MANAGERIAL ECONOMICS

UNIT 1
 LSN 1 Introduction to Managerial Economics: Managerial Economics: Meaning, Nature,
Scope & Relationship with other disciplines, Role of managerial economics in decision Making,
 LSN 2 Basic Concepts: - Opportunity Cost Principle, Production Possibility Curve, Incremental
Concept, Scarcity Concept.
 LSN 3 Demand and the Firm: Demand and its Determination: Demand function; Determinants
of demand
 LSN 4 Demand elasticity – Price, Income and cross elasticity. Use of elasticity for analyzing
demand,
 LSN 5 Demand estimation, Demand forecasting, Demand forecasting of new product
 LSN 6 Indifference Curve Analysis: Meaning, Assumptions, Properties, Consumer Equilibrium,
Importance of Indifference Analysis, Limitations of Indifference Theory

Lesson 1 Introduction to Managerial Economics

Managerial economics deals with the application of the economic concepts, theories, tools, and
methodologies to solve practical problems in a business.

Managerial Economics = Managerial + Economics

Managerial means to manage. It deals with managerial qualities/skills a job requires.

Economics is the social science that studies the production, distribution, and consumption of goods
and services.

Thus managerial economics is application of these economic concepts to help managers in decision
making.
 I) Nature of managerial economics

 Managerial Economic is a Science: We know that science is systematic body of knowledge and
proved. On the other hand M.E is also science because the Principles and theory of Managerial
Economics is proved. Which is applicable for all level of Organization and theory of demand, theory
of price, theory of profit, theory of capital is also proved, So we can say that managerial economic is
science.

 Managerial economic is an art: Managerial economics is an art because an art is application of skills
can used for the purpose of getting some relevant information and the other, In M.E theory is
implement in Practice way in M.E managerial skills is implemented. So ME is an art.

 M.E for administrations of Organization: Managerial economic for administration of organization

because administration give the relevant data. They find out the problem and solve the problem
immediately in organisation and the admin decide the target on the basis of price, Quality of the
products, Demand of product. Administration forecast the demand according to the situation of present
demand of the market.

 M.E is helpful in optimum resources allocation: In the organization are limited resources and this
resources can used in several places at a time by the tools and techniques of managerial economic. The
resources will used to get optimum output. In the organisations our ultimate objective to earn profit so
the limited resources used in such a way to get maximum profit because, resources are limited. Our
resources in human and non-human resources. Human resources that means labor, employees, and
Non-human resources that means land, building, machine, raw materials Etc.
 Managerial economic has component of micro economic: Managerial economics has component of
Micro economics.a. It is related with the internal factors of organization. Internal factor of the
organisations are demand of the products, purchasing the raw materials, How to use the resource to get
maximum profits. These are related with micro component of M.E.

 Managerial economic has components of macro economic: Managerial economic has a component
of macro economic which is related with the out side of the organisation or a external factor of the
organisation. External factor of the organisation are competition market, nature of business,
Government rules and regulations, industrial law, Industrial Policies, Taxes these are the External
factor of the organisation and these types of problems solved by the managerial economics.

 Managerial economic is dynamic in nature: Managerial economics is dynamic in nature that means
managerial economics is used all space of the organisation and all except of the organisation. By the
tools and technique of managerial economic to give the relevant information and to solve the problem
of the organisations So, Managerial economic is dynamic in nature.

II) SCOPE OF MANAGERIAL ECONOMICS

1. DEMAND ANALYSIS :
A business firm is an economic organization which is engaged in transforming productive resources into
goods that are to be sold in the market. A major part of managerial decision-making depends on accurate
estimates of demand. A forecast of future sales serves as a guide to management for preparing production
schedules and employing resources.

It will help management to maintain or strengthen its market position and profit-base. Demand analysis
also identifies a number of other factors influencing the demand for a product. Demand analysis and
forecasting occupies a strategic place in Managerial Economics.

2. COST ANALYSIS:
Cost estimates arc most useful for management decisions. The different factors that cause variations in
cost estimates should be given due consideration for planning purposes.

There is the clement of uncertainty of cost as other factors influencing cost arc either uncontrollable or
not always known.
If one is able to measure cost it is very important for more sound profit planning, cost control and often
for sound pricing practices.

3. PRICING PRACTICES AND POLICIES:

As price gives income to the firm, it constitutes as the most important field of Managerial Economics.

The success of a business firm depends very much on the correctness of the price decisions taken by it.

The various aspects that are dealt under it cover the price determination in various market forms, pricing
policies, pricing method, differential pricing, productive pricing and price forecasting.

4. PROFIT MANAGEMENT:
The chief purpose of a business firm is to earn the maximum profit. There is always an element of
uncertainty about profits because of variation in costs and revenues.

If knowledge about the future were perfect, profit analysis would have been very easy task. But in this
world of uncertainty expectations are not always realized.

Hence profit planning and its measurement constitute the most difficult area of Managerial Economics.

Under profit management we study nature and management of profit, profit policies and techniques of
profit planning like Break Even Analysis.

5. CAPITAL MANAGEMENT:
The problems relating to firm’s capital investments are perhaps the most complex and troublesome.

Capital management implies planning and control of capital expenditure because it involves a large sum
and moreover the problems in disposing the capital assets of arc so complex that they require
considerable time and labour.

The main topics dealt with under capital management arc cost of capital, rate of return and selection of
projects.

The topics discussed under headings from 1 to 5 are related with operational issues of a firm.

6. ANALYSIS OF BUSINESS ENVIRONMENT:

The environmental factors influence the working and performance of a business undertaking. Therefore,
the managers will have to consider the environmental factors in the process of decision-making.
Decisions taken in isolation of environmental factors would prove harmful to the firm. Therefore, the
management must be fully aware of economic environment, particularly those economic factors which
constitute the business climate.

7. ALLIED DISCIPLINES:
The concepts that help the management in taking business decision are quantitative in nature. Therefore,
mathematical tools are widely used in determining relationships between economic variables.

The linear programming techniques, which is mathematical, is used by firms to maximize or minimize
their objective function.

Similarly statistical and accounting principles are used in taking business decision. Therefore,
mathematical tools, statistical technique and accounting principles that are used in analyzing business
problems also come under the scope of Managerial Economics.

IV ) Relation between managerial economics and other disciplines

Managerial Economics and Economics:

Managerial Economics is economics applied to decision making. It is a special branch of

economics, bridging the gap between pure economic theory and managerial practice. Economics has two
main branches—micro-economics and macro-economics.

Micro-economics:

‘Micro’ means small. It studies the behaviour of the individual units and small groups of units.
It is a study of particular firms, particular households, individual prices, wages, incomes, individual
industries and particular commodities. Thus micro-economics gives a microscopic view of the economy.

The roots of managerial economics spring from micro-economic theory. In price theory,
demand concepts, elasticity of demand, marginal cost marginal revenue, the short and long runs and
theories of market structure are sources of the elements of micro-economics which managerial economics
draws upon. It makes use of well known models in price theory such as the model for monopoly price, the
kinked demand theory and the model of price discrimination.

Macro-economics:

‘Macro’ means large. It deals with the behaviour of the large aggregates in the economy. The
large aggregates are total saving, total consumption, total income, total employment, general price level,
wage level, cost structure, etc. Thus macro-economics is aggregative economics.

It examines the interrelations among the various aggregates, and causes of fluctuations in
them. Problems of determination of total income, total employment and general price level are the central
problems in macro-economics.
 Macro-economies is also related to managerial economics. The environment, in which a
business operates, fluctuations in national income, changes in fiscal and monetary measures and
variations in the level of business activity have relevance to business decisions. The understanding of the
overall operation of the economic system is very useful to the managerial economist in the formulation of
his policies.

Macro-economics contributes to business forecasting. The most widely used model in modern
forecasting is the gross national product model.

Managerial Economics and Theory of Decision Making:

The theory of decision making is relatively a new subject that has a significance for managerial
economics. In the process of management such as planning, organising, leading and controlling, decision
making is always essential. Decision making is an integral part of today’s business management. A
manager faces a number of problems connected with his/her business such as production, inventory, cost,
marketing, pricing, investment and personnel.

