CHAPT 2

ER

UNIT -1: LAW OF DEMAND AND ELASTICITY OF DEMAND

LEARNING OUTCOMES

 Explain the meaning of Demand.

 Describe what Determines Demand.
 Explain the Law of Demand.
 Explain the difference between Movement along the Demand Curve and Shift of the
Demand Curve.
 Define and Measure Elasticity.
 Apply the Concepts of Price, Cross and Income Elasticities.
 Explain the Determinants of Elasticity.
 Explain the Importance of Demand Forecasting in Business.
 Describe the various Forecasting Techniques.

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2.2 BUSINESS ECONOMICS

CHAPTER OVERVIEW

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 THEORY OF DEMAND AND SUPPLY 2.3

1.0 MEANING OF DEMAND

‘demand’ refers to the quantity of a good or service that buyers are willing and able to purchase at various prices during a given
period of time.

It is to be noted that demand, in Economics, is something more than the desire to purchase, though desire is one element of it.

The effective demand for a thing depends on

(i) desire

(ii) means (Resources) to purchase (Ability to pay)

(iii) willingness to use those means for that purchase. (willingness to pay)

Unless desire is backed by purchasing power or ability to pay and willingness to pay, it does not constitute demand.

Two things are to be noted about the quantity demanded.

(i) The quantity demanded is always expressed at a given price
(ii) The quantity demanded is a flow. We are concerned not with a single isolated purchase,

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2.4 BUSINESS ECONOMICS

DETERMINANTS OF DEMAND (FACTORS)

(i) Price of the commodity:
 Ceteris paribus i.e. other things being equal (other factors remain constant), the demand for a
commodity is inversely related to its price.
 It implies that a rise in the price of a commodity brings about a fall in the quantity purchased and vice-
versa.
 This happens because of income and substitution effects.

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 THEORY OF DEMAND AND SUPPLY 2.5

(ii) Price of related commodities:

Related commodities are of two types:
(i) complementary goods and
(ii) competing goods or substitutes

i. Complementary goods-

 Complementary goods are those goods which are

consumed together or simultaneously.

 When two commodities are complements, a fall in

the price of one (other things being equal) will
cause the demand for the other to rise.

 Demand of a commodity INVERSLY related with price of complimentary goods.

 For example; tea and sugar, automobile and

petrol and pen and ink.

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Substitute goods-

 Two commodities are called competing goods or substitutes when they satisfy
the same want and can be used with ease in place of one another.
 When goods are substitutes, a fall in the price of one (ceteris paribus) leads to
a fall in the quantity demanded of its substitutes.
 Demand of a commodity is directly related with price of substitute goods.
 For example, tea and coffee, ink pen and ball pen, are substitutes for each
other and can be used in place of one another easily

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 THEORY OF DEMAND AND SUPPLY 2.7

(iii) Disposable Income of the consumer:

The purchasing power of a buyer is determined by their disposable income level. Holding other factors constant, the demand for a
commodity is influenced by the disposable income of potential buyers. Generally, an increase in disposable income leads to an
increase in the demand for specific goods and services, regardless of the price. Conversely, a decrease in disposable income
generally results in a decrease in the quantity demanded across all price levels.

The relationship between disposable income and quantity demanded depends on the nature of the goods. Normal goods are those
that experience an increase in demand as consumers' income rises. Most goods and services fall into this category, such as
household furniture, clothing, automobiles, and consumer durables. However, during periods of reduced income, such as
during a recession, the demand for normal goods tends to decline.

On the other hand, there are goods known as inferior goods, where the quantity demanded rises only up to a certain income level
and decreases as income increases beyond that threshold. Inferior goods do not follow the typical pattern of increasing
demand with increasing income.

Essential consumer goods, such as food grains, fuel, cooking oil, and necessary clothing, satisfy basic life necessities and
are consumed by all individuals in society. When consumers' income increases, the demand for these necessities also
increases, but not in direct proportion to the income rise. This is because as people become wealthier, the relative
importance of non-durable goods like food decreases, while the significance of durable goods like TVs, cars, and houses
increases

(iv) Tastes and preferences of buyers:

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 The demand for a commodity is also influenced by the tastes and preferences of buyers, which
can change over time.
 Goods that are considered modern or fashionable tend to have higher demand compared to those
with outdated designs or out of fashion.
 Sometime consumer may even discard the commodity even before it is fully utilized and prefer
another item which is in fashion

(v) Consumers’ Expectations

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 THEORY OF DEMAND AND SUPPLY 2.9
Consumers’ expectations regarding future prices, income, supply conditions etc. influence current demand.
If the consumers expect increase in future prices, increase in income and shortages in supply, more quantities will
be demanded.
If they expect a fall in price or fall in income they will postpone their purchases of nonessential commodities and
therefore, the current demand for them will fall.

(vi)Size of population:
larger the size of population of a country or a region, larger would be the number of buyers and the quantity demanded
in the market would be higher at every price and vice-versa

(vii)Age Distribution of population (composition of population)

If there are more old people in a region, the

demand for spectacles, walking sticks, etc. will
be high. Similarly, if the population consists of
more of children, demand for toys, baby foods,
toffees, etc. will be more

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(a) The level of National Income and its Distribution:

o the level of national income is a key determinant of market demand, it is
crucial to consider the distribution of wealth within a country.
o A more equal distribution of income tends to result in a higher propensity to
consume and consequently, higher demand for goods and services.
 If the national income is unevenly
distributed the propensity to consume
will be relatively less and consequently,
the demand for consumer goods will be
comparatively less.

(b) Consumer-credit facility and interest rates:

Availability of credit facilities induces people to purchase more than what their current incomes permit
them.
For example Low rates of interest encourage people to borrow and therefore demand will be more.

(c) Government policies and regulations; The governments influence demand through its taxation,
purchases, expenditure, and subsidy policies.
Ex: taxes increase prices and decrease the quantity demanded,
subsidies decrease the prices and increase the quantity demanded.

