9/20/2011

Demand and Business Forecasting

PGDM (PT) 2012-15
P C Padhan
pcpadhan@xlri.ac.in

Demand Analysis:
Theory, Estimation and Forecasting

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Types of Goods
Based on Income

Normal Goods: An increase in income causes an increase in demand. Ex. Rice, Toothpaste, soap, sampoo.

Luxury Goods: A luxury good means an increase in income causes a bigger % increase in demand.
Ex. high Definition TVs would be luxury. (Note: a luxury good is also a normal good, but a normal good isnt
necessarily a luxury good)

Inferior Goods: An inferior good means an increase in income causes a fall in demand. Ex. Tesco value bread.
When your income rises you buy less Tesco value bread and more high quality organic bread.
Based on Related Goods
Complementary Goods: Goods which are used together, e.g. TV and DVD player.

Substitute Goods:
Goods which are alternatives, e.g. Pepsi and coca-cola. .

Giffen Goods: A rare type of good, where an increase in price causes an increase in demand. Ex., if the price of
wheat rises, a poor peasant may not be able to afford meat any more, so has to buy more wheat.

Veblen Goods:. A good where an increase in price encourages people to buy more of it. This is because they
think more expensive goods are better. Ex. Rollys Royce, D&G

Snob Goods: A goods where a decrease in demand occurs due to more purchase of the same good. Ex.
Piccaso Painting, Sports Car

Based on Market Failure

Public Goods: goods with characteristics of non-rivalry and non-excludability, e.g. national defence.

Merit Goods: Goods which people may underestimate benefits of. it Also often has positive externalities, e.g.
education.

Demerit Goods: Goods where people may underestimate costs of consuming it. Often has negative
externalities, e.g. smoking, drugs.

Private Goods: Goods which do have rivalry and excludability. The opposite of a public good, Ex. house

Free Goods: A good with no opportunity cost, e.g. breathing air.

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Demand Analysis

An important contributor to firm risk

arises from sudden shifts in demand for
the product or service.

Demand analysis serves two managerial

objectives:
(1) it provides the insights necessary for
effective management of demand, and
(2) it aids in forecasting sales and
revenues.
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Demand Analysis
Market System

Firms sell goods/services to buyers

Consumers (individuals) : utility
Firms : make profits
Buyers / Consumer's buy the goods and
services by paying a price of it.
Maximum price the buyer will pay for the
goods
Lower prices is always preferred by consumer
So what do you mean by demand?

Demand for a Commodity: Meaning

Manufacturer

Demand is the willingness and capacity

of a customer to purchase the product
(s) or service(s) at each possible price
during a given period of time.
Price is a tool by which the market
coordinates individual desires.

Customer

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Consumer

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Demand for a Commodity: Meaning

The Quantity demand is the amount of a
product that people are willing and able to
purchase at one specific price.
The Law of demand Inverse relationship
between Price of a good and Quantity
Demanded (Q) of it, assuming other thing held
constant (ceteris paribus)
A rational consumer maximizes satisfaction by
reorganizing consumption until the marginal utility in
each good per price(rupees) is equal:

Two Reasons for Law of Demand

1. Income Effect
2. Substitution Effect

Components of Demand: The Income

Effect

Income Effect: The change in quantity demanded that occurs

when the purchasing power of income is altered as a result of price
changes.

Ex: When the price of a commodity falls , a consumer can purchase

more of a commodity with given money income( i.e his /her real
income increases)

A change in the real value of income:

will have a direct effect on quantity demanded if a good is
normal.
will have an inverse effect on quantity demanded if a good is
inferior.
( Hotdogs. Bread etc.)

The income effect is consistent with the law of demand only if a

good is normal.

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Components of Demand: The Substitution

Effect

Substitution Effect: When the price of a good falls, the

quantity demanded of the commodity by the individual
increases because the individual substitutes in consumption
of commodity X for other commodities.

Assuming that real income is constant:

If the relative price of a good rises, then consumers will

try to substitute away from the good. Less will be
purchased. ( Ex. Coffee, Tea)

If the relative price of a good falls, then consumers will try

to substitute away from other goods. More will be
purchased.
The substitution effect is consistent with the law of
demand.

Law of Demand(Market): Where it Fails?

