UNIT 2

ECONOMIC THEORY
THEORY OF UTILITY AND DEMAND
Utility
The term ‘utility’ referes to the capacity of a commodity to satisfy a human want.
Approaches to utility:
Economists have offered their theories of consumer behavior on the basis of measurement of the utility
Cardinal utility: Utility is cardinal in the sense that utility is measurable in terms of units called utils. According
to the concept of cardinal utility, the utility can be measured in numerical terms.
Ordinal utility: Utility is ordinal in the sense that utility derived from a commodity cannot be measured in
numerical terms but can be compared by giving ranks.
Types of Utility
There are two types of utility:
1. Total Utility
2. Marginal Utility
Total Utility The term total utility means the total satisfaction derived from the consumption of commodities.
Marginal Utility Marginal utility be defined as the additional utility derived from the consumption of an additional
unit of a commodity. Therefore ,we can say that Marginal utility is the extra satisfaction gained from an one more
additional unit of that particular commodity. Marginal utility may be calculated as follows:
Marginal Utility = change in Total Utility ÷ change in quantity consumed
Or
MUn = TUn – TUn-1
Approaches to Cardinal Utility Analysis
The two approaches of Cardinal utility analysis are as follows:
1. Law of Diminishing Marginal Utility
2. Law of Equi-Marginal Utility
The Law of Diminishing Marginal Utility

This is an important law under Marginal Utility Analysis. Alfred Marshall, British Economist defines the law of
diminishing marginal utility as follows:

“The additional benefit which a person derives from a given increase in the stock of a thing diminishes with every
increase in the stock that he already has.”
This law is based on the fundamental tendency of human nature. Human wants are virtually unlimited. However,
every single want is satiable. Hence, as we consume more and more units of a good, the intensity of our want for the
good decreases. Eventually, it reaches a point where we no longer want it.

In other words, as we consume more units of a good, the extra satisfaction that we derive from the extra unit keeps
falling. However, it is important to remember that the marginal utility declines NOT the total utility.

Assumptions of Law of Diminishing Marginal Utility:

The law of DMU operates under certain specific conditions. Economists call them the ‘assumptions’ of this law.
Following are the assumptions of the law of diminishing marginal utility:

1. Cardinal measurement of utility: It is assumed that utility can be measured and a consumer can express his
satisfaction in quantitative terms such as 1, 2, 3, etc.

2. Monetary measurement of utility: It is assumed that utility is measurable in monetary terms.

3. Consumption of reasonable quantity: It is assumed that a reasonable quantity of the commodity is consumed. For
example, we should compare MU of glassfuls of water and not of spoonful’s. If a thirsty person is given water in a
spoon, then every additional spoon will yield him more utility. So, to hold the law true, suitable and proper quantity
of the commodity should be consumed.

4. Continuous consumption: It is assumed that consumption is a continuous process. For example, if one glass of
juice is eam is consumed in the morning and another in the afternoon, then the second glass may provide equal or
higher satisfaction as compared to the first one.

5. No change in Quality: Quality of the commodity consumed is assumed to be uniform. A second cup of ice-cream
with nuts and toppings may give more satisfaction than the first one, if the first ice-cream was without nuts or
toppings.

6. Rational consumer: The consumer is assumed to be rational who measures, calculates and compares the utilities
of different commodities and aims at maximising total satisfaction.

7. Independent utilities: It is assumed that all the commodities consumed by a consumer are independent. It means,
MU of one commodity has no relation with MU of another commodity. Further, it is also assumed that one person’s
utility is not affected by the utility of any other person.

8. MU of money remains constant: As a consumer spends money on the commodity, he is left with lesser money to
spend on other commodities. In this process, the remaining money becomes dearer to the consumer and it increases
MU of money for the consumer. But, such an increase in MU of money is ignored. As MU of a commodity has to be
measured in monetary terms, it is assumed that MU of money remains constant.

9. Fixed Income and prices: It is assumed that income of the consumer and prices of the goods which the consumer
wishes to purchase remain constant.
10. Goods are divisible: It is assumed that whatever the goods are consumed they must be divisible. If the goods are
not divisible the comparison of utility is not possible.

11. Homogeneity: Another important assumption is that goods consumed should be homogeneous in regard to quality
size, taste, flavors, colour etc.

Illustration
Let us see an example. The table below presents the total and marginal utility derived by Peter from consuming cups
of tea per day.

Quantity of Teas Total Utility Marginal Utility

1 30 30

2 50 20

3 65 15

4 75 10

5 83 8

6 89 6

7 93 4
 8 96 3

9 98 2

10 99 0

11 95 -4

As seen in the table above, when Peter consumes one cup of tea in a day, he derives a total utility of 30 utils (unit of
utility) and a marginal utility of 30 utils. When he takes two cups per day, the total utility rises to 50 utils but the
marginal utility falls to 20. This trend continues until the last row where the marginal utility is negative. This means
that if Peter consumes 11 or more cups of tea per day, then he might fall sick. Here is a graph representing the table:

Relationship between Total and Marginal utility

1. As the total utility rises, the marginal utility diminishes

2. When the total utility is maximum, the marginal utility is zero.

3. As the total utility starts diminishing, the marginal utility becomes negative.
This law helps us understand how a consumer reaches equilibrium in case of a single commodity. Typically, a
consumer utilizes a commodity until its marginal utility becomes equal to the market price. This ensures that he
derives maximum satisfaction by being in equilibrium in respect of the quantity of the commodity.

In case of a fall in the price of the commodity, the equality between marginal utility and price gets disturbed.
Therefore, the consumer will consume more units of the good leading to a fall in the marginal utility. He continues
consuming until the equilibrium is achieved. On the other hand, in case of a rise in the price of the commodity, he
will consume less and achieve equilibrium too.

Limitations of the Law

The law of diminishing marginal utility applies only under certain assumptions:

1. Homogeneous units – The different units of a commodity are identical in all respects. The income,
taste, temperament, habit, etc. of the consumer also remains unchanged.

2. Standard units of consumption – The units of consumption consist of standard units. If a man is thirsty,
then water should be given in units of a glass. If you give him a spoonful of water, then the second
spoon would conceivably have higher utility than the first.

3. Continuous consumption – There is a continuous consumption of units. That is, there is no gap between
the consumption of two units.

4. Not applicable to prestigious goods – The law does not apply to prestigious goods like gold, cash, etc.
where a greater quantity can increase the lust for it.

5. Related goods – If you don’t have sugar, then you will consume less tea. Hence, the utility of goods
can be affected by the absence of related goods.
 Law of Equi-Marginal Utility
Law of Equi-Marginal Utility explains the relation between the consumption of two or more products and what
combination of consumption these products will give optimum satisfaction.

This law is based on the principle of obtaining maximum satisfaction from a limited income. It explains the behavior
of a consumer when he consumes more than one commodity.

The idea of equi-marginal principle was first mentioned by H.H.Gossen (1810-1858) of Germany. Hence it
is called Gossen's second Law. Alfred Marshall made significant refinements of this law in his 'Principles of
Economics'.

The law of equi-marginal utility explains the behaviour of a consumer when he consumers more than one
commodity. Wants are unlimited but the income which is available to the consumers to satisfy all his wants is
limited. This law explains how the consumer spends his limited income on various commodities to get maximum
satisfaction. The law of equi-marginal utility is also known as the law of substitution or the law of maximum
satisfaction or the principle of proportionality between prices and marginal utility.
Definition
In the words of Prof. Marshall, 'If a person has a thing which can be put to several uses, he will distribute it
among these uses in such a way that it has the same marginal utility in all'.
Assumptions
1. The consumer is rational so he wants to get maximum satisfaction.
2. The utility of each commodity is measurable.
3. The marginal utility of money remains constant.
4. The income of the consumer is given.
5. The prices of the commodities are given.
6. The law is based on the law of diminishing marginal utility.