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 THEORY OF DEMAND AND SUPPLY 2.11

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2.12 BUSINESS ECONOMICS

THE DEMAND FUNCTION

 function is a symbolic statement of a relationship between the dependent and the independent variables.
 The demand function states the relationship between the demand for a product ( dependent variable) and its
determinants ( independent variables).
 demand function may be expressed as follows:
Qx = f (PX, Y, Pr,)
Where Qx is the quantity demanded of product X PX
is the price of the commodity

Y is the money income of the consumer, and Pr is

the price of related goods

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 THEORY OF DEMAND AND SUPPLY 2.13

THE LAW OF DEMAND

Law of Demand:

Prof. Alfred Marshall defined the Law of Demand

The law of demand states :
 That other things being equal,
 When the price of a good rises the quantity demanded of the good will fall and vice versa.
 Thus, there is an inverse relationship between price and quantity demanded, ceteris paribus.

SPECIAL NOTE
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Other Factors remaining constant MEANS ??

The other things which are assumed to be equal or constant are:-
(a) Prices of related commodities (complementary goods or substitute goods)
(b) Income of consumers
(c) Tastes and preferences of consumers, and
(d) Such other factors which influence demand.(etc)

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 THEORY OF DEMAND AND SUPPLY 2.15
The Demand Schedule
A demand schedule is a tabular representation of quantities of a good that buyers would choose to purchase at different
prices, per unit of time, with all other variables held constant.
Table 1: Demand Schedule of an Individual Buyer
Quantity of ice-cream demanded
Price per cup of ice-cream (per week)
(in Rupees) (Cups)
A 60 0
B 50 2

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C 40 4
D 30 6
E 20 8
F 10 10
G 0 12

table shows an inverse relationship between price and quantity of ice-cream demanded, As the price of ice-cream increases,
ceteris paribus, the quantity demanded falls.

1.3.0 The Demand Curve

A demand curve is a graphical presentation of the demand schedule.

Fig. 1 : Demand Curve for Ice-cream

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 THEORY OF DEMAND AND SUPPLY 2.17

FEATURES OF DEMAND CURVE:

1. Demand curve slopes downwards from left to right

2. Demand curve is negatively sloped
3. Demand curve may sometimes be a straight-line or sometimes a free hand curve
4. Demand curve is also called Average Revenue curve (ARC). Since the price paid for each
unit by the consumer is revenue per unit for the seller.
5. The Market Demand curve is a lateral summation of individual Demand curve, and also slopes
downwards from left to right

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Market Demand Schedule

When we add up the various quantities demanded by different consumers in the market, we can obtain the market demand
schedule.
The market demand schedule also indicates inverse relationship between price and quantity demanded of ‘X’.

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 Suppose there are only two individual buyers of good X in the market namely, A and B. The Table 2 shows their individual demand at
various prices.
Table 2: Market Demand Schedule of Good Z (per day)
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Quantity demanded by
Price of Good X in (Rs) A B Total Market Demand
0 3 2 5
10 2 1 3
20 1 0 1
30 0 0 0

When we add the quantities demanded at each price by consumers A and B, we get the total market demand.

Fig. 2 : The Market Demand Curve for Good X

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 The Market Demand Curve THEORY OF DEMAND AND SUPPLY 2.19

The market demand curve is obtained by horizontal summation of all individual demand curves.
If we plot the market demand schedule on a graph, we get the market demand curve.

Rationale of the Law of Demand (Why do people buy more at less price? )

Other things being equal, if the price of a commodity falls, its Demand quantity will rise, and Vice- versa.
This is due to the following reasons

1. Law of diminishing marginal utility

(a) Consumer will buy more quantity at lower price because they want to equalise the marginal
utility of the commodity and price.
(b) The Diminishing Marginal utility and equalising price is the cause of downward sloping of
demand curve

2. Substitution effect:
(a) When the price of a commodity falls, it becomes relatively cheaper than other commodities.
(b) So, consumers now substitute the commodity whose price has fallen for other commodities which
have now become relatively expensive.
(c) Therefore total demand for the commodity whose price has fallen increases

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3. Income effect:
(a) When the price of a commodity falls, the consumer can buy the same quantity of the
commodity with lesser money.
(b) In other words, as a result of fall in the price of the commodity, consumer’s real income or
purchasing power increases.
(c) This increase in the real income induces him to buy more of that commodity. Thus, the
demand for that commodity (whose price has fallen) increases. This is called income effect.

4. Arrival of new consumer:

(a) When the price of a commodity falls, more consumers start buying it because some of those
who could not afford to buy it earlier may now be able to buy it.
(b) This raises the number of consumers of a commodity at a lower price and hence the demand
increases.

5. Different uses:
(a) Certain commodities have multiple uses. If their prices fall, they will be used for varied
purposes and therefore their demand for such commodities will increase
(b) On the other hand, when the price of such commodities are high (or rises) they will be put to
limited uses only.

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 THEORY OF DEMAND AND SUPPLY 2.21

1.3.1 Exceptions to the Law of Demand

there are certain cases where this law does not hold good. The following are the important exceptions to the law of demand.
Conspicuous goods:

 Some consumers measure utility of a commodity by its price i.e. if the commodity is
expensive they think it has got more utility and vice versa.
 Therefore, they buy less at lower price and more of it at higher price. Example: Diamonds,
fancy cars, dinning at 5 stars, high priced shoes, ties, etc….
 Higher prices are indicators of higher utilities.
 A higher price means higher prestige value and higher appeal and vice versa.
 Thus a fall in their price would lead to fall in their quantities demanded. This is against the
law of demand.
 This was found out by Veblen in his doctrine of “Conspicuous Consumption” and hence this
effect is called Vebleri effect or prestige effect

Giffen goods:

 In some cases, demand for a commodity falls when its price fall and vice versa.
 In case of inferior goods like jawar, bajra, cheap bread, etc. also called “Giffen Goods”
(known after its discoverer Sir Robert Giffens) demand is of this nature.
 When the price of such inferior goods fall, less quantity is purchased due consumer’s
increased preference for superior commodity with the rise in their “real income” (i.e.
purchasing power).
 Hence, other things being equal, if price of a Giffen good fall its demand also falls.
 There is positive price effect in this case.

