DEMAND ANALYSIS

 Demand is one of the most critical economic decision variables.

Demand reflects the size & pattern of market.

Information on the size & type of demand helps management in

planning its strategies e.g.

a) If the demand for a product is subject to temporary

business recession, the firm may plan to pile up the stock
of unsold products.

b) If the demand for a product shows a trend towards a

substantial & sustained increase in the long run, the firm
may plan to install additional plant & equipment to meet
the demand on a permanent basis.

c) If the demand for a firm’s product is falling, while its rival’s

sale is increasing, the firm needs to plan its sales strategy
& sales tactics.

d) If the firm’s SS of the product is unable to meet its existing

demand, the firm may be required to revise its production
plan & schedule.

e) Larger the demand for a firm’s product, the higher is the

price the firm can charge.

- The whole range of planning by the firm – production planning,

inventory planning, cost budgeting, purchase plan, pricing decision,
advertisement budget, profit planning etc. call for an analysis of
demand:

 DEMAND for a product implies:

a) Desires to acquire it,

b) Willingness to pay for it, &
c) Ability to pay for it.

- A poor man’s desire to stay in a five – star hotel room & his willingness
to pay rent for that room is not ‘demand’, because he lacks the
necessary purchasing power & so it is merely his wishful thinking.
- A miser’s desire for and his ability to pay for a car is not demand
because he does not have willingness to pay for a car.
- One may also come across a well-established person who possesses
both the willingness and the ability to pay for higher education. But he
has really no desire to have it ; he pays the fees for a regular course,
and eventually does not attend his classes. In an economic sense, he
does not have a ‘demand’ for higher education degree /diploma.

 DEMAND function & DEMAND curve :

- DEMAND function is a comprehensive formulation which specifies the

factors that influence the demand for a product.

Dx = D( Px Py, Pz,,B,W,A,E,T,U)

Px , its own price.

Py , the price of its substitutes

(Other brands / models)

Pz , the price of its complements

(Like petrol)

B , the income (budget) of the purchases

(User, consumer)

W, the wealth of the purchaser

A, the adv. for the product

E, the price expectation of the user

U, all other factors.

- By contrast, a demand curve only considers the price – demand

relation, other things remaining the same.

(Cateris Paribus )

 The law of demand has reference to ‘ extension’ or ‘ contraction’ of

demand, but the changes in demand as a concept has reference to
‘increase’ or ‘decrease’ in demand. The former is limited to the
 movement along the demand curve, but the later refers to shifts in
the demand curve:

 Normal, Inferior and Giffen Goods

- The price effect is defined as the total change in quantity demanded,

due to a change in price, cateris paribus. The PE is – ve for normal
goods since for normal goods, price &quantity demanded have an
inverse relationship.

- If the price of good x falls, cateris paribus, two effects take place
simultaneously:
a) There is a change in the relative prices of all goods. Since good
x is now relatively cheaper to all other goods, it is now
substituted for other goods. This change in quantity demanded
due to a change in relative prices (alone) is called the
substitution effect.

The SE is – ve whether x is a normal good or an inferior good or

Giffen good since when the price of x decreases the quantity
demanded of x as a result of the SE  increases.

b) The real income (purchasing power) of the consumer  increases

even though his (actual) money income has remained the same.
If x is a normal good, an  increase in real income will mean that
more of good x will be demanded. If x is an inferior good, an 
increase in real income will mean that less of good x will be
demanded. Since all Giffen goods are inferior, it follows that for
Giffen goods too, an increase in income will mean a reduction in
quantity demanded. This change in quantity demanded of good
x due a change in real income is called the income effect.

The IE is – ve for normal goods, since, when price ↓es the

quantity demanded as a result of the income effect increases.
The IE is + ve for inferior & Gifen goods, since, when price ↓es
the quantity demanded as a result of the income effect ↓es.

