Module - 1

Demand and Supply

Dr.R.Ramanujam
VIT.

1
 Introduction
• Demand refers to the quantity of a good that is desired by buyers.

• The quantity demanded refers to the specific amount of that product that buyers are

willing to buy at a given price.

• This relationship between price and the quantity of product demanded at that price is

defined as the demand relationship.

• Supply is defined as the total quantity of a product or service that the marketplace can

offer.

• The quantity supplied is the amount of a product/service that suppliers are willing to

supply at a given price.

• This relationship between price and the amount of a good/service supplied is known as the

supply relationship.

2
 Law of Demand

• The law of demand states that if all other factors remain constant, if a good's
price is higher, fewer people will demand it.
• As the price of that good goes down, the quantity of that good that the market
will demand will increase.
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 Law of Supply

• The law of supply states that as the price rises for a given product/service,
suppliers are willing to supply more.

• Selling more goods/services at a higher price means more revenue.

4
 Equilibrium Price
• When thinking about demand and supply together, the supply relationship

and demand relationship basically mirror each other at equilibrium.

• At equilibrium, the quantity supplied and quantity demanded intersect and

are equal.

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 Equilibrium Price
Demand Schedule Supply Schedule

At $2.00, the quantity

demanded is equal to the
quantity supplied!
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 The Equilibrium of Supply and Demand

Price of
Ice-Cream
Cone

Supply

Equilibrium Equilibri
$2.00 price um

Demand

Equilibrium
quantity

0 1 2 3 4 5 6 7 8 9 10 11 Quantity of Ice-
Cream Cones

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 Significance of Equilibrium Price
• Surplus
– When price > equilibrium price, then quantity supplied >
quantity demanded.
• There is excess supply or a surplus.
• Suppliers will lower the price to increase sales, thereby
moving toward equilibrium.
• Shortage
– When price < equilibrium price, then quantity demanded > the
quantity supplied.
• There is excess demand or a shortage.
• Suppliers will raise the price due to too many buyers chasing
too few goods, thereby moving toward equilibrium.

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 Excess Supply
Price of
Ice-Cream
Cone
Surplus
Supply
$2.50

$2.00

Demand

0 1 2 3 4 5 6 7 8 9 10 11 Quantity of
Ice-Cream
Quantity Quantity Cones
Demanded Supplied

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 Excess Demand
Price of
Ice-Cream
Cone

Supply

$2.00

$1.50

Shortage
Demand

0 1 2 3 4 5 6 7 8 9 10 11 Quantity of
Ice-Cream Cone
Quantity Quantity
Supplied Demanded
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 What factors can change demand?
(that is, shift the entire curve)?
1. Price of the substitutes
2. Price of the complimentary
goods
3. Consumer’s income
4. Size of population
5. Arrival of new goods
6. Availability of credit
7. Taste and fashion of buyers
8. Advertisement expenditure
9. State of trade (Govt. fiscal
policy, interest rate, tax,
etc.)
10.Non monetary
determinants (Natural
disasters, Seasonality,
sociological factors).
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 Factors influencing Supply

1. Cost of input factors (resources)

2. Price of other goods

3. Changes in technology

4. Number of sellers

5. Changes in Expectation (future

price of a product)

6. Taxes and subsidies.

7. Changes in the taste/preference

8. Other factors like weather, war,

strike, etc.

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Change in quantity demanded Vs Change in
demand
• In economics the terms change in quantity demanded and change in
demand are two different concepts.
• Change in quantity demanded refers to change in the quantity purchased
due to increase or decrease in the price of a product.

• On the other hand, change in demand refers to increase or decrease in

demand of a product due to various determinants of demand, while keeping
price at constant.
• Changes in quantity demanded can be measured by the movement of
demand curve, while changes in demand are measured by shifts in demand
curve.
• The terms, change in quantity demanded refers to expansion or
contraction of demand, while change in demand means increase or
decrease in demand.