Bandwagon Effect: Extent to which demand for a consumer goods

increased owing to the fact that others are consuming more of the same
commodity. The tendency to follow the actions or beliefs of others.
Ex. Ronaldo hair style during football world cup

Snob Effect: Extent to which demand for a consumer goods decreased

owing to the fact that others are consuming more of the same commodity.
Opposite to Bandwagon effect.
EX. rare works of art, designer clothing, and sports cars.

Veblen Effect( Conspicuous consumptions). Extent to which demand for

a consumers goods is increased because it bears a higher price than a
lower price. Higher the price, higher the demand. Veblen effect is a
function of price.
Ex. high-status goods, such as high-end wines, designer handbags (
D&G, Gucci) and luxury cars ( Rolls Royce, BMW).

Giffen Goods Effects: people paradoxically consume more of it as the

price rises ( not the same as Veblen good). Here income effect dominates
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and substitution effect doesnt work.
Ex. Inferior quality staple foods whose demand is driven by poverty.

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How to Determine the Demand Function?

Based on the definition of demand:
a. Willingness to pay is determined by
Buyers tastes or needs
Types of goods/products:
Necessity or luxurious
Inferior or superior
Durable or perishable
Conspicuous or griffin etc.
Prices of the product
Substitutes goods
Complementary goods
Other factors
b. Capacity to pay is determined by
Income and wealth

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Individual Consumers Demand

Function
An equation representing the demand curve

QdX = f(PX, I, PY, T.)

QdX =quantity demanded of commodity X by an individual per time
period
PX =price per unit of commodity X
I =consumers income
PY =Price of related (substitute or complementary) commodity
T =tastes of the consumer
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Individual Demand Table and Demand

Curve
The demand curve is the graphic representation of the law of demand which slopes
down ward to the right

Price per DVD rentals

cassette demanded per
week
A
B
C
D
E

$0.50
1.00
2.00
3.00
4.00

9
8
6
4
2

Price per DVDs (in dollars)

A Demand Table

A Demand Curve

$6.00
5.00
4.00
3.50
3.00

2.00
1.00
.50
0

G
Demand
for DVDs

C
F

B
A

1 2 3 4 5 6 7 8 9 10111213
Quantity of DVDs demanded (per week)

The

demand table assumes other things remaining the same

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Market Demand Function

QDX = f(PX, N, I, PY, T, D, Ms..)
QDx=quantity demanded of commodity X
Px=price per unit of commodity X
N=number of consumers on the market
I=consumer income
PY=price of related (substitute or complementary)
commodity
T=consumer tastes
D= Demographic distribution
Ms= Market Saturation

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How to Derive Market Demand Curves

A market demand curve is the horizontal sum of all

individual demand curves.

This is determined by adding the individual demand

curves of all individual consumers each price.

Arrays individual buyers in order of willingness to pay

Identical goods? Product differentiation?

Sellers estimate total market demand for their

product which becomes smooth and downward
sloping curve.
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From Individual Demand to a Market

Demand Curve
Market Demand curve is the horizontal summation of individual demand curve

A $.0.50
B
1.00
C
1.50
D
2.00
E
2.50
F
3.00
G
3.50
H
4.00

9
8
7
6
5
4
3
2

6
5
4
3
2
1
0
0

(2)
Cathys
demand

(3)
Market
demand

1
1
0
0
0
0
0
0

16
14
11
9
7
5
3
2

$4.00
Price per cassette (in dollars)

(1)
(2)
(3)
Price per Alices Bruces
cassette demand demand

3.50

3.00

2.50

2.00

1.50

1.00
0.50
0

A
Cathy

Bruce Alice Market demand

8 10 12 14 16

Quantity of cassettes demanded per week

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Price (per unit)

A Sample Demand Curve

PA

D
0

QA

Quantity demanded (per unit of time)

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Assumption of Law of Demand: Other

Things Constant

Other things constant places a limitation on the

application of the law of demand.

All other factors that affect quantity demanded are

assumed to remain constant, whether they actually
remain constant or not.

These factors may include changing tastes, prices of

other goods, income, weather etc.

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Changes in Demand Versus Changes in Quantity

Demand
A. Changes in Quantity Demanded

Price (per unit)

A movement along a demand curve is the graphical representation of the effect of a change in price on the
quantity demanded. In other words it refers to Change in Quantity Demanded - movement along the same
demand curve in response to a price change.