- PE = IE + SE

a) For normal goods, the – ve income effect is reinforced by the – ve

substitution effect, so that the PE is – ve i.e. for normal goods price &
quantity are inversely related, Cateris paribus.

b) For inferior goods, the + ve income effect & the – ve substitution effect,
work in opposite directions. However, the – ve substitution effect is
 stronger than the + ve income effect so that the price effect is –ve. i.e.
for inferior goods, price & quantity are inversely related, Cateris
Paribus.

c) For Giffen goods, too, the + ve income effect & the – ve substn. effect,
work in opposite directions. But the + ve Income effect is stronger than
the –ve susbstn. effect so that the price effect is + ve. Effectively, this
means that for Giffen goods price & quantity are directly related, Cateris
Paribus.
 ELASTICITY

 The demand schedule & the demand curve indicate the direction of change
of demand when price varies. The intensity with which demand reacts to
price change cannot be captured by them. Hence the need to introduce
the concept of elasticity of demand.

 A price change can either increase or decrease total revenue, depending

on the nature of the demand function. The uncertainty involved in pricing
decisions could be reduced if managers had a method of measuring the
probable effect of price changes on total revenue. One such measure is
price elasticity of demand.

Proportionate change in quantity demanded

 Price Elasticity = -----------------------------------------------------------
(n) Proportionate change in price

= Change in Qy. demanded

Original Quantity
____________________

Change in price
Original Price

 Price Elasticity & changes in Total Exp.: This is of great significance in the
theory of price.

a) When price elasticity of demand is equal to unity, the total expenditure

remains the same with the fall or rise in price.
b) When ep >1, the total expenditure will increase with the fall in price and
will ↓se with the rise in price.
c) When ep < 1, the total expenditure will ↓se with the fall in price and will
↑se with the rise in price.

 Determinants of Price Elasticity of Demand

a) Availability of substitutes: The higher the degree of the closeness of

the substitutes, the greater the elasticity of demand for the
commodity. e.g. soaps, toothpastes, cigarettes etc. are available in
different brands, each brand being a close substitute for the other.

Sugar ,salt, electricity don’t have their close substitute & hence their
ep is lower.
b) Nature of commodity:

Luxuries & Necessities. Demand for luxury goods e.g. of

refrigerator, TV sets, car etc. is more elastic becoz their
consumption can be dispensed with or postponed when their prices
rise. Consumption of necessary goods e.g. sugar, clothes,
vegetables can’t be postponed and hence their demand is inelastic.
Similarly for durable & non-durable goods.

People get the old one repaired or buy a ‘second hand’ when price
increases

c) Weightage in the Total consumption: Proportion of income which

consumers spend on a particular commodity. E.g. salt, matches,
books, pens etc. are generally inelastic because ↑se in the price of
such goods does not substantially affect Cr s consumption pattern.

d) Time period : Demand is usually more elastic in the long run than in
the short run. Given more time, the Consumer has more
opportunities to adjust to changes in prices. e.g. if price of TV sets is
decreased, demand will not immediately ↑se unless people possess
excess purchasing power.

e) Range of commodity use : the wider the range of uses of a product,

the higher the elasticity. As the price of a multi-use commodity
decreases, people extend their consumption to its other uses. e.g.
milk & electricity

(f) The no. & closeness of substitutes: the more & the better the
substitutes, the greater is the price n. e.g.

Chocolate ice-cream has substitutes of other flavours like strawberry

or butter – scotch. Hence it is highly elastic salt-highly inelastic.

(g) No. & uses the commodity satisfies:

Directly related –e.g. Aluminum has several uses &hence if the price
of aluminium fell by a small amount, the quantity demanded would
↑se substantially since it can be put to so many uses. Since the %
age change in price is small and the % age change in Qy large,
Aluminium has a high elasticity.

(h) Time period: the greater the time period, the greater is the price n.
The % age change in quantity demanded is greater in the long run
for the same % age change in price.

(i) How narrowly the commodity is defined:

The more narrowly a commodity is defined, the greater is its price n.

 Price n of Marlboro cigarettes is greater than the price n of
cigarettes. There are many other good substitutes for Malboro
(namely the many other brands of cigarettes) than cigarettes in
general (namely Cigars & Pipes).

PRICE ELASTICITY & DECISION MAKING

( i) For Businessmen & Firms:

- Efforts in reducing price will be fruitful when the demand for the product
in relatively more elastic. The demand will ↑se substantially, revenue
will expand significantly & profits will ↑se.

