UNIT - II: DEMAND AND SUPPLY ANALYSIS

In common parlance, demand means the desire for an object. But in economics
demand is something more than this. According to Stonier and Hague, ―Demand in
economics means demand backed up by enough money to pay for the goods
demanded‖. This means that the demand becomes effective only it if is backed by
the purchasing power. In addition to this, there must be willingness to buy a
commodity.
Thus demand in economics means the desire backed by the willingness to buy a
commodity and the purchasing power to pay.
In the words of ―Benham‖ ―The demand for anything at a given price is the
amount of it which will be bought per unit of time at that Price‖.
Hence, demand refers to the amount of commodity which an individual consumer is
willing to purchase atgiven price in a given period. The demand is said to exist when
the following three conditions are fulfilled.
1. Desire to purchase
2. Ability to pay
3. Willing to pay
Ex: A beggar may have desire to purchase a car but he
cannot pay money for it.Ex: A miser does not purchase a
car but he can pay money for it.

DEMAND FUNCTION
Demand function is a function which describes a relationship between one variable
and its determinants. The demand function for a good relates the quantity of good
which consumers demand during a given period to the factors which influence the
demand. Quantity demanded is dependent variable and all the factors are
independent variables. The factors can be built up into a demand function. The
demand function can be mathematically expressed as follows:
Q = f(P, I, T, P1..Pn, EP, EI, A, O)

Q = Quantity demandedf = Function of

P = Price of goods itself I = Income of
consumers
T = Taster and preferences P1..Pn = Price
of related goods
E = Expectation about future
 LAW OF DEMAND:
Law of demand shows the relationship between price and quantity demanded of a
commodity in the market. In the words of Marshall, ―the amount demand increases
with a fall in price and The law of demand states that “ other things remaining
constant, the higher the price of the commodity, the lower is the demand and
lower the price, higher is the demand”. paribus
 The law of demand may be explained with the help of the following demand schedule.

Demand Schedule: Demand Curve:

Price of Apple
Quantity
Demanded

(In. Rs.)
2 6
3 4
4 3

When the price falls from Rs. 6 to 5, quantity demand increases from 1 to 2. In the same
way as pricefalls, quantity demanded increases. On the basis of the demand schedule, we
can draw the demand curve. The above demand curve shows the inverse relationship
between price and quantity demanded of apple.It is downward sloping.
EXCEPTIONS TO LAW OF DEMAND
According to law of demand, other things being constant, as the price increases, the
demand for the commodity decreases and vice-versa. But this is not true all the time.
In some cases, as the price increases, the demand for the commodity will also
increase and the demand decreases when the price decreases. All these cases are
considered as exceptions to the law of demand.

When price increases from OP to Op1, quantity demanded also increases from OQ
to OQ1 and vice versa.The following are the exceptions to the law of demand.
1. Giffen goods or Giffen paradox:
The Giffen good or inferior good or cheap good is an exception to the law of
demand. The demand for these goods varies directly with the variations in prices i.e.,
there exists direct relation between the quantity demanded and the price of the
commodity. Giffen goods may or may not exist in the real world.
.
2. Goods of status
In some situations, certain commodities are demanded just because they are
expensive or prestige goods and are usually used as status symbols to display one‘s
wealth in the society. Examples of such commodities are diamonds, air conditioned
car, duplex houses etc. as the price of these commodities increase, they are more
considered as status symbols and hence their demand gets raised. This goesagainst
the law of demand.
3. Ignorance:
Sometimes, the quality of the commodity is Judged by its price. Consumers think
that the product is superior if the price is high. As such they buy more at a higher
price.
4.consumer expectations of future prices
If the price of the commodity is increasing, the consumers will buy more of it
because of the fear that it increase still further. Similarly, if the consumer expects the
future prices to decrease, he may not purchasethe commodity thinking that the good
may be of bad quality. This violates the law of demand.

ELASTICITY OF DEMAND

Elasticity of demand explains the relationship between a change in price and

consequent change inamount demanded. ―Marshall‖ introduced the concept
of elasticity of demand. Elasticity of demand shows the extent of change in
quantity demanded to a change in price.

Definition Of Elasticity Of Demand:

In the words of ―Marshall‖, ―The elasticity of demand in a market is great or

small according as the amount demanded increases much or little for a given fall in
the price and diminishes much or little for a given rise in Price‖

Elastic demand: A small change in price may lead to a great change in quantity
demanded. In this case, demand is elastic.