Conspicuous necessities:
(c) The demand for certain goods is affected by the demonstration
effect of the consumption pattern of a social group to which an
individual belongs.
(d) Due to their constant usage these goods have become necessities
of life.
(e) For example, TVs, refrigerators, coolers, cooking gas etc.

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Future expectations about prices:

(f) When the prices show increasing trend, consumers tend to buy larger quantities of such
commodities, expecting that the prices in the future will be still higher
(g) For example, when there is wide-spread drought, people expect that prices of food grains
would rise in future. They demand greater quantities of food grains even at the higher price.

Irrational consumer- It is assumed that consumers are rational and knowledgeable about
market-conditions. However, at times, consumers tend to be irrational and make impulsive
purchases without any rational calculations about the price and usefulness of the product.

Demand for necessaries

(h) Irrespective of price changes, people have to consume the minimum quantities of necessary
commodities. Example- cooking gas, Petrol.

Ignorant consumer: A household may demand larger quantity of a commodity even at a higher price
because it may be ignorant of the ruling price of the commodity.

Speculative goods: In the speculative market, more will be demanded when the prices are rising
and less will be demanded when prices decline.
Example stocks and shares showing increasing trend.

1.4 EXPANSION AND CONTRACTION OF DEMAND

Meaning- Expansion and contraction in demand

takes place as a result of change in price, while
the other factors influencing demand remains
constant.

Movement along the curve- The position of

Demand curve remains the same. The consumer
merely moves upwards or downwards on the Same
Demand Curve

Example-
(a) The present price is P and the
quantity demanded at Price P is M.
(b) Expansion- When the price falls from P to P’ the quantity demanded increases from M to N, on
the same demand curve. Thus this downward movement along the same Demand curve is
called as Expansion of demand.
(c) Contraction- When the price rises from P to P’’ the quantity demanded decreases from M to L,
on the same demand curve. Thus this Upward movement along the same Demand curve is
called as Contraction of demand.

Note- Expansion of Demand is also called as Extension of Demand

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 THEORY OF DEMAND AND SUPPLY 2.23

1.4.1 Increase and Decrease in Demand

Meaning- Increase or decrease in demand as a result of changes in factors other than price, while
price remains constant.

Shift of Demand Curve- Increase or decrease in demand

indicate rightward/leftward shift of the Demand curve
respectively.

Example
Current level of demand is depicted by demand curve D0
Increase in Demand-When the curve shifts rightward
from D0 to D3, it is called as increase in demand. Increase
in Demand happens when more quantities are demanded
at each price.
Decrease in Demand- When the curve shifts leftward
from D0 to D2, it is called as decrease in demand.
Decrease in
Demand happens when lesser quantities are demanded at each price.

Reasons for Increase in Demand

 Rise in income,
 Rise in the price of a substitute,
 Fall in the price of a complement,
 Change in tastes in favour of this commodity,
 An increase in population, and
 Redistribution of income to groups who favour this commodity

Reasons for Decrease in Demand

 Fall in income
 Fall in the price of a substitute,
 Rise in the price of a complement,
 Change in tastes against this commodity,
 Decrease in population, and
 Redistribution of income away from groups who favour this commodity.

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Fig. 5(a): Rightward shift in the Fig. 5(b): Leftward shift in the
demand Curve demand Curve
Movements along the Demand Curve vs. Shift of Demand Curve
IMPORTANT CRUX FOR EXAM

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 THEORY OF DEMAND AND SUPPLY 2.25

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2.26 BUSINESS ECONOMICS

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 THEORY OF DEMAND AND SUPPLY 2.27

ELASTICITY OF DEMAND

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1 Elasticity of demand is defined as the responsiveness or sensitiveness of the
quantity demanded of a commodity to the changes in any one of the
variables on which demand depends.
2 These variables are price of the commodity, prices of the related
commodities, income of the consumers and many other factors on which
demand depends.
3 Accordingly, we have price elasticity, cross elasticity, elasticity of substitution,
income elasticity and advertisement elasticity.
4 Unless mentioned otherwise, it is price elasticity of demand which is
generally referred.

Different measures of Elasticity for different factors

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 THEORY OF DEMAND AND SUPPLY 2.29

Price Elasticity of Demand

1 MEANING
→ Price elasticity measures the degree of responsiveness of quantity
demanded of a commodity to a change in its price, given the consumer’s
income, his tastes and prices of all other goods.

→ It reflects how sensitive buyers are to change in price.

→ Price elasticity of demand can be defined “as a ratio of the percentage

change in the quantity demanded of a commodity to the percentage change
in its own price”.

2 FORMULA

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3.Negative sign -since price and quantity are inversely related (with a few
exceptions), price elasticity is negative. But, for the sake of convenience, we ignore
the negative sign and consider only the numerical value of the elasticity.

ILLUSTRATION 1
The price of a commodity decreases from Rs 6 to Rs 4 and quantity demanded of the good increases from 10 units to 15 units.
Find the coefficient of price elasticity.
SOLUTION
Price elasticity = (-)  q /  p × p/q = 5/2 × 6/10 = (-) 1.5
ILLUSTRATION 2
A 5% fall in the price of a good leads to a 15% rise in its demand. Determine the elasticity and comment on its value.
SOLUTION

% change in quantity demanded

Price Elasticity = Ep = % change in Price

= 15% / 5% = 3

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 THEORY OF DEMAND AND SUPPLY 2.31

Comment: The good in question has elastic demand

ILLUSTRATION 3
The price of a good decreases from ` 100 to ` 60 per unit. If the price elasticity of demand for it is 1.5 and the original quantity
demanded is 30 units, calculate the new quantity demanded.
SOLUTION
q p
Ep = ×
p q
q 100
Here 1.5 = × =18
40 30
Therefore new quantity demanded = 30+18 = 48 units
ILLUSTRATION 4
The quantity demanded by a consumer at price Rs 9 per unit is 800 units. Its price falls by 25% and quantity
demanded rises by 160 units. Calculate its price elasticity of demand.
SOLUTION
Change in quantity demanded = 160
Therefore, % change in quantity demanded = = 20%
% change in price = 25%

% change in q
Ed = % change in p
20
 Ea =  0.8
25
ILLUSTRATION 5
A consumer buys 80 units of a good at a price of Rs 4 per unit. Suppose price elasticity of demand is - 4. At what price will he
buy 60 units?
SOLUTION
q p
Ed = ×
p q
20 4
Or 4= ×
x – 4 80
1
Or 4=
x– 4

 x = 4.2 per unit

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Point Elasticity (METHOD OF DERIVATIVE )

1.Meaning
a) In point elasticity, we measure elasticity at a given
point on a demand curve.
b) The concept of point elasticity is used for measuring
price elasticity where the change in price is
infinitesimal (very small)
c) Point elasticity makes use of derivative rather than
finite changes in price and quantity.