Explanation of the law

Suppose there are two goods X and Y on which a consumer has to spend a given income. The consumer
being rational, he will try to spend his limited income on goods X and Y to maximise his total utility or satisfaction.
Only at that point the consumer will be in equilibrium.

According to the law of equi-marginal utility, the consumer will be in equilibrium at the point where the
utility derived from the last rupee spent on each is equal.
 DEMAND CONCEPTS
Meaning of Demand:
Ordinarily, by demand is meant the desire or want for something. In economics, however demand means much
more than that, it is effective demand i.e. the amount buyers are willing to purchase at a given price and over a
given period of time.
From managerial economics point of view, thus, the demand may be looked upon as follows: - Demand is the
desire or want backed up by money. Demand means effective desire or want for a commodity, which is backed
up by the ability (i.e. money or purchasing power) and willingness to pay for it. The demand does not mean
simply the desire or even need for a commodity obviously, a buyer’s wish for the product without possessing
money to buy it or unwillingness to pay a given price for it will not constitute a demand for it for example a
beggar’s wish for a Bike will not constitute its potential demand, as he has no ability to pay for it.
In short Demand = Desire + Ability to pay + Willingness to spend
Therefore, a desire should include following factors to be termed itself into demand.
a. Effective Effective desire
b. Willingness or ready to pay
c. Ability to pay and
d. A fixed period of time.
FEATURES OF DEMAND

a. Effective Desire: - Demand in economics means demand is backed up money to pay for the goods demanded.

b. Price:-We cannot speak of demand without specifying some price. Thus, demand is always.

c. Time:-Demand has to be stated with reference to a period of time.

d. Market:-Demand is always held in the market. Market is a set of points of contact between buyers and sellers
.It need not be in a definite geographical area.

e. Amount:-Demand is always a specific amount in which a person is willing to purchase. It is not an

approximation, but is to be expressed in numbers.

In economics, therefore, demand is defined as a schedule of quantities of a given commodity or services which
consumers are willing to buy at various prices in one market at a given period of time or over a given period of
time
TYPES OF DEMAND
A product with more number of uses is naturally more in demand than one with a single use.

 Consumer goods Vs producer goods

 Autonomous demand Vs derived demand
 Durable Vs perishable goods
 Firm demand Vs industry goods
 Short run demand Vs long run demand
 New demand Vs replacement demand
 Total market Vs segment market demand
 Joint Demand Vs Composite Demand
i. Individual and Market Demand:

It refers to the classification of demand of a product based on the number of consumers in the market. Individual
demand can be defined as a quantity demanded by an individual for a product at a particular price and within the
specific period of time. For example, Mr. X demands 200 units of a product at Rs. 50 per unit in a week.

In simple terms, market demand is the aggregate of individual demands of all the consumers of a product over a
period of time at a specific price, while other factors are constant. For example, there are four consumers of oil.
These four consumers consume 30 litres, 40 litres, 50 litres, and 60 litres of oil respectively in a month. Thus, the
market demand for oil is 180 litres in a month.

ii. Organization and Industry Demand:

It refers to the classification of demand on the basis of market. The demand for a product of an organization at
given price over a point of time is known as organization demand. For example, the demand for Toyota cars is
organization demand. The sum total of demand for products of all organizations in a particular industry is known
as industry demand. For example: the demand for cars of various brands, such as Toyota, Maruti Suzuki, Tata,
and Hyundai, in India constitutes the industry’ demand. The distinction between organization demand and
industry demand is not so useful in a highly competitive market.

iii. Autonomous and Derived Demand:

It refers to the classification of demand on the basis of dependency on other products. The demand for a product
that is not associated with the demand of other products is known as autonomous or direct demand. On the other
hand, derived demand refers to the demand for a product that arises due to the demand for other products.

For example, the demand for petrol, diesel, and other lubricants depends on the demand of vehicles. Apart from
this, the demand for raw materials is also derived demand as it is dependent on the production of other products.
Moreover, the demand for substitutes and complementary goods is also derived demand.

iv. Demand for Perishable and Durable Goods:

It refers to the classification of demand on the basis of usage of goods. The goods are divided into two categories,
perishable goods and durable goods. Perishable or non-durable goods refer to the goods that have a single use.
For example: cement, coal, fuel, and eatables. On the other hand, durable goods refer to goods that can be used
repeatedly.

For example, clothes, shoes, machines, and buildings. Perishable goods satisfy the present demand of individuals.
However, durable goods satisfy both present as well as future demand of individuals. Therefore, consumers
purchase durable items by considering its durability.

v. Short-term and Long-term Demand:

It refers to the classification of demand on the basis of time period. Short-term demand refers to the demand for
products that are used for a shorter duration of time or for current period. This demand depends on the current
tastes and preferences of consumers.

For example, demand for umbrellas, raincoats, sweaters, long boots is short term and seasonal in nature. On the
other hand, long-term demand refers to the demand for products over a longer period of time.
vi. Joint demand and Composite demand: when two goods are demanded in conjunction with one another at
the same time to satisfy a single want, it is called as joint or complementary demand. (example: demand for petrol
and two wheelers) A composite demand is one in which a good is wanted for several different uses. ( example:
demand for iron rods for various purposes)

vii. Price demand, income demand and cross demand: demand for commodities by the consumers at alternative
prices are called as price demand. Quantity demanded by the consumers at alternative levels of income is income
demand. Cross demand refers to the quantity demanded of commodity ‘X’ at a price of a related commodity ‘Y’
which may be a substitute or complementary to X.

DEMAND FUNCTION

Demand is influenced by different factors, such as, the price of the commodities tastes preferences weather
etc. The functional relationship between the demand determining factors is known as the demand function. In
short, it can be expressed as

D = f (Px, Ps, Pc, Y, W, A, E, T, U)

Where, D =Demand
f =functional relationship
Px =price of the commodity
Ps = Price of Substitutes
Pc = Price of Compliments
Y=Consumer’s income
W = Wealth of the purchaser
A = Advertisement for the product
E = Future price expectations
T =Tastes and Preferences o the customer
U = All other factors such as population, weather, Govt. policies etc.

For simplicity, demand function is expressed only as a function of price of a commodity, i.e.
D =f (P)
P= price of a commodity

Determinants of Demand:
1. Price of the commodities or products: There is an inverse relationship between price and demand of a
commodity if the price increases demand will decrease and vice versa .
According to the law of demand “A fall in the price of a commodity causes the house hold to buy more of
that commodity and less of the other commodity which compete with it, while a rise in price causes the
household to buy less of this commodity and more of competing commodities”.

2. Nature of commodity:-
  Necessities
 comforts
 luxuries

3. Price of related goods:-

A. Substitute goods: - These are the goods that can be used as substitute in the place of other goods with
equal satisfaction.
EX:- coffee (or) tea.
B. Complementary goods:- these are the goods that are demanded only when their related goods are
available.
Ex:-ink is complimentary to the pen
4. Income of the consumers: - If the income of the consumers increase the demand of commodity will
increase the demand of the commodity will also increase because with the increase in income he can also
spend more amounts on the purchase of commodity.
5. Taste and preferences of the consumers:- Tastes and preferences along with fashion habit and customs
of consumers affect the demand for example the demand of goods of fashion goes on increasing at the
same price or even if the prices of these goods increase if a consumer is habitual of consuming he will
purchase it on all the price levels.
6. Size of the population: - The demand of almost all the commodities increases on an increase in the
population and it decreases on a decrease in population.
7. Government policy:- Government policy affects the demand of the commodity for example if heavy
taxes are imposed on the commodity the demand of such commodity will decrease substantially
conversely if the government announces the tax concession for certain commodity their demand will
increase.
8. Expectations regarding future prices: - Expectations of consumers regarding future prices of a
commodity affects its demand for example if there is a hope of raise in price of a commodity in future, its
demand will increase even at high price because the consumer would like to store such commodity
conversely if there is hope of fall in the prices of a commodity in future, the demand of such commodity
will decrease.
9. Quality of the product: - Demand of the goods of better quality is more than of cheaper quality.
10. Advertisement:-Advertisement creates increase and maintains demand of goods advertisement helps in
increasing the demand.

