DEMAND AND SUPPLY ANALYSIS
Demand - Types of demand - Determinants of demand - Demand function - Demand elasticity Demand forecasting - Supply - Determinants of supply - Supply function - Supply elasticity. •
Demand is the willingness to buy a commodity and ability to buy it.
Demand is always referred with time & price. Demand of commodity can be defined as quantity of the commodity at a particular price during a given point of time. •
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Dema Demand nd and and pri price ce are are inv inver erse sely ly rela relate ted. d. Othe Otherr tha than n pric pricee dema demand nd for for a comm commod odit ity y depe depend ndss upon a host of other factors like: i.) income of consumer ii.) pri prices of rela elated comm ommodit dities iii.) taste & preferences iv.) iv.) expe expect ctat atio ions ns reg regar ardi ding ng fut futur uree pric pricee v.) geographical location vi.) vi.) com composi positi tion on of popu popula lati tion on etc. etc. These are the determinants of demand.
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Price
Demand
;
Price
Demand
i.) Income of consumers
Income and Demand are Directly related. Income Demand Income Demand People’s purchasing power increases or decreases as case may be. ii.) Prices of related commodities
a.) a.)
If subs substi titu tute tess of a part partic icul ular ar comm commod odit ity y are avai availa labl blee in the mark market et and and the pric pricee of the substitute rises, demand for the commodity rises. Substitute Demand Substitute
b.) b.)
Demand
If compleme ements are avail ailable Complements
Demand
iii.) Changes in taste & preferences
If something is in fashion, demand for the product is high. If not in fashion, demand may be low. iv.) People’s expectation expectation regarding regarding future prices prices
If expectation of future prices is high, then more demand is there at present and vice versa. *
Other her tha than above ove menti ntioned ned det determi rminant nants, s, quan quanttity dem demanded ded is als also depend pendaant upon pon population, composition of population, geographical conditions etc. For example : i.) Population Demand ii.) ii.) More More the the male male pop popula ulati tion, on, great greater er the deman demand d for for Mal Malee prod product uctss iii.) iii.) Blanket Blanketss : Price Price of Blanket Blanketss doesn doesn’t ’t affect affect Mumbai Mumbai but Canada Canada is affecte affected. d.
Demand Curve Demand Curve is downward downward sloping. The factors responsible responsible for downward sloping sloping demand curve is as follows :
i.)
Law of Diminishing Return According to this law every additional unit consumed would give less and less satisfaction to the consumer. So the amount of money the consumer is willing to pay for additional unit of a commodity commodity becomes lesser and and lesser. So consumer consumer will purchase additional additional commodity commodity only when the price is lower. Therefore, more quantity is brought at a lower price.
ii.)
Income Effect As the price of the commodity falls, the consumer’s real income increases. His purchasing power increases. He is in a position to buy more of the given commodity.
iii.)
Change in the number of consumers As the commodity becomes cheaper, many more people who couldn’t afford it earlier will be in a position to to buy the commodity commodity.. As a result, result, number of consumers will will increase. increase. Hence, the demand for a commodity goes up when it’s price goes down.
iv.)
Substitution Effect When the price of a commodity goes up and the substitutes substitutes are cheaper, then the people will go for commodities which are cheaper. Thus demand for commodity will go down.
v.)
Diverse use of a commodity Many commod commoditie itiess can be used for several several purposes purposes.. When the price price is high, high, it’s use is restricted to a few applications. When it becomes cheaper, people can afford to use it in other ways as well. As a result, demand for a commodity goes up as price falls.
The Law of Demand
The Law of Demand Demand express the inverse relationship relationship between between quantity demanded demanded and price. But there are some exceptional situations under which there may be a direct relationship between price and quantity demanded. One of the exceptions is associated with THORESTEIN VEBLER. (VEBLER EFFECT) According to him, if consumer measures utility of a commodity only by its price & nothing else, then they tend to buy more of a commodity commodity at a higher price and less of it at lower price. These goods are
known as VEBLER’S VEBLER’S GOODS GOODS.. These goods goods loose their their appeal when price price falls. Therefore, Therefore, the laws of demand do not apply to these goods, which are status symbols. Another exception exception is associated with ROBERT ROBERT GIFFEN. GIFFEN. He observed that when the price of bread was rising rising in Britain, Britain, British British workers workers brought brought more more of bread. They They substit substitute uted d bread bread for meat, because meat meat was very expensive and unaffordable. unaffordable. Such goods which which are the basic requirements requirements are known as GIFFEN’S GOODS. For example, potatoes, bajra etc., which are generally consumed by the poor families families and a large part of consumer’s consumer’s income is spent on these goods. goods. Price effect effect is negligible. i. e. P.E. = S.E. +ve < I. E. –ve But normally, P.E. = S.E.+ve > I.E.-ve Where, S.E. = Substitution Effect & I.E. = Income Effect may be –ve, +ve. Laws of Demand do not hold good in the times of EMERGENCIES such as Flood, Famine, war etc. This This is because because of a fear fear of shortage shortagess of goods goods in future future increase increase the demand. demand. People People become become panicky and buy more amount of goods even at higher prices. Laws of Demand does not hold true during the PROSPERITY PHASE and the DEPRESSION PHASE. PHASE. During During prosperity prosperity,, while the prices rise, the demand demand for the goods also keeps rising, rising, because the income of the people is also rising, during this phase. On the other hand, during depression, while the prices fall, the demand of the goods and services also falls, because because during Depression Depression employment employment and incomes in the Economy are low. Thought he prices are affordable, affordable, people people are not in a position to buy goods goods and services. More over since the prices are falling, people expect a further fall in prices in future and therefore, postpone their buying. So the low of demand does not hold true during phases of prosperity and depression phases of the Business cycle.