2. Formula
Ep = –dq × p
dp q

3.NOTE
dq
Where
dp is the derivative of quantity with respect to price at a point on the demand curve, and p and q are the
price and quantity at that point. Economists generally use the word “elasticity” to refer to point elasticity.

Fig 6: Point Elasticity

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 THEORY OF DEMAND AND SUPPLY 2.33

Measurement of Elasticity on a Linear Demand Curve – Geometric Method

(POINT ELASTICTY: METHOD OF GRAPH)

a) This method is applicable only for Straight- line Demand curve touching both the axes.
b) It is to be noted that elasticity is different at different
points on the same demand curve, since the length of
lower and upper segments will differ at various points
on the Demand curve
c) Under Graphical method Elasticity is calculate using
the following formula-

D Using the above formula we can get elasticity at various points on the demand curve.

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Elasticity at Different Points on the Demand Curve

Thus, we see that as we move from T towards t, elasticity goes on increasing. At the mid-point it is equal to one, at point t, it
is infinity and at T it is zero.

Arc-Elasticity
 When there is large change in the price or we have to measure
elasticity over an arc of the demand curve, we use the “arc method” to
measure price elasticity of demand.

→ The arc elasticity is a measure of the “average elasticity” ie. elasticity at

MID-POINT that connects the two points on the demand curve.

→ Thus, an arc is a portion of a curved line, hence a portion of a demand

curve. Here instead of using original or new data as the basis of
measurement, we use average of the two.

Fig. 8: Arc Elasticity

The arc elasticity can be found out by using the formula: We drop the minus sign and use the absolute value.

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 THEORY OF DEMAND AND SUPPLY 2.35

Q2 –Q1
(Q2 +Q1 )/2
Ep =
P2 –P1
(P2 +P1 )/2

Ep = Q2 –Q1 × P2 +P1
Q2 +Q1 P2 –P1

Where P1, Q1are the original price and quantity and P2, Q2are the new ones.

EXAMPLE

if we have to find elasticity of demand for headphones between:

P1= Rs.500 Q1= 100
P2 = Rs. 400 Q2= 150
We will use the formula

Ep = Q2 –Q1 × P2 +P1
Q2 +Q1 P2 –P1

Or Ep = 50  900
250 100

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2.36 BUSINESS ECONOMICS

or Ep = 1.8
The arc elasticity will always lie somewhere (but not necessarily in the middle) between the point elasticities calculated at
the lower and the higher prices.

Interpretation of the Numerical Values of Elasticity of Demand

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 THEORY OF DEMAND AND SUPPLY 2.37

The value of elasticity coefficients will vary from zero to infinity.

 When the coefficient is zero, demand is said to be perfectly inelastic.

 When the coefficient lies between zero and unity, demand is said to be inelastic.
 When coefficient is equal to unity, demand has unit elasticity.
 When coefficient is greater than one, demand is said to elastic.
 In extreme cases co-efficient could be infinite.

Perfectly Inelastic Demand: (Ep = 0):

When change in price has no effect on quantity demanded, then demand is perfectly inelastic.

Example – If price falls by 20% and the quantity demanded remains unchanged then,
Ep = 0/20 = 0.
In this case, the demand curve is a vertical straight line curve parallel to y-axis as shown in
the figure.

2. Perfectly Elastic Demand: (Ep = ∞):

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When with no change in price or with very little change in price, the demand for a
commodity expands or contracts to any extent, the demand is said to be perfectly elastic.

In this case, the demand curve is a horizontal and parallel to X-axis.

3. Unit Elastic Demand: (Ep = 1):

When the percentage or proportionate change in price is equal to the percentage or

proportionate change in quantity demanded, then the demand is said to be unit elastic.

Example: If price falls by 10% and the demand rises by 10% then, Demand Curve DD is a
rectangular hyperbola curve suggesting unitary elastic demand.

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 THEORY OF DEMAND AND SUPPLY 2.39
4. Relatively Elastic Demand (more elastic): ( Ep > 1):

When a small change in price leads to more than proportionate change in quantity
demanded then the demand is said to be relatively elastic OR more elastic

Example: If price falls by 20% and demand rises to by 60% then, Ep = 60/20 = 3 > 1.

The elastic demand curve is flatter as shown in figure.

Demand curve is flat suggesting that the demand is highly elastic. highly elastic demand
occurs in case of less urgent wants or if the expenditure on commodity is large or if close
substitutes are available.

5. Relatively Inelastic Demand (less elastic): (Ep < 1):

When a big change in price leads to less than proportionate change in quantity
demanded, then the demand is said to be relatively inelastic or less elastic

Example: If price falls by 40% and demand rises by 10% then, E p = 10/40 = 1/4 < 1
The demand curve in this case has steeper

Demand curve is steeper suggesting that demand is less elastic or relatively inelastic.
Relatively inelastic demand occurs in case compulsory goods i.e. necessities of life.

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: Elasticity Measures, Meaning and Nomenclature

Numerical measure of Verbal description Terminology

elasticity
Zero Quantity demanded does not change as price Perfectly (or completely)
changes inelastic
Greater than zero, but less Quantity demanded changes by a smaller Inelastic
than one percentage than does price
One Quantity demanded changes by exactly the Unit elasticity
same percentage as does price
Greater than one, but less Quantity demanded changes by a larger Elastic
than infinity percentage than does price
Infinity Purchasers are prepared to buy all they can Perfectly (or infinitely) elastic
obtain at some price and none at all at an even
slightly higher price

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 THEORY OF DEMAND AND SUPPLY 2.41

Total Outlay Method of Calculating Price Elasticity

• The Total Outlay also known as Expenditure Method or Seller’s Total
Revenue Method:

•
The total outlay refers to the total expenditure done by a consumer on the
purchase of a commodity.

