DEMAND AND SUPPLY ANALYSIS

Demand - Types of demand - Determinants of demand - Demand function - Demand elasticity -

Demand forecasting - Supply - Determinants of supply - Supply function - Supply elasticity.

• Demand is the willingness to buy a commodity and ability to buy it.

• Demand is always referred with time & price.

Demand of commodity can be defined as quantity of the commodity at a particular price
during a given point of time.

* Demand and price are inversely related. Other than price demand for a commodity depends
upon a host of other factors like:
i.) income of consumer
ii.) prices of related commodities
iii.) taste & preferences
iv.) expectations regarding future price
v.) geographical location
vi.) composition of population etc.
These are the determinants of demand.

* Price Demand ; Price Demand

i.) Income of consumers

Income and Demand are Directly related.

Income Demand
Income Demand
People’s purchasing power increases or decreases as case may be.

ii.) Prices of related commodities

a.) If substitutes of a particular commodity are available in the market and the price of
the substitute rises, demand for the commodity rises.
Substitute Demand

Substitute Demand

b.) If complements are available

Complements Demand

iii.) Changes in taste & preferences

If something is in fashion, demand for the product is high. If not in fashion, demand may be low.

iv.) People’s expectation regarding future prices

If expectation of future prices is high, then more demand is there at present and vice versa.

* Other than above mentioned determinants, quantity demanded is also dependant upon
population, composition of population, geographical conditions etc.
For example :
i.) Population Demand
ii.) More the male population, greater the demand for Male products
iii.) Blankets : Price of Blankets doesn’t affect Mumbai but Canada is affected.

Demand Curve
Demand Curve is downward sloping. The factors responsible for downward sloping demand curve
is as follows :

i.) Law of Diminishing Return

According to this law every additional unit consumed would give less and less satisfaction to
the consumer. So the amount of money the consumer is willing to pay for additional unit of a
commodity becomes lesser and lesser. So consumer will purchase additional commodity
only when the price is lower. Therefore, more quantity is brought at a lower price.

ii.) Income Effect

As the price of the commodity falls, the consumer’s real income increases. His purchasing
power increases. He is in a position to buy more of the given commodity.

iii.) Change in the number of consumers

As the commodity becomes cheaper, many more people who couldn’t afford it earlier will be
in a position to buy the commodity. As a result, number of consumers will increase. Hence,
the demand for a commodity goes up when it’s price goes down.

iv.) Substitution Effect

When the price of a commodity goes up and the substitutes are cheaper, then the people will
go for commodities which are cheaper. Thus demand for commodity will go down.

v.) Diverse use of a commodity

Many commodities can be used for several purposes. When the price is high, it’s use is
restricted to a few applications. When it becomes cheaper, people can afford to use it in other
ways as well. As a result, demand for a commodity goes up as price falls.

The Law of Demand

The Law of Demand express the inverse relationship between quantity demanded and price. But
there are some exceptional situations under which there may be a direct relationship between price
and quantity demanded.

One of the exceptions is associated with THORESTEIN VEBLER. (VEBLER EFFECT)

According to him, if consumer measures utility of a commodity only by its price & nothing else, then
they tend to buy more of a commodity at a higher price and less of it at lower price. These goods are
known as VEBLER’S GOODS. These goods loose their appeal when price falls. Therefore, the
laws of demand do not apply to these goods, which are status symbols.

Another exception is associated with ROBERT GIFFEN. He observed that when the price of bread
was rising in Britain, British workers brought more of bread. They substituted bread for meat,
because meat was very expensive and unaffordable. Such goods which are the basic requirements
are known as GIFFEN’S GOODS. For example, potatoes, bajra etc., which are generally consumed
by the poor families and a large part of consumer’s income is spent on these goods. Price effect is
negligible.

i. e. P.E. = S.E.+ve < I. E. –ve

But normally,
P.E. = S.E.+ve > I.E.-ve
Where,
S.E. = Substitution Effect &
I.E. = Income Effect may be –ve, +ve.

Laws of Demand do not hold good in the times of EMERGENCIES such as Flood, Famine, war etc.
This is because of a fear of shortages of goods in future increase the demand. People become
panicky and buy more amount of goods even at higher prices.

Laws of Demand does not hold true during the PROSPERITY PHASE and the DEPRESSION
PHASE. During prosperity, while the prices rise, the demand for the goods also keeps rising,
because the income of the people is also rising, during this phase.
On the other hand, during depression, while the prices fall, the demand of the goods and services also
falls, because during Depression employment and incomes in the Economy are low. Thought he
prices are affordable, people are not in a position to buy goods and services. More over since the
prices are falling, people expect a further fall in prices in future and therefore, postpone their buying.
So the low of demand does not hold true during phases of prosperity and depression phases of the
Business cycle.