Economist are interested in the efficient use of scarce resources hence they are naturally
interested in business decision problems and they apply economics in management of business problems.
Hence managerial economics is economics applied in decision making.

Managerial Economics and Operations Research:

Mathematicians, statisticians, engineers and others join together and developed models and
analytical tools which have grown into a specialised subject known as operation research. The basic
purpose of the approach is to develop a scientific model of the system which may be utilised for policy
making.

The development of techniques and concepts such as Linear Programming, Dynamic

Programming, Input-output Analysis, Inventory Theory, Information Theory, Probability Theory,
Queuing Theory, Game Theory, Decision Theory and Symbolic Logic.

Managerial Economics and Statistics:

Statistics is important to managerial economics. It provides the basis for the empirical testing of
theory. It provides the individual firm with measures of appropriate functional relationship involved in
decision making. Statistics is a very useful science for business executives because a business runs on
estimates and probabilities.

Statistics supplies many tools to managerial economics. Suppose forecasting has to be done.
For this purpose, trend projections are used. Similarly, multiple regression technique is used. In
managerial economics, measures of central tendency like the mean, median, mode, and measures of
dispersion, correlation, regression, least square, estimators are widely used.

Statistical tools are widely used in the solution of managerial problems. For eg. sampling is
very useful in data collection. Managerial economics makes use of correlation and multiple regression in
business problems involving some kind of cause and effect relationship.
Managerial Economics and Accounting:

Managerial economics is closely related to accounting. It is recording the financial operation of

a business firm. A business is started with the main aim of earning profit. Capital is invested / employed
for purchasing properties such as building, furniture, etc and for meeting the current expenses of the
business.

Goods are bought and sold for cash as well as credit. Cash is paid to credit sellers. It is received
from credit buyers. Expenses are met and incomes derived. This goes on the daily routine work of the
business. The buying of goods, sale of goods, payment of cash, receipt of cash and similar dealings are
called business transactions.

The business transactions are varied and multifarious. This has given rise to the necessity of
recording business transaction in books. They are written in a set of books in a systematic manner so as to
facilitate proper study of their results.

There are three classes of accounts:

(i) Personal account,

(ii) Property accounts, and

(iii) Nominal accounts.

Management accounting provides the accounting data for taking business decisions. The
accounting techniques are very essential for the success of the firm because profit maximisation is the
major objective of the firm.

Managerial Economics and Mathematics:

Mathematics is another important subject closely related to managerial economics. For the
derivation and exposition of economic analysis, we require a set of mathematical tools. Mathematics has
helped in the development of economic theories and now mathematical economics has become a very
important branch of economics.

Mathematical approach to economic theories makes them more precise and logical. For the
estimation and prediction of economic factors for decision making and forward planning, mathematical
method is very helpful. The important branches of mathematics generally used by a managerial economist
are geometry, algebra and calculus.

The mathematical concepts used by the managerial economists are the logarithms and
exponential, vectors and determinants, input-out tables. Operations research which is closely related
to managerial economics is mathematical in character.
 v) ROLE OF MANAGERIAL ECONOMICS IN DECISION MAKING

1. USEFUL IN BUSINESS ORGANIZATION

In any institution or firm. How should any production be done, and for whom should be
produced? The answer to all these questions remains only with the managerial economy.
Because he plays the most important role in these tasks. So we can say that managerial
economics plays a very big role and significance in the important decisions of the
business.

2. HELPFUL IN CHALKING OUT BUSINESS POLICIES

The art is only in business economics to maximize the profit of any institution
andminimize cost. And whatever policies are made from this.

It is very useful for any business or firm so that every firm and business can get
the maximum benefit.

Then we can say that there is a huge contribution of managerial economics to profit
maximization and determining policies. It also helps in doing it.

3. HELP IN BUSINESS PLANNING

Business economics is very useful in planning a complete prospect among the successful
operation and production of any business or firm.

Which acts as a balance bridge between the production tools and operating systems and
where to go.

So this is the biggest and important role of business economics in any business or firm.

4. HELPFUL IN COST CONTROL

Managerial economics decides the business is going towards profit or loss. managerial
economics decides which way is good for the business.

And it is only possible when managerial economics plays a very big and important role in
cost control decisions.

5. USEFUL IN COORDINATION OF BUSINESS ACTIVITIES

Managerial economics is useful in coordinating the various activities of a business.

6. USEFUL IN DEMAND FOR CASTING

Managerial economics provides useful tools for economics managers in demand forecasts
and is useful in demanding production planning.

The managerial economy deals with future losses easily. So that any business can be
protected against future losses.

7. HELPFUL IN PROFIT PLANNING AND CONTROL

Managerial economics helps managers to decide on the planning and control of the
benefits.

Managerial Economics is synchronized between the planning and control of any institution
or firm and hence its importance increases.

Thus, It plays a huge role in business decisions. So its Role And Importance Of
Managerial Economics In taking Right Decisions.

8. HELPFUL FOR BUSINESS PREDICTION

It is not known to anyone about what is going on in the business. therefore, business
economics tells us that the business can see what is troubling in the future.

So Then the managerial economics gives its solutions. So that they can be avoided and the
benefits can be increased.

9. HELPFUL IN PRICE DETERMINATION

Managerial Economics provides the necessary guidance in managing the pricing of its
business. This proves this in order to raise the required data in pricing and get
the maximum benefit.

So That is the major role of managerial economics in the business decision critical.
Without this, no business can progress.

10. HELPFUL IN SOLUTIONS OF BUSINESS TAXATION PROBLEMS

Managerial Economics provides useful guidance in solving problems caused by various
types of tax done in business. And contracting of business helps reduce problems. To
maximize profit at low cost and minimize business costs.
11. USEFUL IN UNDERSTANDING THE MECHANISM OF ECONOMIC SYSTEM
Managerial Economics/Business economics is useful in understanding the complex cause
of the entire economy. From which business decisions get help.

The entire economy is very complex but business economics solves it with ease.it is
helpful to understand that in this way.

Lesson 2 Basic Concepts

OPPORTUNITY COST PRINCIPLE

Opportunity cost principle is related and applied to scarce resource. When there are
alternative uses of scarce resource, one should know which best alternative is and which is
not. We should know what gain by best alternative is and what loss by left alternative is.

The opportunity cost of any action is simply the next best alternative to that action - or put
more simply, "What you would have done if you didn't make the choice that you did".

The income or benefit foregone as the result of carrying out a particular decision, when
resources are limited or when mutually exclusive projects are involved.

Definitions

— In the words of Left witch, "Opportunity cost of a particular product is the value of the
foregone alternative products that resources used in its production, could have produced."

Opportunity cost is not what you choose when you make a choice —it is what you
did not choose in making a choice. Opportunity cost is the value of the forgone alternative
— what you gave up when you got something.

Example 1: If a person is having cash in hand Rs. 100000/-, he may think of two
alternatives to increase cash.

Option 1: Investing in bank. We will get returns amount 10000/-

Option2: Investing in business. We get returns amount 17000/-

Generally we chose the option 2 because we will get more returns than the option 1. Here the
option 1 is the opportunity cost, that what we have not chosen.
Prodution Possibility Curve

A production possibility curve measures the maximum output of two goods using a fixed
amount of input. The input is any combination of the four factors of production. They are
land and other natural resources, labor, capital goods, and entrepreneurship. The manufacture
of most goods requires a mix of all four.

In this diagram AF is the production possibility curve, also called or the

production possibility frontier, which shows the various combinations of the
two goods which the economy can produce with a given amount of
resources. The production possibility curve is also called transformation
curve, because when we move from one position to another, we are really
transforming one good into another by shifting resources from one use to
another.

It is to be remembered that all the points representing the various reduction

possibilities must lie on the production possibility curve AF and not inside or
outside of it. For example, the combined output of the two goods can neither be
at U nor H. (See Fig. 21.3) This is so because at U the economy will be under-
employing its resources and H is beyond the resources available.