Boom
Prosperity Recession
EXTENSION & CONTRACTION OF DEMAND
It refers to increase in quantity demanded or decrease in quantity demanded with respect to change in price only. Other determinants remaining constant, an EXTENSION of demand due to a fall in price, there is an increase in demand and vice versa. If the price of a commodity increases and demand decreases, it is known as CONTRACTION.
P2 Price P1
Q1
Q2 Quantity
INCREASE & DECREASE IN DEMAND
When there is a change in quantity demanded due to factors other than price, it is known as INCREASE or DECREASE of demand. In case of Increase in demand, the quantity demanded increases at same price i. e. at the same price the consumers consumers are prepared to but more and more. Therefore, Therefore, the demand curve shifts towards towards the right.
D1
D2
P
Price
Q1
Q3 Quantity
A fall in quantity demanded due to any other factor than price is known as Decrease in demand. i. e. at the same price less quantity is demanded. demanded. In case of decrease in demand the demand curve shifts to the left.
CLASSIFICATION CLASSIFICATION OF DEMAND Autonomous & Induced demand
Autonomous Demand is that demand which is not tied up with demand for other goods & services. It is independent of the use of other goods. For example : Consumer Goods. Derived or induced Demand is that demand which is dependent on the demand for some other product. It is known also known as derived demand. For example example : Produce Producerr Goods. He demand demand for inputs inputs depends depends on the demand demand for the finished finished goods. Industry or Company Demand
Demand faced faced by an individual firm is known known as company demand. demand. But demand faced faced by several companies producing same commodity (Substance) i. e. industry is known as Industry Demand. Company demand is a small percentage of the Industry Demand. Individual / Market Demand Demand for certain products can be studied not only in its totality but also by breaking it up in two different segments on the basis of product, use, distribution channel, age, income etc. Division of demand into different segments gives rise to the concept of Market Segment Demand. Problems of pricing, distribution etc. fall in the purview of analysis of market segment. Demand for the entire market in totality is known as Market Demand.
Study of Sales Forecasting, demand forecasting etc. relate to the total market. Demand for Durable & Non-durable Goods
Durable Goods Goods are those goods which are used over a period of time. time. They need Present Present as well as future demand. They can be consumer or producer goods. Non-durable goods are those goods which deteriorate in quality with passage of time and become non-useable non-useable after the the initial usage. usage. e.g. Fruits Fruits etc. There are perishable perishable or non-durable non-durable consumer consumer goods. Goods like coal, electricity etc. are non-durable producer goods. LONG TERM & SHORT TERM DEMAND
Short term demand refers to existing demand which is dependent on seasonal pattern and cyclical pattern. In short term existing buyers will raise the demand of the product, if price comes down. Short term demand is a temporary demand. Long term demand does not depend on seasonal or cyclical situation. Long term demand trends are useful to Business firms for investments, inventories and product planning.
ELASTICITY OF DEMAND
Elast Elastici icity ty of demand demand refers refers to the the degree degree of change change in quant quantit ity y demand demanded ed or the degre degreee of responsiveness of the quantity to a change in any one of the determinants of demand, the other determinants remaining constant. Elasticity of demand may be of following types : 1) 2) 3) 4)
Price El Elasticity Income Elasticity Cross El Elasticity Promotional Elasticity
Measurement Measurement of Price Elasticity
1)
Percentage Method
According to the percentage method, there is a proportionate change in quantity demanded to a proportionate change in price. ^Q
e p
e p
q = _______ ^P p
=
^Q ^P
= ^Q x ^P
x
p q
p q
The value of Price Elasticity varies from 0 to infinity (0-infinity) i.) Elasticity will be less than 1, if % change in quantity demanded is less than the % change in price. ii.) Elasticity will be > 1, if the % change in demand is > than the change in price. i.e. e p > 1 ; ^ Q > ^ P q p iii.) Elasticity will be infinity, when a small change in price will bring about a very large change in demand. i.e. e p = Oo D D1 D2 Price
D3
Quantity Demanded 2)
Total Outlay Method
Total outlay outlay refer to the total expenditure expenditure of the product. By knowing knowing the change in total expenditure due to a change in the price, we can find out the elasticity of the demand. By this method we don’t get the exact value of elasticity. We can only say whether e p = 1 or e p > 1 or e p < 1 e p = 1 : Total expenditure on commodity does not change due to change in price. e. g. P = Rs. 5; Q = 100 units P Rs. 4; Q 125 units e p > 1 : If a fall in price leads to an increase in total layout or a rise in price leads to a decrease in total outlay. e. g. P = Rs. 5; Q = 100 units 500 units
P = Rs. 4; Q = 140 units
560 units
e p < 1 : If total outlay declines with a fall in price and rises with a rise in price. e.g. P = Rs. 5; Q = 100 units 500 units P Rs. 4; Q 120 units 480 units
Ep>1
Ep=1
Ep<1
3)
Arc Method
The point method can can for elasticity can be used only for for marginal changes. changes. Generally, Generally, the change change in price is not very small. small. In that case, case, we have to measure measure elastici elasticity ty over the substantial range of the demand curve. Arc Elasticity (e p) =
e p =
^Q (Q1 + Q2) 2 ^P (P1 + P2) 2 ^Q x ^P
P 1 + P2 Q 1 + Q2
DETERMINANTS OF ELASTICITY OF DEMAND
Elasticity Elasticity of demand depends on nature nature of commodity. If the commodity commodity is a necessity, a change in price will will not lead to a change change in demand demand for that product. product. Similarly, Similarly, goods goods with the status status symbol also have an inelastic inelastic demand. These goods are high priced priced goods and only the richer richer section of society society can afford afford these goods. Even Even with a change change in price, demand demand does not change change much for goods which are luxurious in nature.