Boom

Prosperity
Recession
EXTENSION & CONTRACTION OF DEMAND

It refers to increase in quantity demanded or decrease in quantity demanded with respect to change in
price only.
Other determinants remaining constant, an EXTENSION of demand due to a fall in price, there is an
increase in demand and vice versa. If the price of a commodity increases and demand decreases, it is
known as CONTRACTION.

P2

Price

P1

Q1 Q2

Quantity

INCREASE & DECREASE IN DEMAND

When there is a change in quantity demanded due to factors other than price, it is known as
INCREASE or DECREASE of demand.
In case of Increase in demand, the quantity demanded increases at same price i. e. at the same price
the consumers are prepared to but more and more. Therefore, the demand curve shifts towards the
right.
 D1 D2

Price

Q1 Q3
Quantity

A fall in quantity demanded due to any other factor than price is known as Decrease in demand. i. e.
at the same price less quantity is demanded. In case of decrease in demand the demand curve shifts
to the left.

CLASSIFICATION OF DEMAND

Autonomous & Induced demand

Autonomous Demand is that demand which is not tied up with demand for other goods & services.
It is independent of the use of other goods.
For example : Consumer Goods.

Derived or induced Demand is that demand which is dependent on the demand for some other
product. It is known also known as derived demand.
For example : Producer Goods. He demand for inputs depends on the demand for the finished
goods.

Industry or Company Demand

Demand faced by an individual firm is known as company demand. But demand faced by several
companies producing same commodity (Substance) i. e. industry is known as Industry Demand.
Company demand is a small percentage of the Industry Demand.
Individual / Market Demand

Demand for certain products can be studied not only in its totality but also by breaking it up in two
different segments on the basis of product, use, distribution channel, age, income etc.
Division of demand into different segments gives rise to the concept of Market Segment Demand.
Problems of pricing, distribution etc. fall in the purview of analysis of market segment.
Demand for the entire market in totality is known as Market Demand.
Study of Sales Forecasting, demand forecasting etc. relate to the total market.

Demand for Durable & Non-durable Goods

Durable Goods are those goods which are used over a period of time. They need Present as well as
future demand. They can be consumer or producer goods.
Non-durable goods are those goods which deteriorate in quality with passage of time and become
non-useable after the initial usage. e.g. Fruits etc. There are perishable or non-durable consumer
goods. Goods like coal, electricity etc. are non-durable producer goods.

LONG TERM & SHORT TERM DEMAND

Short term demand refers to existing demand which is dependent on seasonal pattern and cyclical
pattern.
In short term existing buyers will raise the demand of the product, if price comes down.
Short term demand is a temporary demand.

Long term demand does not depend on seasonal or cyclical situation. Long term demand trends are
useful to Business firms for investments, inventories and product planning.

ELASTICITY OF DEMAND

Elasticity of demand refers to the degree of change in quantity demanded or the degree of
responsiveness of the quantity to a change in any one of the determinants of demand, the other
determinants remaining constant.

Elasticity of demand may be of following types :

1) Price Elasticity
2) Income Elasticity
3) Cross Elasticity
4) Promotional Elasticity

Measurement of Price Elasticity

1) Percentage Method

According to the percentage method, there is a proportionate change in quantity demanded to

a proportionate change in price.

^Q
 q
ep = _______ = ^Q x p
^P ^P q
p

ep = ^Q x p
^P q

The value of Price Elasticity varies from 0 to infinity (0-infinity)

i.) Elasticity will be less than 1, if % change in quantity demanded is less than the %
change in price.
ii.) Elasticity will be > 1, if the % change in demand is > than the change in price.
i.e. ep > 1 ; ^ Q > ^ P
q p
iii.) Elasticity will be infinity, when a small change in price will bring about a very large
change in demand.
i.e. ep = Oo

D
D1

D2

Price

D3

Quantity Demanded
2) Total Outlay Method

Total outlay refer to the total expenditure of the product. By knowing the change in total
expenditure due to a change in the price, we can find out the elasticity of the demand. By this
method we don’t get the exact value of elasticity. We can only say whether

ep = 1 or ep > 1 or ep < 1

ep = 1 : Total expenditure on commodity does not change due to change in price.

e. g. P = Rs. 5; Q = 100 units
P Rs. 4; Q 125 units

ep > 1 : If a fall in price leads to an increase in total layout or a rise in price leads
to a decrease in total outlay.
e. g. P = Rs. 5; Q = 100 units 500 units
 P = Rs. 4; Q = 140 units 560 units

ep < 1 : If total outlay declines with a fall in price and rises with a rise in price.
e.g. P = Rs. 5; Q = 100 units 500 units
P Rs. 4; Q 120 units 480 units

Ep>1

Ep=1

Ep<1

3) Arc Method

The point method can for elasticity can be used only for marginal changes. Generally, the
change in price is not very small. In that case, we have to measure elasticity over the
substantial range of the demand curve.