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Change in quantity demanded Vs Change in
demand

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 Change in Demand (SHIFT)

Left Shift in the demand curve • Right Shift in the demand curve

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 Example Problem - 1
Suppose, the demand function Qd = 1000-20P, and supply
function Qs = 100+40P, then fill the Table given below.
Also find the equilibrium price and quantity.
Price Qd Qs
5
10
15
20
25
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 Example Problem - 1
Suppose, the demand function Qd = 1000-20P, and supply
function Qs = 100+40P, then fill the Table given below.
Also find the equilibrium price and quantity.
Price Qd Qs
5 900 300
10 800 500
15 700 700
20 600 900
25 500 1100
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 Example Problem - 2

A market consists of three consumers A, B and C. whose

individual demand equations are as follows:
A: P = 35-0.50 QA
B: P = 50- 0.25 QB
C: P = 40 – 2.00 QC
The market supply equation is given by, QS= 40+35P.
Determine the market equilibrium price and quantity?

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 Elasticity of Demand

• Elasticity: It is a measure of the responsiveness of one

variable to change on other.

• Elasticity of Demand, therefore indicates how much quantity

demanded of a good will change with change in its price or
income of the consumer or price of related goods.
E = % change in quantity demanded / % change in price

E = P/Q x (ΔQ/ΔP)

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 Elasticity of Demand

(a) Perfectly inelastic (b) Perfectly elastic (c) Unitary elastic

(d) Elastic (e) Inelastic
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 Elasticity of Demand

Types of Elasticity
Price Quantity
1. Price Elasticity
2. Income Elasticity
3. Cross Elasticity 10 100

12 50

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 Calculation of Elasticity of Demand
When calculating elasticity of demand there are two possible ways.

• Point elasticity of demand takes the elasticity of demand at a particular

point on a curve (or between two points).

• Arc elasticity measures elasticity at the mid point between the two
selected points:

Point elasticity A to B
Quantity increase from 200 to 300 = 100/200 = 50%
Price falls from 4 to 3 = 1/4 = -25%
Therefore PED = 50/ -25 = – 2.0
Mid Point Elasticity A to B
Mid point of Q = (200+300) / 2 = 250
Mid Point of P = (3+4) / 2 = 3.5
Q % = (100/250) = 40%
P % = 1/3.5 = 28.57
PED = 40/-28.57 = – 1.4 (or ( 3.5/250) * 100/1 = – 1.4)

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Mid Point Method

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24
 Price Elasticity of Demand

A consumer purchases 80 units of a commodity when its price

is Re. 1 per unit and purchases 48 units when its price rises to
Rs. 2 per unit. What is the price elasticity of demand for the
commodity?

• Ans: 0.5

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Demand, Elasticity, and Total Revenue

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 Price Elasticity of demand Vs
Total Revenue
• Understanding the relationship between price elasticity and changes in total
revenue is an important component for pricing strategy for the business
manager.

• How does a firm go about determining the price at which they should sell their
product in order to maximize total revenue?

Total Revenue = Price X Quantity

 For example if you are a marketing manager for Intel,

 A new computer chip has been developed
 Decision to be made
Do you sell the new chip at a high price ($400)?
Do you sell the new chip at a low price ($200)?
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 A raising the price of an elastic good will decrease total revenue while lowering the
price of an elastic good increases total revenue. (Luxury goods)

A price increase for an inelastic good will increase total revenue while a price decrease
for an inelastic good decreases total revenue. (E.g. Necessities, Salt, gasoline, physician 28
services).
In these two examples, we can compare the slopes of the demand curves.
• steeper slope reflects a more inelastic demand
• flatter or more horizontal slope reflects a more elastic demand.

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 Example Problem
Suppose a firm sells 70 units when the price is $6, but sells 80 units
when the price falls to $4.
(i) Calculate the firm's revenue at each of the prices.
(ii) Use the total-revenue test to determine whether demand is elastic
or inelastic over this range.

The Firm’s revenue: TR1= 70x6 = Rs.420

TR2= 80x4 = Rs.320
When Price falls, the quantity increases, but Total Revenue decreases.
Therefore the demand is Inelastic.

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 Cross Elasticity of demand
• The cross-price elasticity of demand is the degree of responsiveness of
quantity demanded of a commodity due to the change in price of another
commodity.