Availability of substitutes substitutes
If substitut substitutes es are available available in the market, market, demand for commoditi commodities es will will be relatively relatively elastic. elastic. If substitutes are not available, demand will be inelastic in nature. Price of product
If the price of a product is very low, low, demand is inelastic inelastic in nature. A rise in price or a fall in price is not going to change the demand for the product. Position of the product in the consumer’s budget
If the amount of money spent on the product is a small percentage of the consumer’s income, the demand of the product will be inelastic in nature. Postponement Postponement of demand
If the demand for a product can be postponed postponed to a future date, demand will be relatively relatively inelastic. inelastic. If demand can be postponed, postponed, the people will be willing willing to pay a higher price. Therefore, Therefore, the demand will be inelastic in nature.
Number of users
If the commodity can be used for a large number of purposes, its demand will go up with a fall in price. Therefore, Therefore, the demand for the product will be elastic elastic in nature, on the other hand single use goods will have an inelastic demand.
IMPORTANCE OF KNOWLEDGE OF ELASTICITY OF DEMAND Government decision making
Knowledge Knowledge of elasticity elasticity is of great importance in framing important policies of the government like tax policies, trade policies, agricultural pricing policy etc. i.)
Tax policy Government imposes various taxes for raising revenue. While imposing taxes and fixing tax rates, the knowledge of elasticity becomes very important. While imposing taxes , the government government has to keep in mind mind the nature of elasticity elasticity of demand. demand. For goods which have an elastic demand, high tax rates can not be fixed. Fixing the taxes
or increasing would would imply a rise in price of the product. If the demand for a product is elastic, with rise rise in price, quantity demanded demanded will come down. down. For goods having inelastic demand, a rise in tax will fetch more revenue to the government. ii.)
International tr trade po policy Knowledge of elasticity is of great importance in international trade, if the goods exported have an inelastic inelastic demand. Domestic Domestic country is at a favorable position to as it can quote a high price price for its exports. exports. If Imports Imports have an elastic elastic demand, demand, it is favora favorable ble for a domest domestic ic count country ry.. Th Thee succe success ss of deval devaluat uatio ion n also also depend dependss on elastici elasticity ty of demand. demand. Devaluat Devaluation ion refers to lowering lowering value of domesti domesticc currency currency against a foreign currency. currency. Devaluation Devaluation makes Exports Exports cheaper and imports costlier. costlier. However, it will be successful only when exports are elastic in nature and imports are also elastic in nature. Government frames international trade policies according to the elasticity of demand.
iii.)
Agri gricult ultural ral pol policies Government fixes up the minimum price of agricultural products in order to prevent a fall in the price of the agricultural produce during a good harvest. When the harvest is good and productivity is high, there is a great supply of food grains in the market. But the demand for food grains and the agricultural products is inelastic in nature. Therefore, Therefore, prices of agricultural agricultural products products fall because of excess of supply. supply. This is a loss to farming farming communi community. ty. Therefo Therefore, re, minimum minimum support support prices are fixed by the government to prevent price of crops from falling to a very low level. In order to fix the price, knowledge knowledge of elasticity elasticity becomes very importan important. t. Certain Certain products are necessities and yet there is a shortage of these products in the market. To prevent rise in price of such necessities the government fixes a price ceiling. It helps government government to identif identify y certain certain services services as public public utility utility services services.. Certain Certain services have an inelastic demand because it is a necessity and at the same time there is a scar scarcit city y of such servic services. es. In order order to prevent prevent growt growth h of mono[po mono[poly ly and exploitation of the consumer, these services are taken over by the government and declared as public utility and provided to the public at a highly subsidized rate.
iv.) v.)
Busine sinesss deci ecision-m on-maakin king Pricing policy policy is an important part of the business decisions. decisions. The prices that are fixed should cover the cost of production production and fetch profits for the producer. producer. The producer will always try to maximize his profits. A higher price will fetch a higher profit but it will not always be possible for the producer to charge a higher price. In case of goods having an elastic demand, a rise in price will lead to a fall in quantity demanded bringing down the profits profits of the producer. So, the producer will will not be successful in charging a high price and making more profits.
Knowledge of elasticity and trade unions
When the workers bargain for the higher wages, whether they will be successful or not depends on the nature of elastici elasticity ty of the product product which they help to produce. produce. Higher wages wages will increase increase the cost of production. production. The cost of production production is reflected reflected in the price price of the product. product. Thus the price price of the product will rise. rise. If the demand of the product is elastic in nature, the quantity quantity demanded demanded will
fall fall with a rise in price. price. As a result many many workers workers will will loose their their jobs. jobs. So for product productss having elastic demand, the workers demand for higher wages will not be successful.