Shape of PPC  It is downward sloping and concave to the point of origin

Reasons for Such  It is downward sloping because few units we sacrifice for another. As there
Shape of PPC exists an inverse relationship between change in the quantity of one
commodity and change in the quantity of then other commodities
 PPC is concave shaped because more and more units of one commodity are
sacrificed to gain an additional unit of another commodity.

Under Utilization of  But if there is unemployment or inefficiency in resource utilization then we

Resources will produce at any point inside PPC.
(Any Point Under the
PPC)

INCREMENTAL CONCEPT /PRINCIPLE

The main objective of this principle is maximization of profits. Or In
other words to raise the profits in the business

General rule:

By increasing in the production, the total cost of the product raises and
simultaneously profit also rises.

Practicality in the business:

How much we extra we should produce to get the best profits and how
much extra cost is incurring for the extra production.

It is related to the marginal cost and marginal revenue concepts in

economic theory. Incremental concept involves estimating the impact of
decision alternatives on costs and revenues, emphasizing the changes in
total cost and total revenue resulting from changes in prices, products,
procedures, investments or whatever else may be at stake in the decisions.
The two basic components of incremental reasoning are:

1. Incremental cost
2. Incremental revenue.

Incremental cost may be defined as the change in total cost resulting from
a particular decision. Incremental revenue is the change in total revenue
resulting from a particular decision.

The incremental principle may be stated as follows: A decision is a

profitable one if—
a) it increases revenue more than cost
b) it decreases some costs to a greater extent than it increases others
c) it increases some revenues more than it decreases others and
d) it reduces cost more than revenues.

Suppose a firm gets an order that brings additional revenue of Rs 3,000.

The cost of production from this order is:

Rs

 Labour 800
 Materials 1,300
 Overheads 1,000
 Selling and administration expenses 700

Full cost 3,800

At a glance, the order appears to be unprofitable. But suppose the firm has
some idle capacity that can be utilised to produce output for new order.
There may be more efficient use of existing labour and no additional
selling and administration expenses to be incurred. Then the incremental
cost to accept the order will be:

Rs

 Labour 600
 Materials 1,000
 Overheads 800

Total incremental cost 2,400

Incremental reasoning shows that the firm would earn a net profit of Rs
600 (Rs 3,000 – 2,400), though initially it appeared to result in a loss of
Rs 800. The order should be accepted.

SCARCITY CONCEPT

Scarcity doesnot mean that only a little of something is available.

For example, In my country there is less of one product that other countries have in
abundance, but the atmosphere is such that we don’t need that product so it will not be treated
as scarce..

Because nobody wants it. For there to be scarcity things must be LIMITED and WANTED.

Goods and services are scarce. These are the things that we want. Goods are tangible things
that satisfy our wants (like boats, computers, cars, etc.), services are intangible things that
satisfy our wants (like the services of an accountant, or a dentist, or a lawyer).

This is what economics is really all about - MAKING CHOICES. Because of scarcity we as
individuals, and our society as a whole, must make choices.
 For example when I was thinking about buying a boat, I also needed shoes for my daughter.
If we assume that I couldn't afford both (again - can you afford everyhting that you want?) I
had a choice to make a boat or shoes? Because there is scarcity of money.

Our goal is to make choices that reduce scarcity as much as we can. Because of unlimited
wants we can never eliminate scarcity, but it can be reduced by the right choices.

we want to get the MAXIMUM SATISFACTION possible out of our limited resources. We
don't want to make just any choice, we want to make the BEST choice.

There are three options (choices) for society to deal with scarcity, and all societies must deal
with scarcity because there are limited resources and unlimited wants.

Those three options are:

1. economic growth
2. reduce our wants, and
3. use our existing resources wisely (Don't waste the few resources that we do have.)

Economic Growth

Economic Growth is an increase in the ABILITY to produce goods and services.

Reducing Wants

A second way for a society to handle scarcity is to reduce its wants. If we just didn't want so
much then there would be less scarcity.

Using our existing resources wisely = maximizing satisfaction

Societies can reduce scarcity not just by (1) getting more resources, better resources, or better
technology (i.e. ECONOMIC GROWTH), or by (2) REDUCING ITS WANTS, but also by
(3) USING ITS EXISTING RESOURCES WISELY

There are four ways that societies can use their EXISTING resources to reduce scarcity.
These are the 4 Es of economics - four ways to use our existing resources to reduce scarcity
and obtain the maximum satisfaction possible.

The four ways that societies can use their EXISTING resources to reduce scarcity are:

1. Productive Efficiency
2. Allocative Efficiency
3. Full Employment, and
4. Equity

Lesson 3 Demand and Change in Demand

Meaning of Demand:-
Demand is an economic term that refers to the amount of products or services
that consumers wish to purchase at any given price level. The mere desire of
a consumer for a product is not demand. Demand includes the purchasing
power of the consumer to acquire a given product at a given period. In other
words, it‟s the amount of products or services that consumers are willing and
able to purchase.

Demand is the quantity of a good that consumers are willing and able to
purchase at various prices during a given period of time.
The demand arises out of the following three things:

i. DESIRE OR WANT OF THE COMMODITY.

ii. Ability to pay,
iii. Willingness to pay.

Only when all these three things are present then the consumer presents his
demand in the market.
  Definition:

―The demand for anything, at a given price, is the amount of it which will be
bought per unit of time at that price.‖ -PROF. BENHAM

The relationship between price and quantity demanded is also known as

the demand curve.
  Determination of demand :-

Individual demand Market demand

1) Individual demand
Individual Demand Schedule:

It represents the demand of an individual‟ for a commodity at different prices

at a particular time period. The adjoining table 7.1 shows a demand schedule
for oranges on 7th July, 2009.

INDIVIDUAL DEMAND CURVE:

An Individual Demand Curve is a graphical representation of the quantities of
a commodity that an individual (a particular consumer) stands ready to take
off the market at a given instant of time against different prices. In Fig. 7.1,
an Individual Demand Curve is drawn on the basis of Individual Demand
Schedule given above in table 7.1.
2) Market demand

Market Demand Schedule:

Market Demand Schedule is defined as a table showing the quantities

of a given commodity which all consumers will buy at all possible
prices at given moment of time.

Market demand schedule:-

Price of Milk Demand by Mr Demand by Mr Market Demand

per litre (in rs) X ( in Litres) Y ( in Litres)
5 1 2 1+2=3
4 2 3 5
3 3 4 7
2 4 5 9
1 5 6 11

Market Demand Curve:

A Market Demand Curve is a graphical representation of the quantities

of a commodity which all the buyers in the market stand ready to take
off at all possible prices at a given moment of time.
 Determinants of Demand

1) Determinants of Individual demand

1. PRICE OF THE PRODUCT:
Demand for a commodity depends on its price. As price rises, for a
normal good, demand falls and vice-versa. However, there are
exceptions, i.e., for Giffen goods, as price rises demand also rises.

2. INCOME OF THE CONSUMER:

A key determinant of demand is the level of income i.e., the higher the
level of income the higher the demand for a given commodity.
Consumer‟s income and quantity demanded are generally related
positively. It means that when income of the consumer rises he wants to
have more units of that commodity and when his income falls he
reduces the demand.

3. PRICES OF RELATED GOODS:

Consumption choices are also influenced by the alternative options

available to users in the relevant market place. Market information
regarding alternative products, quality, convenience and dependability
all influence choices.
The two products may be related in two ways- Firstly, as
complementary goods and secondly as substitute goods.
Complementary goods are those goods which are used jointly and
consumed together like tennis ball and a racket, petrol and car. The
relationship between the price of a product and the quantity demanded
of another is inverse. For example if the price of cars were to rise, less
people would choose to buy and use cars, switching perhaps to public
transport-trains. It follows that under these circumstances the demand
for the complementary good petrol would also decrease.

Goods which are perceived by the consumer to be alternatives to a

product are termed as substitute goods. There is direct relationship
between the demand for a product and the price of its substitute.
Example- scooter and a motorcycle, tea and coffee.
The increase in price of tea would decrease its quantity demanded and
people would switch over to its substitute commodity coffee.