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 Cross Elasticity of demand
Tea and coffee are substitutes to each other. If the price of coffee rises from Rs.10 per 100
grams to Rs.15 per 100 grams and as a result, consumer demand for tea increases from
30/100 grams to 40/100 grams, find out the cross elasticity of demand between tea and
coffee.
Here, If we suppose tea as good x and coffee as good y.

Thus, the coefficient of cross elasticity is 2/3 which shows that the quantity
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demanded for tea increases 2% when the price of coffee rises by 3%.
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 Income Elasticity of demand
Income elasticity of demand measures the extent to which the quantity of a
product demanded is affected by a change in income.

% change in quantity demanded

Income elasticity of demand=
% Change in Income

For most normal products

A rise in consumer income will result in a rise in demand
A fall in consumer income will result in a fall in demand
Basic or necessity goods have a low income elasticity i.e. >0 < 1.
Extent of the change (elasticity)
This will vary depending on the type of product (e.g. luxury v necessity)
Luxury goods have high income elasticity i.e. > 1.
Inferior goods have an negative income elasticity.
For inferior goods, as income rises demand actually falls. Why does demand
fall?
Consumers switch to better alternatives
Substitute products become affordable 34
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36
Demand Forecasting

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 Forecasting - Introduction
• Forecasting means ‘prediction’ or ‘estimation’.
• Forecasting is one of the important business functions because all other
business decisions are based on a forecast of the future.
• Everyday managers make decisions without knowing what will happen
in future.
– Inventory decision
– Purchase decision
– Investment decision, etc.
• Managers are always trying to reduce this uncertainty and to make
better estimates of what will happen in the future.
• Accomplishing this is the main objective of forecasting.
• Demand forecasting is an estimate of sales in monetary or physical
units for a specified future period under a proposed business plan or
program or under an assumed set of economic and other
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environmental forces.
 Demand Forecasting
Steps in demand forecasting:
1. Determine the use of the forecast – What objective?
2. Select the items or quantities that are to be forecasted.
3. Determine the time horizon of the forecast –
 short term (<30 days),
 medium term (1 month to 1 year) or
 long term (more than 1 year)
4. Select the forecasting model
5. Gather the data or information needed to make the forecast.
6. Validate the forecasting model.
7. Make the forecast.
8. Implement the results.
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 METHODS OF FORECASTING

1. Subjective or Qualitative methods

2. Objective or Quantitative methods.

VS

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Methods of Forecasting

41
Forecasting Techniques

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 Qualitative Analysis
• Consumer Survey:

Market research is used mostly for product research in the sense

of looking for new product ideas, like and dislikes about existing
products, which competitive products within a particular class are
preferred, and so on.
It uses surveys and interviews to determine customer
preferences.

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 Qualitative Analysis
• Sales Force Composite:

• A technique used by production managers to project the future

demand for a good or service based on the total amount that each
salesperson anticipates being able to sell in their region.

• For example, a sales force composite analysis might be helpful to a

manufacturing business deciding how much goods to produce within a
given time frame and what amount of raw materials will be needed.

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 Qualitative Analysis
• Delphi Technique:

• The Delphi Technique of forecasting seeks to achieve a

consensus among group members through a series of
questionnaires.
• The series questionnaires sent either by mail or via computerised
systems, to a pre-selected group of experts.
• Nobody ‘looses face’ because the questionnaires are answered
anonymously and individually by each member of the group.
• The answers are summarised and sent back to the group
members along with the next set of questionnaire.

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 Qualitative Analysis
• Delphi Technique:

• This process is repeated until a group consensus is reached.

• This method is especially useful for futuristic projects (long

range forecasting).

• Top secret and complex military projects.

• Opportunity for large number of experts to participate.

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 Qualitative Analysis
• Panel Consensus (or) Executive Opinion:

In a panel consensus, the idea that two heads are better than one is
extrapolated to the idea that a panel of people from a variety of
positions can develop a more reliable forecast that a narrow group.
Panel forecasts are developed through open meetings with free
exchange of idea from all levels of management and individuals.