Demand
In economics, demand for a commodity commodity does not simply mean desire or need or want. In addition to these, the consumer must be able and willing to pay the price. Whenever desire for anything is backed by ability and willingness willingness to pay for that thing, it flows out in the form of effective demand. Thus demand in economics is ‘desire backed by ability and willingness to pay.’ In words of Prof. J. Harvey, “Demand in Economics is the desire to possess something and the willingness and ability to pay a certain price in order to possess it.”
A complete statement of demand must include the market-dimension, market-dimension, the price- dimension and the time- dimension i.e. whose demand, at what price and for what period of time.
A simple statement saying ‘demand for milk is 30 litres,’ is an incomplete statement. To be a complete and meaningful statement it should read ‘when the price of milk is Rs. 22/- per litre then family X demands 30 litres of milk per month.’ This makes sense.
Demand Schedules:
A demand schedule is a table which lists the possible prices for a good and service and the associated quan quanti tity ty dema demand nded ed.. Th Thee dema demand nd sche schedu dule le for for oran orange gess coul could d look look (in (in part part)) as foll follow ows: s:
75 cents – 270 oranges a week 70cents – 300 oranges a week 65cents – 320 oranges a week 60 cents - 400 oranges a week
Demand Curves:
A demand curve is simply a demand schedule presented in graphical form. The standard presentation of a demand curve has price given on the Y-axis and quantity demanded on the X-axis.
The Law of Demand:
The law of demand states that, ceterib ceteribus us paribus (latin for 'assuming all else is held constant'), the quantity demanded for a good rises as the price falls. In other words, the quantity demanded and price are inversely related. Demand curves are drawn as 'downard sloping' due to this inverse relationship between price and quantity demanded.
Price Elasticity of Demand:
The price elasticity of demand represents how sensitive quantity demanded is to changes in price.
The Price Elasticity of Demand (commonly known as just price elasticity) measures the rate of response of quantity demanded due to a price change. The formula for the Price Elasticity of Demand (PEoD) is:
PEoD = (% Change in Quantity Demanded)/
(% Change in Price) Calculating the Price Elasticity of Demand
You may be asked the question "Given the following data, calculate the price elasticity of demand when the price changes from $9.00 to $10.00" First we'll need to find the data we need. We know that the original price is $9 and the new price is $10, so we have Price(OLD)=$9 and Price(NEW)=$10. If the quantity demanded when the price is $9 is 150 and the quantity demanded when the price is $10 is 110, Since we're going from $9 to $10, we have QDemand(OLD)=150 and QDemand(NEW)=110, where "QDemand" is short for "Quantity Demanded". So we have: Price(OLD)=9 Price(NEW)=10 QDemand(OLD)=150 QDemand(NEW)=110
To calculate the price elasticity, we need to know what the percentage change in quantity demand demand is and what the percentage change in price is. It's best to calculate these one at a time. Calculating the Percentage Change in Quantity Demanded
The formula used to calculate the percentage change in quantity demanded is: [QDemand(NEW) [QDemand(NEW) - QDemand(OLD)] / QDemand(OLD)
By filling in the values we wrote down, we get: [110 - 150] / 150 = (-40/150) = -0.2667
We note that % Change in Quantity Demanded = -0.2667 (We leave this in decimal terms. In percentage terms this would be -26.67%). Now we need to calculate the percentage change in price. Calculating the Percentage Change in Price
Similar to before, the formula used to calculate the percentage change in price is: [Price(NEW) [Price(NEW) - Price(OLD)] / Price(OLD)
By filling in the values we wrote down, we get: [10 - 9] / 9 = (1/9) = 0.1111
We have both the percentage change in quantity demand and the percentage change in price, so we can calculate the price elasticity of demand. Final Step of Calculating the Price Elasticity of Demand
We go back to our formula of: PEoD = (% Change in Quantity Demanded)/(% Change Change in Price)
We can now fill in the two percentages in this equation using the figures we calculated earlier. PEoD = (-0.2667)/(0.1111) = -2.4005
When we analyze price elasticities we're concerned with their absolute value, so we ignore the negative negative value. We conclude that the price elasticity elasticity of demand when the price increases from $9 to $10 is 2.4005.
How Do We Interpret the Price Elasticity of Demand?
A good economist is not just interested in calculating calculating numbers. The number is a means to an end; in the case of price elasticity of demand it is used to see how sensitive the demand for a good is to a price change. The higher the price elasticity, the more sensitive consumers are to price changes. A very high price elasticity elasticity suggests that when the price of a good goes up, consumers will will buy a great deal less of it and when the price of that good goes down, consumers will buy a great deal more. A very low price elasticity implies just the opposite, that changes in price have little influence on demand. Often an assignment or a test will ask you a follow up question such as "Is the product price elastic or inelastic between $9 and $10". To answer that question, you use the following rule of thumb:
•
If PEoD > 1 then Demand is Price Elastic (Demand is sensitive to price changes)
•
If PEoD = 1 then Demand is Unit Elastic
•
If PEoD < 1 then Demand is Price Inelastic (Demand is not sensitive to price changes)
Recall that we always ignore the negative sign when analyzing price elasticity, so PEoD is always positive. In the case of our good, we calculated the price elasticity of demand to be 2.4005, so our good is price elastic and thus demand is very sensitive to price changes.