• It is obtained by multiplying the price with the quantity demanded.

• Thus,
Total Outlay (TO) = Price (P) X Quantity (Q)

• In this method, we measure price elasticity by examining the change in

total outlay due to change in price.

• Here we can not find out exact coefficient of price elasticity

• We can only say demand is elastic or in elastic

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 2.42 BUSINESS ECONOMICS

• Dr. Alfred Marshall laid the following propositions:

example

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 THEORY OF DEMAND AND SUPPLY 2.43

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 2.44 BUSINESS ECONOMICS

The Relationship between Price elasticity and Total Revenue (TR)

Demand
Elastic Unitary Elastic Inelastic
Price increase TR Decreases TR remains same TR Increases
Price decrease TR Increases TR remains same TR Decreases

Determinants of Price Elasticity of Demand

 Nature of commodity:

 The demand for necessities of life like food, clothing, housing etc. is less elastic or
inelastic because people have to buy them whatever be the price.
 Whereas, demand for luxury goods like cars, air-conditioners, cellular phone, etc. is
elastic.
2. Availability of Substitutes:

 If for a commodity wide range of close substitutes are available i.e. if a commodity is
easily replaceable by others, its demand is relatively elastic. Example – Demand for cold
drinks like Thumbs-up, Coca-cola, Limca, etc.
 Conversely, a commodity having no close substitute has inelastic demand. Example –
Salt (but demand for TATA BRAND SALT is elastic.)
3. Number of uses of a commodity:

 A commodity which has many uses will have relatively elastic demand.
 Example – Electricity can be put to many uses like lighting, cooking, motive-power, etc. If
the price of electricity falls, its consumption for various purposes will rise and vice versa.
 On the other hand if a commodity has limited uses will have inelastic demand.
4. Price range:

 If price of a commodity is either too high or too low, its demand is inelastic but those
which are in middle price range have elastic demand.
5. Position of a commodity in the budget of consumer:

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 THEORY OF DEMAND AND SUPPLY 2.45
 If a consumer spends a small proportion of his income to purchase a commodity, the
demand is inelastic.
 Example – Newspaper, match box, salt, buttons, needles.
 But if consumer spends a large proportion of his income to purchase a commodity, the
demand is elastic.
 Example -Clothes, milk, etc.
6. Time period:

 The longer any price change remains the greater is the price elasticity of demand.
 On the other hand, shorter any price change remains, the lesser is the price elasticity of
demand.
7. Habits:

 Habits makes the demand for a commodity relatively inelastic.

 Example – A smoker’s demand for cigarettes tend to be relatively inelastic even at
higher price.
8. Tied Demand (Joint Demand):

 Some goods are demanded because they are used jointly with other goods. Such goods
normally have inelastic demand as against goods having autonomous demand.
 Example – Printers & Cartridges.

Summary

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2.46 BUSINESS ECONOMICS

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 THEORY OF DEMAND AND SUPPLY 2.47

Income Elasticity of Demand

Meaning

Income elasticity of demand is the degree of responsiveness of the quantity demanded of a good to changes in the income of
consumers

Usefulness

Estimates of income elasticity of demand are useful for businesses to predict the possible growth in sales as the average
incomes of consumers grow over time.
formula,
Percentge change in demand
Ei 
Percentge change in income

This can be given mathematically as follows:

Q Y
E  

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 2.48 BUSINESS ECONOMICS
i
Q Y
Q Y
= ×
Q

Ei = Y

Q Y
×
Y Q
Ei = Income elasticity of demand
∆Q = Change in demand
Q = Original demand
Y = Original money income

The income elasticity of demand is Positive for all normal or luxury goods and the income
elasticity of demand is Negative for inferior goods. Income elasticity can be classified under
five heads:
1. Zero Income Elasticity:

 It means that a given increase in income does not at all lead to any increase in quantity
demanded of the commodity.
 In other words, demand for the commodity is completely income inelastic or E y < 0.
 Commodities having zero income elasticity are called Neutral Goods.
 Example – Demand in case of Salt, Match Box, Kerosene Oil, Post Cards, etc.
2. Negative Income Elasticity;

 It means that an increase in income results in fall in the quantity demanded of the
commodity or Ey <0.
 Commodities having negative income elasticity are called Inferior Goods. Example –
Jawar, Bajra, etc.
3. Unitary Income Elasticity:

 It means that the proportion of consumer’s income spent on the commodity remains
unchanged before and after the increase in income or E y = 1. This represents a useful
dividing line.
4. Income Elasticity Greater Than Unity:

 It refers to a situation where the consumers spends Greater proportion of his income on
a commodity when he becomes richer. Ey > 1,
 Example – In the case of Luxuries like cars, T.V. sets, music system, etc.

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 THEORY OF DEMAND AND SUPPLY 2.49
6. Income Elasticity Less Than Unity:
It refers to a situation where the consumer spends a Smaller proportion of his income on
a commodity when he becomes richer. Ey < 1,

ILLUSTRATION 6
Income Elasticity of Demand
A car dealer sells new as well as used cars. Sales during the previous year were as follows;

Car type Price Quantity ( Nos)

New 6 .5 lakhs 400
Used 60,000 4000

During the previous year, other things remaining the same, the real incomes of the customers rose on average by 10%.
During the last year sales of new cars increased to 500, but sales of used cars declined to 3,850.
What is the income elasticity of demand for the new as well as used cars? What inference do you draw from these measures of
income elasticity?
SOLUTION
Income Elasticity of demand for new cars
Percentage change in income = 10%, given
Percentage change in quantity of new cars demanded = (∆ Q/Q) X 100 = (100/400 ) X100 = 25% Income
elasticity of demand = 25%/ 10% = + 2.5
New car is therefore income elastic. Since income elasticity is positive, new car is a normal good.
Income Elasticity of demand for used cars
Percentage change in income = 10%, given
% change in quantity of used cars demanded = (∆ Q/Q )X 100 =( -1 50/4000 ) x100 = - 3.75%Income elasticity of demand =
– 3.75/ 10= –.375
Since income elasticity is negative, used car is an inferior good.

summary

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2.50 BUSINESS ECONOMICS

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 THEORY OF DEMAND AND SUPPLY 2.51

CROSS - PRICE ELASTICITY OF DEMAND

Price of Related Goods and Demand

meaning

In the case of the cross-price elasticity of demand, the sign (plus or minus) is very important: it
tells us whether the two goods are complements or substitutes.

