Basic demand and supply analysis—some important terms

• Market—an institutional arrangement under which buyers and sellers exchange some good at a mutually agreeable price

• Market may or may not be a specific place or location where buyers and sellers actually face to face

• Purpose is to transact biz

Meaning of demand• General meaning—desire for something• Economics—effective demand—amount buyers are

willing to purchase at a given price at a given point of time

• Demand is desire backed up by money• Demand=desire + ability to pay (purchasing power) + will

to spend• Demand is always related to price and time—relative

term, not an absolute concept, economists define apples per household per week—ref to price and time

• Demand viewed ex-ante or ex-post—intended demand or what is actually purchased

• Individual demand and market demand

Determinants of demand

• Price of the commodity

• Income

• Tastes, habits and preferences

• Relative prices of other goods—substitutes and complementary goods

• Consumers’ expectations of future changes in prices

• Advt effect

Factors influencing market demand

• Price of the product• Distribution of income and wealth in community• Community’s common habits and scale of

preferences• General standards of living and spending habits

of people• No. of buyers in mkt and population growth• Age structure of population

Factors influencing market demand

• Future expectations

• Level of taxation and tax structure

• Inventions and innovations

• Fashions

• Climate or weather conditions

• Customs and rituals

• Advt and sales propoganda

Demand function

• Own price P• Price of substitute and complementary goods Ps

or Pc• Level of disposable income with buyers Yd• Change in buyers’ tastes and preferences T• Advt effect A• Change in population N• Dx=f{Px, Ps,Pc, Yd, T, A, N, u}• U= Unspecified or unknown determinant

Demand curve

• A graphical representation of a demand schedule

• A negative slope reflecting the inverse relationship between price and qty demanded

• A particular point on the demand curve depicts specifically a single price-qty relation

• Linear—straight line or non-linear--curvature

Law of demand

• Ceteris paribus, higher the price of a commodity, smaller is the qty demanded and vice versa

• Downward sloping curve

Assumptions underlying law of demand

• No change in consumers’ income• No change in customers’ preference• No change in fashion • No change in size and age composition of

population• No change in range of goods avbl to consumers• No change in distribution of wealth of community• No change in govt policy• No change in weather conditions• No expectation of future price changes or

shortages

Upward sloping demand curve

• Is this possible

• Yes with a few exceptional cases

• Giffen goods—price falls less qty is purchased because of people’s increasing preference to a superior commodity

• Articles of snob appeal—veblen effect—expensive or prestige goods

• Speculation—expectations of prices to rise further purchase more

• Consumers’ psychological bias or illusion—stock clearance sale—inferior goods

Change in qty demanded

• Extension and contraction of demand

• Increase or decrease in demand

• Increase signifies more will be demanded at a given price

Nature of demand

• Derived demand and autonomous demand• Demand for producers’ goods and

consumers’ goods• Durable and non-durable goods—durable

goods meet both current and future demand, storability, style, convenience, income

• Non-durables only current demand—perishable and non-perishable

• Industry demand and firm demand

• Joint or complementary demand and composite demand

Factors influencing elasticity of dd

• Nature of commodity• Availability of substitutes• Number of uses• Consumer’s income• Proportion of expenditure—items constituting

small amt of exp in consumer’s budget has inelastic dd

• Durability of commodity• Influence of habit and custom

• Complementary goods

• Time

• Recurrence of dd

Elasticity of demand

• Factors like price, income, etc indicate only the directional impact of changes

• Magnitude of impact of these factors• % change in qty demanded caused by a

1% change in demand determinant under consideration

• Larger the absolute value of elasticity, more responsive is qty demanded

• 5 kinds of elasticity

Kinds of elasticity measurements

• Point elasticity—found for each demand determinant

• Arc elasticity—measure of average elasticity

Price elasticity of demand

• Price falls qty demanded increases

• Price and qty have offsetting effects

• Proportionate change in qty demanded of pdt X/ proportionate change in price of pdt X

• Higher the elasticity of demand, greater will be the % change in qty demanded

Types of price elasticity

• Perfectly elastic dd: slight rise in price consumer stops buying it, rarely encountered in practice, dd curve is horizontal, e=infinity

• Perfectly inelastic dd: no response to changes in prices, dd remains the same, e=0

• Relatively elastic dd: change in qty demanded is greater than price, gradually sloping curve, a flatter curve e>1

• Relatively inelastic dd: proportion of change in qty demanded is less than that of price, e<1, e lies between 0 and 1

• Unitary elastic demand: proportion of change in qty demanded is equal to that of price, e=1