4. CONSUMER’S TASTES AND PREFERENCES:

Demand for a product is also affected by the tastes and preferences of

the consumers. As tastes and preferences shift from one commodity to
the other, demand for the first commodity reduces and that of the other
rises.
5. EXPECTATION OF FUTURE PRICES:
The current demand of a product also depends on its expected price in
future. If future price is expected to rise, its present demand
immediately increases because the consumer has a tendency to store it
at low prices for his future consumption. If, however the price of a
product is expected to fall then he has a tendency to postpone its
consumption and as a result the present demand would also fall.
This is often the case on Budget Day, when consumers rush to fill their
petrol tanks prior to an expected increase in taxation. The reverse is
also true, in that an expectation that prices are about to fall, will
decrease current demand, as consumers will await for the expected
price reduction.
6. ECONOMIC CONDITIONS:
 The demand for commodities also depends upon prevailing business
conditions in the country. For, example- during the inflationary period,
more money is in circulation and people have more purchasing power.
This causes an increase in demand of various goods even at higher
prices. Similarly, during deflation (depression), the demand for various
goods reduces in spite of lower prices because people do not have
enough money to buy.

2) Determinants of Market demand

1. PATTERN OF INCOME DISTRIBUTION:

If National income is equitably distributed, there will be more demand and
vice-versa. If income distribution moves in favour of downtrodden people,
then demand for such commodities, which are used by common people
would increase. On the other hand, if the major part of National income is
concentrated in the hands of only some rich people, the demand for luxury
goods will increase.
2. DEMOGRAPHIC STRUCTURE:
Market demand is influenced by change in size and composition of
population. Increase in population leads to more demand for all types of
goods and decrease in population means less demand for them. Composition
of population also affects its demand. Composition refers to the number of
children, adults, males, females etc., in the population.
When the composition changes, for example, when the number of females
exceeds to that of the males, then there will be more demand for goods
required by women folk.
3. GOVERNMENT POLICY:
Government policy of a country can also affect the demand for a particular
commodity or commodities through taxation. Reduction in the taxes and
duties will allow more persons to enter a particular market and thus raising
the demand for a particular product.
4. SEASON AND WEATHER:
Demands for commodities also depend upon the climate of an area and
weather. In cold hilly areas woolens are demanded. During summer and rainy
season demand for umbrellas may rise. In winter ice is not so much
demanded.
5. STATE OF BUSINESS:
The levels of demand in a market for different goods depend upon the
business condition of the country. If the country is passing through boom, the
trade is active and brisk. The demand for all commodities tends to rise. But in
the days of depression, when trade is dull and slow, demand tends to fall.

 Law of demand

1. Meaning of demand
Demand is the quantity of a good that consumers are willing and able to
purchase at various prices during a given period of time.

2. LAW OF DEMAND
The law of demand expresses functional relationship between price and
the quantity. It has been universally observed that people buy more
quantity of goods when, they are available at a lower price and the
quantity purchased declines with an increase in its price.

―A rise in the price of a commodity or service is followed by a fall in

quantity demanded, and a fall in price is followed by an increase in quantity
demanded‖. Thus, lower the price, the larger is the quantity demanded of a
commodity and vice-versa.

3. ASSUMPTIONS OF LAW OF DEMAND:

i. The income of the consumer remains same during the period
under consideration.
ii. The prices of related goods remain unchanged during the period.
iii. The preferences and tastes of consumers must remain the same during
the period of consumption.
iv. The quality of similar goods available in the market is almost unchanged.
v. During the period under study, it is presumed that prices are not likely
to change in near future.
vi. No substitutes for the commodity in question are available

1. DEMAND SCHEDULE
The demand schedule in economics is a table of quantity demanded of a
good at different price levels.
Price Quantity Demanded
10 40
20 30
30 20
40 10

2. Demand curve
The demand curve is a graphic statement or presentation of the
relationship between product price and the quantity of the product
demanded.

P 40
R
I 30
C
E 20

10

10 20 30 40
Qty demanded
 The above table and diagram shows the relationship between price and
quantity demanded. In above figure quantity demanded is taken on x axis and
price on y axis. When price of a product was 10 Rs the quantity demanded
was 40 units and when price increased to 40 rs the quantity demanded
reduced to 10 units which shows the negative relationship between demand
and price and thus explains the law of demand.

Causes for Downward Sloping of Demand Curves

The following are some of the causes explaining why demand curves always
slope downwards:

1) The law of diminishing the marginal utility

According to this principle, the marginal utility of a commodity reduces when the
quantity of goods is more. Consequently, when the quantity is more, the prices will
fall and demand will increase. Hence, consumers will demand more goods when
prices are less. This is why the demand curve slopes downwards.

2) Substitution effect
Consumers often classify various commodities as substitutes. For example,
many Indian consumers may substitute coffee and tea with each other for
various reasons. When the price of coffee rises, consumers may switch to
buying tea more as it will become relatively cheaper.

Economists refer to this as the substitution effect. Hence, if the price

of tea reduces, its demand will increase and the demand curve will be
downward sloping.
 3) Income effect
According to this principle, the real income of people increases when the prices of
commodities reduce. This happens because they spend less in case of falling
prices and end up with more money. With more money, they will, in turn,
purchase more and more. Therefore, the demand increases as prices fall.

4) New buyers
Whenever the price of a commodity decreases, new buyers enter the market and
start purchasing it. This is because they were unable to purchase it when the
prices were high but now they can afford it. Thus, as the price falls, the demand
rises and the demand curve becomes downward sloping.

5) Old buyers
This rule is basically a corollary of the new buyers rule. When the price of a commodity
decreases, the old buyers can afford to buy even more quantities of it. As a result, this
results in demand increasing and the demand curve slopes downwards.

Exceptions to the Law of Demand:

There are certain exceptions to the law of demand. It means that under certain
circumstances, consumers buy more when the price of a commodity rises and
less when the price falls. In such case the demand curve slopes upward from
left to right i.e. demand curve has a positive slope as is shown in Fig. 7.5.
Many causes can be attributed to an upward sloping demand curve.
1. IGNORANCE:
Sometimes consumers are fascinated with the high priced goods from the
idea of getting a superior quality. However, this may not be always true.
Superior/deceptive packing and high price deceive the people. This can be
called as „Ignorance effect’.
2. SPECULATIVE EFFECT:
When the price of a commodity goes up, people may buy larger quantity than
before, if they anticipate or speculate a further rise in its price. On the other
hand, when the price falls, people may not react immediately and may still
purchase the same quantity as before, waiting for another fall in the price. In
both the cases, the law of demand fails to operate. This is known as
speculative effect.

3. THE GIFFEN EFFECT:

A fall in the price of inferior goods (Giffen Goods) tends to reduce its
demand and a rise in its price tends to extend its demand. This
phenomenon was first observed by SIR ROBERT GIFFEN, popularly known
as Giffen effect.
He observed that the working class families of U.K. were compelled to
curtail their consumption of meat in order to be able to spend more on bread
Mr. Giffen, British economist, observed that rise in the price of bread caused
the low paid British workers to buy more bread.
These workers lived mainly on the diet of bread, when price rose, as they had
to spend more for a given quantity of bread, they could not buy as much meat
as before. Bread still being comparatively cheaper was substituted for meat
even at its high price.

4. FEAR OF SHORTAGE:

People may buy more of a commodity even at higher prices when they fear of
a shortage of that commodity in near future. This is contrary to the law of
demand. It may happen during times of war and inflation and mostly in the
case of goods which fall in the category of necessities of life like sugar,
kerosene oil, etc.

5. PRESTIGIOUS GOODS:

If consumers measure the desirability of a good entirely by its price and not
by its use, then they buy more of a good at high price and less of a good at
low price, Diamond, Jewellery and big cars etc., are such prestigious
goods. In their case demand relates to consumers who use them as status
symbol.
As their prices go up and become costlier, rich people think it is more
prestigious to have them. So they purchase more. On the other hand, when
their prices fall sharply, they buy less, as they are no more prestigious goods.

