BUSINESS ECONOMICS AND FINANCIAL ANALYSIS

UNIT-2

Elasticity of Demand
The ‘elasticity’ is defined as the rate of responsiveness in the demand of a commodity for a
given change in price or any other determinants of demand. In other words, it explains the
extent of change in quantity demanded because of given change in the other determining
factors, may be price or any other factors

Three important kinds of elasticities of demand:

• Price elasticity
• Income elasticity of demand
• Cross price elasticity of demand or just cross elasticity.

Price Elasticity of Demand

The extent of response of demand for a commodity to a given change in price, other demand
determinants remaining constant, is termed as the price elasticity of demand. The price
elasticity of demand may, thus, be defined as the ratio of the relative change in demand and
price variables.

Income Elasticity of Demand

Definition Other things remaining the same, it is degree of responsiveness of quantity
demanded of a commodity due to change in consumer’s income

In other words, Income Elasticity of Demand measures by how much the quantity demanded
changes with respect to the change in income. Practical Example Suppose that the initial
income of a person is Rs.2000 and quantity demanded for the commodity by him is 20 units.
When his income increases to Rs.3000, quantity demanded by him also increases to 40 units.
Types of Income Elasticity
1. Positive income elasticity of demand (EY>0) If the quantity demanded for a commodity
increases with the rise in income of the consumer and vice versa, it is said to be positive
income elasticity of demand. For example: As the income of consumer increases, they
consume more of superior (luxurious) goods.

a) Income elasticity greater than unity (EY > 1) Percentage change in quantity
demanded for a commodity is greater than percentage change in income of the
consumer, it is said to be income greater than unity. For Example, When the
consumer's income rises by 3% and the demand rises by 7%

b) b) Income elasticity equal to unity (EY = 1) Percentage change in quantity

demanded for a commodity is equal to percentage change in income of the
consumer. For example, if income increases by 50% and demand also rises by
50%.
 c) Income elasticity less then unity (EY < 1) Percentage change in quantity
demanded for a commodity is less than percentage change in income of the
consumer

2. Negative income elasticity of demand (EY<0) Quantity demanded for a commodity

decreases with the rise in income of the consumer and vice versa.

3. Zero income elasticity of demand (EY=0) Quantity demanded for a commodity remains
constant with any rise or fall in income of the consumer
Cross Price Elasticity of Demand
Cross Price Elasticity of Demand (XED) measures the relationship between two goods when
the price of one change.

So, if a Hershey’s chocolate bar increases by 20%, how will that impact on demand for
Snickers? In other words, it calculates how the demand for one product is affected by the
change in the price of another.

Cross Price Elasticity of Demand (XED) covers three types of goods;

Substitute goods, (When a want can be satisfied by alternative similar goods, they are called
substitutes. For example, peas and beans, groundnut oil and til oil, tea and coffee, jowar and
bajra, etc., are substitutes of each other.)
Complementary goods, (Similarly, the demand for a commodity is also affected by its
complementary product. In order to satisfy a given want, two or more goods)

For instance, two goods with a positive XED are substitute goods. This is because when the
price of one good increases, it creates demand for the other good which is now cheaper. By
contrast, a complementary good has a negative XED. So, when the price of one good goes up,
it actually reduces demand for the good being compared.

Cross Price Elasticity Formula

Measurement of Elasticity Demand

a) Perfectly Elastic Demand
When any quantity can be sold at a given price and when there is no need to reduce the
price, the demand is said to be perfectly elastic. In such cases, even a small increase in the
price will lead to complete fall in demand
The figure reveals that quantity demanded increases from OQ to OQ1 to OQ2 even though
there is no change in price. Price is fixed at OP.

b) Perfectly Inelastic Demand

When a significant degree of change in price leads to little or no change in the quantity
demanded, then the elasticity is said to be perfectly inelastic. In other words the demand is
said to be perfectly inelastic when there is no change in the quantity demanded even through
there is big change in price (Increase or decrease).

