CHAPTER 2

DEMAND AND SUPPLY, ANALYSIS, ESTIMATION AND FORECASTING

A fundamental understanding of demand and supply concepts is essential to the

successful operation of any economic organization.

Lesson 1.Basis of Demand

Demand is the quantity of a good or service that customers are willing and able to
purchase under a given set of economic conditions.
Direct demand is the demand for the products that directly satisfy consumer desires. The
value or worth of a good or service, its utility, is the prime determinant of direct demand. Demand
for consumption of products.
Derived demand is a demand for all inputs and determined by the profitability of using
various inputs to produce output. Demand for inputs used in production.

Law of Demand:
“As price goes up, the quantity demanded by consumers goes down.
As the price falls, the quantity demanded by consumers rises.”

If everything else remains the same, people will demand more of something at a lower price than
they will at a higher price.

Demand Schedule- a list of how many units are willing to buy at different prices.

Demand

Lesson 2.Market Demand Function

The market demand function for a product is a statement of the relation between the
aggregate quantity demanded and all factors that affect this quantity.

Determinants of demand: Increase Demand: Decrease Demand:

1. Change in buyer tastes.
2. Change in number of buyers.
3. Change in income.
4. Change in prices of related goods.
5. Change in expectations.
Favorable change.
Increase number
Increase if normal/
superior good
Fall if inferior good
An increase of related good
If Y is substitute to X;
A decrease of related goods
If Y is complementary good to X.
Increase expectations of
Future increase in income
& prices
Unfavorable
decrease number
A rise if inferior good’
A fall if normal/superior
good
An increase of related good
If Y is complementary to X;
A decrease of related goods
If Y is substitute to X
Decline in future price
and income

Lesson 3.Demand Curve

The demand curve expresses the relation between the price charged for a product and the
quantity demanded, holding constant the effects of all other variables.
A change in the quantity demanded is a movement along a single demand curve.
A shift in demand, or shift from one demand curve to another, reflects a change in one or
more of the non-price variables in the product demand function.
Lesson 4.Basis of Supply

Supply refers to the quantity of a good or service that produces are willing and able to sell
under a given set of conditions.

Law of Supply:
“ If everything else remain the same, business will supply more of a product or service at a
higher price than they will at a lower price”

Supply Schedule- a list of how many units of a product sellers are willing to supply at
different prices.

Lesson 5.Market Supply Function

Market supply function for a product is a statement of the relation between the quantity
supplied and all factors affecting that quantity.

Determinants of supply:
1. Resources prices.
2. Technology
3. Taxes and subsidies
4. Prices of other goods.
5. Future price expectation.
6. Number of Sellers

Lesson 6.Supply Curves

Supply curve expresses the relation between the price charged and the quantity supplied,
holding constant the effects of all other variables.

Movement along supply curve reflects change in the quantity supplied. A shift in
supply, or a switch from one supply curve to another, indicates a change in one or more of the
non-price variables in the product supply function.

Lesson 7. Market Equilibrium

Market is an institution or mechanism which brings together buyer and sellers(suppliers of

particular goods and services.

A market is in equilibrium when the quantity demanded and the quantity supplied is in perfect
balance at a given price. Surplus describes a condition of excess supply. Shortage is created
when buyers demand more of a product at a given price than producers are willing to supply. The
market equilibrium price or market clearing price just clears the market of all supplied product.

Lesson 8. Demand Analysis

Managerial Economics provides a useful framework for understanding how consumers

make trade-offs. Every consumer decision involves trade-offs between price, quantity, quality,
timeliness, and a host of related factors. The consideration of such trade-offs,, and the methods
used by consumers to make consumption decisions, is called the study of consumer behavior.
Its obvious practical relevance when considering the pricing, and production decisions
made by businesses, also of practical relevance when considering public policy decisions
that directly or indirectly affect consumers. Consumer behavior theory is useful for both
describing and predicting consumer decisions.
In a comparative static analysis, the role of factors influencing demand and supply is
analyzed while holding all else equal.
UTILITY THEORY
The ability of goods and services to satisfy consumer wants is the basis for
consumer demand.

Utility-Satisfaction tied to consumption. Utils- Unit of utility or satisfaction.

Three Basic Assumptions

With these basic assumptions, the foundation exists for a more detailed examination of the
benefits tied to consumption.

1st. NONSATIATION PRINCIPLE-“More is better”, consumers always prefer more to less of any
good or service at any specific place and time, and consumers do become sated. It is best
considered within the context of money income where more money brings additional satisfaction
or well-being.

2nd.INDIFFERENCE-“Preference are complete”, consumers are able to compare and rank the
benefits tied to consumption. Indifference implies equivalence in the eyes of the consumer, it
yields the same amount of satisfaction.

3rd.PREFERENCES ARE TRANSITIVE, consumers are able to rank the desirability of various
goods and services. Ordinal utility, rank ordering of preferences (A is better than B). Cardinal
utility, understanding of the intensity of preferences (A=2B).

UTILITY FUNCTIONS
It is a descriptive statement that relates satisfaction or well-being to the consumption of
goods and services and can be written in general form: Utility= f(goods/services)

Market baskets-bundles of items desired by consumers.

Total Utility- measures the consumers overall level of satisfaction derived from
consumption
Marginal Uitility-measures the added satisfaction derived from a 1-unit increase in
consumption of a particular good or service, holding consumption of other goods and services
constant. It tends to diminish as consumption increase within a given time interval.

LAW OF DIMINISHING MARGINAL UTILITY:

“As an individual increases consumption of a given product within a set of period of time,
the marginal utility gained from consumption eventually declines.”