6. CONSPICUOUS NECESSITIES:

Another exception occurs in use of such commodities as due to their constant

use, have become necessities of life. For example, inspite of the fact that the
prices of television sets, refrigerators, washing machines, cooking gas,
scooters, etc., have been continuously rising, their demand does not show any
tendency to fall. More or less same tendency can be observed in case of most
of other commodities that can be termed as „Upper-Sector Goods‟.
Change in Demand
 a) I were a se i n demanrl

2. Dua to chano•° In othar tnan Price — Shift In damand

( Price at the commodity remalnJng the aame )

C3LMrltit y rJur1i<‹r›duc1

a) Increase in demand

£. Oue to changes In other than Prlce — •hIft In demand

( Price of the commodity remelnlng tho BBme )

b) decreasing demand - <Iow‹awai r.I all ill ›ia ml c' i›a and

Ou antity domanded
 Lesson 4 Demand Elasticity
WHAT IS DEMAND ELASTICITY?
In economics, the demand elasticity (elasticity of demand) refers to how
sensitive the demand for a good is to changes in other economic variables,
such as prices and consumer income. Demand elasticity is calculated as the
percent change in the quantity demanded divided by a percent change in
another economic variable. A higher demand elasticity for an economic
variable means that consumers are more responsive to changes in this
variable.

PRICE ELASTICITY OF DEMAND

It is the ratio between percentage change in quantity demanded and
percentage change in price. It is calculated by dividing the percentage change
in quantity demanded by the percentage change in price of commodity.

TYPES OF OWN (PRICE) ELASTICITY OF DEMAND:

For all types of commodities, the rate of change of quantity demanded to a
change in own price is not uniform. For some commodities, demand is said to
be more responsive to price changes compared to other commodities. That is
why there are various types of elasticities of demand.

They are of the following five types:

(1) Elastic Demand (EP > 1):
Demand is said to be elastic if the change in price causes a more than
proportionate change in quantity demanded. A 10 p.c. change in price causes
quantity demanded to change by more than 10 p.c. In other words, if E is
greater than one, demand is said to be elastic

Normally, demand is elastic for luxury goods. Let the price of gold per gm
decline from Rs. 160 to Rs. 140. As a result, demand for gold rises from
1,000 kilograms to 2,000 kilograms. Thus,

EP = 1,000/1,000 ÷ 20/160 = 1,000/20 .160/1,000 = 8

Since elasticity of demand for gold is greater than one, gold is a luxury item.
(2) Inelastic Demand (EP < 1):
When the change in price causes a less than proportionate change in quantity
demanded, demand is inelastic. A 10 p.c. cut in price may cause quantity
demanded to fall by, say, 1 p.c. Thus, demand is said to be inelastic (Ep< 1),
shown in Fig. 2.43. Usually, demand is inelastic for necessary goods.

Suppose that following a drop in the price of wheat from paisa 40 per
kilogram to paisa 20 per kilogram, demand for wheat rises from 1,600
kilograms to 2,000 kilograms. This means

EP = 400/160 ÷ 20/40 = 400/20. 40/1,600 = 0.5

Thus, wheat has an inelastic demand since EP < 1 and wheat is a necessary
article.
(3) Unit elasticity of Demand (EP = 1):
When the change in price causes the same proportionate change in quantity
demanded, demand has unit elasticity. A 10 p.c. decline in price will lead to
an exactly 10 p.c. increase in quantity demanded. Then EP = 1 (Fig. 2.44).
Suppose that the price of a commodity declines from Rs. 200 to Rs. 100 per
kilogram. As a result, demand for that commodity rises from 400 kilograms
to 800 kilograms. Thus,

EP = 400/400 ÷ 100/100 = 400/100. 100/400 = 1

(4) Perfectly Elastic Demand (EP = ∞)
When a slight change in price causes a great change in quantity demanded,
the value of elasticity of demand tends to be infinity and demand is said to be
infinite or perfectly elastic. In this case, the demand curve (DD,) becomes
parallel to the horizontal axis (Fig. 2.45). Under perfectly competitive
market, the demand curve for a product of an individual firm becomes
perfectly elastic.
(5) Perfectly Inelastic Demand (EP = 0):
If quantity demanded becomes completely unresponsive to price changes, the
coefficient tends to be zero. In this case, whatever the price, even if it is zero,
quantity demanded will remain fixed at a particular level. The demand curve,
thus, becomes parallel to the vertical axis (Fig. 2.46) and demand is said to be
completely (perfectly) inelastic.

Thus, elasticity of demand varies from zero to infinity.

b) Income elasticity
Income elasticity of demand measures the relationship between a change in quantity
demanded for good X and a change in real income.

The formula for calculating income elasticity is:

% Change in demand divided by the % change in income

Explain Normal Goods

 Normal goods have a positive income elasticity of demand so as consumers'

income rises more is demanded at each price i.e. there is an outward shift of the
demand curve

 Normal necessities have an income elasticity of demand of between 0 and +1 for

example, if income increases by 10% and the demand for fresh fruit increases by
4% then the income elasticity is +0.4. Demand is rising less than proportionately
to income.
  Luxury goods and services have an income elasticity of demand > +1 i.e. demand
rises more than proportionate to a change in income – for example a 8%
increase in income might lead to a 10% rise in the demand for new kitchens. The
income elasticity of demand in this example is +1.25.

Explain Inferior Goods

 Inferior goods have a negative income elasticity of demand meaning that demand
falls as income rises. Typically inferior goods or services exist where superior
goods are available if the consumer has the money to be able to buy it. Examples
include the demand for cigarettes, low-priced own label foods in supermarkets
and the demand for council-owned properties.

C) Cross elasticity of demand

ross Elasticity of Demand: Definitions, Types and

Measurement of Cross Elasticity of Demand!
It is the ratio of proportionate change in the quantity demanded of Y
to a given proportionate change in the price of the related commodity
X.

It is a measure of relative change in the quantity demanded of a

commodity due to a change in the price of its substitute/complement.
It can be expressed as:

Cross elasticity may be infinite or zero if the slightest change in the

price of X causes a substantial change in the quantity demanded of Y.
It is always the case with goods which have perfect substitutes for one
another. Cross elasticity is zero, if a change in the price of one
commodity will not affect the quantity demanded of the other. In the
case of goods which are not related to each other, cross elasticity of
demand is zero.
DEFINITION:
“The cross elasticity of demand is the proportional change in the
quantity of X good demanded resulting from a given relative change in
the price of a related good Y” Ferguson
“The cross elasticity of demand is a measure of the responsiveness of
purchases of Y to change in the price of X” Leibafsky

TYPES OF CROSS ELASTICITY OF DEMAND:

1. Positive:
When goods are substitute of each other then cross elasticity of
demand is positive. In other words, when an increase in the price of Y
leads to an increase in the demand of X. For instance, with the
increase in price of tea, demand of coffee will increase.

In fig. 21 quantity has been measured on OX-axis and price on OY-

axis. At price OP of Y-commodity, demand of X-commodity is OM.
Now as price of Y commodity increases to OP1 demand of X-
commodity increases to OM1 Thus, cross elasticity of demand is
positive.

2. Negative:
In case of complementary goods, cross elasticity of demand is
negative. A proportionate increase in price of one commodity leads to
a proportionate fall in the demand of another commodity because both
are demanded jointly. In fig. 22 quantity has been measured on OX-
axis while price has been measured on OY-axis. When the price of
commodity increases from OP to OP1 quantity demanded falls from
OM to OM1. Thus, cross elasticity of demand is negative.
3. Zero:
Cross elasticity of demand is zero when two goods are not related to
each other. For instance, increase in price of car does not effect the
demand of cloth. Thus, cross elasticity of demand is zero. It has been
shown in fig. 23.

Therefore, it depends upon substitutability of goods. If substitutability

is perfect, cross elasticity is infinite; if on the other hand,
substitutability does not exist, cross elasticity is zero. In the case of
complementary goods like jointly demanded goods cross elasticity is
negative. A rise in the price of one commodity X will mean not only
decrease in the quantity of X but also decrease in the quantity
demanded of Y because both are demanded together.
IMPORTANCE OF THE CONCEPT OF ELASTICITY OF DEMAND:

(a) Price Determination:

Use of the concept of elasticity of demand is required in the price determination of a commodity
under different market conditions. Under perfect competition, in the short run in which supply is
absolutely inelastic price depends upon the elasticity of demand.