- For a Monopolist :

If the demand is inelastic or less elastic a monopolist will not hesitate to

raise the price & make more profits, as the price – rise will not reduce
the demand much. If the demand is highly elastic, it would be profitable
to reduce price slightly & produce more, sell more and make larger
profits.

(ii) For Tax Authorities:

- If the purpose of commodity taxation is to gather more revenue, goods

with inelastic or less elastic demand ( e.g. essential goods) will have to
be taxed .

- If goods with elastic demand are taxed the purpose of revenue

collection will be defeated, since the sale of taxed good will fall much
and so will the tax revenue.

(iii) Determining rewards of factors of prodn:

- If the demand for a factor is inelastic, the factor can command a high
remuneration. Firms employing such skilled labour can’t afford to
reduce their demand for such labour, even if they have to pay high
wages.

- If the demand for labour is relatively more elastic, low wages will prevail.
Efforts of trade unions in getting high wages through strikes etc. would
not materialise.

- Factors of Prodn. With more elastic demand have to accept low wages
& factors with less elastic demand can command high wages.

(iv) Terms of trade between two countries

 The TOT between two countries are also determined by the elasticity of
demand for their products. A country having less elastic demand for
imports from abroad & more elastic demand for its exports, has
unfavourable TOT.

 Price Elasticity & decision making : Information about price elasticities can
be extremely useful to managers as they contemplate pricing decisions. If
demand is inelastic at the current price, a price ↓se will result in a ↓se in
total revenue. Alternatively, reducing the price of a product with elastic
demand would cause revenue to ↑se.

- However, a price reduction is not always the correct strategy when

demand is elastic. The decision must also take into account the
impact on the firm’s costs & profits.

 Income Elasticity of demand :

This measures the degree of responsiveness of quantity demanded of

commodity or goods with respect to a change in the level of income of a Cr,
other things remaining constant:

∆ xq ∆ xq y
exy = ____ = ____ . ____
xq ∆y xq
_________
∆y
____
y

- Unlike the price n of demand which is always negative, income n is

always +ve except for inferior goods.

- The value of income elasticity provides us with information regarding

the class of goods in question. For necessary goods, income n is less
than one; luxury goods will have income n greater than one. For inferior
goods, it is – ve.

- Income Elasticity & Decision making:

- The income n for a firm’s product is an important determinant of the

firm’s success at different stages of the business cycle.

- During periods of expansion, incomes are rising & firms selling luxury
tems such as exotic vacations will find that the demand for their
products will ↑ se at a rate faster than the rate of income growth.
However, during a recession, demand may ↓se rapidly.
 - Conversely, sellers of necessities such as fuel & basic food items will not
benefit as much during periods of economic prosperity, but will also find
that their markets are some what recession – proof. i.e. the change in
demand will be less than that in the economy in general.

The concept can be useful in estimating future demand provided the rate
of ↑se in income & income n of demand for the products are known.

 CROSS ELASTICITY OF DEMAND :

- DEMAND depends not only on own price but also on other factors. e.g.
it may depend on the prices of related goods like coffee & tea
( substitutes ) or coffee & sugar (Complements).

- In order to evaluate the effect of variations in the price of a product (tea)

on the quantity demanded of another product (coffee) we define Cross
elasticity of demand as follows.

Proportionate change in demand for

coffee
e
c,t = --------------------------------------------------
Proportionate change in price of tea

- e i j > o then i & j are substitute goods. i.e. an ↑se in the price of jth
goods (tea) ↑es the quantity demanded of the ith goods (coffee).

- eij = o ; i & j are independent goods.

- eij < 0 ; i & j are complementary goods. Am ↑se in the price of the jth
goods (sugar) reduces the quantity demanded of the ith goods (tea).

- Cross n & decision Making.

Many large corporations produce several related products. Gillette makes

both razors & razor blades. Where a company’s products are related, the
pricing of one good can influence the demand for other products. Gillette will
sell more razor blades if it lowers the price of its razors.