Arc Elasticity (ep) = ^Q

(Q1 + Q2)
2
^P
(P1 + P2)
2

ep = ^ Q x P1 + P2
^P Q1 + Q2

DETERMINANTS OF ELASTICITY OF DEMAND

Elasticity of demand depends on nature of commodity. If the commodity is a necessity, a change in

price will not lead to a change in demand for that product. Similarly, goods with the status symbol
also have an inelastic demand. These goods are high priced goods and only the richer section of
society can afford these goods. Even with a change in price, demand does not change much for
goods which are luxurious in nature.
Availability of substitutes

If substitutes are available in the market, demand for commodities will be relatively elastic. If
substitutes are not available, demand will be inelastic in nature.

Price of product

If the price of a product is very low, demand is inelastic in nature. A rise in price or a fall in price is
not going to change the demand for the product.

Position of the product in the consumer’s budget

If the amount of money spent on the product is a small percentage of the consumer’s income, the
demand of the product will be inelastic in nature.

Postponement of demand

If the demand for a product can be postponed to a future date, demand will be relatively inelastic. If
demand can be postponed, the people will be willing to pay a higher price. Therefore, the demand
will be inelastic in nature.

Number of users

If the commodity can be used for a large number of purposes, its demand will go up with a fall in
price. Therefore, the demand for the product will be elastic in nature, on the other hand single use
goods will have an inelastic demand.

IMPORTANCE OF KNOWLEDGE OF ELASTICITY OF DEMAND

Government decision making

Knowledge of elasticity is of great importance in framing important policies of the government like
tax policies, trade policies, agricultural pricing policy etc.

i.) Tax policy

Government imposes various taxes for raising revenue. While imposing taxes and
fixing tax rates, the knowledge of elasticity becomes very important. While imposing
taxes , the government has to keep in mind the nature of elasticity of demand. For
goods which have an elastic demand, high tax rates can not be fixed. Fixing the taxes
 or increasing would imply a rise in price of the product. If the demand for a product
is elastic, with rise in price, quantity demanded will come down. For goods having
inelastic demand, a rise in tax will fetch more revenue to the government.

ii.) International trade policy

Knowledge of elasticity is of great importance in international trade, if the goods

exported have an inelastic demand. Domestic country is at a favorable position to as
it can quote a high price for its exports. If Imports have an elastic demand, it is
favorable for a domestic country. The success of devaluation also depends on
elasticity of demand. Devaluation refers to lowering value of domestic currency
against a foreign currency. Devaluation makes Exports cheaper and imports costlier.
However, it will be successful only when exports are elastic in nature and imports are
also elastic in nature. Government frames international trade policies according to the
elasticity of demand.

iii.) Agricultural policies

Government fixes up the minimum price of agricultural products in order to prevent a

fall in the price of the agricultural produce during a good harvest. When the harvest is
good and productivity is high, there is a great supply of food grains in the market.
But the demand for food grains and the agricultural products is inelastic in nature.
Therefore, prices of agricultural products fall because of excess of supply. This is a
loss to farming community. Therefore, minimum support prices are fixed by the
government to prevent price of crops from falling to a very low level.
In order to fix the price, knowledge of elasticity becomes very important. Certain
products are necessities and yet there is a shortage of these products in the market. To
prevent rise in price of such necessities the government fixes a price ceiling.
It helps government to identify certain services as public utility services. Certain
services have an inelastic demand because it is a necessity and at the same time there
is a scarcity of such services. In order to prevent growth of mono[poly and
exploitation of the consumer, these services are taken over by the government and
declared as public utility and provided to the public at a highly subsidized rate.

iv.) Business decision-making

Pricing policy is an important part of the business decisions. The prices that are fixed
should cover the cost of production and fetch profits for the producer. The producer
will always try to maximize his profits. A higher price will fetch a higher profit but it
will not always be possible for the producer to charge a higher price. In case of goods
having an elastic demand, a rise in price will lead to a fall in quantity demanded
bringing down the profits of the producer. So, the producer will not be successful in
charging a high price and making more profits.

Knowledge of elasticity and trade unions

When the workers bargain for the higher wages, whether they will be successful or not depends on
the nature of elasticity of the product which they help to produce. Higher wages will increase the
cost of production. The cost of production is reflected in the price of the product. Thus the price of
the product will rise. If the demand of the product is elastic in nature, the quantity demanded will
fall with a rise in price. As a result many workers will loose their jobs. So for products having
elastic demand, the workers demand for higher wages will not be successful.