Lesson 9. DEMAND ESTIMATION

Interview And Experimental Methods

Effective means of finding out What do customers want.
1. Consumer interview (or survey) method-requires questioning customers or potential
customers to estimate demand relation and or a variety of underlying factors.
2. Market Experiments-demand estimation in a controlled environment. It is an alternative
technique for obtaining useful product demand information. Firms study one or more markets with
specific prices, packaging, ads, and then vary controllable factors over time or between markets.
This is expensive, undertaken on short periods, low level of confidence in the results.

Simple Demand Curve Estimation

It can give useful insight for pricing and promotion decisions.

Simple Demand Curve-sophisticated demand estimation and cost effective. Offering

discounts that will increase sales and thereby yielding maximum profits.

Simple Market Demand Curve Estimation

Market Demand is the firm’s total demand from various customer proups.

Market Demand Curve shows the total amount customers are willing to buy at various
prices under current market conditions. Total amount of demand=sum of demand curve of every
group(class a,b,c or local,foreign). Evaluate the market demand in every group in every specific
price.

Identification problem
Firms sometimes face problems in estimating demand relations because of the interplay
between demand and supply conditions.

Simultaneous relation-concurrent association, market price-output equilibrium at any point

in time is determined by the forces of demand and supply.
Identification problem-difficulty of estimating an economic relation in the presence of
simultaneous relations.

Regression Analysis
It is a powerful statistical technique used to describe the ways in which important
economic variables are related.

Deterministic relation is an association between variables that is known with certainty. Ex:
Total Revenue=PricexQuantity.
Statistical relation exists between two economic variables if the average is related to
another but it is impossible to predict with certainty the value of one based on the value of another.
Imprecise link between two variables.
Time Series of data-daily weekly, monthly, or annual sequence of economic data.
Cross-section of data-a group of observation on an important economic variable atany
given point of time.
Scatter diagram-is a plot of data where the dependent variable is plotted on the vertical
axis(Y) and the independend variable on horizontal axis (X).

Lesson10. Forecasting
Predicting trends in macroeconomic conditions and their impact on costs or demand
for company goods and services is one of the most difficult responsibilities facing
management however Forecasting is a necessary task because, for better or worse, all
decisions are made on the basis of future expectations. A number of forecasting
techniques have proven successful in forming accurate expectations in a wide variety of
real-world applications.

Macroeconomic forecasting –prediction of aggregate economic activity at the international,

national, regional, or state levels. Prediction of gross domestic products (GDP),
unemployment,interest rates.GDP-is the value of final point of sale of all goods and services
produced in the domestic economy during a given period by both domestic and foreign-owned
enterprises. GNP- is the value of final point of sale of all goods and services produced bydomestic
firms.

Microeconomic forecasting-prediction of partial economic data, involves the prediction of

economic data at the industry, firm,plant, or product levels.

Forecast Techniques:
1. Qualitative analyses
2. Trend analysis and projection
3. Exponential smoothing
4. Econometric methods

1. Qualitative analyses –an intuitive judgmental approach to forecasting based on opinion.

Expert Opinion:
a. Personal insight-method based on personal or organizational experience.
b. Panel consensus- method based on the informed opinion of several individuals.
c. Delphi method- method that uses forecasts derived from an independent analysis of
expert opinion.
Survey Techniques
Generally use interviews or mailed questionnaire approach to forecasting.

2. Trend analysis and projection-is based on the premise that future economic performance
follows anestablished historical pattern
Trends in Economic Data:
a.Secular Trend-long run pattern of increase or decrease.
b.Cyclical Fluctuation- Rythmic fluctuation in an economic series due to expansion or
contraction in the overall economy.
c.Seasonality- Rythmic annual patterns in sales or profits.
d. Irregular or random Influences-Unpredictable shocks to the economic system and the
paced of economic activity such as wars, strikes, natural catastrophes and the like.

Linear Trend Analysis –assumes a constant period-by-period unit change in an important

economic variable over time.
Growth Trend Analysis- assumes constant period-by-period percentage change in an
important economic variable over time.

3. Exponential smoothing-averaging techniques to predict unit sales growth, revenue,

costs and profit performance

a. Exponential smoothing or averaging is a method of forecasting trends in unit sales,

unit costs, wage expenses, and so on. Identifies historical patterns of trend or seasonality in the
data and then extrapolates these patterns forward into the forecast data. Most widely used
techniques.
b. One-parameter (Simple) Exponential Smoothing- the sole regular component is the
level of the forecast data series, ppropriate for forecasting sales in mature markets with stable
activity
c. Two-parameter (HOLT) Exponential Smoothing- by C.C.Holt, appropriate for
forecasting sales in established markets with stable growth.
d. Three-parameter (Winters) Exponential Smoothing – by P.R.Winters, economic data
involve both growth trend, and seasonal considerations, best suited for forecasting problems that
involve rapid and/or changing rates of growth combined with seasonal influences.
4. Econometric methods- combined economic theory with statistical tools topredict
economic relations.

Advantage:
a. Force the forecaster to make explicit assumptions about the linkages among the variables on
the economic system being examined, forecaster must deal with causal relations to produce
logical consistency and increase reliability.
b. Forecaster can compare forecasts with actual results and use insights gained to improve the
forecast model.
c. Output offers estimates of actual values for forecasted variables that includes direction and
magnitude of change.
d. Their ability to explain economic phenomena.

Judging Forecast Reliability

Forecast Reliability, or predictive consistency must be adequately assessed prior to the
implementation of any successful forecasting program. A given forecast model is often estimated
by using test group of data and evaluated by using forecast group data. No forecasting
assignment is complete until reliability has been quantified and complete. The sample mean
forecast error is one useful measure of predictive capability.

Choosing the best forecast technique

The best forecast technique is one that carefully balances marginal costs and marginal benefits
and depends on:
a. data requirements
b. time horizon considerations
c. role of judgment