$2

B
Change in quantity demanded
(a movement along the curve)
A

$1

D1
0

100
200
Quantity demanded (per unit of time)
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B. Change/Shift in Demand

Price (per unit)

Change in Demand - shift in entire

demand curve in response to a
change in a determinant of demand
(a ceteris paribus variable)

Change in demand
(a shift of the curve)

$2

$1

A
D0
D1

250
200
100
Quantity demanded (per unit of time)
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Determinants and Shift Factors of Demand

Societys
Income
Taxes or subsidies
to consumers

Prices of related goods

Tastes

Number of buyers

Expectations

Shift factors of demand are factors that cause shifts in the demand curve:21

The Income

The demand for any goods and services depends upon income.
The higher the income the higher the quantity demanded.

A change in the real value of income

will have a direct effect on quantity demanded if a good is
normal. So an increase in income will increase demand for
normal goods. Ex. Rice, wheat, soap, toothpaste etc.

will have an inverse effect on quantity demanded if a good is

inferior. So an increase in income will decrease demand for
inferior goods. Ex. Corn, bread.

The income effect is consistent with the law of demand only if a

goods are normal.
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Prices of Related Goods: The Substitution:

Assuming that real income is constant:

If the relative price of a good rises, then consumers will try

to substitute away from the good. Less will be purchased.

If the relative price of a good falls, then consumers will try

to substitute away from other goods. More will be purchased.

The substitution effect is consistent with the law of demand.

When the price of a substitute good falls, demand falls for the
good whose price has not changed. Ex. BMW and Mercedes
Benz

When the price of a complement good falls, demand rises for

the good whose price has not changed. Ex. Car and Petrol
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Tastes and Expectations and Number of

buyers
a) A change in taste will change demand with no change in price.
b) If you expect your income to rise, you may consume more now.
If you expect prices to fall in the future, you may put off
purchases today.
c) Number of Buyers: Higher the number of buyers, greater the
demand for the product

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Shift Factors of Demand: Math Notations

QdX = f(PX, I, PY, T)

1. Price(Px): QdX/PX < 0

2. Income(I): QdX/I > 0 if a good is normal, Ex. Rice, wheat, tooth paste etc.
QdX/I < 0 if a good is inferior, Ex. Corn, bread.
An increase in income will increase demand for normal goods.
An increase in income will decrease demand for inferior goods.
3. Price of Related Goods(Py):
QdX/PY > 0 if X and Y are substitutes Ex. BMW and Mercedes Benz
QdX/PY < 0 if X and Y are complements, Ex. Car and Petrol
When the price of a substitute good falls, demand falls for the good whose price has
not changed.
When the price of a complement good falls, demand rises for the good whose price
has not changed.
4. Taste(T): QdX/taste > 0 for Good taste/choice
QdX/taste < 0 for Bad taste /choice
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Factors Affecting Demand for a commodity

(Internal vs External Factors)

Product life-cycle
management

o
o
o

Planned price changes

Changes in the sales force

Resource constraints

Marketing and sales

promotion

o
o
o
o
o

Advertising

Product substitution

o
o
o
o
o
o
o
o

Income
Prices of Substitutes
Prices of Complements
Expectations,
Changing customer Tastes and
preferences
Random fluctuation
Seasonality
Competition
New customers
Plans of major customers
Government policies
Regulatory concerns
Economic conditions/cycles
Environmental issues
Weather conditions
Global and local trends

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The Elasticity of Demand

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The Concept of Elasticity

Elasticity is a measure of the degree of responsiveness

of one variable to another.

The greater the elasticity, the greater the

responsiveness.

Elasticity = % change in quantity demand

%change in independent variable

Types:
Price Elasticity of Demand
Income Elasticity of Demand
Cross Elasticity of Demand
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Defining Elasticities
1) Demand is Inelastic if E<1
or When price elasticity is
between zero and -1 we
say demand is inelastic.
Perfectly elastic E=

2) Demand is Elastic if E>1

or When price elasticity is
between -1 and - infinity, we
say demand is elastic.
3) Unitary Elastic if E=1
or When price elasticity is -1, we
say demand is unit elastic.

Perfectly inelastic E=0

4) Perfectly Elastic E=
5) Perfectly inelastic E=0

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1. Price Elasticity and Its sign

The price elasticity of demand is

ED =

Percentage change in quantity demanded

Percentage change in price

Economists use the average of the end points to calculate the

percentage change.
Q1
Q
0r
P 2 P1
P

Q
% Q
E

% P

1
2
1
2

(Q

P 2 P1
( P1 P 2 )

According to the law of demand, whenever the price rises, the quantity
demanded falls. Thus the price elasticity of demand is always
negative.