The Income Elasticity of Demand measures the rate of response of quantity demand due to a raise
(or lowering) in a consumer’s income. The formula for the Income Elasticity of Demand (IEoD) is given by: IEoD = (% Change in Quantity Demanded)/(% Demanded)/(% Change in Income)
Calculating the Income Elasticity of Demand
On an assignment or a test, you might be asked "Given the following data, calculate the income elasticity of demand when a consumer's income changes from $40,000 to $50,000 The first thing we'll do is find the data we need. We know that the original income is $40,000 and the new price is $50,000 so we have Income(OLD)=$40,000 and Income(NEW)=$50,000. From the given data, we have, the quantity demanded when income is $40,000 is 150 and when the price is $50,000 is 180. Since we're going from $40,000 to $50,000 we have QDemand(OLD)=150 and QDemand(NEW)=180, where "QDemand" is short for "Quantity Demanded". So you should have these four figures written down: Income(OLD)=40,000 Income(NEW)=50,000 QDemand(OLD)=150 QDemand(NEW)=180
To calculate the price elasticity, we need to know what the percentage change in quantity demand demand is and what the percentage change in price is. It's best to calculate these one at a time.
Calculating the Percentage Change in Quantity Demanded
The formula used to calculate the percentage change in quantity demanded is: [QDemand(NEW) [QDemand(NEW) - QDemand(OLD)] / QDemand(OLD)
By filling in the values we wrote down, we get: [180 - 150] / 150 = (30/150) = 0.2
So we note that % Change in Quantity Demanded = 0.2 (We leave this in decimal terms. In percentage percentage terms this would be 20%) and we save this figure for later. Now we need to calculate the percentage change in price. Calculating the Percentage Change in Income
Similar to before, the formula used to calculate the percentage change in income is: [Income(NEW) [Income(NEW) - Income(OLD)] Income(OLD)] / Income(OLD)
By filling in the values we wrote down, we get: [50,000 - 40,000] / 40,000 = (10,000/40,000) (10,000/40,000) = 0.25
We have both the percentage change in quantity demand and the percentage change in income, so we can calculate the income elasticity of demand. Final Step of Calculating the Income Elasticity of Demand
We go back to our formula of: IEoD = (% Change in Quantity Demanded)/(% Demanded)/(% Change in Income)
We can now fill in the two percentages in this equation using the figures we calculated earlier. IEoD = (0.20)/(0.25) = 0.8
Unlike price elasticities, we do care about negative values, so do not drop the negative sign if you get one. Here we have a positive price elasticity, and we conclude that the income elasticity of demand
when income increases from $40,000 to $50,000 is 0.8.
How Do We Interpret the Income Elasticity of Demand?
Income elasticity of demand is used to see how sensitive the demand for a good is to an income change. The higher the income elasticity, the more sensitive demand for a good is to income changes. A very high income elasticity suggests that when a consumer's consumer's income goes up, consumers consumers will buy a great deal more of that good. A very low price elasticity implies just the opposite, that changes in a consumer's income has little influence on demand. Often an assignment or a test will ask you the follow up question "Is the good a luxury good, a normal good, or an inferior good between the income range of $40,000 and $50,000?" To answer that use the following rule of thumb: •
If IEoD > 1 then the good is a Luxury Good and Income Elastic
•
If IEoD < 1 and IEOD > 0 then the good is a Normal Good and Income Inelastic
•
If IEoD < 0 then the good is an Inferior Good and Negative Income Inelastic
In our case, we calculated calculated the income elasticity of demand to be 0.8 so our good is income inelastic inelastic and a normal good and thus demand is not very sensitive to income changes. The Cross-Price Elasticity of Demand measures the rate of response of quantity demanded of one
good, due to a price change of another good. If two goods are substitutes, we should expect to see consumers consumers purchase more of one good when the price of its substitute increases. increases. Similarly if the two goods are complements, we should see a price rise in one good cause the demand for both goods to fall The common formula for the Cross-Price Elasticity of Demand (CPEoD) is given by: CPEoD = (% Change in Quantity Demand for Good X)/(% Change in Price for Good Y) Calculating the Cross-Price Elasticity of Demand
You're given the question: "With the following data, calculate the cross-price elasticity of demand for good X when the price of good Y changes from $9.00 to $10.00." Using the given data, we'll answer this question. We know that the original price of Y is $9 and the new price of Y is $10, so we have Price(OLD)=$9 and Price(NEW)=$10. Price(NEW)=$10. From the given data, we see that the quantity quantity demanded of X when the price of Y is $9 is 150 and when the price is $10 is 190. Since we're going from $9 to $10, we have QDemand(OLD)=150 and QDemand(NEW)=190. You should have these four figures written down: Price(OLD)=9 Price(NEW)=10 QDemand(OLD)=150 QDemand(NEW)=190
To calculat calculatee the cross-pr cross-price ice elastic elasticity ity,, we need to calcula calculate te the percent percentage age change change in quantit quantity y demanded and the percentage change in price. We'll calculate these one at a time. Calculating the Percentage Change in Quantity Demanded of Good X
The formula used to calculate the percentage change in quantity demanded is: [QDemand(NEW) [QDemand(NEW) - QDemand(OLD)] / QDemand(OLD)
By filling in the values we wrote down, we get: [190 - 150] / 150 = (40/150) = 0.2667
So we note that % Change in Quantity Demanded = 0.2667 (This in decimal terms. In percentage terms this would be 26.67%). Calculating the Percentage Change in Price of Good Y
The formula used to calculate the percentage change in price is: [Price(NEW) [Price(NEW) - Price(OLD)] / Price(OLD)
We fill in the values and get:
[10 - 9] / 9 = (1/9) = 0.1111
We have our percentage changes, so we can complete the final step of calculating the cross-price elasticity of demand. Final Step of Calculating the Cross-Price Elasticity of Demand
We go back to our formula of: CPEoD = (% Change in Quantity Demanded of Good X)/(% Change in Price of Good Y)
We can now get this value by using the figures we calculated earlier. CPEoD = (0.2667)/(0.1111) = 2.4005
We conclude that the cross-price elasticity of demand for X when the price of Y increases from $9 to $10 is 2.4005.
