanded due to a change in price.
The price elasticity of demand may be measured by the following formula:

(or)

where,
Q1 = Quantity demanded before price change
Q2 = Quantity demanded after price change
P1 = Price charged before price change
P2 = Price charged after price change
 Illustration:
If Q1=2000; Q2=2500
P1=10; P2=9 then

The price elasticity is negative emphasizing the inverse relationship between

price and demand.
In practice, however, the minus sign is omitted from the final result as the
inverse relationship is implied.

Interpretation:
A one percent reduction in price will result in a 2.5 percent in the quantity demanded.
Types of Price Elasticity
• Perfectly Elastic Demand
• Where no reduction in price is needed to cause an
increase in demand. In this case, a firm can sell
the quantity it wants at the prevailing price. Here,
the shape of the demand curve is horizontal.
• Perfectly Inelastic Demand
• Where a change in price, howsoever, large, causes
no change in quantity demanded. Here, the shape
of the curve is vertical.
• Demand with Unity Elasticity
• Where a given proportionate change in price
causes an equal proportionate change in the
quantity demanded. Here, the shape of the demand
curve is that of a rectangular hyperbola.
• Relatively Elastic Demand
• Where a reduction in price leads to more than
proportionate change in demand. Hence, the shape
of the demand curve is flat.
• Relatively Inelastic Demand
• Where a decline in price leads to less than
proportionate increase in demand. Here, the shape
of the demand curve is steep.
Factors determining Price Elasticity of Demand
The elasticity of demand depends on the
following factors:
Nature of the Commodity:
• The demand for necessities is generally inelastic
because the consumption of a necessary articles
(eg. Salt) does not change much with a change in
price. The demand for luxuries (eg. Car) changes
much due to a price change and is, therefore
elastic.
• Eg. With drastic reduction in the prices of TVs,
leads to its sales increase.
Extent of usage:
• A commodity having a variety of uses has a comparatively
elastic demand. For example, steel can be used for many
purposes.
• A slight fall in its price will bring forth demand from many
quarters and hence demand is elastic.
• On the other hand, a commodity having a limited use will
have a comparatively inelastic demand.
Range of Substitutes:
• A commodity having a number of substitutes has relatively
elastic demand because if its price rises, its consumption
can be curtailed in favor of the substitutes.
• For example – If train fares rise, people will use buses.
• A commodity without substitute or with weak substitutes
has relatively inelastic demand.
Income Level:
• People with high income are less affected by price
changes than people with low incomes. A rich man
will not curtail consumption of a commodity even if
their price rises and will continue to purchase the
same product as before. But poor man cannot do so.
• Hence, the demand for that commodity is inelastic
for rich but elastic for the poor.
Proportion of Income spent on the Commodity:
• Where an individual spends only a small part of his
income on the commodity, the price charge does not
affect his demand for the commodity.
• Eg. In case of Regular needs the demand is inelastic.
Durability of a Commodity:
• In case the commodity is durable or repairable
(eg. Shoes), if the price rises considerably, one is
likely to use the commodity for a longer time, if
necessary, after getting it repaired. Thus, the more
durable and repairable a commodity is, the higher
is its elasticity of demand likely to be.
Income and Demand
• The income of buyers is a basic demand determinant
and along with price often accounts for most of the
variations in the sales of many commodities.
• The relationship between the income and sales can
be of considerable use to the businessman in
planning sales, allocating territories, etc. In order to
study the income-sales/demand relationship, four
aspects are to be distinguished:
1. Consumption function
2. Product consumption function
3. Differences in regional incomes and
4. Income expectations and demand.
1. Consumption Function
• Consumption function refers to the relationship of total
expenditure on consumption to total income.
The following characteristics of the consumption function:
• The long-run relation of consumption to income is somewhat
stable, and expenditure on consumption is regularly about 85 to
90 per cent of the income. Unless there is a change in the income
distribution pattern, the average tendency to consume, i.e., the
ratio of total expenditure on consumption to aggregate income,
will remain fairly stable.
• In the short run, the consumption function recorded great
instability. As such, the relationship between income and
consumption cannot be predicted by any mathematical formula.
• During periods of economic prosperity, expenditure on
consumption tends to increase absolutely but decreases as a
percentage of income.
• On the other hand, in periods of depression,
consumption declines absolutely but the expenditure
on consumption increases as a percentage of income.
• In underdeveloped countries, where people live below
the subsistence level, the propensity to consume is very
high. Any increase in income of the people with low
income, is likely to be spent on consumption goods.
• Thus, it can be concluded that there is a definite and
predictable relationship between aggregate income and
total consumption.
• That is why, the consumption function was considered
to be of substantial importance in managerial decision-
making.
2. Product Consumption Function
• It is the relationship between the total income and sales of
particular products. There is a definite direct relationship between
changes in income and demand for specific product groups.
• Eg. Furniture.