The figure reveals that there is no change in the quantity demanded there is change in price,
increase or decrease. In other words, despite of the increase in price from OP to OP1, the
quantity demanded has not fallen down. Similarly, though there is a fall in the price from OP1
to OP2 the quantity demanded remains unchanged

c) Relatively Elastic Demand

The Demand is said to be relatively elastic when the change in demand is more than the
change in price. The figure reveals that the quantity demanded increases from OQ1 to OQ2
because of decrease in price from OP1 to OP2. The extent of increase in the quantity
demanded is greater than the extent of fall in the price

d) Relatively Inelastic Demand

The Demand is said to be relatively elastic when the change in demand is less than the change
in price. The figure reveals that the quantity demanded increases from OQ1 to OQ2 because
of decrease in price from OP1 to OP2. The extent of increase in the quantity demanded is
lesser than the extent of fall in the price.
e) Unity Elastic Demand
The elasticity in demand is said to be unity when the change in demand is equal to the change
in price. The figure reveals that quantity demanded increases from OQ1 to OQ2 because of a
decrease in price from OP1 and OP2. The extent of increase in the quantity demanded is equal
to the extent of fall in the price.

Significance of Elasticity of Demand

The elasticity of demand is a crucial concept in economics, measuring the responsiveness of

demand to changes in price or other factors. It plays a pivotal role in various economic
decisions, including pricing strategies, resource allocation, and government policies. Here's a
detailed explanation of the significance of elasticity of demand:

Pricing Strategies: Businesses heavily rely on the elasticity of demand to determine optimal
pricing strategies. For products with elastic demand, a small price increase can lead to a
significant decrease in demand, potentially reducing overall revenue. Conversely, for
products with inelastic demand, even substantial price changes may have a minimal impact
on demand, allowing businesses to maintain prices and potentially increase profits.

Resource Allocation: Firms utilize the concept of elasticity of demand to allocate resources
efficiently. By understanding the demand sensitivity for different products, companies can
prioritize production and marketing efforts towards goods with more elastic demand,
maximizing overall revenue and profitability.

Government Policies: Governments employ elasticity of demand to assess the impact of taxes
and subsidies on various goods and services. For products with elastic demand, imposing
taxes can significantly reduce demand and revenue, while subsidizing such products may not
lead to a substantial increase in consumption. Conversely, for inelastic goods, taxes may have
a smaller impact on demand, potentially generating revenue for the government.

Understanding Consumer Behavior: Elasticity of demand provides valuable insights into

consumer behavior and preferences. It helps businesses identify products that are considered
necessities or luxuries, allowing them to tailor their marketing and pricing strategies
accordingly.

Economic Forecasting: Elasticity of demand is a crucial factor in economic forecasting models.

By understanding how demand for various products responds to economic changes,
policymakers can better anticipate the impact of fiscal and monetary policies on the overall
economy.

Product Differentiation: Businesses can leverage elasticity of demand to differentiate their

products from competitors. By offering unique features or superior quality, they can create a
more elastic demand curve, potentially allowing them to charge premium prices without
significantly impacting sales.

Market Entry and Expansion: Elasticity of demand plays a role in evaluating the potential
success of market entry or expansion strategies. Businesses can assess the demand
responsiveness of existing products and identify opportunities to introduce new offerings or
expand into new markets.

Marketing Effectiveness: Elasticity of demand can be used to evaluate the effectiveness of

marketing campaigns. By analysing demand changes before, during, and after marketing
initiatives, companies can determine the impact of their marketing efforts on consumer
behavior.

Price Discrimination: Businesses can employ price discrimination strategies based on the
elasticity of demand for different consumer segments. For instance, they may charge higher
prices to consumers who are less price-sensitive, while offering lower prices to those who are
more sensitive to price changes.