Demand

In economics, demand for a commodity does not simply mean desire or need or want. In addition to
these, the consumer must be able and willing to pay the price. Whenever desire for anything is
backed by ability and willingness to pay for that thing, it flows out in the form of effective demand.
Thus demand in economics is ‘desire backed by ability and willingness to pay.’ In words of Prof.
J. Harvey, “Demand in Economics is the desire to possess something and the willingness and
ability to pay a certain price in order to possess it.”
A complete statement of demand must include the market-dimension, the price- dimension and the
time- dimension i.e. whose demand, at what price and for what period of time.
A simple statement saying ‘demand for milk is 30 litres,’ is an incomplete statement.
To be a complete and meaningful statement it should read ‘when the price of milk is Rs. 22/- per
litre then family X demands 30 litres of milk per month.’ This makes sense.

Demand Schedules:

A demand schedule is a table which lists the possible prices for a good and service and the associated
quantity demanded. The demand schedule for oranges could look (in part) as follows:

75 cents – 270 oranges a week

70cents – 300 oranges a week
65cents – 320 oranges a week
60 cents - 400 oranges a week

Demand Curves:

A demand curve is simply a demand schedule presented in graphical form. The standard presentation
of a demand curve has price given on the Y-axis and quantity demanded on the X-axis.

The Law of Demand:

The law of demand states that, ceteribus paribus (latin for 'assuming all else is held constant'), the
quantity demanded for a good rises as the price falls. In other words, the quantity demanded and
price are inversely related. Demand curves are drawn as 'downard sloping' due to this inverse
relationship between price and quantity demanded.

Price Elasticity of Demand:

The price elasticity of demand represents how sensitive quantity demanded is to changes in price.

The Price Elasticity of Demand (commonly known as just price elasticity) measures the rate of
response of quantity demanded due to a price change. The formula for the Price Elasticity of
Demand (PEoD) is:
PEoD = (% Change in Quantity Demanded)/

(% Change in Price)

Calculating the Price Elasticity of Demand

You may be asked the question "Given the following data, calculate the price elasticity of demand
when the price changes from $9.00 to $10.00"

First we'll need to find the data we need. We know that the original price is $9 and the new price is
$10, so we have Price(OLD)=$9 and Price(NEW)=$10. If the quantity demanded when the price is
$9 is 150 and the quantity demanded when the price is $10 is 110, Since we're going from $9 to $10,
we have QDemand(OLD)=150 and QDemand(NEW)=110, where "QDemand" is short for "Quantity
Demanded". So we have:

Price(OLD)=9
Price(NEW)=10
QDemand(OLD)=150
QDemand(NEW)=110

To calculate the price elasticity, we need to know what the percentage change in quantity demand is
and what the percentage change in price is. It's best to calculate these one at a time.

Calculating the Percentage Change in Quantity Demanded

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

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

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

[110 - 150] / 150 = (-40/150) = -0.2667

We note that % Change in Quantity Demanded = -0.2667 (We leave this in decimal terms. In
percentage terms this would be -26.67%). Now we need to calculate the percentage change in price.

Calculating the Percentage Change in Price

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

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

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

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

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

Final Step of Calculating the Price Elasticity of Demand

We go back to our formula of:

PEoD = (% Change in Quantity Demanded)/(% Change in Price)

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

PEoD = (-0.2667)/(0.1111) = -2.4005

When we analyze price elasticities we're concerned with their absolute value, so we ignore the
negative value. We conclude that the price elasticity of demand when the price increases from $9 to
$10 is 2.4005.

How Do We Interpret the Price Elasticity of Demand?

A good economist is not just interested in calculating numbers. The number is a means to an end; in
the case of price elasticity of demand it is used to see how sensitive the demand for a good is to a
price change. The higher the price elasticity, the more sensitive consumers are to price changes. A
very high price elasticity suggests that when the price of a good goes up, consumers will buy a great
deal less of it and when the price of that good goes down, consumers will buy a great deal more. A
very low price elasticity implies just the opposite, that changes in price have little influence on
demand.

Often an assignment or a test will ask you a follow up question such as "Is the product price elastic
or inelastic between $9 and $10". To answer that question, you use the following rule of thumb:
 • If PEoD > 1 then Demand is Price Elastic (Demand is sensitive to price changes)
• If PEoD = 1 then Demand is Unit Elastic
• If PEoD < 1 then Demand is Price Inelastic (Demand is not sensitive to price changes)

Recall that we always ignore the negative sign when analyzing price elasticity, so PEoD is always
positive. In the case of our good, we calculated the price elasticity of demand to be 2.4005, so our
good is price elastic and thus demand is very sensitive to price changes.