In-elastic demand: If a big change in price is followed by a small change in

demanded then the demand in ―inelastic‖.

TYPES OF ELASTICITY OF DEMAND:

There are four types of elasticity of demand:

1. Price elasticity of demand

2. Income elasticity of demand
3. Cross elasticity of demand
4. Advertisement elasticity of demand

I. Price elasticity of demand:

Marshall was the first economist to define price elasticity of demand. Price elasticity
of demand measureschanges in quantity demand to a change in Price. It is the ratio
of percentage change in quantitydemanded to a percentage change in price.
 Proportionate change in the quantity demand of commodity
Ep = Price elasticity =

Proportionate change in the price of commodity

Q2 − Q1
Q1 = Old
E =
Q1 demand Q2 =
P P2 − New demand
P1 p1 = Old price
P1
p2 = New price

There are five cases of price elasticity of demand

A. Perfectly elastic demand:

When small change in price leads to an infinitely large change is quantity demand, it
is called perfectly or infinitely elastic demand. In this case E=∞. Sometimes, even
there is no change in the price, the demand changes in huge quantity. In case of
perfect elastic demand, the demand for a commodity changes even though there is
no change in price. This elasticity is very rarely found in practice. We can see a
straight
line demand curve parallel to the
Price Demand
10 100
10 1000
Ep = ((Q2 − Q1)/Q1) /((P2 − P1)/P1)

𝐸𝑝 = (1000 − 100)/100 /(10 − 10)/10 = ∞

The demand curve is horizontal straight line. It shows

the at Rs. 10 price any quantity is demanded and if
price increases, the consumer will not purchase the
commodity.

B. Perfectly Inelastic Demand

A commodity is said to have perfectly inelastic

demand, when even a large change in price of the
commodity causes no change in the quantity
demanded. The elasticity coefficient of perfectly in
elastic demand is Ep = 0.

The shape of the demand curve for perfectly inelastic is vertical as shown below.
Price Demand
10 100
20 100
Ep = ((Q2 − Q1)/Q1) /((P2 − P1)/P1)

𝐸𝑝 = (100 − 100)/100 /(20 − 10)/10 = 0

When price increases from Rs. 10 to Rs.20, the quantity demanded remains the same. In
other words theresponse of demand to a change in Price is nil. In this case ‗E‘=0.

C. Relatively elastic demand:

Demand changes more than proportionately to a change in price. i.e. a small change in price leads to a very big change in the quantity
will be flatter.

Price Demand
10 300
15 100
Ep = ((Q2 − Q1)/Q1) /((P2 − P1)/P1)

𝐸𝑝 = (100 − 300)/300 /(15 − 10)/10 = −1.34

When price increases from Rs.10 to Rs.15, quantity demanded decreases from 300units to 100units whichis larger than the change in
D. Relatively in-elastic demand.
Quantity demanded changes less than proportional to a change in price. A large change in price leads tosmall change in quantity dem

Price Demand
Ep10
= ((Q2 − Q1)/Q1) /((P2
100 − P1)/P1)

𝐸𝑝 = (80 − 100)/100 /(15 − 10)/10 = −0.40

15 80

When price increases from Rs.10 to Rs.15 quantity demanded decreases from100units to units, which is smaller than the change in

E. Unitary elasticity of demand:

The change in demand is exactly equal to the change in

price. When bothare equal, E=1 and elasticity is said to be
unitary.

Price Demand
10 200
 15 100

Ep = ((Q2 − Q1)/Q1) /((P2 − P1)/P1)

𝐸𝑝 = (100 − 200)/200 /(15 − 10)/10 = −1

When price increases from Rs.10 to Rs.15, quantity demanded decreases from
200units to 100units. Thusa change in price has resulted in an equal change in
quantity demanded so price elasticity of demand is equal to unity.

1) Arc Elasticity or Mid–Point Method:

Arc elasticity of demand is the average elasticity over a segment of the demand
curve. In point elasticity, we find elasticity on straight line demand curve. We cannot
always find a demand curve in the form of straight line. A demand curve is not
linear. So, how do we find elasticity on such a curve?. What we do is that we have to
identify two points, say point A and point B and then draw a chord (a straight line
joining two points on a curve) between these two points. Join these two points with a
straight line. What happens is we get a straight line with arc (a part of a curve). Now,
how do we find elasticity between these two points?. We have a formula for that:
The following graph presents the clear meaning of the arc elasticity.
DEMAND FORECASTING

Forecasting is predicting or expecting the needs of the consumers in future.