Anticipating Economic Trends: Elasticity of demand can help businesses anticipate changes
in consumer preferences and economic trends. By monitoring demand patterns for various
products, companies can identify emerging trends and adapt their strategies accordingly.
Factors affecting Elasticity of Demand
Several factors can affect the elasticity of demand, including:

Availability of substitutes: If there are many close substitutes for a product, then demand for
that product will tend to be more elastic. This is because consumers can easily switch to
substitutes if the price of the original product rises. For example, if the price of gasoline rises,
consumers may switch to driving less, using public transportation, or carpooling.

Necessity vs. luxury: Necessities are goods or services that are essential for people to survive,
such as food, water, and shelter. Demand for necessities tends to be inelastic, meaning that
consumers will not significantly reduce their consumption of these goods even if the price
rises. Luxuries, on the other hand, are goods or services that are not essential for survival, but
are instead desired for pleasure or convenience. Demand for luxuries tends to be more elastic,
meaning that consumers will be more likely to reduce their consumption of these goods if the
price rises.

Proportion of income spent on the good: The proportion of income spent on a good is a
measure of how important the good is to the consumer. If a good represents a large
proportion of a consumer's income, then demand for that good will tend to be more elastic.
This is because consumers will be more likely to reduce their consumption of the good if the
price rises, in order to make ends meet.

Time period: Demand for a good is typically more elastic in the long run than in the short run.
This is because consumers have more time to adjust their consumption habits in the long run.
For example, if the price of gasoline rises, consumers may not be able to immediately switch
to a more fuel-efficient car, but they may be able to do so in the long run.

Cross-price elasticity of demand: Cross-price elasticity of demand is a measure of the

responsiveness of demand for one good to a change in the price of another good. If the cross-
price elasticity of demand is positive, then the two goods are substitutes, and a decrease in
the price of one good will lead to an increase in the demand for the other good. If the cross-
price elasticity of demand is negative, then the two goods are complements, and a decrease
in the price of one good will lead to a decrease in the demand for the other good.

Habit: Demand for goods that consumers have become accustomed to using may be less
elastic than demand for new goods. This is because consumers may be willing to pay a higher
price for a familiar good than for a new good, even if the new good is cheaper.

Advertising: Advertising can affect the elasticity of demand by making consumers more aware
of the availability of substitutes or by creating a brand loyalty that makes consumers less likely
to switch to a substitute.

Government policy: Government policies, such as taxes and subsidies, can also affect the
elasticity of demand. For example, a tax on a good will increase the price of the good, which
will tend to reduce demand for the good.
Demand is an economic principle referring to a consumer's desire to purchase goods and
services and willingness to pay a price for a specific good or service

INDIVIDUAL DEMAND AND MARKET DEMAND

Consumer demand for a product may be viewed at two levels: (i) Individual demand, and (ii)
Market demand

Individual demand refers to the demand for a commodity from the individual point of view.
The quantity of a product consumer would buy at a given price over a given period of time is
his individual demand for that particular product.

Individual demand is considered from one person’s point of view or from that of a family or
household’s point of view. Individual demand is a single consuming entity’s demand.

Market demand for a product, on the other hand, refers to the total demand of all the buyers,
taken together. Market demand is an aggregate of the quantities of a product demanded by
all the individual buyers at a given price over a given period of time. Market demand function
is the sum total of individual demand function. It is derived by aggregating all individual
buyer’s demand function in the market

Market demand is more important from the business point of view. Sales depend on the
market demand. Business policy and planning are based on the market demand. Prices are
determined on the basis of market demand for the product. In a competitive market,
interaction between total or market demand and market supply determine the equilibrium
price. Under monopoly also, the seller has to determine the price of his product with due
consideration to the position of market demand. He simply cannot determine any high price,
disregarding the market demand for the product.

LAW OF DEMAND
The law of demand describes the general tendency of consumers’ behaviour in demanding a
commodity in relation to the changes in its price.

The law of demand expresses the nature of functional relationship between two variables of
the demand relation, viz., the price and the quantity demanded.