Strategic Forecasting, unusual business cycle or unexpected

competition.
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 Qualitative Analysis

• Historical Analogy:

A judgmental forecasting technique based on identifying a

sales history that is analogous to a present situation, such
as the sales history of a similar product, and using that
past pattern to predict future sales.

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 Quantitative Analysis
Quantitative Analysis

Time Series Analysis Causal Analysis

1. Naïve Approach Linear Regression

2. Moving Average
3. Weighted Moving Average
4. Simple Exponential
5. Trend Adjusted Exponential
6. Seasonality Adjustment
7. Trend Analysis

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 Time Series Components

Trend Cyclical

Seasonal Random
 Components of Demand

Trend
component
Demand for product or service

Seasonal peaks

Actual demand
line

Average demand
over 4 years

Random variation
| | | |
1 2 3 4
Time (years)
Figure 4.1
 Trend Component

 Persistent, overall upward or

downward pattern
 Changes due to population,
technology, age, culture, etc.
 Typically several years duration
 Seasonal Component
 Regular pattern of up and down
fluctuations
 Due to weather, customs, etc.
 Occurs within a single year
Number of
Period Length Seasons
Week Day 7
Month Week 4-4.5
Month Day 28-31
Year Quarter 4
Year Month 12
Year Week 52
 Cyclical Component
 Repeating up and down movements
 Affected by business cycle, political, and
economic factors
 Multiple years duration
 Often causal or
associative
relationships

0 5 10 15 20
 Random Component

 Erratic, unsystematic, ‘residual’ fluctuations

 Due to random variation or unforeseen
events
 Short duration
and nonrepeating

M T W T F
 Time Series Models
1. Naïve Approach
1. It assumes that the next period’s forecast is equal to the
current period’s actual.
e.g.) if sales for January = 50 units, then in naïve method
forecast for February is 500 units.

• Naïve method can be modified to take trend in to account.

• It can also be used for seasonal data.
• It works well, if the variation from one period to the next is less.
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 Time Series Models
2. Simple Mean or Average:

• Model is only good for level data pattern

• Larger and larger data set, the random
Variation, and
• the forecast become more stable.

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Simple Mean or Average:

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 Time Series Models
3. Moving Average Method:
• Similar to simple average except instead of taking an average of all
the data, but only “n” of the most recent periods in the average.

• Good only for level pattern.

• Not suitable for trend in the data.
• Forecast “lagging” behind the actual.
• Selection of number of observations is based on
characteristics of the data.
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Moving Average Method

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Time Series Models

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 Time Series Models
4. Weighted Moving Average Method

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Weighted Moving Average Method

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 Time Series Models
5. Simple Exponential Method

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 Time Series Models

• Selecting α :
• Low values of α , say 0.1 or 0.2 , generate
forecasts that are very stable because the models
does not place much weight on the current
period’s actual demand.

• High values of α, say 0.7 or 0.8 place a lot of

weight on the current period’s actual demand and
can be influenced by random variation in the data.
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Time Series Models

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 Time Series Models
6. Trend Adjusted (or) Double Exponential Method

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Trend Adjusted (or) Double Exponential Method

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Trend Adjusted (or) Double Exponential Method

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Trend Adjusted (or) Double Exponential Method

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Trend Adjusted Exponential Method - Example

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 Time Series Models
7. Seasonal Adjustment Method

• Regularly repeating pattern is a seasonal pattern.

• The amount of seasonality is the extent to which actual values
deviate from the average or mean of the data.
• Multiplicative seasonality – seasonality is expressed as a
Percentage of average (seasonality Index).