Forecasting the demand for itsproducts is the essential function for an organization
irrespective of its nature. Forecasting customer demand for products and services is a
proactive process of determining what products are needed, where, when and in
what quantities. So, demand forecasting is a customer focused activity. It supports
other planning activities such as capacity planning, inventory planning and even
overall business planning. Many organizations follow it as a custom to completely
and accurately forecast the demand of its products regularly. Demand forecasting is
not helpful at the firm level but also at national level. The need for demand
forecasting arises due to the following purposes.

 It serves as a road map for production plans.

 It plays a significant role in situations of uncertain production or demand.
 It facilitates the managers to line up their business activities.
 It is a basis for export and import policy and fiscal policy.
 It can help businessman to take decisions regarding inputs of production
process such as labor,capital etc.

STEPS IN DEMAND FORECASTING

1. Determining the objectives

The first step in this regard is to consider the objectives of sales forecasting carefully.

2. Period of forecasting

Before taking up forecasting, the company has to decide the period of forecasting —
Whether it is a short-term forecast or long-term research.

3. Scope of forecast

The next step is to decide the scope of forecasting— Whether it is for the products,
or for a particular areaor total industry or at the national/international level.

4. Sub-dividing the task

Sub-dividing the task into homogeneous groups, according to product, area,

activities or consumers. The figure of sales forecasting shall be the sum total of the
sales forecasts of all the groups.

5. Identify the variables

The different variables or factors affecting the sales should be identified so that due
weight age may be given to those different factors.
 6. Selecting the method

Appropriate method of sales forecasting is selected by the company taking into account all the relevant
information, purpose of forecasting and the degree of accuracy required

7. Study of correlation between sales forecasts and sales promotion plans

Making the forecast reliable, the sales promotion plans such as advertising, personal
selling and othersales programmes should be reviewed. A study of correlation
between sales forecasts and sales promotionplans should be made in order to
establish their role in promoting the sales.

8. Competitors activities

Volume of sales of a company is largely affected by the activities of competitors

and, therefore, the forecaster must also study the competitors‘ activities, policies,
programmes and strategies.

9. Preparing final sales forecasts

The preliminary sales forecasts figure should be reviewed and final sales forecast
figures should be arrived at after making all adjustments.

10. Evaluation and adjustments

The figures of final sales forecasts form the basis for the operations of the
company in the next period. The actual sales performance in the forthcoming period
should be reviewed and evaluated from time to time viz, monthly, quarterly, half-
yearly or yearly and so on. The forecast figures should be revised in the light of
difficulties experienced during actual performance. At the end of the forecast period,
actual performance should be reviewed and rectified while forecasting the demand
for the next period.

METHODS OF FORECASTING:
This method of forecasting trend is elementary, easy and quick as it involves merely
the plotting theactual sales data on a chart and then estimating just by observation
where the trend line lies. The line can be extended towards a future period and
corresponding sales forecast read from the graph.

1. Least squares method:

Here, certain statistical formulas are used to find the trend line which best fits the
available data. It is assumed that there is a proportional change in sales over period
of time. In such a case, the trend line equation is in linear form.

The estimating linear trend equation of sales is written as: S = x + y(T), where x and
y have been calculated form past data, S is sales and T is the year number for which
the forecast is made. To find the values of x and y, the following equations have to
be used.

ΣS = Nx +
yΣT ΣST =
xΣT + yΣT2
Where S is the sales; T is the year number, N= number of years.

2. Times series analysis:

Time series forecasting is the use of a model to predict future values based on
previously observed values. The first step in making estimates for the future consists
of gathering information from the past. In this connection one usually deals with
statistical data which are collected, observed or recorded at successive intervals of
time. Such data are generally referred to as time series. Thus when we observe
numerical dataat different points of time the set of observations is known as time
series. It may be noted that any or allof the components may be present in any
particular series. The components are Secular trend(Long term trend), Seasonal trend
, Cyclical trend (periods in the business cycle such as prosperity, decline, depression,
improvement), Irregular trend(also called as erratic or accidental or random
variations in business). From the following equation future sales can be
measured. The constants T,S,C,I. are
calculated from past data.
3. Y = Future
sales T =
Secular trend S
Y=T+S+ C+ I = Seasonal
trend C =
Cyclical trend I
= Irregular
trend
 3. Moving average method
This method considers that the average of past events determine the future events. As
the name itself suggests, under this method, the average keeps on moving depending
up on the number of years selected. This method is easy to compute.