It simply states that demand varies inversely to changes in price. The nature of this inverse
relationship stressed by the law of demand which forms one of the best known and most
significant laws in economics.

In other words, the demand for a commodity extends (i.e., the demand rises) as the price falls
and contracts (i.e., demand falls) as the price rises.
Or briefly stated, the law of demand stresses that, other things remaining unchanged, demand
varies inversely with price. The conventional law of demand, however, relates to the much
simplified demand function: D = f (P)

Where, D represents demand, P the price and f, connotes a functional relationship. It,
however, assumes that other determinants of demand are constant, and only price is the
variable and influencing factor. The relation between price and quantity of demand is usually
an inverse or negative relation, indicating a larger quantity demanded at a lower price and
smaller quantity demanded at a higher price.

Explanation of the Law of Demand

From the view point of Managerial Economics, the law of demand should be referred to the
market demand. The law of demand can be illustrated with the help of a market demand
schedule, i.e., as the price of a commodity decreases the corresponding quantity demanded
for that commodity increases and vice versa.

Market Demand Schedule

Price of Commodity X Quantity Demanded (Units
(in Rs) Per Week)

5 100

4 200

3 300

2 400

1 500
Assumptions Underlying the Law of Demand

The above stated law of demand is conditional. It is based on certain conditions as given. It is,
therefore, always stated with the ‘other things being equal.’ It relates to the change in price
variable only, assuming other determinants of demand to be constant. The law of demand is,
thus, based on the following ceteris paribus assumptions:

No change in consumer’s income. Throughout the operation of the law, the consumer’s
income should remain the same. If the level of a buyer’s income changes, he may buy more
even at a higher price, invalidating the law of demand.

No change in consumer’s preferences. The consumer’s taste, habits and preferences should
remain constant.

No change in the fashion. If the commodity concerned goes out the fashion, a buyer may not
buy more of it even at a substantial price of reduction.

No change in the price of related goods. Prices of other goods like substitutes and supportive,
i.e., complementary or jointly demanded products remain unchanged. If the prices of other
related goods change, the consumer’s preferences would change which may invalidate the
law of demand.

No expectation of future price changes or shortages. The law requires that the given price
change for the commodity is a normal one and has no speculative consideration. That is to
say, the buyers do not expect any shortages in the supply of the commodity.

No change in size, age composition and sex ratio of the population. For the operation of the
law in respect of total market demand, it is essential that the number of buyers and their
preferences should remain constant. This necessitates that the size of population as well as
the age structure and sex ratio of the population should remain the same throughout the
operation of the law. Otherwise, if population changes, there will be additional buyers in the
market, so the total market demand may not contract with a rise in price.

No change in the range of goods available to the consumers. This implies that there is no
innovation and arrival of new varieties of product in the market which may distort consumer’s
preferences.

No change in the distribution of income and wealth of the community. There is no

redistribution of incomes either, so that the levels of income of the consumers remain the
same.

No change in government policy. The level of taxation and fiscal policy of the government
remains the same throughout the operation of the law. Otherwise, changes in income-tax, for
instance, may cause changes in consumer’s income or commodity taxes (sales tax or excise
duties) and may lead to distortion in consumer’s preferences.

No change in weather conditions. It is assumed that the climatic and weather conditions are
unchanged in affecting the demand for certain goods like woollen clothes, umbrella, etc.

In short, the law of demand presumes that except for the price of the product, all other
determinants of its demand are unchanged. Apparently, the validity of the law of demand or
the inference about inverse relationship between price and demand depends on the existence
of these conditions or assumption.

EXCEPTIONS TO THE LAW OF DEMAND OR EXCEPTIONAL DEMAND CURVE (UPWARD

SLOPING DEMAND CURVE)

It is almost a universal phenomenon of the law of demand that when the price falls, the
demand extends and it contracts when the price rises. But sometimes, it may be observed,
though, of course, very rarely, that with a fall in price, demand also falls and with a rise in
price, demand also rises.