The Income Elasticity of Demand measures the rate of response of quantity demand due to a raise
(or lowering) in a consumer’s income. The formula for the Income Elasticity of Demand (IEoD) is
given by:

IEoD = (% Change in Quantity Demanded)/(% Change in Income)

Calculating the Income Elasticity of Demand

On an assignment or a test, you might be asked "Given the following data, calculate the income
elasticity of demand when a consumer's income changes from $40,000 to $50,000

The first thing we'll do is find the data we need. We know that the original income is $40,000 and the
new price is $50,000 so we have Income(OLD)=$40,000 and Income(NEW)=$50,000. From the
given data, we have, the quantity demanded when income is $40,000 is 150 and when the price is
$50,000 is 180. Since we're going from $40,000 to $50,000 we have QDemand(OLD)=150 and
QDemand(NEW)=180, where "QDemand" is short for "Quantity Demanded". So you should have
these four figures written down:

Income(OLD)=40,000
Income(NEW)=50,000
QDemand(OLD)=150
QDemand(NEW)=180

To calculate the price elasticity, we need to know what the percentage change in quantity demand is
and what the percentage change in price is. It's best to calculate these one at a time.
Calculating the Percentage Change in Quantity Demanded

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

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

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

[180 - 150] / 150 = (30/150) = 0.2

So we note that % Change in Quantity Demanded = 0.2 (We leave this in decimal terms. In
percentage terms this would be 20%) and we save this figure for later. Now we need to calculate the
percentage change in price.

Calculating the Percentage Change in Income

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

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

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

[50,000 - 40,000] / 40,000 = (10,000/40,000) = 0.25

We have both the percentage change in quantity demand and the percentage change in income, so we
can calculate the income elasticity of demand.

Final Step of Calculating the Income Elasticity of Demand

We go back to our formula of:

IEoD = (% Change in Quantity Demanded)/(% Change in Income)

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

IEoD = (0.20)/(0.25) = 0.8

Unlike price elasticities, we do care about negative values, so do not drop the negative sign if you get
one. Here we have a positive price elasticity, and we conclude that the income elasticity of demand
when income increases from $40,000 to $50,000 is 0.8.

How Do We Interpret the Income Elasticity of Demand?

Income elasticity of demand is used to see how sensitive the demand for a good is to an income
change. The higher the income elasticity, the more sensitive demand for a good is to income
changes. A very high income elasticity suggests that when a consumer's income goes up, consumers
will buy a great deal more of that good. A very low price elasticity implies just the opposite, that
changes in a consumer's income has little influence on demand.

Often an assignment or a test will ask you the follow up question "Is the good a luxury good, a
normal good, or an inferior good between the income range of $40,000 and $50,000?" To answer
that use the following rule of thumb:

• If IEoD > 1 then the good is a Luxury Good and Income Elastic
• If IEoD < 1 and IEOD > 0 then the good is a Normal Good and Income Inelastic
• If IEoD < 0 then the good is an Inferior Good and Negative Income Inelastic

In our case, we calculated the income elasticity of demand to be 0.8 so our good is income inelastic
and a normal good and thus demand is not very sensitive to income changes.

The Cross-Price Elasticity of Demand measures the rate of response of quantity demanded of one
good, due to a price change of another good. If two goods are substitutes, we should expect to see
consumers purchase more of one good when the price of its substitute increases. Similarly if the two
goods are complements, we should see a price rise in one good cause the demand for both goods to
fall
The common formula for the Cross-Price Elasticity of Demand (CPEoD) is given by:

CPEoD = (% Change in Quantity Demand for Good X)/(% Change in Price for Good Y)

Calculating the Cross-Price Elasticity of Demand

You're given the question: "With the following data, calculate the cross-price elasticity of demand
for good X when the price of good Y changes from $9.00 to $10.00." Using the given data, we'll
answer this question.

We know that the original price of Y is $9 and the new price of Y is $10, so we have Price(OLD)=$9
and Price(NEW)=$10. From the given data, we see that the quantity demanded of X when the price
of Y is $9 is 150 and when the price is $10 is 190. Since we're going from $9 to $10, we have
QDemand(OLD)=150 and QDemand(NEW)=190. You should have these four figures written down:

Price(OLD)=9
Price(NEW)=10
QDemand(OLD)=150
QDemand(NEW)=190

To calculate the cross-price elasticity, we need to calculate the percentage change in quantity
demanded and the percentage change in price. We'll calculate these one at a time.

Calculating the Percentage Change in Quantity Demanded of Good X

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

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

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

[190 - 150] / 150 = (40/150) = 0.2667

So we note that % Change in Quantity Demanded = 0.2667 (This in decimal terms. In percentage
terms this would be 26.67%).

Calculating the Percentage Change in Price of Good Y

The formula used to calculate the percentage change in price is:

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

We fill in the values and get:

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

We have our percentage changes, so we can complete the final step of calculating the cross-price
elasticity of demand.

Final Step of Calculating the Cross-Price Elasticity of Demand

We go back to our formula of:

CPEoD = (% Change in Quantity Demanded of Good X)/(% Change in Price of Good Y)

We can now get this value by using the figures we calculated earlier.

CPEoD = (0.2667)/(0.1111) = 2.4005

We conclude that the cross-price elasticity of demand for X when the price of Y increases from $9 to
$10 is 2.4005.

How Do We Interpret the Cross-Price Elasticity of Demand?