DEMAND SCHEDULE
A demand schedule is a tabular form which shows the list of price and the quantities purchased at those prices are
known. Demand schedule can be divided into two categories. They are:
A. Individual demand schedule
B. Market demand schedule
 A. Individual demand schedule: - An individual demand schedule is a list of the various quantities of a
commodity which an individual consumer purchases at various levels of price in the market.
EX:-
PRICE OF THE QUANTITY
MANGOES(RS) DEMANDED

9 1

8 2

7 3

6 4

5 5

4 6

3 7

2 8

B. MARKET DEMAND SCHEDULE:-

A Market demand schedule shows the total demand for a good at a particular time at different prices in
the market.
Market demand schedule can be obtained by adding up all the individual demand schedule of all
consumers in the market.

Price of Market
Apples Quantity Demanded demand
A B C
10 6 6 10 22
9 8 10 15 33
8 10 14 20 44
7 12 18 25 55
6 14 22 30 66
5 16 26 35 77

It is clear from the above figure that adding up the individual curves A, B, C; we can arrive at the market demand
curve.

LAW OF DEMAND
The law of demand describes the general tendency of consumers behavior in demanding a commodity in relation
to the changes in its price. The Law of demand expresses the relationship between price and quantity demanded
of a commodity. According to the law of demand the demand of a commodity extends with fall in its price and
contracts with rise in the price, other things being constant. 'Other things being constant' means that the other
determinates of demand except price remain unchanged. it explains the inverse relationship between price and
quantity demanded.
Statement of law of demand:- “Ceteris paribus, the higher the price of a commodity, the smaller is the quantity
demanded and lower the price, larger the quantity demanded”.
Chief Characteristics of the Law of Demand:
The following are the chief characteristics of the Law of Demand.
1. Inverse Relationship. The relationship between price and the demand of a particular commodity is inverse i.e.,
the demand of a commodity will fall with the increase in the price of the commodity or it will increase with the
fall in-the price.
2. Price an Independent Variable and Demand a Dependent Variable. In the Law of Demand, price is regarded
as an independent variable that affects the demand inversely. Thus, it is the effect of price on demand that is to be
examined and not the effect of demand on price.
3. It is a Qualitative Statement: The Law of Demand simply explains the direction of change in the demand with
the increase or decrease in the price of a commodity. It does not explain the quantum of change. The law is thus,
a qualitative statement? and not a quantitative statement.
4. Other thing remains the same: The Law of Demand applies only when other things remain the same. In other
words, there should be no change in factors influencing demand except price.
The law of demand can be illustrated with the help of a demand schedule. The demand schedules shows that with
the fall in the price of the commodity its demand is increasing. A market demand schedule.

From the above example, we can say that with a fall in price at each stage demand tends to rise. There is an inverse
relationship between price and the quantity demanded.
ASSUMPTIONS OF THE LAW OF DEMAND:
The Law of Demand is based on the following assumptions :
(1) No change in taste, habits, preferences : It is assumed that there is no change in the taste, habits, preferences
of a rational consumer. Thus, consumers' choice of product must remain the same.
(2) No change in the income level: If the consumer's income rises, he will demand more though the prices of
commodities rise. In such a situation, the law will not hold good.
(3) No change in population : The law is based on the assumption that there should be no change in population,
size, sex ratio, age composition, etc.
(4) No change in prices of related goods : The law assumes that the prices of close substitutes and the
complementary products should remain constant.
(5) No expectation of future change in the price: If the consumers expect high rise in the price in future, they
demand more though current price is high. In such condition, the Law of Demand cannot be verified.
(6) No change in taxation : It is assumed that the structure of direct and indirect taxes remain constant. Thus, the
disposable income of a consumer should remain the same.
(7) No introduction of new product: It is assumed that there is no introduction of a new product in the market.
Thus, the consumer's taste, habits and preferences remain constant.
(8) No change in technology : The law assumes that the present technology of production remains constant.
(9) No change in weather conditions : Climatic and weather conditions may bring sudden change in demand,
though there is no change in the price. Therefore, it is assumed that weather conditions remain constant.

EXCEPTIONS TO THE LAW OF DEMAND

Followings are the exceptions of the law of demand :
1. Articles of Distinction/prestigious goods/Veblen effect: This exception to the law of demand is associated with
the doctrine propounded by Thorsten Veblen. The articles of distinction such as diamonds, gems, costly carpets,
etc. are in more demand when their prices are high. The reason is that rich people measure the desirability of these
articles in terms of their prices alone and consider these goods as honour possession. Therefore, rich people
demand more of articles of distinction when their prices are high.
2. Giffen Goods: Price effect is the composite effect of 'income effect' and 'substitution effect. Giffen goods (most
inferior goods) are those inferior goods for which 'income effect' of change in price is negative and is greater than
the substitution effect. Therefore, the demand of Giffen goods increases with rise in price and decreases with fall
in their price.
3. Ignorance of buyers about Quality: Many a times, buyers due inertia or out of sheer ignorance consider the
price of the commodity as index of its quality. Due to this ignorance, a lower-price commodity may be considered
inferior. Therefore, purchasers buy lesser quantity of the commodity at its lower price. But when the price of
commodity is more, buyers consider it to be superior and thus buy more of it than before.
4. Future changes in Prices: Purchaser also act as speculators. When the price has increased and is expected to
rise further, buyers tend to purchase more quantities of the commodity out of the apprehension of rise in price in
future. Likewise when prices are expected to fall further, a reduced price may not induce the buyers to purchase
more of the commodity.
 5. Necessities of Life: We cannot reduce the consumption of necessaries of life and conventional necessaries
even if their prices have increased sharply.
6. Change in quality: people are to demand more even at a higher price provided quality is good.
7. Fashionable goods: Goods that are in fashion are purchased by consumers regardless of price even at a higher
price. Consumers purchases the goods which are in fashion.
8. Ignorance: A consumer’s ignorance is another factor that at times induces him to purchase more of the
commodity at a higher price. This is especially true, when the consumer believes that a highpriced and branded
commodity is better in quality than a low-priced one.
9. Emergencies: During emergencies like war, famine etc, households behave in an abnormal way. Households
accentuate scarcities and induce further price rise by making increased purchases even at higher prices because
of the apprehension that they may not be available. . On the other hand during depression, , fall in prices is not a
sufficient condition for consumers to demand more if they are needed.
10. Change In Fashion: A change in fashion and tastes affects the market for a commodity. When a digital camera
replaces a normal manual camera, no amount of reduction in the price of the latter is sufficient to clear the stocks.
Digital cameras on the other hand, will have more customers even though its price may be going up. The law of
demand becomes ineffective.
11. Demonstration Effect: It refers to a tendency of low income groups to imitate the consumption pattern of
high income groups. They will buy a commodity to imitate the consumption of their neighbors even if they do
not have the purchasing power.
12. Snob Effect: Some buyers have a desire to own unusual or unique products to show that they are different
from others. In this situation even when the price rises the demand for the commodity will be more.
13. Speculative Goods/ Outdated Goods/ Seasonal Goods: Speculative goods such as shares do not follow the
law of demand. Whenever the prices rise, the traders expect the prices to rise further so they buy more. Goods
that go out of use due to advancement in the underlying technology are called outdated goods. The demand for
such goods does not rise even with fall in prices.