This is a paradoxical situation or a situation which apparently is contrary to the law of demand.
Cases in which this tendency is observed are referred to as exceptions to the general law of
demand. The demand curve for such cases will be typically unusual. It will be upward sloping
demand curve as shown in Figure It is described as an exceptional demand curve

In Figure DD is the demand curve which slopes upward from left to right. It appears that when
OP1, is the price, OQ1 is the demand and when the price rises to OP2, demand also extends
to OQ2. It represents a direct functional relationship between price and demand.

Such upward sloping demand curves are unusual and quite contradictory to the law of
demand as they represent the phenomenon that ‘more will be demanded at a higher price
and vice versa.’ The upward sloping demand curve thus, refers to the exceptions to the law of
demand. There are a few such exceptional cases, which may be categorized as follows
Giffen goods. In the case of certain inferior goods called Giffen goods (named after Sir Robert
Giffen), when the price falls, quite often less quantity will be purchased than before because
of the negative income effect and people’s increasing preference for a superior commodity
with the rise in their real income. Probably, a few appropriate examples of inferior goods may
be listed, such as staple foodstuffs like cheap potatoes, cheap bread, pucca rice, vegetable
ghee, etc., as against superior commodities like good potatoes, cake, basmati rice and pure
ghee.

Articles of snob appeal. Sometimes, certain commodities are demanded just because they
happen to be expensive or prestige goods, and have a ‘snob appeal.’ They satisfy the
aristocratic desire to preserve exclusiveness for unique goods. These are generally
ostentatious articles, and purchased by the fewer rich people or using them as ‘status symbol.’
It is observed that, when prices of such articles like, say diamonds, rise their demand also
rises. Similarly, Rolls Royce cars are another outstanding illustration.

Speculation. When people speculate about changes in the price of a commodity in the future,
they may not act according to the law of demand at the present price say, when people are
convinced that the price of a particular commodity will rise still further, they will not contract
their demand with the given price rise: on the contrary, they may purchase more for the
purpose of hoarding. In the stock exchange market, some people tend to buy more shares
when their prices are rising, in the hope that the rising trend would continue, so they can
make a good fortune in future.

Consumer’s psychological bias or illusion. When the consumer is wrongly biased against the
quality of a commodity with the price change, he may contract this demand with a fall in price.
Some sophisticated consumers do not buy when there is stock clearance sale at reduced
prices, thinking that the goods may be of bad quality

Demand Forecasting
Demand forecasting is a technique that is used for the estimation of what can be the demand
for the upcoming product or services in the future.
Need 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.

(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.
Demand Forecasting Methods

Qualitative Techniques

Qualitative techniques rely on collecting data on the buying behaviour of consumers from
experts or through conducting surveys in order to forecast demand. These techniques are
generally used to make short term forecasts of demand.

Qualitative techniques are especially useful in situations when historical data is not available;
for example, introduction of a new product or service. These techniques are based on
experience, judgment, intuition, conjecture, etc. Survey Methods

Survey methods are the most commonly used methods of forecasting demand in the short
run. This method relies on the future purchase plans of consumers and their intentions to
anticipate demand.
Thus, in this method, an organization conducts surveys with consumers to determine the
demand for their existing products and services and anticipate the future demand accordingly.
The two types of survey methods are explained as follows:

Complete enumeration survey: This method is also referred to as the census method of
demand forecasting. In this method, almost all potential users of the product are contacted
and surveyed about their purchasing plans.
Sample survey: In this method, only a few potential consumers (called sample) are selected
from the market and surveyed. In this method, the average demand is calculated based on
the information gathered from the sample.

Opinion poll: Opinion poll methods involve taking the opinion of those who possess
knowledge of market trends, such as sales representatives, marketing experts, and
consultants. The most commonly used opinion polls methods are explained as follows:

Expert opinion method: In this method, sales representatives of different

organisations get in touch with consumers in specific areas. They gather information
related to consumers’ buying behaviour, their reactions and responses to market
changes, their opinion about new products, etc.