The cross-price elasticity of demand is used to see how sensitive the demand for a good is to a price
change of another good. A high positive cross-price elasticity tells us that if the price of one good
goes up, the demand for the other good goes up as well. A negative tells us just the opposite, that an
increase in the price of one good causes a drop in the demand for the other good. A small value
(either negative or positive) tells us that there is little relation between the two goods.

Often an assignment or a test will ask you a follow up question such as "Are the two goods
complements or substitutes?". To answer that question, you use the following rule of thumb:

• If CPEoD > 0 then the two goods are substitutes

• If CPEoD =0 then the two goods are independent (no relationship between the two goods
• If CPEoD < 0 then the two goods are complements

In the case of our good, we calculated the cross-price elasticity of demand to be 2.4005, so our two
goods are substitutes when the price of good Y is between $9 and $10.
Demand Function

As the quantity demanded of commodity X is a function of (depends on) so many variables the
demand function can be written as

Qxd = f (Px, PI, Yd, U, T, ……… etc)

Where,
Px : Price of x
PI : Price of substitute of x
Yd : Disposable income of the consumer
T : Tastes & Fashion (Customer expectation)
U : Population

As this is a complicated functional relationship it would become difficult to develop a simple

theory of demand if we simultaneously consider the effect of changes in all variables on
demand for X. Therefore we assume that all the other variables are held constant and establish
relation between price of X and quantity demanded of X.

Mathematically stated:

Qxd = f (Px)

The Law of Demand

The law of demand establishes the functional relationship between price of X and the quantity
demanded of commodity X, assuming factors other than price of commodity X, remain constant. The
law of demand states “other things remaining the same quantity demanded of a commodity is
inversely related to its price,” i.e. when the price of commodity X rises, the demand for it declines
and when the price of commodity X falls, the demand for it rises. The law of demand can be
explained with the help of a demand schedule and the corresponding demand curve.

The Demand Schedule

The Demand Schedule is a tabular representation expressing the various amounts of commodity X
demanded at different possible prices of X at any given time. Thus a tabular statement showing the
relationship between different alternative prices of commodity X and the different quantities of X
demanded at these prices is technically referred to as demand schedule.

A Demand Schedule

Price per unit Quantity demanded of

of Commodity X (Rs) Commodity X per day
(Units)
5 8
4 12
3 20
2 30
1 50

The demand schedule shows the inverse relationship between price and quantity demanded, i.e., at
lower price more units are demanded and at higher price few units are demanded.

The Demand Curve

On the basis of the demand schedule when we plot points on a graph and join these points we get the
Demand Curve. A demand curve refers to a graphical presentation of the relation between price
and quantity demanded. It is customary to represent price on the Y-axis and the quantity demanded
on the X-axis.
 The demand curve slopes downwards from left to right indicating an inverse or a negative
relationship between price and quantity demanded.

Assumptions underlying the Law of Demand

The law of demand is based on the assumption, viz, “other things remaining the same”.
What then are the ‘other things remaining the same’?

I. The income of the consumer must remain the same.

II. Prices of other commodities must remain the same.
III. The taste of the consumer must remain the same.
IV. The consumer should not anticipate further changes in prices.
V. The size and the composition of population must remain reasonably
stable etc.

Exceptions to the Law of Demand

I. Expectations of further changes in Prices and Speculation :

The law of demand will not hold good when people expect prices to rise still further. In that
case although the prices have risen today consumers will demand more in anticipation of
further increase in price. This type of behaviour can be observed on the Stock Exchange.

II. Giffen’s Paradox: Once it so happened in England that when the price of bread declined the
demand for bread also declined and when price of bread increased the demand for bread also
increased. This was against the law of demand. Sir Robert Giffen said that in case of bread,
 which is an inferior good of a special kind, when price of bread declined, the real income of the
consumer increased and out of this increase in real income, the consumers decided to consume
more of some other commodities, instead of demanding more of bread. This explanation came
to be called the Giffen’s Paradox, which is an exception to the law of demand.
Eg: Irish potato

III. Qualitative changes: The law of demand does not consider qualitative changes in the
commodity. If the price is taken by the consumer as the yardstick of quality of commodity,
mere rise in price of the commodity may raise the demand for it.

IV. Price–illusions: Consumers are, in modern world, governed more by price-illusions e.g. the
consumer strongly believes that ‘higher the price, better the product’, and thus greater is the
demand for it.

V. Display of Standard of Living : The law of demand fails to operate in the case of prestige
articles having snob appeal. The consumer is very often governed by what is called as
demonstration effect. Expensive jewellery, paintings, antique and other similar commodities
are bought not because they are needed but the purchase of such articles will enable the
possessor to display his wealth.

Movement along the Curve V/S Shift of Curves

It is important to distinguish between a movement along a demand curve and a shift of the
entire demand curve.