CHANGES IN DEMAND:-
1. Increase in demand
2. Decrease in demand
3. Extension and contraction in demand

1. Increase in Demand:-
If the consumer is willing and able to buy more of the product or services at the same price, the result will
be an increase in demand then the demand curve will shift to the right.
2. Decrease in Demand:-
A decrease in demand occurs when buyers are ready to buy less of a product at the same price because of
facts like fall income, rise in price of complimentary goods and so on. Movement along a demand curve
indicates that a higher quantity is demand for a given fall in the price of the goods.

3. Extension and contraction in demand:-

A contraction is the upward movement along a demand curve which indicates that a lower quantity is
demanded for a given increase in the price of the goods.
In the above figure we can see that at OP price, the quantity demanded is OM. When the price decreases from OP
to OP2, the quantity demanded extends from OM to OM2, this is called extension in demand.
Contraction refers to the movement upwards along the same demand curve when the price increases from OP to
OP1, the demand contrast from OM to OM2 along the same demand curve, this is called contraction in demand

ELASTICITY OF DEMAND
The law of demand does not tell us by how much or to what extent the quantity demanded of a good will change
in response to a change in its price. It will be explained by the concept of “ELASTICITY OF DEMAND”.
Definition of Elasticity of Demand
The elasticity of demand is defined as the rate of responsiveness in the demand of a commodity for a given change
in price or any other determinants of demand.
In other words, elasticity of demand refers to the degree of sensitiveness or responsiveness in the demand due to
change in price.
TYPES OF ELASTICITY OF DEMAND

1. Price elasticity of demand

2. Income elasticity of demand
3. Cross elasticity of demand
4. Advertising elasticity of demand
1. Price elasticity of demand:-
It refers to the quantity demanded of a commodity in response to a given change in price. Price elasticity
is always negative which indicates that the customer tends to buy more with every fall in the price. There
exists inverse relationship between the price and the quantity demanded.
Price elasticity of demand = Proportional change in the quantity demanded

Proportional change in the price

 2. Income elasticity of demanded:-
Income elasticity of demand refers to the quantity demanded of a commodity in response to a given change
in income of consumer
Income elasticity is normally positive which indicates that the consumer tends to by more and more with
every increase in income
Income elasticity of demand = Proportional change in the quantity demanded
Proportional change in the Income

3. Cross elasticity of demand:-

Cross elasticity of demand refers to the quantity demanded of a commodity in response to a change in the
price of a related good which maybe substitute or complement.
Cross elasticity of demand= Proportional change in the qty demanded of product X
Proportional change in the price of Product Y
Product Y here refers to related good. Complementary goods will have negative cross elasticity of demand
where as substitutes will have positive cross elasticity of demand.

4. Advertising elasticity of demand:-

It refers to increase in the sales revenue because of change in the advertising expenditure. There is a direct
relationship between the amount of money spent on advertising and its impact on sales. Advertising
elasticity is always positive.

Advertising elasticity of demand= Proportional change in the quantity demanded

Proportional change in the advertisement expenditure

Types od Price Elasticity of Demand:

The degree of responsiveness of quantity demanded to a change in price may differ i.e. elasticity of demand could
also differ. In this context, the price elasticity of demand is generally classified into following five categories:
(i) Perfectly inelastic demand (ed = 0) : The demand for a commodity is called perfectly inelastic when
quantity demanded does not change at all in response to change in its prices .
Graphically, the demand curve in parallel to y-axis

(ii) Less than unit elastic demand or Realtively Inelastic demand (ed < 1) : The demand for a commodity
is called less than unit elastic or relatively inelastic when the percentage change in quantity demanded
 is less than the percentage change in price of the commodity. Graphically, demand curve is steeper.
The demand for necessary goods like medicines and food items etc. is less than unit elastic.

(iii) Unit elastic demand (ed = 1):When percentage change in quantity demanded of a commodity equals
percentage change in its price, the demand for the commodity is called unit elastic. Graphically,
demand curve is rectangular hyperbola. (Rectangular hyperbola is a curve on which all the rectangles
formed on the curve have same area)

(iv) More than unit elastic demand or Realtively Elastic demand (ed >1): When the percentage change
in quantity demanded of a commodity is more than the percentage change in its price, the demand for
the commodity is called more than unit elastic or highly elastic Graphically, the demand curve is
flatter. The demand for luxury goods is more than unit elastic.

(v) Perfectly elastic demand (ed = ∞):The demand for the commodity is called perfectly elastic when its
demand expands or contracts to any extent without or very little change in its price Graphically, the
demand curve is parallel to X-axis
Determinants of Price Elasticity of Demand
Whether the demand for a commodity is elastic or inelastic will depend on a variety of factors. The major factors
affecting elasticity of demand are:
1. Nature of Commodity. According to the nature of satisfaction the goods give they may be classified into luxury,
comfort or necessary goods. In general, luxury and comfort goods are price elastic, while necessary goods are
price inelastic. Thus, for example, the demand for foodgrains, cloth, salt etc., is inelastic while that for radio,
furniture, car, etc., is elastic.
2. Availability of Substitutes. Where there exists a close substitute in the relevant price range, its will tend to be
elastic. But in respect of commodities having no substitutes, their demand will be somewhat inelastic. Thus, for
example, demand for salt, potatoes, onions, etc, is highly inelastic as there are no close or effective substitutes for
these commodities, while commodities like tea, coffee or beverages such as Thums-up, Mangola, Gold Spot,
Fanta, Sosyo, etc., having a wide range of substitutes, have a more elastic demand in general.
3. Number of Uses:. Single-use goods will have generally less elastic demand as compared to multi-use goods,
e.g., for commodities like coal or electricity having a composite demand, elasticity is relatively high. With a fall
in price, these commodities may be demanded greatly for various uses. It is, however, also possible that the
demand for a commodity which has a variety of uses may be elastic in some of the uses, and may be inelastic in
some other uses, e.g., coal is used by railways and consumers as fuel. But the former's demand is inelastic as
compared to the latter's.
4. Consumer's Income. Generally, larger the income, the overall demand for commodities tends to be relatively
inelastic. The demand pattern of a millionaire is rarely affected even by significant price changes. Similarly, the
redistribution of income in favour of low-income people may tend to make demand for some goods relatively
inelastic.
5. Height of Price and Range of Price Change. There are certain goods like costly luxury items or bulky goods
such as refrigerators, TV sets, etc., which are highly priced in general. In their case, a small change in price will
have an insignificant effect on their demand. Their demand will, therefore, be inelastic. However, if the price
change is large enough, then their demand will be inelastic. Similarly, there are perishable goods like potatoes
and onions, etc., which are relatively low priced and bought in bulk, so a small variation in their prices will not
have much effect on their demand, hence their demand tends to be inelastic.
6. Proportion of Expenditure. Items that constitute a smaller amount of expenditure in a consumer's family
budget tend to have a relatively inelastic demand, e.g., a cinegoer who sees a film every fortnight is not likely to
give it up when the ticket rates are raised. But one who sees a film every alternate day perhaps may cut down his
number of films.
7. Durability of the Commodity. In the case of durable goods, the demand generally tends to be inelastic in the
short run, e.g., furniture, bicycle, radio, etc. In the case of perishable commodities, on the other hand, demand is
relatively elastic, e.g., milk, vegetables, etc.
8. Influence of Habit and Custom. There are certain articles which have a demand on account of conventions,
customs or habit and in these cases, elasticity is less, e.g., Mangal Sutra to a Hindu bride or cigarettes to a smoker
have inelasticity of demand.
9. Complementary Goods. Goods which are jointly demanded have less elasticity, e.g., ink, petrol have inelastic
demand for this reason.
10. Time. In the short period, demand in general will be less elastic, while in the long period, it becomes more
elastic. This is because (i) it takes some time for the news of a price change to become known to all the buyers,
(ii) consumers may expect a further change, so they may not react to an immediate change in price, (iii) people
are reluctant to change their habits all of a sudden, (iv) durable goods take some time to exhaust their utility. In
the long run, thus, when durable goods are worn out, these are demanded more, (v) demand for certain
commodities may be postponed for some time, but in the long run, it has to be satisfied.
11. Recurrence of Demand. If the demand for a commodity is of a recurring nature, its price elasticity is higher
than that of a commodity is purchased only once. For instance, bicycles, tape recorders, radios, etc., are purchased
only once, hence their price elasticity will be less. But, the demand for cassettes or tape-spools would be more
price elastic.
12. Possibility of Postponement. When the demand for a product is postponable, it will tend to be price elastic.
In the case of consumption goods which are urgently and immediately required, their demand will be inelastic.
MEASUREMENT OF PRICE ELASTICITY OF DEMAND
Different methods have been devised by the economist to measure the degree of elasticity they are
1. Total outlay method
2. The proportionate method
3. The point method
4. The arc method