Determinants of price elasticity

• No. and closeness of substitutes—large no of substitutes, dd highly elastic

• Share of commodity in buyers’ budget—small amt spent dd inelastic

• Nature of commodity—necessities inelastic, luxuries elastic

• No. of uses a commodity can be put to—larger the uses, greater elasticity

• Habit forming characteristics—dd inelastic• Time period—dd elastic in long run and inelastic

in short run

Income elasticity

• % change in qty demanded of pdt X / % change in income of consumer

• Income elasticity positive for all normal goods

• Inferior goods—negative

• Personal disposable income

• Current income—transitory income and discretionary income

• Increase in transitory income leads to increased dd for consumer durables

Types of income elasticity

• High income elasticity ey>1—jewellery, luxuries

• Unitary income elasticity ey=1• Low income elasticity ey<1—salt • Zero income elasticity ey=0• Negative income elasticity ey<0• Generally income elasticity ey positive,

commodity normal type, income elasticity ey negative commodity inferior type

Use of concept of income elasticity of demand

• Biz planning for firm’s growth—goods with high income elasticity means greater sales volatility

• Forecasting demand

• Formulating marketing strategy—fast food items in affluent urban india

Cross elasticity

• Ratio of change in dd for one good to % change in price of some other related good

• Substitutes or complementary goods

• Exy is positive if goods are substitutes

• Exy is negative if goods are complements

Advertising or promotional elasticity

• Response of qty dd to change in expenditure on advt and other sales promotion activities

• Cosmetics

• Generally advt and corresponding sales are plotted, we get an S shaped curve

Factors influencing advt elasticity

• Stage of product mkt—new/old pdt, established mkt/growing mkt

• Effect of advt in terms of time—longer time for durable items and after existing articles are used up

• Influence of advt by rivals—coke and pepsi

Demand elasticity of substitution

• Degree to which one good may be substituted for another as a consequence of a given change in their price ratio, if consumers enjoy the same satisfaction

Types of substitution elasticity

• Infinite substitution elasticity—perfect substitutes, elasticity infinite

• Zero substitution elasticity—no substitution, elasticity zero

• High and low elasticity—neither high or low, shoes and sandals

Significance of concept of dd elasticity

• To know the level of output and price—price and cross elasticity—monopolist knowledge of dd for his product helpful in practicing price discrimination. Inelastic dd—high prices charged

• Fixation of rewards for factors of production—dd for workers inelastic efforts of trade unions successful to raise wages, otherwise not

• Govt policies—statutory price control—to stabilize prices

• --large stocks and falling prices govt follows policy of output control

• --public utilities• --taxation policy—govt follows optimal tax policy

ensuring burdens are equitably distributed between different groups of tax payers. Knowledge of elasticity helps govt to know how much more burden can be borne by tax payers

• --rate of exchange for currency—decision to revalue or devalue –elasticity of dd for its exports and imports come handy in analyzing the impact

• Demand forecasting—income elasticity

• Helpful to policy makers—useful in solving the mystery of how farmers may remain poor despite a bumper crop

Demand estimation

• Biz seek to estimate dd function for its product

• Attempt made to quantify relationship between dd for a product and its determinant variables such as price, national income, advt exp, price of substitute, population, etc

Major steps in dd estimation

• Specification of the dd function• Adoption of form of dd function—simple

regression-2 variables, multiple regression-3 variables

• Choice of statistical technique—regression analysis, description statistics

• Data collection• Empirical process• Result and interpretation• Evaluation—results evaluated and cross

checked by market surveys, customer interviews, marketing tests, expert manager’s opinions

Demand forecasting

• Demand results in sales constituting the primary source of revenue for biz

• Forecast is a prediction or estimation of a future situation under given conditions

• Undertaken at foll levels—micro, industry and macro levels

Purpose of forecasting dd

• Short run—seasonal patterns, to prepare suitable sales policy and proper scheduling of output to avoid over stocking or costly delays

• Long run—capital planning

Steps in forecasting

• Identification of objective

• Determining the nature of goods under consideration—capital, consumer or non durables

• Selecting a proper method of forecasting—general trend for long run forecasting, seasonal patterns—short run forecasts

• Interpretation of results

Determining the scope of forecasting

• Period of forecast—short run, medium term, long run

• Levels of forecast—macro, industry, firm dd, product line forecasting

• General purpose or specific purpose for commodities, areas of sale, domestic or export markets

• Forecasts for established or new products• Type of commodity for which forecast is

done

Determinants of dd forecast

• Durable consumer goods

• Non-durable consumer goods

• Capital goods

Durable consumer goods

• Change in size and characteristics of population

• Saturation limit of the market

• Existing stock of good

• Replacement dd vs. new dd

• Income levels of consumers

• Tastes and preferences of consumers

Non-durable consumer goods

• Disposable income

• Price

• Size and characteristics of population

Capital goods• Replacement or new dd

Factors affecting dd• Extent of existing stock• Age distribution • Rate of obsolescence• Nature of tax provisions• Prices of substitutes and complementary

goods• Market structure

Significance of dd forecasting

• Production planning

• Sales forecasting

• Control of biz

• Inventory control

• Growth and long-run investment program

• Stability

• Economic planning and policy making

Sources of data collection for dd forecasting

• Primary data

• Secondary data—official publications of central, state, international bodies, trade, economic journals, market reports, publications of research institutions, universities, etc