Extension and Contraction of Demand

If we consider changes in the price of a commodity as the only factor influencing its quantity
demanded, then we experience movements on the same curve. We either have extension or
contraction of demand. When the price of a commodity falls from OP to OP1, the demand for it
goes up from OM to OM1. This is what is called Extension of Demanded.

When the price of the commodity rises from OP1 to OP the demand for it contracts from OM1 to
OM. This is called Contraction of Demand.
Both extension and contraction of demand can be shown by movement along the same demand
curve.

Increase and Decrease in Demand

When factors other than price of the commodity influence the demand for that commodity,
then we have either increase or decrease in demand shown by complete shifts in the demand
curve.

Demand is said to have increased when:

i) At the same price more is demanded.

ii)At higher price same quantity is demanded.
Let us assume, to begin with, that when price is OP, quantity demanded is OM. Now at the same
price, OP more is demanded or at a higher price the same quantity, i.e. OM, is demanded, both these
conditions tend to reveal that the demand curve will shift to the right and we have the demand curve
D2D3. Therefore, when demand increases, the demand curve shifts to the right.

Demand is said to have decreased when:

i) At same price, less quantity is demanded.

ii) At a lower price, the same quantity is demanded.
Both the arrows point to the fact that there is the tendency for the demand curve to shift to the left
and we have the new demand curve D2D3 which is to left of the original. Therefore, when demand
decreases, the demand curve shifts to the left.

Hence extension and contraction of demand are shown by movement along the curve;
whereas increase or decrease in demand will be shown by shifts in the curve.

How is demand forecast determined?

There are two approaches to determine demand forecast – (1) the qualitative approach, (2) the
quantitative approach. The comparison of these two approaches is shown below:

Description Qualitative Approach Quantitative Approach

Applicability Used when situation is vague & Used when situation is stable &
little data exist (e.g., new products historical data exist
and technologies)
(e.g. existing products, current
technology)
Considerations Involves intuition and experience Involves mathematical techniques
Techniques Jury of executive opinion Time series models

Sales force composite Causal models

Delphi method

Consumer market survey

Qualitative Forecasting Methods

Your company may wish to try any of the qualitative forecasting methods below if you do not have
historical data on your products' sales.

Qualitative Method Description

Jury of executive The opinions of a small group of high-level managers are
opinion pooled and together they estimate demand. The group uses
their managerial experience, and in some cases, combines the
results of statistical models.
Sales force composite Each salesperson (for example for a territorial coverage) is
asked to project their sales. Since the salesperson is the one
closest to the marketplace, he has the capacity to know what
the customer wants. These projections are then combined at
the municipal, provincial and regional levels.
Delphi method A panel of experts is identified where an expert could be a
decision maker, an ordinary employee, or an industry expert.
Each of them will be asked individually for their estimate of
the demand. An iterative process is conducted until the
experts have reached a consensus.
Consumer market The customers are asked about their purchasing plans and
survey their projected buying behavior. A large number of
respondents is needed here to be able to generalize certain
results.

Quantitative Forecasting Methods

There are two forecasting models here – (1) the time series model and (2) the causal model. A time
series is a s et of evenly spaced numerical data and is o btained by observing responses at regular
time periods. In the time series model , the forecast is based only on past values and assumes that
factors that influence the past, the present and the future sales of your products will continue.

On the other hand, t he causal model uses a mathematical technique known as the regression
analysis that relates a dependent variable (for example, demand) to an independent variable (for
example, price, advertisement, etc.) in the form of a linear equation. The time series forecasting
methods are described below:
 Description

Time Series
Forecasting
Method
Naïve Approach Assumes that demand in the next period is the same as demand in
most recent period; demand pattern may not always be that stable

For example:

If July sales were 50, then Augusts sales will also be 50

Description

Time Series
Forecasting
Method
Moving Averages MA is a series of arithmetic means and is used if little or no trend is
(MA) present in the data; provides an overall impression of data over time

A simple moving average uses average demand for a fixed sequence

of periods and is good for stable demand with no pronounced
behavioral patterns.

Equation:

F 4 = [D 1 + D2 + D3] / 4

F – forecast, D – Demand, No. – Period

(see illustrative example – simple moving average)

A weighted moving average adjusts the moving average method to

reflect fluctuations more closely by assigning weights to the most
recent data, meaning, that the older data is usually less important.
The weights are based on intuition and lie between 0 and 1 for a total
of 1.0

Equation:

WMA 4 = (W) (D3) + (W) (D2) + (W) (D1)

WMA – Weighted moving average, W – Weight, D – Demand, No. –

Period
 (see illustrative example – weighted moving average)
Exponential The exponential smoothing is an averaging method that reacts more
Smoothing strongly to recent changes in demand by assigning a smoothing
constant to the most recent data more strongly; useful if recent
changes in data are the results of actual change (e.g., seasonal
pattern) instead of just random fluctuations