1. The Total out lay/Revenue method

Under this method, we compare the total outlay of the buyer or total revenue of the seller before and after
the change in price. we can calculate total out lay as follows:
P*q = price*quantity
P*q = total outlay=total revenue
According to this method, price elasticity of demand is expressed in three forms, they are:
 Elastic demand
 Unity elasticity
 Inelastic demand
 Price of product Total outlay
(p) Q.D (P x Q) Elasticity
9 40 360
8 50 400 elasticity demand Ep>1
7 60 420
6 70 420 elasticity demand Ep=1
5 80 400
4 90 360 elasticity demand Ep<1

2. Proportionate Method: This method also known as the Percentage Method, Flux Method, Ratio Method,
and Arithmetic Method is also associated with the name of Dr. Marshall. According to this method, “price
elasticity of demand is the ratio of percentage change in the amount demanded to the percentage change in
price of the commodity.” It is. Its formula is as under:
Ed = % change in quantity demanded ÷ % change in price

3. Point method:-
This method helps us to measure the elasticity of demand at any point on the demand curve this method is
also given by Alfred Marshall and is known as “Geo-metrical method”.
According to this method, elasticity at any point is the ratio to the lower position of the demand curve to the
upper position.
4. Arc method:-The main drawback to the point method is that it can be used only when we have complete
data on the changes in the price of the good and quantity demand but in real life, it is not easy to get and
quantity this means that there will be gaps in the demand schedules in such cases, it is not possible to apply
the point method to get the desired results. In the arc method, the mid-points b/w the old and new data in the
case of price and quantity are used. This method studies a portion or segment (Arc) of the demand curve
between the two points

Change in the quantity demanded/ original quantity +new quantity

Ep= Change in the price/Old price + new price.

Income Elasticity of Demand

Income is a major determinant of demand for a number of goods. We may have an income demand function thus:
D=f (M)
where, M refers to the money income of the buyer.
It suggests that the demand may change due to a change in the consumer's income, other factors remaining
constant.
The income elasticity of demand measures the degree of responsiveness of demand for a good to changes in the
consumer's income.
Definition: The income elasticity is defined as a ratio percentage or proportional change in the quantity demanded
to the percentage or proportional change in income.
Income elasticity = Percentage change in quantity demanded / Percentage change in income
Symbolically, ΔQ/Q ÷ M / ΔM = ΔQ / ΔM X M / Q
Where, ΔQ = Change in demand
Q = Initial Demand
M = Initial Income
ΔM = Change in Income

Types of Income Elasticity

Income elasticity on the basis of its coefficient (e) may thus be classified as under:
(i) Unitary income elasticity of demand;
(ii) Income elasticity of demand greater than unity;
(iii) Income elasticity of demand less than unity;
(iv) Zero income elasticity of demand; and
(v) Negative income elasticity of demand.

(i) Unitary Income Elasticity. When the percentage change in demand is equal to the percentage change in price,
the demand is unitary income elastic. Thus e = 1.
The demand curve representing income-demand function D = f (M) will have an upward slope, and it will be at
45° angle, as shown by curve D, in Fig. 9.
(ii) Income Elasticity Greater than Unity. When the percentage change in quantity demanded is greater than the
percentage change in price, the income elasticity of demand is greater than unity. Thus, e> 1. The demand curve
will be flatter as D, in this case.
(iii) Income Elasticity Less than Unity. When the percentage change in demand is less than the percentage change
in price, the income elasticity of demand is less than unity. Thus, e< 1.. Thus demand curve in this case will be
steeper.

(iv) Zero Income Elasticity. When the income changes in any direction or in any proportion but carries no effect
on demand, so that the quantity demanded remains unchanged, it is referred to as zero income elasticity of
demand. Thus, e = 0. The demand curve in this case is a vertical straight line.
(v) Negative Income Elasticity. When an increase in income causes a in the demand for a commodity, the demand
is said to be negative income elastic. The income elasticity coefficient, e> 0. The demand curve in this case will
be downward sloping
Income elasticity is generally positive, as there is a positive correlation between income and demand. Other things
remaining the same, with an increase in income, there will be an increase in demand and vice versa.
Sometimes, however, negative income elasticity is also observed. Especially, in the case of Giffen goods and
inferior goods, That is to say, when with a rise in income, the consumer buys less of a commodity, then there is
negative income effect.
The income elasticity helps us in classifying the commodities.
1. When income elasticity (e) is positive, the commodity is of a normal type.
2. When income elasticity (e) is negative, the commodity is inferior. For instance, cereals like jowar, bajra, etc.,
are inferior goods, so their income elasticity is negative.
3. If income elasticity coefficient is positive and greater than one (e> 1), the commodity is a luxury. For example,
the demand for TV sets, cars, etc., is highly income elastic.
4. If income elasticity coefficient is positive but less than unity (e < 1), the commodity is an essential one, e.g.,
the demand for foodgrains is income inelastic.
5. If income elasticity coefficient is zero (e= 0), the commodity is neutral. For instance, consumption of
commodities like salt, matches, etc., has zero income elasticity.

CROSS ELASTICITY OF DEMAND

In cross elasticity of demand, we take into account the change in the price of commodity Y and its effects on the
demand for commodity X. The concept of cross elasticity is important in the case of commodities which are
substitutes and complementary. Tea and coffee are substitutes for each other while pen and ink, car and petrol are
complementary goods,
Definition: The cross elasticity of demand refers to the degree of responsiveness of demand for a commodity to
a given change in the price of some other related commodity.
cross elasticity of demand between any two goods X and Y is measured by dividing the proportionate change in
the quantity demanded of X by the proportionate change in the price of Y.
Thus, cross elasticity of demand =
Proportionate or percentage change in demand for X ÷ Proportionate or percentage change in price of Y
Symbolically. Exy = ΔQx /Qx ÷ ΔPy / Py
alternatively, Exy = (ΔQx / ΔPy) X (Py / Qx)
where,
Exy = cross elasticity of demand-(demand for X in relation to the price of Y)
ΔQx = change in quantity demanded for commodity X
Qx = initial demand for X
Py = initial price of commodity Y
Py = change in the price of commodity Y.
The numerical coefficient of cross elasticity of demand may be either positive or negative. Substitute goods have
positive price elasticity of demand. Jointly demanded or complementary products have negative price cross
elasticity of demand. Two unrelated goods have zero cross elasticity. Graphically

When the demand function like Dx = f(Py) is plotted graphically, it will take different positions as per the e price
cross elasticity, It will have an upward slope, if X is a substitute of Y. It will have a down- ward slope if X is a
complementary to Y. It will be a vertical line (D) if X is unrelated to Y. So any change in the price of Y has no
effect on the demand for X.