If demand suddenly falls—supply remaining fixed—prices will fall, and, if demand suddenly
rises, prices will rise as output cannot be increased. Again, the stability of prices also depends on
the elasticity of demand and elasticity of supply. If either the demand or the supply is elastic,
fluctuations in prices will be within narrow limits.

Further, if the demand for an agricultural commodity is inelastic, increased production may spell
disaster to the economic condition of farmers. So the government can adopt measures to save the
plight of the farmers.

A monopoly seller must have a knowledge relating to the elasticity of demand for his product
while determining the price of his commodity.

A monopolist will produce a commodity in the range of his demand curve where demand is said
to be elastic. He will never produce in the range of the demand curve where demand is inelastic.
Obviously, price determination of the monopoly product will be governed by the elasticity of
demand.

(b) Wage Determination:

The concept of elasticity of demand is employed in wage determination. Wages, in modern days,
are determined through the process of collective bargaining. Trade union will be successful in
raising the wage rate provided labour demand is deemed to be inelastic. This is because of the
fact that the degree of substitution between labour and other labour substituting inputs is less.

Trade union becomes cautious in demanding higher wage rates when the demand for labour is
said to be elastic. Under the circumstance, the employer may be forced to employ more machines
(assumed to be a cheaper input) than labour.
c) Policy Determination:
The concept of elasticity of demand is of great importance to a finance minister. While imposing
tax or raising the existing tax rates, the finance minister must have sufficient knowledge of the
elasticity of demand for the taxed commodity.

If the demand for the product is inelastic, the purpose of the tax—say revenue-earning—will be
served. That is why taxes are mostly imposed or rates of taxes are raised in the case of
commodities having inelastic demand.

Again, the concept may be used in the determination of incidence of a tax. It is easier to shift the
burden of taxes on to the consumers if the product demand is assumed to be inelastic. Further,
whether exportable or importable be taxed or not, the concept of elasticity may be of great use.

Lesson 5 Demand Estimation

Demand estimation
Demand estimation is a prediction focusing on future consumer behavior. It predicts demand for
a business’s products or services by applying a set of variables that show how, for example, price
changes, a competitor's pricing strategy or changes in consumer income levels will affect product
demand. Once armed with this information, management can then begin to make strategic
business decisions ranging from reviewing pricing strategies to setting product inventory levels
to deciding whether to make fixed asset investments and whether to introduce a new product or
enter a new market.

 Demand Forecasting: Concept, Significance, Objectives and Factors

An organization faces several internal and external risks, such as high competition, failure of
technology, labor unrest, inflation, recession, and change in government laws.

Therefore, most of the business decisions of an organization are made under the conditions of
risk and uncertainty.

An organization can lessen the adverse effects of risks by determining the demand or sales
prospects for its products and services in future. Demand forecasting is a systematic process that
involves anticipating the demand for the product and services of an organization in future under
a set of uncontrollable and competitive forces.
Some of the popular definitions of demand forecasting are as follows:
According to Evan J. Douglas, ―Demand estimation (forecasting) may be defined as a process of
finding values for demand in future time periods.‖

SIGNIFICANCE OF DEMAND FORECASTING:

Demand plays a crucial role in the management of every business. It helps an organization to
reduce risks involved in business activities and make important business decisions. Apart from
this, demand forecasting provides an insight into the organization’s capital investment and
expansion decisions.

The significance of demand forecasting is shown in the following points:

i. Fulfilling objectives:
Implies that every business unit starts with certain pre-decided objectives. Demand forecasting
helps in fulfilling these objectives. An organization estimates the current demand for its products
and services in the market and move forward to achieve the set goals.

For example, an organization has set a target of selling 50, 000 units of its products. In such a
case, the organization would perform demand forecasting for its products. If the demand for the
organization’s products is low, the organization would take corrective actions, so that the set
objective can be achieved.

ii. Preparing the budget:

Plays a crucial role in making budget by estimating costs and expected revenues. For instance, an
organization has forecasted that the demand for its product, which is priced at Rs. 10, would be
10, 00, 00 units. In such a case, the total expected revenue would be 10* 100000 = Rs. 10, 00,
000. In this way, demand forecasting enables organizations to prepare their budget.

iii. Stabilizing employment and production:

Helps an organization to control its production and recruitment activities. Producing according to
the forecasted demand of products helps in avoiding the wastage of the resources of an
organization. This further helps an organization to hire human resource according to
requirement. For example, if an organization expects a rise in the demand for its products, it may
opt for extra labor to fulfill the increased demand.

iv. Expanding organizations:

Implies that demand forecasting helps in deciding about the expansion of the business of the
organization. If the expected demand for products is higher, then the organization may plan to
expand further. On the other hand, if the demand for products is expected to fall, the organization
may cut down the investment in the business.

v. Taking Management Decisions:

Helps in making critical decisions, such as deciding the plant capacity, determining the
requirement of raw material, and ensuring the availability of labor and capital.

vi. Evaluating Performance:

Helps in making corrections. For example, if the demand for an organization’s products is less, it
may take corrective actions and improve the level of demand by enhancing the quality of its
products or spending more on advertisements.

vii. Helping Government:

Enables the government to coordinate import and export activities and plan international trade.

OBJECTIVES OF DEMAND FORECASTING:

Demand forecasting constitutes an important part in making crucial business decisions.

i. Short-term Objectives:
a. Formulating production policy:
Helps in covering the gap between the demand and supply of the product. The demand
forecasting helps in estimating the requirement of raw material in future, so that the regular
supply of raw material can be maintained. It further helps in maximum utilization of resources as
operations are planned according to forecasts. Similarly, human resource requirements are easily
met with the help of demand forecasting.

b. Formulating price policy:

Refers to one of the most important objectives of demand forecasting. An organization sets
prices of its products according to their demand. For example, if an economy enters into
depression or recession phase, the demand for products falls. In such a case, the organization sets
low prices of its products.

c. Controlling sales:
Helps in setting sales targets, which act as a basis for evaluating sales performance. An
organization make demand forecasts for different regions and fix sales targets for each region
accordingly.
d. Arranging finance:
Implies that the financial requirements of the enterprise are estimated with the help of demand
forecasting. This helps in ensuring proper liquidity within the organization.

ii. Long-term Objectives:

a. Deciding the production capacity:
Implies that with the help of demand forecasting, an organization can determine the size of the
plant required for production. The size of the plant should conform to the sales requirement of
the organization.

b. Planning long-term activities:

Implies that demand forecasting helps in planning for long term. For example, if the forecasted
demand for the organization’s products is high, then it may plan to invest in various expansion
and development projects in the long term.

FACTORS INFLUENCING DEMAND FORECASTING :

Demand forecasting is a proactive process that helps in determining what products are needed
where, when, and in what quantities. There are a number of factors that affect demand
forecasting.

i. Types of Goods:
Affect the demand forecasting process to a larger extent. Goods can be producer’s goods,
consumer goods, or services. Apart from this, goods can be established and new goods.
Established goods are those goods which already exist in the market, whereas new goods are
those which are yet to be introduced in the market.

Information regarding the demand, substitutes and level of competition of goods is known only
in case of established goods. On the other hand, it is difficult to forecast demand for the new
goods. Therefore, forecasting is different for different types of goods.

ii. Competition Level:

Influence the process of demand forecasting. In a highly competitive market, demand for
products also depend on the number of competitors existing in the market. Moreover, in a highly
competitive market, there is always a risk of new entrants. In such a case, demand forecasting
becomes difficult and challenging.
iii. Price of Goods:
Acts as a major factor that influences the demand forecasting process. The demand forecasts of
organizations are highly affected by change in their pricing policies. In such a scenario, it is
difficult to estimate the exact demand of products.

iv. Level of Technology:

Constitutes an important factor in obtaining reliable demand forecasts. If there is a rapid change
in technology, the existing technology or products may become obsolete. For example, there is a
high decline in the demand of floppy disks with the introduction of compact disks (CDs) and pen
drives for saving data in computer. In such a case, it is difficult to forecast demand for existing
products in future.

v. Economic Viewpoint:
Play a crucial role in obtaining demand forecasts. For example, if there is a positive development
in an economy, such as globalization and high level of investment, the demand forecasts of
organizations would also be positive.