How Do We Interpret the Cross-Price Elasticity of Demand?
The cross-price cross-price elasticity of demand is used to see how sensitive the demand for a good is to a price change of another good. A high positive cross-price elasticity tells us that if the price of one good goes up, the demand for the other good goes up as well. A negative tells us just the opposite, that an increase in the price of one good causes a drop in the demand for the other good. A small value (either negative or positive) tells us that there is little relation between the two goods. Often an assignment or a test will ask you a follow up question such as "Are the two goods complements or substitutes?". To answer that question, you use the following rule of thumb: •
If CPEoD > 0 then the two goods are substitutes
•
If CPEoD =0 then the two goods are independent (no relationship between the two goods
•
If CPEoD < 0 then the two goods are complements
In the case of our good, we calculated the cross-price elasticity of demand to be 2.4005, so our two goods are substitutes when the price of good Y is between $9 and $10.
Demand Function
As the quantity demanded of commodity X is a function of (depends on) so many variables the demand function can be written as
Qxd = f (P f (Px, PI, Yd, U, T, ……… etc)
Where, Px : Price of x PI : Price of substitute of x Yd : Disposable income of the consumer T
: Tastes & Fashion (Customer expectation)
U
: Population
As this is a complicated functional relationship it would become difficult to develop a simple theory of demand if we simultaneously consider the effect of changes in all variables on demand for X. Therefore we assume that all the other variables are held constant and establish establish relation between price of X and quantity demanded of X.
Mathematically stated:
Qxd = f (Px)
The Law of Demand
The law of demand establishes the functional relationship between price of X and the quantity demanded of commodity X, assuming factors other than price of commodity X, remain constant. The law of demand states “other things remaining the same quantity demanded of a commodity is commodity X rises, the demand for it declines inversely related to its price,” i.e. when the price of commodity and when the price of commodity X falls, the demand for it rises. The law of demand can be explained with the help of a demand schedule and the corresponding demand curve. The Demand Schedule
The Demand Schedule is a tabular representation expressing the various amounts of commodity X demanded at different possible prices of X at any given time. Thus a tabular statement showing the relationship between different alternative prices of commodity X and the different quantities of X demanded at these prices is technically referred to as demand schedule.
A Demand Schedule
Price per unit
Quantity demanded of
of Commodity X (Rs)
Commodity
X
per
day
(Units) 5 4 3 2 1
8 12 20 30 50
The demand schedule shows the inverse relationship between price and quantity demanded, i.e., at lower price more units are demanded and at higher price few units are demanded.
The Demand Curve
On the basis of the demand schedule when we plot points on a graph and join these points we get the Demand Curve. A demand curve refers to a graphical presentation of the relation between price and quantity demanded. It is customary to represent price on the Y-axis and the quantity demanded
on the X-axis.
The demand curve slopes downwards from left to right indicating an inverse or a negative
relationship between price and quantity demanded. Assumptions underlying the Law of Demand
The law of demand is based on the assumption, viz, “other things remaining the same”. What then are the ‘other things remaining the same’?
I.
The income of of the consumer must remain th the same.
I I.
Prices of other her comm ommodit dities must ust rema emain the sam same.
I I I.
The ta taste of of th the co consumer mu must re remain th the sa same.
IV.
The cons consum umer er shou should ld not not anti antici cipa pate te furt furthe herr cha chang nges es in pric prices es..
V.
The size size and and the the com composi positi tion on of popu popula lati tion on must must rema remain in reas reason onab ably ly stable etc.
Exceptions to the Law of Demand
I.
Expect Expectati ations ons of fur furthe therr chan changes ges in Price Pricess and and Spe Specul culat ation ion :
The law of demand will not hold good when people expect prices to rise still further. In that case although the prices have risen today consumers will demand more in anticipation of further increase in price. This type of behaviour can be observed on the Stock Exchange.
II.
Giffen’s Paradox: Once it so happened in England that when the price of bread declined the
demand for bread also declined and when price of bread increased the demand for bread also increased. This was against the law of demand. Sir Robert Giffen said that in case of bread,
which is an inferior good of a special kind, when price of bread declined, the real income of the consumer increased increased and out of this increase in real income, the consumers decided to consume more of some other commodities, commodities, instead of demanding more of bread. This explanation explanation came to be called the Giffen’s Paradox, which is an exception to the law of demand. Eg: Irish potato
III.