Promotional Elasticity / Advertising Elasticity of Demand:

Advertising elasticity of demand measures the responsiveness of quantity demanded to changes in advertising
expenditure.
The formula for advertising elasticity is
Percentage change in quantity demanded ÷ Percentage change in advertising expenditure
Alternatively, Ea = (ΔQ / ΔA) X (A / Q)
The advertising elasticity of demand is affected by number of factors. A businessman trying to measure and make
use of advertisement elasticity in business-decision should keep in mind these factors:
(a) Stage of Products Market Development: In the initial stages of a product, that is, when a product is newly
introduced, the advertisement elasticity will be greater than unit. At later stages, the elasticity decreases
(b) Competition:The advertisement elasticity in a competitive ma effectiveness of advertisement the competing
firms. determined by the relative
(c) Cumulative effect of Past Advertisement: The advertisement elasticity may be very low in the initial stages
due to inadequate expenditure on advertisement. As the firm spends more and more on advertisement in the later
stages, it will have cumulative effect on the promotion of sales. Consequently advertising elasticity increases.
(d) Non-advertising Determinants of Demand: The advertising elasticity of demand is also affected by factors
like change in price, consumers income, growth of substitutes etc. For example advertising elasticity of demand
may not increase when the price is very high, consumers income is low and there are number of close substitutes
for the product.
SIGNIFICANCE OF ELASTICITY OF DEMAND
1. Price determination:- The individual producer consider the elasticity of demand of his commodity
before fixing the price when the commodity has inelastic demand he will fix a lower price to maximum
his profit vice versa.
2. Joint products: In case of joint products, separate costs are not ascertainable. In such cases the product
will be guided mostly by elasticity of demand. So a lower price is fixed in the case of goods having
elastic demand and a higher price of inelastic demand.
3. To government:- The concept of elasticity of demand also enables the government to decide as what
particular industries should be declared as “Public utilities” to be taken over and operated by the state.
4. International trade: It is possible to calculate the terms of trade between two countries only by taking
into account the natural elasticity of demand for each other products.
5. To the finance minister: The finance minister also takes in to the account elasticity of demand for
goods when selecting the goods for taxation. When the government is in need of more revenue it
chooses those goods which have inelastic demand.

DEMAND ESTIMATION AND FORECASTING

Introduction:
Estimating the future demand for products, either existing or new is a significant aspect of demand
analysis. A manager needs to have information about likely future demand of its product to enable the firm
to produce the required quantities of a product at the right time and arrange well in advance for the various
inputs (like labor, raw material, machines etc.) as well as to pursue optimal pricing strategies. Demand
estimation and forecasting means predicting future demand for the product under given conditions and
helped the manager in making decisions with regard to production, sales, investment, expansion,
employment of manpower etc., both in the short run as well as in the long run.

Demand Estimation and Demand Forecasting

In Demand estimation manager attempts to quantify the links or relationship between the level of demand
and the variables which are determinants to it and is generally used in designing pricing strategy of the
firm. In demand estimation manager analyse the impact of future change in price on the quantity
demanded.
In Demand forecasting mangers forecast the most likely future demand of a product so that he can make
necessary arrangement for the various factor of production i.e labor, raw material, machines, money etc.
Demand forecasting tells the expected level of demand at some future date on the basis of past and present
information. It helped in production planning, new product development, capacity enhancement or new
schemes etc. Demand forecasting is generally used for short term estimation as well as long term
forecasting.
Features of Demand Forecasting
The main features of the demand forecasting are;
1. Demand Forecasting is a process to investigate and measure the forces that determine sales for existing
and new products.
2. It is an estimation of most likely future demand for a product under given business conditions.
3. It is basically an educated and well thought out guesswork in terms of specific quantities
4. Demand Forecasting is done in an uncertain business environment.
5. Demand Forecasting is done for a specific period of time (i.e. the sufficient time required to take a
decision and put it into action).
6. It is based on historical and present information and data.
7. It tells us only the approximate expected future demand for a product based on certain assumptions and
cannot be 100% precise.

Why Demand Forecasting?

As business is done in an uncertain and risky business environment and managers have to take decisions
under uncertain and risky conditions. Demand forecasting help the managers in forecasting the most likely
future sale of their products, accordingly manager plan their production, arrange various inputs like labour,
material, capital and techniques etc. This will help up to certain extent in managing the future risks caused
due to varied business conditions as well as in optimum utilization of available business resources.
In short run demand forecasting helps in determining the optimum level of output at various periods to
avoid under or over production. It helps in better inventory management, of buying inputs and control its
inventory level which cuts down overall cost of production. A balanced pricing policy can be formulated
to suit short run and seasonal variations in demand. It helps the company to set realistic sales targets for
each individual salesman and for the firm as a whole. It helps in advance financial planning required for
achieving the budgeted production and sales and to raise the required funds well in advance at reasonable
cost. It also helps the firm in evolving a suitable labour policy and to determine the exact number of
workers to be employed in the short run.
In long run, the demand for a product of a firm is forecasted generally for a period of 4 to 6 or 10 years
and it helped in taking capital expenditure decisions relating business expansion, capacity enhancement
or setting up a new production unit, modification and up gradation of technology as it involves large scale
production as well as long gestation period. Accordingly firms can plan long run financial requirements,
capital structure and investment programs .
Demand forecasting can play a significant role in controlling over total costs and revenues of a company
and determining the value and volume of business, estimating future profits of the firm and regulating
business effectively to meet the challenges of the market.

Demand Forecasting Process:

To have efficient, accurate and reliable demand forecasting a manager must take the following steps;
1. Specifying the objective of Demand Forecasting: While forecasting demand one may have different
objectives like quantity and composition of demand, price to be quoted, production planning, inventory
planning or capital budgeting, short or long term demand, firm’s market share etc. Thus, the objective for
which demand is to be estimated must be clearly defined at first stage.
2. Determining the nature of goods: The next step in demand forecasting is identification of type of goods
as different type of goods such as consumer goods, capital goods, industrial goods, durable and nondurable
goods; perishable or seasonal goods have different type of demand pattern. This will help in applying
write approach to demand estimation process.
3. Determining the time perspective: Depending upon the nature of goods and firm’s objective, the
demand can be forecasted for short term as well as for long term. In short term many of the determinants
of demand may remain constant or not to be change significantly but in long run these determinants may
change significantly. Thus, while forecasting demand one has to define the time span for the forecast.
4. Determining the level of forecasting: Demand forecasting may be undertaken at micro or firm level,
industry level, macro level or international level. It may be done for product line forecasting, general or
specific purpose or for established or new products. There are different factors that influence the demand
at different level of forecasting. Thus one must specify the level of forecasting beforehand.
5. Selection of proper method or technique of forecasting : Economists have developed different methods
or techniques for forecasting. However, these methods are not suitable for all type of demand forecasting
due to the type or objectives of forecasting, data requirement, availability of data and time frame. One has
to select an appropriate method for demand forecasting to achieve stated objectives. It also depends upon
the purpose, knowledge and experience of the forecaster.
6. Data Collection and modification: Depending upon the objective and method of forecasting next step
in demand forecasting is to collect the required data. There are different method of collection of primary
data like observation, interview, survey or questionnaire, focus group discussion methods etc. Data can
also be collected from various secondary sources but, this data required modification as it may not be
available in the required mode.
7. Data analysis and estimations: Once the data has been collected and method of data analysis has been
finalised the next step in demand forecasting is analysis of data and interpretations of results. The
Efficiency of estimation depends upon the efficiency with which it has been analysed and interpretive.
Sometimes, estimation required support from background factors which has not been used in estimation
process. One mist frequently revised the estimates depending upon the changed business conditions.