Apart from aforementioned factors, following are some of the other important factors that
influence demand forecasting:
a. Time Period of Forecasts:
Act as a crucial factor that affect demand forecasting. The accuracy of demand forecasting
depends on its time period.

Forecasts can be of three types, which are explained as follows:

1. Short Period Forecasts:
Refer to the forecasts that are generally for one year and based upon the judgment of the
experienced staff. Short period forecasts are important for deciding the production policy, price
policy, credit policy, and distribution policy of the organization.

2. Long Period Forecasts:

Refer to the forecasts that are for a period of 5-10 years and based on scientific analysis and
statistical methods. The forecasts help in deciding about the introduction of a new product,
expansion of the business, or requirement of extra funds.

3. Very Long Period Forecasts:

Refer to the forecasts that are for a period of more than 10 years. These forecasts are carried to
determine the growth of population, development of the economy, political situation in a
country, and changes in international trade in future.

Among the aforementioned forecasts, short period forecast deals with deviation in long period
forecast. Therefore, short period forecasts are more accurate than long period forecasts.

4. Level of Forecasts:
Influences demand forecasting to a larger extent. A demand forecast can be carried at three
levels, namely, macro level, industry level, and firm level. At macro level, forecasts are
undertaken for general economic conditions, such as industrial production and allocation of
national income. At the industry level, forecasts are prepared by trade associations and based on
the statistical data.

Moreover, at the industry level, forecasts deal with products whose sales are dependent on the
specific policy of a particular industry. On the other hand, at the firm level, forecasts are done to
estimate the demand of those products whose sales depends on the specific policy of a particular
firm. A firm considers various factors, such as changes in income, consumer’s tastes and
preferences, technology, and competitive strategies, while forecasting demand for its products.

5. Nature of Forecasts:
Constitutes an important factor that affects demand forecasting. A forecast can be specific or
general. A general forecast provides a global picture of business environment, while a specific
forecast provides an insight into the business environment in which an organization operates.
Generally, organizations opt for both the forecasts together because over-generalization restricts
accurate estimation of demand and too specific information provides an inadequate basis for
planning and execution.

Steps of Demand Forecasting:

The Demand forecasting process of an organization can be effective only when it is conducted
systematically and scientifically.

1. Setting the Objective:

Refers to first and foremost step of the demand forecasting process. An organization needs to
clearly state the purpose of demand forecasting before initiating it.

Setting objective of demand forecasting involves the following:

a. Deciding the time period of forecasting whether an organization should opt for short-term
forecasting or long-term forecasting

b. Deciding whether to forecast the overall demand for a product in the market or only- for the
organizations own products

c. Deciding whether to forecast the demand for the whole market or for the segment of the
market

d. Deciding whether to forecast the market share of the organization

2. Determining Time Period:

Involves deciding the time perspective for demand forecasting. Demand can be forecasted for a
long period or short period. In the short run, determinants of demand may not change
significantly or may remain constant, whereas in the long run, there is a significant change in the
determinants of demand. Therefore, an organization determines the time period on the basis of its
set objectives.

3. Selecting a Method for Demand Forecasting:

Constitutes one of the most important steps of the demand forecasting process Demand can be
forecasted by using various methods. The method of demand forecasting differs from
organization to organization depending on the purpose of forecasting, time frame, and data
requirement and its availability. Selecting the suitable method is necessary for saving time and
cost and ensuring the reliability of the data.

4. Collecting Data:
Requires gathering primary or secondary data. Primary’ data refers to the data that is collected by
researchers through observation, interviews, and questionnaires for a particular research. On the
other hand, secondary data refers to the data that is collected in the past; but can be utilized in the
present scenario/research work.

5. Estimating Results:
Involves making an estimate of the forecasted demand for predetermined years. The results
should be easily interpreted and presented in a usable form. The results should be easy to
understand by the readers or management of the organization.
Demand forcasting of new product

Joel Dean makes six possible approaches towards forecasting of new products. They are
as follows:
1. THE EVOLUTIONARY APPROACH IN FORECASTING DEMAND
The principle behind this approach is that the demand for a new product is only an
outgrowth and evolution of the existing product. It means that the demand conditions of
the existing product should be taken into account while accessing the demand for the
product.

Examples: Color TV sets from black and white TV sets; Left-side steering cars from
right-side steering cars, etc. But this approach is useful only when the new product is
very close to the old existing product.

2. SUBSTITUTE APPROACH IN FORECASTING DEMAND

By this the new product is analyzed as a substitute for the old existing product or
service.

3. GROWTH CURVE APPROACH IN FORECASTING DEMAND

The estimates of rate of growth and ultimate level of demand for the new product will be
established on the basis of some growth patterns of an already established product.

For example, the average sales of Talcum powder will give an idea as to how a new
cosmetic will be received in the market.

4. OPINION POLL APPROACH IN FORECASTING DEMAND

Under this, the demand for the new product will be estimated by making direct
enquiries from the ultimate consumers. This is done by sample survey method. But, this
is a very complicated process as there will be problems of sampling, probing the real
intentions of the consumers, etc..

5. SALES EXPERIENCE APPROACH IN FORECASTING DEMAND

According to Sales experience approach method, samples of new products shall be
offered in a sample market to forecast demand. This is done through distributive
channels like departmental stores or cooperative society, etc., or by direct mailing. Total
demand is predicted on the basis of the sample market. But, the difficulty in this lies in
determining the allowance to make for the immaturity of the sample market and full-
fledged market.

6. VICARIOUS APPROACH IN FORECASTING DEMAND

Through vicarious approach method, the reaction of the customer towards new product
can be found out indirectly through the specialized dealers who are able to judge the
needs, tastes and preferences of customers.
 The dealers being the link between the producer and the ultimate consumers, will be
able to know how the customers will receive the new product.

Lesson 6 Indifference Curve Analysis

Indifference curve

Meaning and Definitions of Indifference Curves:

A curve showing different combinations of two commodities giving the
same level of satisfaction is called indifference curve. A consumer is
indifferent to these various combinations because the level of
satisfaction is the same. On account of indifferent or neutrality of an
individual consumer these curves are also called indifference curves.

Different economists have defined indifference curves in different ways.

Some of these definitions are given below:

(1) Prof. Henderson and Prof. Quandt have defined, ―The locus of all
commodity combinations from which a consumer derives the same level
of satisfaction forms an indifference curve.‖

(2) Prof. C.E. Ferguson has defined, ―An indifference curve is a locus of
point—of particular budgets—of combinations of goods—each of which
yields the same level of total utility or to which the consumer is
indifferent.‖

Assumptions of Indifference Curve

1. Only two goods are taken into the consideration. It is assumed that the
customer has to make a choice between two goods, provided their prices
remains constant.
2. It is assumed that the customer is not saturated with both the commodities and
look for more benefits from these two, to have a higher curve to have more
satisfaction.
3. The satisfaction level cannot be measured; thus, the customer ranks his
preferences.
4. It is assumed that the marginal rate of substitution diminishes, as more units
of one good have to be set off by the reduction in the units of the other
commodity. Thus, the indifference curve is convex to the origin.
5. It is assumed that the consumer is rational and will make his choice objectively
to have an increased utility and the satisfaction.
Indifference Map:
An individual consumer has different levels of satisfaction with different
combinations of two commodities. When all the curves of different levels
of satisfaction are shown on a diagram we will get indifference map.
Thus, indifference map shows a set of various indifference curves
available to an individual consumer.

It can be seen from the following diagram:

The diagram shows four indifference curves showing different
combinations of two commodities (X and Y) showing different levels of
satisfaction. All the indifference curves to right side of the original
indifference curve (IC) show higher levels of satisfaction. In other words,
higher the indifference curve higher is the level of satisfaction. It is a
scale of preference.