• The direct relationship between income and product consumption

shows the scope for an individual producer to push up the sales of
his products.
3. Differences in Regional Incomes
• Businessmen whose markets are confined to certain
regions or states are naturally more interested in market
studies that reveal the purchasing power of specific
regions. One method of doing so is the construction of
an index of purchasing power of individual states or
regions
• Eg. Toyota Car in Ethiopia
4. Income Expectations and Demand
• The demand for a vast variety of products is often less
influenced by people’s incomes than by their
expectations of income. Expectations are related to
people’ estimates of the level and durability of future
economic conditions.
• Income Elasticity of Demand
• Income elasticity refers to “the degree of
responsiveness of quantities demanded to a given
change in income”. The income elasticity of demand
can be measured by the following formula:

• where,
• Q1 = Quantities demanded before the change in income
• Q2 = Quantities demanded after the change in income
• Y1 = Income before the change
• Y2 = Income after the change
• Illustration:
• Suppose a consumer’s income is Br. 1000 and
he purchases 10 Kgs. of sugar. If his income
goes up Br. 1100, he is prepared to buy 12
Kgs. of sugar. The income elasticity of
demand will be calculated as under.

• Thus, the demand for sugar is quite income

elastic.
Types of Income Elasticity
The following are the different types of income elasticity.
• Zero Income Elasticity
• Here, a change in income will have no effect on the
quantities demanded.
• Eg. Salt.
• Negative Income Elasticity
• An increase in income may lead to a reduction in the
quantities demanded. Such goods are called “Inferior
Goods”.
• Positive Income Elasticity
• An increase in income may lead to an increase in the
quantities demanded. For most goods, the income elasticity
of demanded is positive. i.e – when income rises, demand
also rises. Such goods are known as “Superior Goods”.
• Positive income elasticity may be three types:
• Unity Elasticity – An increase income leads to a
proportionate change in quantities demanded.
• More than Unity Elasticity – An increase in
income leads to more than proportionate change
in quantities demanded.
Eg. Luxuries.
• Less than Unity of Elasticity – An increase in
income leads to a less than proportionate change
in the quantities demanded.
• Eg. All necessities (wheat and rice)
• Advertising and Demand
• Advertising consists of those activities by which visual or oral
messages are addressed to selected respondents for the purpose
of informing and influencing them to buy products or services
favorably toward ideas, persons, trade marks, institutions or
associations featured.
• The various activities included in advertising are the forms of
messages carried in newspapers and magazines, on outdoor
hoardings, on buses and trains and in radio and television
broadcasts.
• Also included are circulars of all kinds whether distributed by
mail, by person, through tradesmen, or inserts in packages.
• Other forms are dealer help materials, window display and
counter display materials and efforts, store signs, advertising in
motion pictures, novelties carrying advertising messages, labels
and tags etc.
 The salient features of the advertising – sales
relationship are:
 A certain amount of sales is possible even without any
advertising.
 Other things i.e., price, quality, channels of distribution
and similar factors affecting sales remaining the same,
there is a direct relationship between the extent of
advertisement and the volume of sales. Thus, an increase
in the expenditure on advertisement is likely to lead to an
increase in sales.
 Up to a point, an increase in advertisement will lead to a
more than proportionate increase in sales. But beyond this
point, an increase in advertisement will lead to a less than
proportionate increase in sales till the saturation point is
reached after which there will be no increase in sales.
• It will be seen that sales are positive even the
expenditure on advertisement is zero indicating that a
certain amount of sales is taking place even without
advertisement.
• With successive doses of expenditure on advertisement,
the advertising-sales curve moves upwards.
• After a certain point, it is seen that the growth of the
curve is at declining rate, indicating that each
successive increase in the expenditure on advertisement
gives a diminishing return.
• Ultimately, the curve becomes flat indicating that the
saturation point has been reached and there is no
increase in sales due to an increase in the expenditure
on advertisement.
Advertising Elasticity of Demand
• The expansion of demand by means of advertisement
and other promotional efforts may measured by
advertising elasticity of demand, also called
“promotional elasticity”.
• The promotional elasticity measures the
responsiveness of demand to changes in advertising or
other promotional expenses. The formula for its
measurement is as given below:

• Where Q and A stand for Sales and Advertisement

Outlays respectively.
 Demand Forecasting
• Accurate demand forecasting is essential for a firm to enable it
to produce the required quantities at the right time and arrange
well in advance for the various factors of production. viz., raw
materials, equipment, machine accessories, labour, buildings,
etc.
• Some firms may as a policy produce to order but, generally,
firms produce in anticipation of future demand.
• Forecasting helps a firm to assess the probable demand for its
products and plans its production accordingly. In fact,
forecasting is an important aid in effective and efficient
planning.
• Demand forecasting is also helpful in better planning and
allocation of the resources. And it is very popular in
industrially advanced countries where demand conditions are
always more uncertain than the supply conditions.
Purposes of Forecasting
• The purposes of forecasting filter according to types of
forecasting: Short-term forecasting and Long-term forecasting.
Purposes of Short-term Forecasting
• Appropriate production scheduling so as to avoid the problem of
over-production and the problem of short supply. For this purpose,
production schedules have to be geared to expected sales.
• Helping the firm in reducing costs of purchasing raw materials
and controlling inventory by determining its future resource
requirements. And in evolving a suitable advertising and
promotion programme.
• Forecasting short-term financial requirements. Cash requirements
depend on sales level and production operations. Moreover, it
takes time to arrange for funds on reasonable terms. Sales
forecasts will, therefore, enable arrangement of sufficient funds on
reasonable terms well in advance.
• Purpose of Long-term Forecasting
• Planning of a new unit or expansion of an existing unit. It requires an
analysis of the long-term demand potential of the products in
question.
• A multi-product firm must ascertain not only the total demand
situation, but also the demand for different items separately.
• Planning long-term financial requirements. As planning for raising
funds requires considerable advance notice, long-term sales forecasts
are quite essential to assess long-term financial requirements.
• Planning man-power requirements. Training and personnel
development are long-term propositions, taking considerable time to
complete. They can be started well in advance only on the basis of
estimates of manpower requirements assessed according to long-term
sales forecasts.
• The demand forecasts of particular products may also provide a
guideline for demand forecasts for related industries. For example,
the demand forecast of cotton textiles may provide an idea of the
likely demand for the textile machinery industry.
 Methods of Demand Forecasting
The more commonly used methods of demand forecasting are
discussed below.
Survey of Buyers’ Intentions
• The most direct method of estimating demand in the short-run is to ask
customers what they are planning to buy for the forthcoming time period
– usually a year. This method also known as Opinion Surveys, is most
useful when bulk of the sales is made to industrial producers.
• The customers may know what their total requirements are but they may
misjudge or mislead or may be uncertain about the quantity they intend
to purchase from a particular firm. This method is not very useful in the
case of household customers for several reasons, viz., irregularity in
customers’ buying intentions, their inability to foresee their choice when
faced with multiple alternatives, and the possibility that the buyers’ plans
may not be real but only wishful thinking. Again, household customers
are numerous making this method rather impracticable and costly. A
basic limitation of this method is that it is passive and “does not expose
and measure the variables under management’s control”.
Delphi Method
• A variant of the opinion poll and survey method is Delphi method. It
consists of an attempt to arrive at a consensus in an uncertain area
by questioning a group of experts repeatedly until the responses
appear to converge along a single line or the issues causing
disagreement are clearly defined.
• The participants are supplied the responses to previous questions
from others in the group by a coordinator or leader of some sort.
The leader provides each expert with the responses of the others
including their reasons.
• Each expert is given the opportunity to react to the information or
considerations advanced by others but interchange is anonymous so
as to avoid or reduce the ‘halo effect’, ‘bandwagon effect’ and ‘ego
involvements’ associated with publicly expressed opinions.
• Delphi method was originally developed at Rand Corporation of the
USA in the late 1940s by Olaf Helmer, Dalkey and Gordon and has
been successfully used in the area of technological forecasting. i.e.,
predicting technical changes.
Expert Opinion
• An approach to demand forecasting is to ask experts in the field to
provide their own estimates of likely sales. Experts may include
executives directly involved in the market, such as dealers, distributors
and suppliers or other whose major interest is in the forecast itself such
as industry analysts, specialist marketing consultants, officers of trade
associations, etc. Each expert is asked independently to provide a
confidential estimate and the results could be averaged.
• It is, in fact, a very simple method. Also the advantage of this approach
is that there is no danger that the group of experts develop a group-think
mentality where their independent judgment is impaired by their desire
to be seen as loyal and confirming members of the group. On the other
hand, if estimates are produced entirely independently, the experts have
no opportunity to weigh the opinions of others or to take into account
factors known to others but not to themselves.
• Other advantage of this method is that the forecasting is done quickly
and easily without need of elaborate statistics. Also at times, jury of
executive opinion may be the only feasible means of forecasting in the
absence of adequate data.
• Analysis of Time Series and Trend Projections
• A firm which has been in existence for some
time, will have accumulated considerable data on
sales pertaining to different time periods. Such data
when arranged chronologically yield ‘time series’.
The time series relating to sales represent the past
pattern of effective demand for a particular product.
Such data can be presented either in a tabular form or
graphically for further analysis. The most popular
method of analysis of time series is to project the
trend of the time series. A trend line can be fitted
through a series either visually chooses a plausible
algebraic relation between sales and the independent
variable, time. The trend line is then projected into
the future by extrapolation.
• This method is popular because it is simple and
inexpensive and partly because time series data
often exhibit a persistent growth trend. This
technique yields acceptable results so long as
the time series shows a persistent tendency to
move in the same direction. Whenever a
turning point occurs, however, the trend
projection breaks down. The real challenge of
forecasting is in the prediction of turning points
rather than in the projection of trends. It is
when turning points occur that management
will have to alter and revise its sales and
production strategies most drastically.
Approaching to Forecasting
• Identify and clearly state the objectives of forecasting
– short-term or long-term; market share or industry as
a whole.
• Select appropriate method of forecasting
• Indentify the variables affecting the demand for the
product and express them in appropriate forms.
• Gather relevant data or approximations to relevant data
to represent the variables.
• Through the use of statistical techniques, determine the
most probable relationship between the dependent and
the independent variables.
• Prepare the forecast and interpret the results.
Interpretation is more important to the management.
• For forecasting the company’s share in the demand, two
different assumptions may be made:
– The ratio of the company sales to the total industry sales will
continue as in the past.
– On the basis of an analysis of likely competition and industry
trends, the company may assume a market share different from
that of the past.
• It would, however, be useful to prepare alternative forecasts.
They are more meaningful than a single forecast. As
forecasts are based on certain assumptions, forecasts must be
revised when improved information is available. In long-
term forecasts, the projections may be revised every year.
These are sometimes known as rolling forecasts.
• Forecasts may be made either in terms of physical units or in
terms of amount of sales volume. The later may be
converted into physical units by dividing it by the expected
selling price.
• Forecasts may be made in terms of product groups
and then broken for individual products on the basis
of past percentages. Product group may be divided
into individual products in terms of sizes, brands,
labels, colors, etc.
• Forecasts may made on annual basis and then divided
month-wise or week-wise on the basis of past
records.
• For determining the month-wise break-up of the
forecast sales of a new product, either: (i) use may be
made of other firms’ data, if available, or (ii) some
survey may be necessary. Similar will be the situation
when the forecast sales of a product-line have to be
divided product-wise.
Illustration:
The following illustration shows how a sales forecast in
terms of product groups can be divided into individual products:

Sales of
Product Product A
Product –
Group (in terms
Year A Sales
Sales of
Br.
Br. percentag
e)
1996 80000 16000 20
1997 120000 26400 22
1998 100000 24000 24
300000 66400 22
• Suppose that the forecast product group sales for
1999 are Br. 150000. For calculating the forecast
sales of Product A, we can take either the percentage
revealed by the trend (which in this case would be 26
assuming that the same growth trend continues) or the
average percentage which would be 22. Sales forecast
for product A on the basis of 22 per cent is Br. 30000
and on the basis of 26 per cent is Br. 39000.
• The same method may be used to find out the
company’s share of industry sales when there is a
close relationship between the industry sales and
some economic indicators, but there is no relationship
between company sales and the same economic
indicators.
• Sales may change over time by a constant proportion
rather than by a constant absolute amount. For
example, if a firm is projecting its sales for five years
into the future and if it has determined that sales are
increasing at an annual rate of 10 per cent, the
projection would simply involve multiplying the 10
per cent growth factor for 5 years times present sales.
Supposing present sales are Br. 2 million, the forecast
of sales five years from now would be:
Sales in Year 5
= Present Sales x (1 + growth rate)5
= Br. 2 million x (1.10)5 = Br. 2 millon x 1.61
= Br. 3220000
THANK YOU