Thee law law of dema demand nd does does not consi consider der quali qualitat tative ive change changess in the the Qualitative changes: Th commodity. If the price is taken by the consumer as the yardstick of quality of commodity, mere rise in price of the commodity may raise the demand for it.
IV.
Price–illusions: Consumers are, in modern world, governed more by price-illusions e.g. the
consumer strongly believes that ‘higher the price, better the product’, and thus greater is the demand for it.
V.
demand fails to operate operate in the case of prestige prestige Display of Standard of Living : The law of demand articles having snob appeal. The consumer is very often governed by what is called as demonstration effect . Expensive jewellery, paintings, antique and other similar commodities
are bought not because they are needed but the purchase of such articles will enable the possessor to display his wealth.
Movement along the Curve V/S Shift of Curves
It is important to distinguish between a movement along a demand curve and a shift of the entire demand curve.
Extension and Contraction of Demand
If we consider changes in the price of a commodity as the only factor influencing its quantity demanded, then we experience movements on the same curve. We either have extension or contraction of demand . When the price of a commodity falls from OP to OP1, the demand for it
goes up from OM to OM1. This is what is called Extension of Demanded.
When the price of the commodity rises from OP1 to OP the demand for it contracts from OM1 to OM. This is called Contraction of Demand.
Both extension and contraction of demand can be shown by movement along the same demand curve.
Increase and Decrease in Demand
When factors other than price of the commodity influence the demand for that commodity, then we have either increase or decrease in demand shown by complete shifts in the demand curve.
Demand is said to have increased when:
i) At the same price more is demanded. ii)At higher price same quantity is demanded.
Let us assume, to begin with, that when price is OP, quantity demanded is OM. Now at the same price, OP more is demanded or at a higher price the same quantity, i.e. OM, is demanded, both these conditions conditions tend to reveal that the demand curve will shift to the right and we have the demand curve D2D3. Therefore, when demand increases, the demand curve shifts to the right.
Demand is said to have decreased when:
i) At same price, less quantity is demanded. ii) At a lower price, the same quantity is demanded.
Both the arrows point to the fact that there is the tendency for the demand curve to shift to the left and we have the new demand curve D2D3 which is to left of the original. original. Therefore, Therefore, when demand decreases, decreases, the demand curve shifts to the left.
Hence extension and contraction of demand are shown by movement along the curve; whereas increase or decrease in demand will be shown by shifts in the curve.
How is demand forecast determined?
There are two approaches to determine demand forecast – (1) the qualitative approach, (2) the quantitative approach. The comparison of these two approaches is shown below: Description
Qualitative Approach
Quantitative Approach
Appl pplicabil abiliity
Used sed wh when sit situation is va vague & Used when situation is stable & little data exist (e.g., new products historical data exist and technologies) (e.g. existing products, current technology)
Cons Consid ider erat atio ions ns
Invo Involv lves es intu intuit itio ion n and expe experi rien ence ce
Invo Involv lves es math mathem emat atic ical al tech techni niqu ques es
Techniques
Jury of of ex executive op opinion
Time series models
Sales force composite
Causal models
Delphi method Consumer market survey
Qualitative Forecasting Methods
Your company may wish to try any of the qualitative forecasting methods below if you do not have historical data on your products' sales. Qualitative Method
Description
Jury of executive opinion
The opinions of a small group of high-level managers are pooled and together they estimate demand. The group uses their managerial experience, and in some cases, combines the results of statistical models.
Sales force composite
Each salesperson (for example for a territorial coverage) is asked to project their sales. Since the salesperson is the one closest to the marketplace, he has the capacity to know what the customer wants. These projections are then combined at the municipal, provincial and regional levels.
Delphi method
A panel of experts is identified where an expert could be a decision maker, an ordinary employee, or an industry expert. Each of them will be asked individually for their estimate of the demand. An iterative process is conducted until the experts have reached a consensus.
Consumer market survey
The customers are asked about their purchasing plans and their projected buying behavior. A large number of respondents is needed here to be able to generalize certain results.