F t + 1 = a D t + (1 - a ) F t

Where

F t + 1 = the forecast for the next period

D t = actual demand in the present period

F t = the previously determined forecast for the present period

• = a weighting factor referred to as the smoothing constant

(see illustrative example – exponential smoothing)

Time Series The time series decomposition adjusts the seasonality by
Decomposition multiplying the normal forecast by a seasonal factor

(see illustrative example – time series decomposition)

SUPPLY

• Supply
o Refers to the various quantities offered for sale at various prices
• Quantity Supplied
o Refers to a specific quantity offered for sale at a specific price
• Supply Function
o Indicates the relationship between the quantity of the commodity supplied and the unit
price of the commodity
• Law of Supply
o The quantity of a good supplied is directly related to the good’s price, other things
constant.

Example of a Supply Curve

p
 p = f(q)

(0, b)

0 q

• The slope of a supply curve is usually positive, as price increases, quantity supplied increases
and vice-versa.
• The y-intercept of the supply curve (0, b) represents the lowest price at which an item will be
supplied.

The Law of Supply

 Supply is the quantity of a good or service that a producer is willing and able to supply onto
the market at a given price in a given time period
 The basic law of supply is that as the market price of a commodity rises, so producers
expand their supply onto the market
 A supply curve shows a relationship between price and quantity a firm is willing and able to
sell

Causes of shifts in market supply

 Changes in production costs

 Wages,raw materials and components, energy, rents, interest rates
 Government taxes and subsidies
 Changes in technology – ICT can reduce long term costs but are expensive in SR
 Climatic conditions (important for agricultural supply)
 Changes in the number of producers in the market
 Changes in the objectives of suppliers in the market
 Changes in the prices of substitutes in production
 The profitability of alternative products (substitutes) or those with joint supply (crude oil =
petrol and paraffin and diesel)
 Expectation of future price changes
Example: What would cause the supply of butter to rise?
 Reduction in costs of producing – e.g. nitrogen fertiliser = more used by farmers = better
grass = more milk
 Better technology in producing butter
 More govt subsidies to farmers
 Increase in profitability of skimmed milk ….. Because butter and cream products are jointly
produced with skimmed milk.
 Weather conditions favourable for favourable grass yield

Determinants of supply
 Price of the good itself
 Number of sellers
 Technology
 Resource Prices
 Taxes and subsidies
 Expectations of producers
 Prices of other goods the firm could produce

Supply function:
 Qs = f( Px, Pn, Ns, Cost, Tech., W, G)

Distinction between changes in quantity supplied and changes in supply

 Changes in quantity supplied
 A movement along the supply curve due to the changes in the price of the good itself.
 Changes in supply
 The shifts of the supply curve to the left or right due to the changes in the non-price
determinants of supply

Price Elasticity of Supply

 Measure “The responsiveness of quantity supplied to a change in price.“
 Elasticity of supply can be determined by comparing the % change in quantity supplied with
the % change in the price of the product.

Types of Price Elasticity of Supply

 Elastic Supply ( fairly elastic)
 % change in quantity supplied is greater than % change in price.
 Es =% Δ QS > % Δ P
 . Inelastic Supply (fairly inelastic)
 % change in quantity supplied is less than % change in price.
 Es =% Δ QS > % Δ P
 Unitary Elastic
 % change in quantity supplied is equal to the % change in price
Es =% Δ QS > % Δ P
 Perfectly Inelastic
% change in quantity supplied is zero despite the change in the price
Perfectly Elastic
% change in quantity supplied is infinitely large compared to the % change in price

Factors Influencing Elasticity of Supply

1. TIME
In the short run, supply would be inelastic, it is not possible to increase supply immediately
in response to change in price. However, in the long run, supply would be more responsive to price
changes, i.e. is more elastic.
In the long run sellers or producers can fully adjust their supply to the change in prices.
2. NATURE OF THE GOOD
If it takes too long to produce a product, supply is fairly inelastic. Otherwise supply will be
elastic. For example, the supply of agricultural product (primary products) is fairly inelastic whereas
the supply of manufactured goods (secondary products) is fairly elastic

3. COST AND FEASIBILITY OF STORAGE

 If the change in supply requires only a small change in production costs, most likely supply
will be elastic. However if the change in supply involves a major change in costs supply tends to be
inelastic.
Goods that are too costly to be stored will have a low elasticity of supply.
4. SUBSTITUTABILITY OF FACTORS OR INPUTS USED
If land, labor and capital can produce one commodity and these factors can be readily
switched to produce another good, then supply of the factors is elastic.
But if the production of its output require very specialized inputs, supply tends to be more
elastic.
5. PERISHABILITY
If the product is a easily perishable, especially agricultural product, then the supply would be
inelastic. Such products would not be sensitive to price changes, for example, vegetables. Hence, an
increase in price will not bring about a distinctive change or rise in the quantity supplied.