In the diagram the scale of preference of the consumer goes like this
IC3 >IC2> IC1> IC. The consumer is not indifferent among the indifference
curves as higher indifference curve gives him higher level of satisfaction.

Properties of Indifference Curve

(1) INDIFFERENCE CURVES ARE NEGATIVELY S LOPED:

The indifference curves must slope down from left to right. This means that an indifference curve is
negatively sloped. It slopes downward because as the consumer increases the consumption of X
commodity, he has to give up certain units of Y commodity in order to maintain the same level of
satisfaction.
In fig. 3.4 the two combinations of commodity cooking oil and commodity wheat is shown by the points a
and b on the same indifference curve. The consumer is indifferent towards points a and b as they
represent equal level of satisfaction.

At point (a) on the indifference curve, the consumer is satisfied with OE units of ghee and OD units of
wheat. He is equally satisfied with OF units of ghee and OK units of wheat shown by point b on the
indifference curve. It is only on the negatively sloped curve that different points representing different
combinations of goods X and Y give the same level of satisfaction to make the consumer indifferent.

(2) HIGHER INDIFFERENCE CURVE REPRESENTS HIGHER LEVEL:

A higher indifference curve that lies above and to the right of another indifference curve represents a
higher level of satisfaction and combination on a lower indifference curve yields a lower satisfaction.

In other words, we can say that the combination of goods which lies on a higher indifference curve will be
preferred by a consumer to the combination which lies on a lower indifference curve.
 1 2 3
In this diagram (3.5) there are three indifference curves, IC , IC and IC which represents different levels
3
of satisfaction. The indifference curve IC shows greater amount of satisfaction and it contains more of
2 1 3 2 1
both goods than IC and IC (IC > IC > IC ).

(3) INDIFFERENCE CURVE ARE CONVEX TO THE ORIGIN:

This is an important property of indifference curves. They are convex to the origin (bowed inward). This is
equivalent to saying that as the consumer substitutes commodity X for commodity Y, the marginal rate of
substitution diminishes of X for Y along an indifference curve.

In this figure (3.6) as the consumer moves from A to B to C to D, the willingness to substitute good X for
good Y diminishes. This means that as the amount of good X is increased by equal amounts, that of good
Y diminishes by smaller amounts. The marginal rate of substitution of X for Y is the quantity of Y good
that the consumer is willing to give up to gain a marginal unit of good X. The slope of IC is negative. It is
convex to the origin.
(4) INDIFFERENCE CURVE CANNOT INTERSECT EACH OTHER:

Given the definition of indifference curve and the assumptions behind it, the indifference curves cannot
intersect each other. It is because at the point of tangency, the higher curve will give as much as of the
two commodities as is given by the lower indifference curve. This is absurd and impossible.

In fig 3.7, two indifference curves are showing cutting each other at point B. The combinations
represented by points B and F given equal satisfaction to the consumer because both lie on the same
indifference curve IC2. Similarly the combinations shows by points B and E on indifference curve IC 1 give
equal satisfaction top the consumer.

If combination F is equal to combination B in terms of satisfaction and combination E is equal to

combination B in satisfaction. It follows that the combination F will be equivalent to E in terms of
satisfaction. This conclusion looks quite funny because combination F on IC2 contains more of good Y
(wheat) than combination which gives more satisfaction to the consumer. We, therefore, conclude that
indifference curves cannot cut each other.

(5) INDIFFERENCE CURVES DO NOT TOUCH THE HORIZONTAL OR VERTICAL AXIS:

One of the basic assumptions of indifference curves is that the consumer purchases combinations of
different commodities. He is not supposed to purchase only one commodity. In that case indifference
curve will touch one axis. This violates the basic assumption of indifference curves.

In fig. 3.8, it is shown that the in difference IC touches Y axis at point C and X axis at point E. At point C,
the consumer purchase only OC commodity of rice and no commodity of wheat, similarly at point E, he
buys OE quantity of wheat and no amount of rice. Such indifference curves are against our basic
assumption. Our basic assumption is that the consumer buys two goods in combination

Xvi ) Consumer’s Equilibrium by Indifference Curve

Analysis!
Consumer equilibrium refers to a situation, in which a consumer
derives maximum satisfaction, with no intention to change it and
subject to given prices and his given income. The point of maximum
satisfaction is achieved by studying indifference map and budget line
together.
Conditions:

Thus the consumer’s equilibrium under the indifference curve theory must meet the following two
conditions:

First: A given price line should be tangent to an indifference curve or marginal rate of satisfaction of good
X for good Y (MRSxy) must be equal to the price ratio of the two goods. i.e.

MRSxy = Px / Py

Second: The second order condition is that indifference curve must be convex to the origin at the point of
tangency.

Assumptions:

The following assumptions are made to determine the consumer’s equilibrium position.

(i) Rationality: The consumer is rational. He wants to obtain maximum satisfaction given his income and
prices.

(ii) Utility is ordinal: It is assumed that the consumer can rank his preference according to the
satisfaction of each combination of goods.

(iii) Consistency of choice: It is also assumed that the consumer is consistent in the choice of goods.

(iv) Perfect competition: There is perfect competition in the market from where the consumer is
purchasing the goods.

(v) Total utility: The total utility of the consumer depends on the quantities of the good consumed.
Explanation:
The consumer’s consumption decision is explained by combining the budget line and the indifference
map. The consumer’s equilibrium position is only at a point where the price line is tangent to the highest
attainable indifference curve from below.

(1) BUDGET LINE SHOULD BE TANGENT TO THE INDIFFERENCE CURVE:

The consumer’s equilibrium in explained by combining the budget line and the indifference map.

Diagram/Figure:

1 2 3
In the diagram 3.11, there are three indifference curves IC , IC and IC . The price line PT is tangent to
2
the indifference curve IC at point C. The consumer gets the maximum satisfaction or is in equilibrium at
point C by purchasing OE units of good Y and OH units of good X with the given money income.

The consumer cannot be in equilibrium at any other point on indifference curves. For instance, point R
1
and S lie on lower indifference curve IC but yield less satisfaction. As regards point U on indifference
3
curve IC , the consumer no doubt gets higher satisfaction but that is outside the budget line and hence
not achievable to the consumer. The consumer’s equilibrium position is only at point C where the price
2
line is tangent to the highest attainable indifference curve IC from below.

(2) SLOPE OF THE PRICE LINE TO BE EQUAL TO THE SLOPE OF I NDIFFERENCE CURVE:
The second condition for the consumer to be in equilibrium and get the maximum possible satisfaction is
only at a point where the price line is a tangent to the highest possible indifference curve from below. In
2
fig. 3.11, the price line PT is touching the highest possible indifferent curve IC at point C. The point C
shows the combination of the two commodities which the consumer is maximized when he buys OH units
of good X and OE units of good Y.

Geometrically, at tangency point C, the consumer’s substitution ratio is equal to price ratio Px / Py. It
implies that at point C, what the consumer is willing to pay i.e., his personal exchange rate between X and
Y (MRSxy) is equal to what he actually pays i.e., the market exchange rate. So the equilibrium condition
being Px / Py being satisfied at the point C is:

Price of X / Price of Y = MRS of X for Y

The equilibrium conditions given above states that the rate at which the individual is willing to substitute
commodity X for commodity Y must equal the ratio at which he can substitute X for Y in the market at a
given price.

(3) INDIFFERENCE CURVE SHOULD BE CONVEX TO THE ORIGIN:

The third condition for the stable consumer equilibrium is that the indifference curve must be convex to
the origin at the point of equilibrium. In other words, we can say that the MRS of X for Y must be
2
diminishing at the point of equilibrium. It may be noticed that in fig. 3.11, the indifference curve IC is
convex to the origin at point C. So at point C, all three conditions for the stable-consumer’s equilibrium
are satisfied.

Summing up, the consumer is in equilibrium at point C where the budget line PT is tangent to the
2
indifference IC . The market basket OH of good X and OE of good Y yields the greatest satisfaction
because it is on the highest attainable indifference curve. At point C:

MRSxy = Px / Py

Xvii ) importance and limitation of Indifference curve theory

Refer pics