Q. ABC is a publisher of romance novels. The corporation hires an economist

to determine the demand for its product. After months of hard work &
submission of an exorbitant bill, the analyst tells the Co. that demand for
the firm’s novels
(Qx) is given by the equation:

Qx = 12,000 – 5000 Px + 5 I + 500 Pc

Where Px is the price charged for ABC novels; I is income & Pc is the price
of books from competing publishers.

a) Determine what effect a price ↑se would have on total revenues.

b) Evaluate how sale of the novels would change during a period of
rising incomes.
c) Asses the probable impact if competing publishers raise their prices.

Assume initial values of Px, I & Pc as

Rs. 5, Rs. 10,000 & Rs. 6, respectively.

a) Q x = 12,000 + 5 (10,000) + 500 (6) – 5000 (5) = 40000

d Qx
-------- = -5,000
d Px

At Px =Rs. 5, Qx = 40,000 books

 Ep = - 5000 x 5 = -0.625
40,000
Becoz demand is inelastic, raising the price of the novels would ↑se
total revenue.
d Qx
b) -------- = 5
dI

 EI = 5 x 10,000 = 1.25
---------
40,000
Becoz EI > 1, the novels are a luxury good. Thus as income ↑se,
sales should ↑se more than proportionately.

d Qx
c) -------- = 500
d Pc

EC = 500 x 6 = 0.075
40,000

i.e. a 1 per cent ↑se, in the price of other books results in a .075
percent ↑se in demand for ABC’s romance novels.
 Q. When the price of good x falls from Rs. 10 to Rs. 9, the demand for
good y
↑es from 20 kg to 25 kg.

a) What is the cross x of demand of good y for good x.

b) Are goods x & y compliments or substitutes.

Q. “Every time a Cr’s income goes up by 10%, he or she buys 2% to 5%

more cheese.” The implied range of the income elasticity is
from……………… to …………….. Since the average per capita
consumption of cheese is about 13 kg., a 5% annual income ↑se will
↑se cheese cons. by ………….. to ………… per year.

Ans. 1. nc = % change in demand for y

-------------------------------
% change in price of y

= 25 – 20
----------- x 100
20
___________________
9 –10
------------- x 100
10

= -2.5
x and y are complements.

2. a) ei = % change in Qy demanded
------------------------------------
% change in income

= 2% to 5% = 0.2 to 0.5
10% 10%

b) % change in Qy demanded =

ei x % change in income

Using the range of Income elasticity calculated above, we get :

0.2 x 5% = 1% change in Qy demanded to

0.5 x 5% = 2.5% change in Qy demanded

1% of 13 Kg = 0.13 Kg
 & 2.5 % of 13 Kg = 0.325 Kg
thus cheese consn. ↑se by 0.13 kg. to 0.325 kg year.

Cross n of Demand

 Cross price n of demand is a measure of the rate of change in the quantity

demanded of the product, when the price of some other good changes.

e c = % change in Q y demanded of good x

-----------------------------------------------------
% change in price of good y

d Qx d Py
= ------  --------
Qx Py

d Qx Py
= ------  --------
d Py Qx

Q. When the price of substitute good, say coffee, increases from Rs. 65 to Rs.
70 per kg., the quantity of tea sold ↑es from 4000 kg to 5000 kg.

ec = 1000 x 65
5 4000
= 3.25
We find that the cross n of demand for tea against coffee is highly elastic.

 Negative cross elasticity for complementary goods : Cross elasticity

for complementary goods which are jointly demanded is –ve. e.g. if the
price of records goes up, the demand for record players fall.

+ ve Cross n for Substitutes.

 Cross n of Demand & Market structure :

1. Monopoly Market : If cross n is zero, it is a case of pure
monopoly. It means there are no substitutes for the
monopoly. It means there are no substitutes for the
monopoly product & hence any change in prices of other
goods will have no effect on the Qy of monopoly product sold.
2. Monopolistic competition : Here the products are close
substitutes and compete with each other. Any ↑se in the
prices of other products will cause a substantial ↑se in the
quantity demanded of the firm’s product & any fall in the
prices of other products will cause a substantial fall in the Qy
of the product sold by the firm.