Because it is always negative, economists usually state the value

without the sign.
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1. Price Elasticity of Demand: Calculation

a. Point Elasticity: Calculating Elasticity at a Point

$10
9
8
7
6
5
4
3
2
1

To calculate elasticity at a point determine

a range around that point and calculate
the arc elasticity.
Q 2 Q1
E

Q
% Q

P 2 P1
% P
P

Slopeofthe

line

A
B
EatA

20 24 28
Quantity

40

E at

Q
P

2024 4 16 .33
*
.66
54 24 24 .5

28 24
4
4
4

3
1

. 66
24
24
6
31
4
4

1. Price Elasticity of Demand: Calculations

b. Arc Elasticity : Calculating Elasticity of Demand Between Two Points

Q2 Q1

$26
24
22
20
18
16

B
midpoint

Elasticity of demand
1
%Q
2 (Q 1 Q 2 )
between A and B: E % P P2 P1
1
2

C
A

(P1 P2 )

10 14
4
(14 10) 12 .33
ED

1.27
26 20
6
.26
1
23
2 (26 20)
1
2

Demand

14
0

10
12
14
Quantity of software (in hundred thousands)

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1.Price Elasticity of Demand: Shapes of curves

Inelastic
demand

Unitary Elastic
demand
Elastic
demand

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1.Price Elasticity of Demand: Shapes of curves

34

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1. Price Elasticity of Demand: Examples

Price elasticity

Types of goods

Examples

Relatively Elastic
Demand Ed>1

Luxurious Goods
Close Substitutes Gods

Heinz soup, shell petrol, Tesco bread,

Newspaper, Chocolates, Sports car,
different types of meat

Relatively Inelastic
Demand: Ed<1

Necessary Goods
Few or No Substitutes Goods

Petrol, Salt, Goods produced by

monopoly, Tap water, Diamonds, Peak
rail tickets, Cigaratees, Apple iphones,
ipads, foods and fuels products, etc.

Unitary Elastic
Demand: Ed=1

Most luxurious items

Refrigator, AC, Cars, HDTV, icecream,

Perfectly Elastic
Demand: E=

Specialized goods

Rarely available in real life. Ex. One

farmers wheat, Buying of foreign
exchange,

Perfectly Inelastic
Demand:E=0

Most Necessity goods ( life

savings goods)

Insulin, medicines etc.

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1. Price Elasticity of Demand: Determinants

The availability and the closeness of substitutes

More substitutes, more elastic
Less substitutes, less elastic

The more durable is the product

Durable goods are more elastic than non-durables

The percentage of the budget

Larger proportion of the budget, more elastic

The longer the time period permitted

More time, generally, more elastic
Ex. consider an examples of business travel versus vacation travel for
all three above.
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2. Income Elasticity of Demand

a. Point Definition
Or

EY = %Q/ % Y= (Q/Y)( Y/Q)

Linear Function
b. Arc Definition
EY = Q / [(Q1 + Q2)/2]
Y / [(Y1 + Y2)/2]

Normal Goods EY>0,

Inferior Goods EY<0

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2. Income Elasticity of Demand

a. Point Income Elasticity

Eincome
P0

(26 - 20)
1
26
2 (26 20)

1 .3
20
20

P0
Shift due to
20% rise in
D0 D1 income
20 26

Quantity

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2. Income Elasticity of Demand Curve Shapes

EY>0

(D)
Qty
Dd

EY=0

EY<0

EY>1

(E)
Qty
Dd

(F)

EY<1

Qty
Dd

Income

Income

EY=1
D

Income
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2. Income Elasticity of Demand: Examples

Income elasticity

Types of goods

Examples

Negative income elasticity Inferior goods

of demand: Ey<0

Inferior bread, noodles, public Transport

system, cigarette, margarine etc.

Zero income elasticity of Necessary Goods

demand: Ey=0
Sticky Goods
( An Income-neutral
goods)

A rise in 5% increase in income rich

country unchanged the demand for
toothpaste.
Demand for necessaries like kerosene
oil, salt etc.

Positive Income Elasticity

of demand: Ey>0
Low income elasticity of
demand: Ey<1
High income elasticity of
demand: Ey>1
Unitary income elasticity
of demand: Ey=1

Normal goods
A Normal (
Necessity) Goods
A Normal
(Luxurious) Goods

Drinking Water ex. Bisleri water,

gasoline, milk, egg. Fresh vegetable etc.
HD TV, Cars. Automobiles, books,
restaurants meals
Electronic Items, Toys, mobile phones,
certain food items, etc.
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All luxurious goods are normal goods but all normal goods are not luxurious goods.