Delphi method: In this method, market experts are provided with the estimates and
assumptions of forecasts made by other experts in the industry. Experts may
reconsider and revise their own estimates and assumptions based on the information
provided by other experts.

Market studies and experiments: This method is also referred to as market experiment
method. In this method, organisations initially select certain aspects of a market such as
population, income levels, cultural and social background, occupational distribution, and
consumers’ tastes and preferences. Among all these aspects, one aspect is selected and its
effect on demand is determined while keeping all other aspects constant.

Quantitative techniques for demand forecasting usually make use of statistical tools. In these
techniques, demand is forecasted based on historical data.

These methods are generally used to make long-term forecasts of demand. Unlike survey
methods, statistical methods are cost effective and reliable as the element of subjectivity is
minimum in these methods. Let us discuss different types of quantitative methods:

Time Series Analysis

Time series analysis or trend projection method is one of the most popular methods used by
organisations for the prediction of demand in the long run. The term time series refers to a
sequential order of values of a variable (called trend) at equal time intervals.
Using trends, an organisation can predict the demand for its products and services for the
projected time. There are four main components of time series analysis that an organisation
must take into consideration while forecasting the demand for its products and services. These
components are:

Trend A trend exists when there is a long-term increase or decrease in the data. It
does not have to be linear. Sometimes we will refer to a trend as “changing
direction,” when it might go Seasonal A seasonal pattern occurs when a time series
 is affected by seasonal factors such as the time of the year or the day of the week.
Seasonality is always of a fixed and known frequency. The major factors that are
weather conditions and customs of people. – More woolen clothes are sold in winter
than in the season of summer . – each year more ice creams are sold in summer and
very little in Winter season. – The sales in the departmental stores are more during
festive seasons that in the normal days.
Cyclic Apart from seasonal variations, there is another type of fluctuation which
usually lasts for more than a year. This fluctuation is the effect of business cycles. In
every business there are four important phases- i) prosperity, ii) decline, iii)
depression, and v) improvement or regain. The time from prosperity to regain is a
complete cycle. So, this cycle will never show regular periodicity. A period of a cycle
may differ but, importantly, the sequence of changes should be more or less regular
and it is this fact of regularity which enables us to study cyclical fluctuations.

Irregular variations– These are, as the name suggests, totally unpredictable. The
effects due to flood, draughts, famines, earthquakes, etc are known as irregular
variations. All variations excluding trend, seasonal and cyclical variations are irregular.
Sometimes cyclical fluctuations too can get generated from natural calamities, though.
from an increasing trend to a decreasing trend. There is a trend in the antidiabetic drug
sales data shown in.

Barometric Methods
Barometric methods are used to speculate the future trends based on current developments.
These methods are also referred to as the leading indicators approach to demand forecasting.
Many economists use barometric methods to forecast trends in business activities. The basic
approach followed in barometric methods of demand analysis is to prepare an index of
relevant economic indicators and forecast future trends based on the movements shown in
the index.
Leading indicators: When an event that has already occurred is considered to predict
the future event, the past event would act as a leading indicator. For example, the
data relating to working women would act as a leading indicator for the demand of
working women hostels.

Coincident indicators: These indicators move simultaneously with the current event.
For example, a number of employees in the non-agricultural sector, rate of
unemployment, per capita income, etc., act as indicators for the current state of a
nation’s economy.

Lagging indicators: These indicators include events that follow a change. Lagging
indicators are critical to interpret how the economy would shape up in the future.
These indicators are useful in predicting the future economic events. For example,
inflation etc. are the indicators of the performance of a country’s economy.
Econometric Methods make use of statistical tools combined with economic theories to
assess various economic variables (for example, price change, income level of consumers,
changes in economic policies, and so on) for forecasting demand.

The forecasts made using econometric methods are much more reliable than any other
demand forecasting method. An econometric model for demand forecasting could be single
equation regression analysis or a system of simultaneous equations. A detailed explanation of
regression analysis is given in the next section.