Quantitative Forecasting Methods
There are two forecasting models here – (1) the time series model and (2) the causal model. A time series is a s et of evenly spaced numerical data and is o btained by observing responses at regular time periods. In the time series model , the forecast is based only on past values and assumes that factors that influence the past, the present and the future sales of your products will continue. On the other hand, t he causal model uses a mathematical technique known as the regression analysis that relates a dependent variable (for example, demand) to an independent variable (for example, price, advertisement, etc.) in the form of a linear equation. The time series forecasting methods are described below:
Description Time Series Forecasting Method Naïve Approach
Assumes that demand in the next period is the same as demand in most recent period; demand pattern may not always be that stable For example: If July sales were 50, then Augusts sales will also be 50
Description Time Series Forecasting Method Moving Averages MA is a series of arithmetic means and is used if little or no trend is present in the data; provides an overall impression of data over time (MA)
A simple moving average uses average demand for a fixed sequence of periods and is good for stable demand with no pronounced behavioral patterns. Equation: F 4 = [D 1 + D2 + D3] / 4
F – forecast, D – Demand, No. – Period (see illustrative example – simple moving average)
A weighted moving average adjusts the moving average method to reflect fluctuations more closely by assigning weights to the most recent data, meaning, that the older data is usually less important. The weights are based on intuition and lie between 0 and 1 for a total of 1.0 Equation: WMA 4 = (W) (D3) + (W) (D2) + (W) (D1)
WMA – Weighted moving average, W – Weight, D – Demand, No. – Period
(see illustrative example – weighted moving average)
The exponential smoothing is an averaging method that reacts more strongly to recent changes in demand by assigning a smoothing constant to the most recent data more strongly; useful if recent changes in data are the results of actual change (e.g., seasonal pattern) instead of just random fluctuations
Exponential Smoothing
F t + 1 = a D t + (1 - a ) F t
Where F t + 1 = the forecast for the next period D t = actual demand in the present period F t = the previously determined forecast for the present period • = a weighting factor referred to as the smoothing constant (see illustrative example – exponential smoothing) Time Series Decomposition
The time series decomposition adjusts the seasonality by multiplying the normal forecast by a seasonal factor (see illustrative example – time series decomposition)
SUPPLY •
Supply
Refers to the various quantities offered for sale at various prices Quantity Supplied Refers to a specific quantity offered for sale at a specific price o Supply Function Indicates the relationship between the quantity of the commodity supplied and the unit o price of the commodity Law of Supply The quantity of a good supplied is directly related to the good’s price, other things o constant. o
•
•
•
Example of a Supply Curve
p
p = f(q)
(0, b) 0
•
•
q
The slope of a supply curve is usually positive, as price increases, quantity supplied increases and vice-versa. The y-intercept of the supply curve (0, b) represents the lowest price at which an item will be supplied.
The Law of Supply
Supply is the quantity of a good or service that a producer is willing and able to supply onto the market at a given price in a given time period
The basic law of supply is that as the market price of a commodity rises, so producers expand their supply onto the market
A supply curve shows a relationship between price and quantity a firm is willing and able to sell
Causes of shifts in market supply
Changes in production costs
Wages,raw materials and components, energy, rents, interest rates
Government taxes and subsidies
Changes in technology – ICT can reduce long term costs but are expensive in SR
Climatic conditions (important for agricultural supply)
Changes in the number of producers in the market
Changes in the objectives of suppliers in the market
Changes in the prices of substitutes in production
The profitability of alternative products (substitutes) or those with joint supply (crude oil = petrol and paraffin and diesel)
Expectation of future price changes
Example: What would cause the supply of butter to rise?
Reduction in costs of producing – e.g. nitrogen fertiliser = more used by farmers = better grass = more milk
Better technology in producing butter
More govt subsidies to farmers
Increase in profitability of skimmed milk ….. Because butter and cream products are jointly produced with skimmed milk.
Weather conditions favourable for favourable grass yield
Determinants Determinants of supply
Price of the good itself Number of sellers
Technology
Resource Prices
Taxes and subsidies
Expectations of producers
Prices of other goods the firm could produce
Supply function:
Qs
=
f( Px, Pn, Ns, Cost, Tech., W, G)
Distinction between changes in quantity supplied and changes in supply
Changes in quantity supplied A movement along the supply curve due to the changes in the price of the good itself. Changes in supply The shifts of the supply curve to the left or right due to the changes in the non-price determinants of supply Price Elasticity of Supply
Measure “The responsiveness of quantity supplied to a change in price.“
Elasticity of supply can be determined by comparing the % change in quantity supplied with the % change in the price of the product.
Types of Price Elasticity of Supply
Elastic Supply ( fairly elastic)
% change in quantity supplied is greater than % change in price.
Es =% Δ QS > % Δ P
. Inelastic Supply (fairly inelastic)
% change in quantity supplied is less than % change in price.
Es =% Δ QS > % Δ P
Unitary Elastic
% change in quantity supplied is equal to the % change in price Es =% Δ QS > % Δ P
Perfectly Inelastic % change in quantity supplied is zero despite the change in the price
Perfectly Elastic % change in quantity supplied is infinitely large compared to the % change in price
Factors Influencing Elasticity of Supply
1. TIME In the short run, supply would would be inelastic, it is not possible to increase increase supply immediately immediately in response to change in price. However, However, in the long run, supply would be more responsive responsive to price changes, i.e. is more elastic. In the long run sellers or producers can fully adjust their supply to the change in prices. 2.
NATURE OF THE GOOD
If it takes too long to produce a product, product, supply is fairly fairly inelastic. inelastic. Otherwise Otherwise supply will be elastic. For example, the supply of agricultural product (primary products) is fairly inelastic whereas the supply of manufactured goods (secondary products) is fairly elastic
3.
COST AND FEASIBILITY OF STORAGE
If the change in supply requires only a small change in production costs, most likely supply will be elastic. elastic. However However if the change in supply involves involves a major change in costs supply tends to be inelastic. Goods that are too costly to be stored will have a low elasticity of supply. 4.
SUBSTITUTABILITY SUBSTITUTABILIT Y OF FACTORS OR INPUTS USED
If land, labor and capital can produce one commodity and these factors can be readily switched to produce another good, then supply of the factors is elastic. But if the production production of its output require require very specialized specialized inputs, supply supply tends to be more elastic. 5. PERI PERISH SHAB ABIL ILIT ITY Y
If the product is a easily perishable, especially especially agricultural product, product, then the supply would be inelastic. Such products would not be sensitive to price changes, for example, vegetables. Hence, an increase in price will not bring about a distinctive change or rise in the quantity supplied.