Substitute Products and Demand

(a) When two goods X and Y are substitutes, the cross-price elasticity of demand is
positive
(b) • If two goods are perfect substitutes for each other, the cross elasticity between
them is infinite.
(c) • If two goods are close substitutes, the cross-price elasticity will be positive and
large.
(d) • If two goods are not close substitutes, the cross-price elasticity will be positive
and small.
(e) • If two goods are totally unrelated, the cross-price elasticity between them is zero.

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2.52 BUSINESS ECONOMICS

Fig. 10 : Substitutes
(f) Complementary Goods

 When two goods are complementary (tea and sugar) to each other, the cross
elasticity between them is negative
 if the cross-price elasticity is only slightly below zero, they are weak complements;
 if it is negative and very high, they are strong complements.

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 THEORY OF DEMAND AND SUPPLY 2.53

Fig. 11: Complementary Goods

formula

Percentage change in quantity demanded of good X Percentage

Ec  chagne in price of good Y

Symbolically, (mathematically)
qx py
E 
c q py
x

p
E qx  y
c p q
y

Where Ec stands for cross elasticity.

qx stands for original quantity demanded of X.

∆qx stands for change in quantity demanded of X py

stands for the original price of good Y.

∆py stands for a small change in the price of Y.

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 2.54 BUSINESS ECONOMICS
Usefulness
The concept of cross elasticity of demand is useful for a manager while making decisions regarding changing the prices of
his products which have substitutes and complements.
If cross elasticity to change in the price of substitutes is greater than one, the firm may lose by increasing the prices and gain
by reducing the prices of his products.
With proper knowledge of cross elasticity, the firm can plan policies to safeguard against fluctuating prices of substitutes and
complements.

Cross- price elasticity of demand

ILLUSTRATION 7
A shopkeeper sells only two brands of note books Imperial and Royal. It is observed that when the price of Imperial rises by 10%
the demand for Royal increases by 15%.What is the cross price elasticity for Royal against the price of Imperial?
SOLUTION

Percentage change in quantity demanded of good X Percentage

Ec  chagne in price of good Y
15%
Ec    1.5
10%
The two brands of note book Imperial and Royal are substitutes with significant substitutability

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 THEORY OF DEMAND AND SUPPLY 2.55

ILLUSTRATION 8
The cross price elasticity between two goods X and Y is known to be - 0.8. If the price of good Y rises by 20%, how will the
demand for X change?
SOLUTION
Inserting the values in the formula:
-0.8 = X/ 20%
% change in quantity demanded of X = 20% x - 0.8 = - 16%
Since cross elasticity is negative, X and Y are complementary goods
ILLUSTRATION 9
The price of 1kg of tea is ` 30. At this price 5kg of tea is demanded. If the price of coffee rises from ` 25 to
` 35 per kg, the quantity demanded of tea rises from 5kg to 8kg. Find out the cross price elasticity of tea.
SOLUTION
qx py
Cross elasticity = × x = tea
Here
py qx y = coffee
8–5 25 3 25
Ec =      1.5
10 5 10 5
The elasticity of demand of tea is +1.5 showing that the demand of tea is highly elastic with respect to coffee. The positive sign
shows that tea and coffee are substitute goods.
ILLUSTRATION 10
The price of 1 kg of sugar is Rs 50. At this price 10 kg is demanded. If the price of tea falls from Rs 30 to Rs 25 per kg, the
consumption of sugar rises from 10 kg to 12 kg. Find out the cross price elasticity and comment on its value.
SOLUTION
qx py
Cross elasticity = × Here x  Sugar
py qx y  Tea
2 30
=   (–) 1.2
–5 10

Since the elasticity is -1.2, we can say that sugar and tea are complementary in nature.

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2.56 BUSINESS ECONOMICS

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 THEORY OF DEMAND AND SUPPLY 2.57

1.8 ADVERTISEMENT ELASTICITY

Advertisement elasticity also known as promotional elasticity of demand

The advertising elasticity of demand measures the percentage change in demand that occurs given a one
percent change in advertising expenditure.

Advertising elasticity of demand is typically positive. Higher the value of advertising elasticity greater
will be the demand

Advertisement elasticity varies between zero and infinity.

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2.58 BUSINESS ECONOMICS

formula;

% Change in quantity demanded

Ea =% change in spending on advertising

Qd/Qd
Ea =
A/A
Where ∆ Qd denotes increase in demand
∆ A denotes additional expenditure on advertisement Qd
denotes initial demand
A denotes initial expenditure on advertisement

Elasticity Interpretation
Ea = 0 Demand does not respond at all to increase in advertisement expenditure
Ea >0 but < 1 Increase in demand is less than proportionate to the increase in advertisement
expenditure
Ea = 1 Demand increase in the same proportion in which advertisement expenditure increase
Ea> 1 Demand increase at a higher rate than increase in advertisement expenditure

As far as a business firm is concerned, the measure of advertisement elasticity is useful in understanding the effectiveness of
advertising and in determining the optimum level of advertisement expenditure.

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 THEORY OF DEMAND AND SUPPLY 2.59

DEMAND FORECASTING
Meaning
1 Demand forecasting is an estimate of the future market demand for a
product. The process of forecasting is based on reliable statistical data of
past and present behaviour, trends, etc.
2 Demand forecasting cannot be hundred per cent correct. But, it gives a
reliable estimates of the possible outcome with a reasonable accuracy.
3 Demand forecasting may be at international level or local level depending
upon area of operation, cost, time, etc.