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2. Income Elasticity of Demand: Examples

Consider these examples:

1.
Expenditures on new automobiles
2.
Expenditures on new Chevrolets
3.
Expenditures on 1996 Chevy Cavaliers with 150,000 miles
Which of the above is likely to have the largest income elasticity?
Which of the above might have a negative income elasticity?
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3. Cross-Price Elasticity of Demand

Cross-price elasticity of demand the percentage change in quantity

demand divided by the percentage change in the price of another good.

a. Point Definition

E XY

Linear Function

b. Arc Definition
Substitutes Goods : EXY>0
Complements Goods: EXY<0
Not related Goods

QX / QX
Q X PY

PY / PY
PY Q X

X Y

E XY

PY
Q X

Q X 2 Q X 1 PY 2 PY 1

PY 2 PY 1 Q X 2 Q X 1

Ex. Butter & Margarine

Ex. DVD machines and the rental price of
DVDs at Blockbuster

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: EXY=0

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3. Cross-Price Elasticity of Demand: Calculations

Ecross

D1
D0

(108 - 104)
(108 104 ) .038

.12
.33
.33

P0

1
2

P0
Shift due to 33% rise
in price of pork

104
108
Quantity of Beef

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3. Cross Price Elasticity of Demand (Exy) Curve Shape

(A) Two goods that
complement each other
show a negative cross
elasticity of demand: as
the price of good Y rises,
the demand for good X
falls

(A)
QX

EXY<0

(B)Two goods that are

substitutes
have
a
positive cross elasticity
of demand: as the price
of good Y rises, the
demand for good X
rises

(B)
QX

(C)

EXY>0

EXY=0

QX

PY

(C) Two goods that are

independent have a
zero cross elasticity of
demand: as the price of
good Y rises, the
demand for good X
stays constant

PY

PY
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Combined Effect of Demand Elasticities

Most managers find that prices and income

change every year. The combined effect of
several changes are additive.
%Q = ED(% P) + EY(% Y) + EX(% PR)

where P is price, Y is income, and PR is the price of a related good.

If you knew the price, income, and cross

price elasticities, then you can forecast the
percentage changes in quantity.
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Total Revenue, Marginal Revenue

and
Elasticity of Demand

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Elasticity, Total Revenue(TR), Marginal

Revenue (MR) and Demand
The elasticity of demand tells suppliers how their total revenue will
change if their price changes.
a. Total Revenue equals total quantity sold multiplied by price of good.
TR=PQ
b. Marginal Revenue equals the change in total revenue due to change
in output
MR=TR/Q or TR/ Q

If ED is elastic (ED > 1), a rise in price lowers total revenue.

If ED is inelastic (ED < 1), a rise in price increases total revenue.
P & TR move in opposite directions.
If ED is unit elastic (ED = 1), a rise in price leaves total revenue
unchanged.
P & TR move in the same direction.
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Elasticity and Total Revenue

Unit Elastic Demand: E = 1
$10

TR constant
TRE= $4x6=$24
TRF= $6x4=$24
Gained revenue

Price

8
F

4
A

2
0

Lost
revenue

B
3

Quantity
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Elasticity and Total Revenue

Inelastic Demand: E < 1

$10

TR rises if price increases

Price

TRG = $1 x 9 = $9
TRH = $2 x 8 = $16

6
Gained
revenue

Lost
revenue
H

A
0

B
3

Quantity
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Elasticity and Total Revenue

Elastic Demand: E > 1
$10

Price

8
6
4

TR falls if price increases.

K
J

A B

Gained
revenue
Lost
revenue

2
0

TRJ = $8 x 2 = $16
TRK = $9 x 1 = $9

Quantity
50

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Total Revenue Along a Demand Curve:

Example:

Let the demand function is Q= 600-100P

=> P=(600-Q)/100
Since TR=PQ
=>TR=600Q-Q2/100
So, MR= 6-Q/50
With elastic demand a rise in
price lowers total revenue.
With inelastic demand a rise in
price increases total revenue.

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With elastic demand a rise in price lowers total revenue.

With inelastic demand a rise in price increases total revenue.

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Thanks !!!!!!!

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