Determinants of Demand Forecasting

Different type of goods has different determinants. Broadly goods can classified as Capital goods, Durable
and Non durable consumer goods and factors determines the demand of theses goods are discussed below;
Capital Goods i.e factory building, machinery, equipment, tools etc., have derived demand as demand of
these goods depend upon demand of consumer goods industry growth rate, level of capacity utilization,
wage rate and size of the market. The demand for these goods comprises of replacement demand and new
demand and one should consider Growth potential of the Industry, per unit consumption norms and
velocity of their use in estimating the demand of capital goods.
Demand for Consumer Durable goods i.e. residential building, car, refrigerators, furniture, readymade
garments, TV, Computer etc. depend upon social status, prestige, level of money income, obsolescence
rate, maintenance costs, availability of road, petrol, supply of electricity, family size, age-sex distribution
and credit facilities. One should consider the trends of these factors while estimating the demand of
consumer durables. It also depends on consumer credit outstanding, Existing stock of the goods, Saturation
limits of the markets, Tastes and scale of preference of the consumers etc.
Non durable consumer goods are consumed once only i. e. milk, food, vegetables, fruits, medicines etc.
and their demand is effected by disposable income or purchasing power of the household, price elasticity
(own price or price of substitute and complimentary goods) and demographic variables.
Methods of Demand Forecasting
Demand forecasting methods can be broadly classified into two categories i.e.
1.Survey methods and
2 Statistical methods.
Different methods of demand estimation have been presented below;

1. Survey Methods
Survey methods are generally used in short run and estimating the demand for new products. In survey
methods information about the future purchase plans of potential buyers are collected through direct
 interview of potential consumers or experts opinions. The different approaches under survey methods
are
A. Consumers’ Survey method Under this method, efforts are made to collect the relevant
information directly from the consumers with regard to their future purchase plans. It is one of the
oldest methods of demand forecasting. It is also called as “Opinion surveys”. Under this method,
the intentions of the consumer are recorded by trained, reliable and experienced investigators,
through personal interviews, e-mail or post surveys and telephonic interviews. A well structure
questionnaire is designed with regards to preferences and willingness about particular products,
reaction to price change or a change in other variables such as quality, sales promotion,
advertisement, channel of distributions, packing, color etc. and consumers are asked to reveal their
‘future purchase plans with respect to specific items.

There are two type of consumer survey, namely:

(i) Complete enumeration survey and (ii) Sample survey.
i) Under Complete Enumeration Method all potential customers are contacted in the market are
surveyed. Since all potential consumers are interviewed in this method, there is a greater degree of
accuracy, is more useful in introducing new products, for bulky or costly products or products having
few consumers. This method is expensive, time consuming and is not suitable in case of large scattered
consumers.
ii) In Sample survey method different cross sections of customers that make up the bulk of the market
are carefully chosen. Only such selected consumers from the relevant market through some sampling
method are interviewed or surveyed and average demand is calculated on the basis of the consumers
interviewed. This average demand is multiplied by the total number of consumers to find the aggregate
demand of the product. As compared to Complete Enumeration this method is less costly and time
consuming and more information can be collected to make forecasting more reliable.
B. Collective Opinion Method (Sale Force Opinion or Reaction Survey Method)

Another variant of the survey method is Collective Opinion Method also known as “Sales – force
polling” or “Opinion poll method” or “Reaction Survey Method”. In this method, instead of customers,
salesmen, marketing manager, production manager, professional experts and the market consultants
and others are asked to express their considered opinions about the volume of sales expected in the
future. It is very simple method and does not involve the use of any statistical techniques and take
advantage of collective wisdom of salesmen and managers.
C. Experts Opinion Method or Delphi Method
It is a variant of opinion poll and survey method of demand forecasting. Under this method, outside experts
are appointed. They are supplied with all kinds of information, statistical data and posed questions relating
to an underlying forecasting problem. The management requests the experts to express their considered
opinions and views about the expected future sales of the company. Then, an independent party seeks to
form a consensus forecast by providing feedback to the various experts in a manner that prevents
identification of individual positions. The process goes on until some sort of unanimity is arrived at among
all the experts. This method was originally developed at Rand Corporation in the late 1940’s by Olaf
Helmer, Dalkey and Gordon and was used to predict future technological changes and has been proved
more useful and popular in forecasting non– economic rather than economical variables. This method is
 best suited in case where intractable changes are occurring. The method is also less time consuming and
cheap but the effectiveness of this method is sensitive to the expertise of the independent party chosen.

D. Market Studies and Experiments Another way of collecting present and future market information of
a product is to conduct market and experimental study to investigate consumer behaviour under given
environment. Under this method, companies first select some markets or cities having similar features i.e
population, income culture, social or religious factors etc., then carry out the market experiments by
changing prices, quality, packing, advertisement expenditure or other controllable demand determinants
under the assumption that other things remain contestant

2. Statistical Methods
In statistical methods historical or cross sectional data are used to forecast the future probable demand of a
particular product by applying statistical models and mathematical, equations. These methods are considered to
be superior techniques of demand forecasting. The important statistical methods used in demand estimation are;
A. Trend Projection Method In trend analysis past data about the dependent and independent variables is
used to project the sales in the coming years assuming that factors responsible for the past trends will
continue to behave in similar manner in future also as they did in the past in determining the magnitude
and trend of sales of a product.
In this method a data set of past sales are taken at specified time, generally at equal intervals to depict the
historical pattern under normal conditions. On the basis of derived historical pattern, the future sales of a
company are project.
The main aspect of this method lies in the use of time series and changes in time series occur due to
following reasons:-
1. Secular Trend: Secular Trend also known as long term trend indicate the general tendency and direction
in which graph of a time series move in relatively over a long period of time. This can be upward or
downward trend, depending upon the behaviour.
2. Seasonal Trends: This trend reflects the changes in sales a company due to change in various seasons
or climates or due to festival season or sales clearance season etc. These changes are repetitive in nature
and related to twelve months period.
3. Cyclical Trends: These trends reflect the change in the demand for a product during diverse phases of
a business cycle i.e growth, boom, maturity, depression, revival, etc.
4. Random or irregular trends: These changes arise randomly or irregularly due to unforeseen events such
as famines, earth quakes, floods, natural calamities, strikes, elections and crises.
These changes take place only in the short run and have their own impact on the sales of a firm. These
trends cannot be predicted. In trend projection method real problem is to separate and measure each of
these trends separately. In order to estimate the future demand of the product the impact of seasonal,
cyclical and irregular trends are eliminated from the data and only secular trend is used.
The trend in the time series can be eliminated by using any of the following method;
I. Graphical Method,
II. The method of semi average,
III. Moving average method and
IV. The least square method

I. Graphical Method : It is simplest method of trend projection. In this method periodical sales data is
plotted on a graph paper and a line is drawn through the plotted points. Then a free hand line is drawn
 passing through as many points as possible. The direction of this free hand line or curve will reflect the
general trends whereas the actual trend line will show the seasonal, cyclical and irregular trend.