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Seasonality Adjustment

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 Time Series Models
7. Seasonal Adjustment Method

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 Time Series Models
7. Seasonal Adjustment Method

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 Time Series Models
8. Linear Trend Line Model:

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Time Series Models (Trend Line)

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 Causal Models
(Linear regression)
• Often, leading indicators can help to predict changes in
future demand.
• Causal models establish a cause-and-effect relationship
between independent and dependent variables
• A common tool of causal modeling is linear regression:

• Additional related variables may require multiple

regression modeling

Y  a  bx

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 Linear Regression
• Identify dependent (y) and
independent (x) variables
• Solve for the slope of the line

b
 XY  X  Y 
 X 2  X  X  b
 XY  n XY

 X  nX
2 2

• Solve for the y intercept

a  Y  bX
• Develop your equation for the
trend line
Y=a + bX

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 Linear Regression Problem: A maker of golf shirts has been
tracking the relationship between sales and advertising dollars.
Use linear regression to find out what sales might be if the
company invested $53,000 in advertising next year.

Sales $ Adv.$ XY X^2 Y^2 b

 XY  n XY

 X  nX
2
(Y) (X) 2

1 130 32 4160 2304 16,900

28202  447.25 147.25
2 151 52 7852 2704 22,801 b  1.15
9253  447.25 
2

3 150 50 7500 2500 22,500 a  Y  b X  147.25  1.1547.25 

4 158 55 8690 3025 24964 a  92.9
Y  a  bX  92.9  1.15X
5 153.85 53
Y  92.9  1.1553   153.85
Tot 589 189 28202 9253 87165
Avg 147.25 47.25

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 Correlation Coefficient
How Good is the Fit?
• Correlation coefficient (r) measures the direction and strength of the linear
relationship between two variables. The closer the r value is to 1.0 the better the
regression line fits the data points.

n  XY  X  Y 
r
 X   X   Y   Y 
2 2
2 2
n * n
428,202   189589 
r  .982
4(9253) - (189) * 487,165  589 
2 2

r 2  .982   .964
2

r2
• Coefficient of determination ( ) measures the amount of variation in the
dependent variable about its meanr 2 that is explained by the regression line. Values
of ( ) close to 1.0 are desirable.
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Linear Regression- EXAMPLE

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 Measuring Forecast Error
• Forecasts are never perfect
• Need to know how much we should rely on our chosen
forecasting method
• Measuring forecast error:

E t  A t  Ft
• Note that over-forecasts = negative errors and under-
forecasts = positive errors

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 Measuring Forecasting Accuracy

• Mean Absolute Deviation (MAD)

– measures the total error in a forecast
MAD 
 actual  forecast
without regard to sign
n
• Cumulative Forecast Error (CFE)
– Measures any bias in the forecast CFE   actual  forecast 

• Mean Square Error (MSE)

– Penalizes larger errors  actual - forecast 2

MSE 
n
• Tracking Signal (TS)
CFE
– Measures if your model is working TS 
– If TS = +ve, then Actual > Forecast.. MAD
– If TS = -ve, then Actual < Forecast.

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 Accuracy & Tracking Signal Problem: A company is comparing the accuracy
of two forecasting methods. Forecasts using both methods are shown below
along with the actual values for January through May. The company also uses a
tracking signal with ±4 limits to decide when a forecast should be reviewed.
Which forecasting method is best?

Method A Method B
Month Actual F’cast Error Cum. Tracking F’cast Error Cum. Tracking
sales Signal Error Signal
Error

Jan. 30 28 2 2 2 27 2 2 1

Feb. 26 25 1 3 3 25 1 3 1.5
March 32 32 0 3 3 29 3 6 3
April 29 30 -1 2 2 27 2 8 4
May 31 30 1 3 3 29 2 10 5

MAD 1 2
MSE 1.4 4.4
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 Selecting the Right Forecasting Model

1. The amount & type of available data

 Some methods require more data than others
2. Degree of accuracy required
 Increasing accuracy means more data
3. Length of forecast horizon
 Different models for 3 month vs. 10 years
4. Presence of data patterns
 Lagging will occur when a forecasting model meant
for a level pattern is applied with a trend

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 Forecasting Software

• Spreadsheets
– Microsoft Excel, Quattro Pro, Lotus 1-2-3
– Limited statistical analysis of forecast data
• Statistical packages
– SPSS, SAS, NCSS, Minitab
– Forecasting plus statistical and graphics
• Specialty forecasting packages
– Forecast Master, Forecast Pro, Autobox, SCA

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Thank You..

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