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 2.60 BUSINESS ECONOMICS

Usefulness

Demand forecasting is an important function, of managers as it reduces uncertainty of

environment in which Decisions are made. Further, it helps in Planning for future level of
production. Its significance can be stated as follows:

1. Production Planning: Demand forecasting is a pre-requisite for planning of production in a

firm. Expansion of production capacity depends upon likely demand for its output. Otherwise,
there may be overproduction or underproduction leading to losses.

2. Sales Forecasting: Sales forecasting depends upon demand forecasting. Promotional efforts
of the firm like advertisements, suitable pricing etc. should be based on demand forecasting.

3. Control of Business: Demand forecast provide information for budgetary planning and cost
control in functional area of finance and accounting.

4. Inventory Control: Demand forecasting helps in exercising satisfactory control of business

inventories like raw-materials, intermediate goods, semi-finished goods, spare parts, etc.
Estimates of future requirement of inventories is to be done regularly and it can be known
from demand forecasts.

5. Capital Investments: Capital investments yield returns over many years in future. Decision
about investment is to be taken by comparing rate of return on capital investment and current
rate of interest. Demand forecasting helps in taking investment decisions.

Scope of Forecasting
Demand forecasting can be at the individual, firm, national or international level

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 THEORY OF DEMAND AND SUPPLY 2.61

Types of Forecasts
(i) Macro-level forecasting deals with the general economic environment prevailing in the economy as measured
by the Index of Industrial Production (IIP), national income and general level of employment etc.
(ii) Industry- level forecasting is concerned with the demand for the industry’s products as a whole. For
example, demand for cement in India.
(iii) Firm- level forecasting refers to forecasting the demand for a particular firm’s product, say, the demand for ACC
cement

Based on time period, demand forecasts may be short term demand forecasting and long term demand forecasting.

(i) Short term demand forecasting covers a short span of time, depending of the nature of industry. It is done usually for
six months or less than one year and is generally useful in tactical decisions.
(ii) Long term forecasts are for longer periods of time, say two to five years and more. It provides information for
major strategic decisions of the firm such as expansion of plant capacity.

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Demand Distinctions
Business managers should have a clear understanding of the kind of demand which their products have. Before we analyse the different
methods of forecasting demand, it is important for us to understand the demand distinctions which are as follows:

(a) Producer’s goods and Consumer’s goods

(b) Durable goods and Non-durable goods
(c) Derived demand and Autonomous demand
(d) Industry demand and Company demand
(e) Short-run demand and Long-run demand

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 THEORY OF DEMAND AND SUPPLY 2.63

(a) Producer’s goods and Consumer’s goods

Producer’s goods are those which are used for the production of other goods- either consumer goods or producer
goods themselves. Examples of such goods are machines, plant and equipments.

Consumer’s goods are those which are used for final consumption. Examples of consumer’s goods are readymade
clothes, prepared food, residential houses, etc.

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 2.64 BUSINESS ECONOMICS

(b) Demand for Durable goods and Non-durable goods

Durable goods are those which can be consumed more than once and yield utility over a
period of time.

 Producer’s Durable Goods – Example – Building, Plant, Machinery etc.

 Consumer’s Durable Goods – Example – Cars, TV, Refrigerators, etc.
Non-durable goods are those which cannot be consumed more than once. These will meet
only the current demand.

 Producer’s Non-durable Goods – Example – raw material, fuel, power, etc.

 Consumer’s Non-durable Goods – Example – milk, bread, etc.

Further, there are semi- durable goods such as, clothes and umbrella.

(c) Derived demand and Autonomous demand

(d)

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 THEORY OF DEMAND AND SUPPLY 2.65

D
Demand for firm’s product (company demand) and industry demand

(e) Short - run demand and Long-run demand

 Short run demand refers to demand with its immediate reaction to changes in product price and prices of related
commodities, income fluctuations, ability of the consumer to adjust their consumption pattern, their
susceptibility to advertisement of new products etc.
 Long-run demand refers to demand which exists over a long period.
 Most generic goods have long term demand.
 Long term demand depends on long term income trends, availability of substitutes, credit facilities etc.
 In short, long run demand is that which will ultimately exist as a result of changes in pricing, promotion or
product improvement, after enough time is allowed to let the market adjust to the new situation.
 For example, if electricity rates are reduced, in the short run, the existing users will make greater use of electric
appliances. In the long run, more and more people will be induced to buy and use electric appliances.

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Factors Affecting Demand for Non-Durable Consumer Goods

There are three basic factors which influence the demand for these goods:
 Disposable Income: The income left with a person after paying direct taxes and other deduc-
tions is called as disposable income. Other things being equal, more the disposable income of
the household, more is its demand for goods and vice versa.

→ Price: The demand for a commodity depends upon its price and the prices of its substitutes
y and complements. The demand for a commodity is inversely related to its own price and the
price of its complements. The demand for a commodity is positively related to its substitutes.

→ Demography: This involves the characteristics of the populations, human as well as non
human which use the given product. E.g. – If forecast about the demand for toys is to be
made, we will have to estimate the number and characteristics of children whose parents can
afford toys.

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 THEORY OF DEMAND AND SUPPLY 2.67
Factors Affecting the Demand for Durable-Consumer Goods
Demand for durable goods has certain special characteristics. Following are the important factors that affect the demand for
durable goods.

→ Special Facilities: Some goods need special facilities for their use. Example – Roads for cars,
elec-tricity for T.V., refrigerators etc. The expansion of such facilities expands the demand for
such goods.

Long time use or replacement: For how long a consumer can use a good depends on the
factors like his status, prestige attached to good, his level of money income, etc. Replacement
of a good depends upon the factors like the wear and tear rate, the rate of obsolescence, etc.

→ Joint use of a good by household: As consumer durables are used by more than one person,
the decision to purchase may be influenced by family characteristics like size of family, age and
sex consumption.