II The Semi average method: In this method, first of all time series data of sale is divided into two equal parts and
thereafter, separate average sale is calculated for each half. The two values of averages are plotted on graph
corresponding to the time period. A straight line is then drawn by joining these two points. This line become the
trend line and is used to forecast future sale.
III. Moving average Method: Moving average method is very widely used in practice. Under this method, moving
average is calculated. One has to decide what moving year average – 3year or 5year or 7year should be taken up
and it depends upon the periodicity of the data. It is determined by plotting the data on the graph paper and
noticing the average time interval of successive peaks or trough. After deciding the moving year average, moving
average of the given sales data is calculated and these averages are plotted on the graph paper to fit the trend.
IV. The least square method: Fitting trend equation or popularly known as least square method is a scientific,
formal and popular method of projecting the trend line. In this method a trend line is fitted with the help of straight
line regression equation
i.e S = a + bT
where S = annual sales, T = Time, a and b are constants.
The coefficients a and b are calculated by solving following two equations;
i) ΣS = Na + ΣT
ii) ΣST = a ΣT + bΣT 2 Where, ΣS = Sum of the original sales of N years (S) N= Number of years ΣT =
Sum of deviations of the years taken from a central period ΣT2 = Sum of the squared deviations of T
values ΣST = Sum of the product of the deviation and corresponding sales
Thus, Trend projection method requires simple working knowledge of statistics, quite inexpensive and
yields fairly reliable estimates of future course of demand.

B. ARIMA Method ( Box-Jenkin Technique): Box and Jenkin developed a method of forecasting using
Auto Regressive Integrated Moving Averages (ARIMA). This method is highly suitable to situations
where the inherent pattern in the underlying series is highly complex and difficult to understand. This
method combines smooting method with auto regressive method. It can be used primarily for short term
forecasting.
Steps in ARIMA method:
1. Removal of the trend
2. Identify and select a model
3. Estimate the AR, I, and MA parameters
4. Verify the model for “goodness” of fit
5. Forecasting
Factors that affect the accuracy of ARIMA forecasts
 The frequency and time period of the data
 The quality of the time series data
C. Barometric or Economic Indicators Method: Economic indicators as a method of demand
forecasting are developed recently. In this method forecasting follows the method adopted by
meteorologists in weather forecasting and a few economic indicators become the basis for forecasting the
sales of a company.
An economic indicator indicates change in the magnitude of an economic variable. It gives the signal
about the direction of change in an economic variable.
The barometric method of demand forecasting predicts future demand for a product or service by
analyzing external economic indicators, like market trends and industry-specific variables, assuming that
changes in these factors directly influence consumer demand for the product; it relies on identifying and
interpreting "leading," "lagging," and "coincident" indicators to forecast future trends.
1. Economic Indicators: Businesses can monitor economic indicators such as GDP growth, unemployment
rates, inflation rates, or consumer confidence indexes. These indicators reflect the overall economic health
and can provide insights into changes in consumer spending patterns.
2. Industry-specific Indicators: Industries may have specific indicators that serve as leading indicators of
demand. For example, in the retail industry, indicators like housing starts, consumer sentiment, or retail
sales trends can be monitored to forecast consumer demand for retail products.
3. Market-specific Indicators: Market-specific indicators can also be used for barometric forecasting. For
instance, in the automotive industry, indicators like vehicle registrations, interest rates, or oil prices can
be analyzed to anticipate changes in consumer demand for cars.

 Indicator types:
 Leading indicators: These indicators change before a significant shift in the overall economy,
suggesting future trends.
 Lagging indicators: These indicators change after a significant economic shift, confirming
existing trends.
 Coincident indicators: These indicators move in line with overall economic activity, reflecting
the current state of the economy.
 Analysis process:
 Data collection: Gather data on relevant economic indicators.
 Model creation: Develop a statistical model to establish the relationship between the indicators
and the product demand.
 Forecasting: Use the model to predict future demand based on anticipated changes in the
economic indicators.
Advantages of the barometric method:
 Early trend identification:
By analyzing leading indicators, businesses can anticipate changes in demand before they occur.
 External perspective:
Provides a broader understanding of market conditions beyond just historical sales data.
 Suitable for cyclical industries:
Particularly useful for industries highly sensitive to economic fluctuations, like automotive or real estate.

Disadvantages of the barometric method:

 Complexity: Requires accurate identification and interpretation of relevant economic indicators, which
can be challenging.
 Limited accuracy: May not capture specific factors affecting individual product demand.
  External factors beyond control: Forecasts can be significantly impacted by unforeseen external events.

Example of barometric forecasting:

 A car manufacturer might use rising interest rates (a leading indicator) to predict a potential decline in car
sales in the coming months.

D. Econometric Models: This method involves the use of mathematical formulas to predict the future
of customer demand. The method is based on the relationship between various economic factors that can
affect the demand for a certain company’s products.

Demand Forecasting For a New Product

Demand forecasting in case of new products is not easy as in case of established products. In case new
product the firms will not have any past experience or past data for this purpose. It requires an intensive
research of the economic and competitive features of the product should be made to make efficient
forecasts. Professor Joel Dean, however, has suggested a few guidelines to make forecasting of demand
for new products.
a. Evolutionary approach The demand for the new product may be considered as an outgrowth of an
existing product. For e.g., Demand for new Tata Indica, which is a modified version of Old Indica can
most effectively be projected based on the sales of the old Indica, the demand for new Pulsor can be
forecasted based on the sales of the old Pulsor. Thus when a new product is evolved from the old product,
the demand conditions of the old product can be taken as a basis for forecasting the demand for the new
product.
b. Substitute approach If the new product developed serves as substitute for the existing product, the
demand for the new product may be worked out on the basis of a ‘market share’. The growths of demand
for all the products have to be worked out on the basis of intelligent forecasts for independent variables
that influence the demand for the substitutes. After that, a portion of the market can be sliced out for the
new product. For e.g., A moped as a substitute for a scooter, a cell phone as a substitute for a land line. In
some cases price plays an important role in shaping future demand for the product.

DEMAND ESTIMATION:
In order to make understanding of demand analysis more useful, we need to find out the estimates of
demand. The following are the basic methods used to estimate the demand function
i) Market Experimentation
ii) Survey of consumers’ intentions
iii) Regression analysis

(i) Market Experimentation Method:

Market Experimentation methods are of two kinds.

 Actual Market method: Under this method actual consumers’ reactions are observed with the help of sales
outlets opened in different localities. During the experiments prices, advertisement and other controllable
variables affecting demand are varied and customers’ reaction are noted.
 Short comings of this method are:
a) It is expensive
b) Its expansiveness limits to a short run
c) This method cannot include non-controllable variables
 The market simulation method: This method is also known as consumer clinic or laboratory experiment
technique. This method involves giving a sum of money to each customer and asked to shop around a
simulated market. Consumer behaviour is then studied by varying the price, the quality of the product,
packaging, advertisement etc.

Limitations of this method are:

a) As the consumers know that they are part of the experiment it may distort their shopping
behaviour
b) It is expensive.

(ii) Survey of consumers’ intentions method:

In this method consumers are contacted personally to disclose their future purchase plans. This
may be by (i) census method (ii) sample method.

A variant of survey technique is test marketing. This is done mainly for estimating demand of new products or
estimating demand potential in new geographical areas. In this method a test area is selected and product is
launched in this area exactly in the manner it is intended to launch in the market. If the product is successful in
test area then the sales are taken as a basis for estimating sales in the market as a whole.
Limitations of Survey method;
i) More Expensive
ii) More time taken
iii) Customers’ bias are involved
iv) Sample or test market may not represent the population or the whole market.

(iii) Regression Analysis:

This is a statistical technique by which demand is estimated with the help of certain
independent variables such as price of the commodity, income, price of related goods etc..

Simple Regression Analysis is used when the quantity demanded is taken as a function of a
single independent variable.
Multiple Regression Analysis is used to estimate demand as a function of two or more
independent variables that vary simultaneously.

The Regression Model involves five steps:

a) Identifying demand function for the commodity
b) Collecting historical data in all selected variables
c) To select an appropriate functional form for estimation
d) Estimation of the selected demand function
e) Analysing the estimated demand function and suggesting the marketing policy.