4. Exponential Smoothing

It is the most popular technique used for short-run forecasts. Unlike in moving average
method, in this method, all time periods are given varying weights. Recent values are
given higher weights and distance past values are given lower values. The reason is
that the recent past reflects more in nearest future.

The following formula is used for exponential smoothing.

If α is higher, higher weight is given to the most recent information. α is

calculated on the basis ofpast data. If there were fluctuations in past data, the α
value is high.
C. Barometric techniques:

Under the barometric technique, one set of data is used to predict another set. In other
words, to forecast demand for a particular product or service, use some other relevant
indicator (which is known asbarometer) of future demand. Ex: The demand for cable
TV may be linked to the number of new houses occupied in a given area or demand for
new houses in a particular area.

D. Correlation and Regression method:

Correlation and regression methods are statistical techniques. Correlation describes the
degree of association between two variables such as sales and advertisement
expenditure. When the two variables tend to change together, then they are said to be
correlated. The extent to which they are correlated is measured by correlation
coefficient. Of these two variables, one is dependent variable and the other is
independent. If the high values of one variable are associated with the high values of
another, they are said to be positively correlated. Similarly, if the high values of one
variable are associated with the low values of another, then they are said to be
negatively correlated. Correlation coefficient ranges between
+1 and -1. When the correlation coefficient is zero, it indicates that the variables under
study are not related at all.

a) Experts opinion:

Well-informed persons are called experts. Experts constitute yet another source of
information. These persons are generally the outside experts and they do not have any
vested interests in the results of a particular survey.
b) Test marketing:

It is likely that opinions given by buyers, salesmen or other experts may be, at times,
misleading. This is the reason why most of the manufacturers favour to test their
product or service in a limited market as test-run before they launch their products
nationwide. Based on the results of test marketing, valuable lessons can be learnt on
how consumers react to the given product and necessary changes can be introduced to
gain wider acceptability. To forecast the sales of a new product or the likely sales of an
established product in a new channel of distribution or territory, it is customary to find
test marketing in practice.

c) Controlled experiments:

Controlled experiments refer to such exercises where some of the major determinants
of demand are manipulated to suit to the customers with different tastes and
preferences, income groups, and such others. It is further assumed that all other
factors remain the same. In this method, the product is introduced with different
packages, different prices in different markets or same markets to assess which
combination appeals to the customer most.

d) Judgment approach:

When none of the above methods are directly related to the given products or services,
the management has no alternative other than using its own judgment.

SUPPLY

In economics, we have two forces: the producer, who makes things, and the
consumer, who buys them. Supply is the producer's willingness and ability to supply a
given good at various price points, holding all else constant. An increase in price will
increase producers' revenues, so they'll be willing to supply more; a decrease in price
will reduce revenues, and so producers will supply less.

LAW OF SUPPLY

Definition: Law of supply states that other factors remaining constant, price and
quantity supplied of a good are directly related to each other. In other words, when the
price paid by buyers for a good rises, then suppliers increase the supply of that good in
the market.

In the Words of Dooley, ―The law of supply states that other things remaining the
same, higher the prices the greater the quantity supplied and lower the prices the
smaller the quantity supplied‖.
Assumption of the Law :
1. It is assumed that incomes of buyers and sellers remain constant.
2. It is assumed that the tastes and preferences of buyers and sellers remain constant.
3. Cost of all the factors of production is also assumed to be constant.
4. It is also assumed that the level of technology remains constant.
5. It is also assumed that the commodity is divisible.
6. Law of supply states only a static situation.

Description: Law of supply depicts the producer behavior at the time of changes in the
prices of goods and services. When the price of a good rises, the supplier increases the
supply in order to earn a
profit because of higher prices.

Price Quantity
(Rs) Supplied
2 0
4 3
6 6

The above diagram shows the supply curve that is upward sloping (positive relation
between the price andthe quantity supplied). When the price of the good was at P4,
suppliers were supplying Q3 quantity. As the price starts rising, the quantity supplied
also starts rising.

SUPPLY FUNCTION

The supply function is the mathematical expression of the relationship between supply
and those factors that affect the willingness and ability of a supplier to offer goods for
sale.

SX = Supply of goods X

PX = Price of goods X

PF = Factor input employed (used) for production.

· Raw material
· Human resources
· Machinery
O = Factors outside economic sphere.