→ Price and Credit facilities: Demand for consumer durables is very much influenced by their
prices and credit facilities like hire purchase, low interest rates, etc. available to buy them.
More the easy credit facilities higher is the demand for goods like two wheelers, cars TVs. etc

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2.68 BUSINESS ECONOMICS

1.9.0 Factors Affecting the Demand for Producer Goods

Since producers’ goods or capital goods help in further production, the demand for them is derived demand, derived from the
demand of consumer goods they produce.

The demand for them depends upon the rate of profitability of user industry and the size of the market of the user industries.
Hence data required for estimating demand for producer goods (capital goods) are:
(i) growth prospects of the user industries;

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 THEORY OF DEMAND AND SUPPLY 2.69

(ii) norms of consumption of capital goods per unit of installed capacity.

An increase in the price of a substitutable factor of production, say labour, is likely to increase the demand for capital goods. On
the contrary, an increase in the price of a factor which is complementary may cause a decrease in the demand for capital.
Higher the profit making prospects, greater will be the inducement to demand capital goods. If firms are optimistic about
selling a higher output in future, they will have greater incentive to invest in producer goods. Advances in technology
enabling higher efficiency at reduced cost on account of higher productivity of capital will have a positive impact on investment in
capital goods. Investments in producer goods will be greater when lower interest rates prevail as firms will have lower
opportunity cost of investments and lower cost of borrowing.

Methods of Demand Forecasting

There is no easy method or simple formula which enables an individual or a business to predict the future with certainty or
to escape the hard process of thinking. The firm has to apply a proper mix of judgment and scientific formulae in order to
correctly predict the future demand for a product.

The following are the commonly available techniques of demand forecasting:

Survey of Buyers’ Intentions:

In this method, customers are asked what they are planning to buy for the forthcoming time
period usually a year.
1. This method involve use of conducting direct interviews or mailing questionnaire asking
customers about their intentions or plans to buy the product.

2. The survey may be conducted by any of the following methods:

 Complete Enumeration where all potential customers of a product are interviewed about
what they are planning or intending to buy in future. It is cumbersome, costly and time
consuming method.
 Sample Survey where only a few customers are selected and interviewed about their
future plans. It is less cumbersome and less costly method.
 End-use method or Input-output method where the bulk of good is made for industrial
manufactures who usually have definite future plans.
3. This method is useful for short-term forecasts.

4. In this method burden of forecasting is put on the customers

Collective opinion method:

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 2.70 BUSINESS ECONOMICS
T
The method is also known as sales force opinion method or grass roots approach.

1. Under this method, salesmen are asked to estimate expectations of sales in their territories.
Salesmen are considered to be the nearest persons to the customers retailers and wholesalers
and have good knowledge and information about the future demand trend.

2. The estimates of all the sales-force is collected are examined in the light of proposed
changes in selling price, product design, expected competition, etc. and also factors like
purchasing power, employment, population, etc.

3. This method is based on first hand knowledge of the salesmen. However, its main drawback
is that it is subjective. Its accuracy depends on the intelligence, vision and his ability to foresee
the influence of many unknown factors.

Expert Opinion Method

 Also known as Delphi Method

Under this method of demand forecasting views of specialists/experts and consultants are
sought to estimate the demand in future. These experts may be of the firm itself like the
executives and sales managers or consultant firms who are professionally trained for
forecasting demand.

1. The Delphi technique, developed by OLAF HEMLER at the Rand Corporation of the U.S.A. is
used to get the opinion of a number of experts about future demand.

2. Experts are provided with information and opinion feedbacks of other experts at different
rounds and are repeatedly questioned for their opinion and comments till consensus emerges.

3. It is a time saving method.

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 THEORY OF DEMAND AND SUPPLY 2.71
Statistical Method:
Statistical method have proved to be very useful in demand forecasting. Statistical methods
are superior, more scientific, reliable and free from subjectively. The important statistical
methods of demand forecasting are –

1. Trend Projection Method: The method is also known as Classical Method. It is considered as
a ‘naive’ approach to demand forecasting.

 Under this, data on sales over a period of time is chronologically arranged to get a ‘time
series’. The time series shows the past sales pattern. It is assumed that the past sales
pattern will continue in the future also. The techniques of trend projection based on,
time series data are Graphical Method and Fitting trend equation or Least Square
Method.
2. Graphical Method: This is the simplest technique to determine the trend.

 Under this method, all values of sales for different years are plotted and free hand curve
is drawn passing through as many points as possible. The direction of the free hand
curve shows the trend.
 The main drawback of this method is that it may show trend but not measure it.
3. Fitting Trend Equation/Least Square Method: This method is based on the assumption that
the past rate of change will continue in the future. ‘ .

 It is a mathematical procedure for fitting a time to a set of observed data points in such
a way that the sum of the squared deviation between the calculated and observed
values is minimized.
 This method is popular because it is simple and inexpensive.
4. Regression Analysis: This is a very common method of forecasting demand.

 Under this method, a quantitative relationship is established between quantity

demanded (dependent variable) and the independent variables like income, price of
good, price of related goods, etc. Based on this relationship, an estimate is made for
future demand.
 It can be expressed as follows –
Y=a+bX
Where
X, Y are variables
a, b are constants

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 2.72 BUSINESS ECONOMICS
Controlled Experiments: Under this method, an effort is made to vary certain determinants of
demand like price, advertising, etc. and conduct the experiments assuming that the other
factors remain constant.

 The effect of demand determinants on sales can be assessed either by varying then in
different markets or by varying over a period of time in the same market.
 The responses of demand to such changes over a period of time are recorded and are
used for estimating the future demand for the product.
 This method is used less as it is expensive and time consuming.
 This method is also called as market experiment method.

Barometric Method of forecasting: This method is based on the assumption that future can
be predicted from certain events occurring in the present. We need not depend upon the past
observations for demand forecasting.

1. There are economic ups and downs in an economy which indicate the turning points. There
are many economic indicators like income, population, expenditure, investment, etc. which can
be used to forecast demand. There are three types of economic indicators, viz.

 Coincidental Indicators are those which move up and down simultaneously with
aggregate economy. It measures the current economic activity. Example – rate of
employment.
 Leading Indicators reflect future change in the trend of aggregate economy.
 Lagging Indicators reflect future changes in the trend of aggregate economic activities.

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