Regression Analysis: The regression analysis method for demand forecasting measures the
relationship between two variables. Using regression analysis, a relationship is established
between the dependent (quantity demanded) and independent variable (income of the
consumer, price of related goods, advertisements, etc.). For example, regression analysis may
be used to establish a relationship between the income of consumers and their demand for a
luxury product. In other words, regression analysis is a statistical tool to estimate the unknown
value of a variable when the value of the other variable is known. After establishing the
relationship, the regression equation is derived assuming the relationship between variables
is linear.

EY =a + bX
Where Y is the dependent variable for which the demand needs to be forecasted; b is the
slope of the regression curve; X is the independent variable; and a is the Y-intercept. The
intercept a will be equal to Y if the value of X is zero.

Determinants of Supply
1. Price of the Commodity
It is the main and the most important determinant of demand. When the price of the commodity
is high, the producers or suppliers are willing to sell more commodities. Thus, the supply of the
commodity increases. Similarly, when the price is low the supply of the commodity decreases
owing to the direct relationship between the price of a commodity and its supply.

2. Firm Goals
The supply of goods also depends on the goals of an organization. An organization may have
various goals such as profit maximization, sales maximization, employment maximization, etc.
Where the firm’s objective is the maximization of profit, it will sell more goods when profits are
high and less quantity of goods when the profits are low.
3. Price of Inputs or Factors
The price of inputs or the factors of production such as land, labour, capital, and
entrepreneurship also determine the supply of the goods. When the price of inputs is low the
cost of production is also low. Thus, at this point, the firms tend to supply more goods in the
market and vice-versa.
4. Technology
When a firm uses new technology, it saves the inputs and also reduces the cost of production.
Thus, firms produce more and supply more goods.

5. Government Policy
The taxation policies and the subsidies given by the government also impact the supply of goods.
When the taxes are high the producers are unwilling to produce more goods and thus, the supply
will decrease. On the other hand, when the government grants various subsidies and gives
financial aids to the producers, they increase the production of goods. Thus, the supply also
increases.

6. Expectations
When the producers or suppliers expect that the price shall increase in future they hoard the
goods so that they can sell them at higher prices later. This will result in a decrease in the supply
of goods. Similarly, in case they expect a fall in price, they will increase the supply of goods.

7. Prices of other Commodities

When the price of complementary goods increases their supply also increases. Thus, this results
in the increase in the supply of commodity also and vice-versa. Also, when the price of the
substitutes increases their supply also increases. This results in a decrease in the supply of goods.

8. Number of Firms
When the number of firms in the market increase the supply of goods also increases and vice-
versa.

9. Natural Factors
The factors like weather conditions, flood, drought, pests, etc. also affect the supply of goods.
When these factors are favorable the supply will increase.

Supply Function
It explains the relationship between the supply of a commodity and the factors determining its
supply. We can better represent the supply function in the form of the following equation:

Sx = f (Px, PI, T, W, GP)

Where,
Sx = supply of commodity x
Px = Price of commodity x
PI = Price of inputs
T = Technology
W = Weather conditions
GP = Government Policy
Law of Supply
The Law of Supply is a fundamental principle in economics that describes how producers or
sellers will offer more of a good or service at a higher price than they would at a lower price,
assuming all other factors are constant.

The figure is a graph that represents the Law of Supply in economics. It is a supply curve on a
simple two-dimensional graph where the y-axis represents the price of a good or service, and
the x-axis represents the quantity supplied. According to the Law of Supply, there is a direct
relationship between price and the quantity of goods supplied; as the price increases, the
quantity supplied also increases, which is why the supply curve slopes upwards from left to
right. The lines labelled P1, P2, and P3 appear to represent different price levels, with the
corresponding quantities supplied at Q1, Q2, and Q3, respectively. This type of graph is
commonly used in microeconomics to illustrate how changes in price can affect sellers'
willingness to produce goods.