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Demand Analysis

Introduction: Demand is one of the most critical economic decision variables. It reflects the size and pattern of market. Business activity is always market-driven. The manufacturers inducement to invest in a given line of production depends on the size of market. In the process of production, inputs are transformed into flows of output. Output, when sold in the market, yields revenue. Inputs, to be obtained for the productive process, involve costs. Profit is the difference between revenues and cost and it is influenced by the demand-supply conditions for output and input. The demand for output and inputs, the demand for firm and the industry, the demand by the consumer and the stockiest, and the similar becomes therefore relevant for managerial decision making. Concept of Demand The demand for anything, at a given price, is the amount of it, which a person desires to buy per unit of time at a given place. Demand, thus, has three important elements. First, it is a desired quantity and the phrase quantity demanded is used for it. Second, demand must be backed with enough money. So demand in economics is effective demand. Thirdly, quantity demanded is a flow and not a stock. The demand for a product implies (i) desire to acquire it, (ii) willingness to pay for it and, (iii) ability to pay for it. All the three must be checked to identify and establish demand. A beggars desire to stay in a five-star hotel and his willingness to pay the bill is not demand because he lacks necessary money to pay the bill of the hotel. It is merely his wishful thinking. Similarly, a misers desire for and ability to pay for a car is not demand, as he does not have necessary willingness to par for a car. One may come across a wellestablished person who possesses both the willingness and ability to pay for higher education. But he has really no desire to have it; he pays the fee for a regular course, and eventually does not attend his classes. Thus, in economic sense, he does not have a demand for higher education (degree/diploma) To sum up, the demand for a product is the desire for that product backed by willingness as well as ability to pay for it. It is always defined with reference to a particular time, place, price, and given values of other variables on which it depends. Determinants of Demand Price of the product Price of other related goods Consumer income and wealth Distribution of income and wealth Size of population Taste, preferences and fashion Demonstration effect

Advertisement expenditure Price expectation of the consumer Availability of credit facility to consumer Thus demand of a commodity, say X, may be the function of the following variables: Dx = f (Px, Py, Pz, Y, W, De, Di, A, E, T, P, C, ) Where: Px = price of x commodity, Py = price of Y commodity (a substitutive commodity), Pz, = price of z commodity (a complementary commodity), Y = Income of the consumer, W = wealth of the consumer, De = demonstration effect, Di = distribution o0f income and wealth in the society, A = advertisement expenditure, E = price expectation of the consumer, T = taste, preferences and fashion, P = size of population, C = credit facility available to consumer, and = disturbance term or error term Demand Function Demand, as a function of the above variables, becomes a very complicated relationship. It would be difficult to formulate any demand theory. Therefore, we presume that all variables, except the price of a commodity, which we are considering, remain constant. Now we can state the relationship between the quantity demanded of a commodity and its price. Dx = f (Px) In the slope and intercept form, the demand function may be stated as; Dx = a - b Px Law of Demand The law of demand states: if other things remain the same, price of a commodity and its demand have inverse relationship. If the price increases, its demand decreases and vice versa. When the demand-price relation is shown in the form of a table, it is called demand schedule and when it is plotted on a graph, it is called demand curve. The demand curve is downward slopping indicating the inverse relationship between the price of the product and its demand. A demand schedule for Sugar Price per kg Quantity (Rs.) demanded (kg) 2 10 3 8 4 6

5 6

4 2

In the above table, a hypothetical demand schedule, showing the range of prices and the corresponding different quantities of the commodity a buyer will buy, is given. The table shows inverse relationship between the price and quantity demanded. Why does demand curve slope downward? A demand curve normally slopes downward from northwest to southwest. There are various reasons for it. 1) First, when the price is reduced, new buyers of the commodity enter the market. 2) Second, when the price falls, the old consumers buy more of it because of income and substitution effects.3) Third, the principle of different uses is also responsible for the downward slope of demand curve. When the commodity is costly, it is used only in more important uses but when the price falls, the commodity is also demanded for less important uses.4) Lastly, the law of demand operates because of the principles of different desires. People in a society are of different taste, habits, liking etc. Some have stronger desires and others may have weak desire. When the price is higher only those consumers who are of strong desires buy that commodity. When the price falls, people with less strong desires also start buying the commodity. Change in Demand and Change in Quantity Demanded It is important to draw simple distinction between change in demand and change in quantity demanded. The law of demand has reference to extension or contraction of demand (change in quantity demanded) but the change in demand (increase or decrease in demand) is associated with the change in other variable that affect the demand. When there is a movement on the same demand curve due to change in the price of the product, the quantity demanded of the product changes, which is called change in quantity demanded. The movement of consumer from one demand curve to another due to change in all other variables, except the price of the product, is known as change in demand. Exception of Law of Demand 1. Giffen Paradox The law of demand is not applicable to Giffen goods i.e., inferior goods. All Giffen goods are inferior goods but all inferior goods are not Giffen goods. In case of giffen goods, when price of such good, say X, falls, the negative income effect is so powerful to out-weight the positive substitution effect. When the price falls, a consumer demands less. Therefore, the law of demand does not hold true in case of these goods. 2. Conspicuous consumption / Veblen effect / Snob effect There are some goods, which are demanded by rich people only when they are expensive. Rare paintings, diamond jewellery etc., fall in this category. The consumption of these goods is known as conspicuous consumption. 3. Fear of future rise in prices

If it is believed that the price of a commodity is likely to be higher in the future than at present, then even though the price has already risen, more quantity of the commodity may be bought at the higher price by the consumer. Types of Demand 1. Direct and Derived Demand Direct demand refers to demand for goods meant for final consumption. It is the demand for consumer goods. By contrast, derived demand refers to the demand for goods which are needed for further production. Thus, demand for an input is a derived demand. 2. Domestic and Industrial Demand In case of certain industrial raw materials, which are also used for domestic purpose, this distinction is very meaningful. The example of the refrigerator can be given to distinguish between the demand for domestic consumption and demand for industrial use. 3. Autonomous and Induced Demand When the demand for a product is tied to the purchase of some parent product, its demand is called induced demand. For example, demand for cement is induced by the demand for housing. Thus, demand for all producers goods is induced demand. In addition, even in the realm of consumer goods, we may think of induced demand. Like complementary goods, bread and butter. Autonomous demand on the other hand is not induced. Unless a product is totally independent of the use of other products, it is difficult to talk about autonomous demand. In present world of dependence, there is hardly any autonomous demand. No body consumes just a single commodity but a bundle of commodities. Even then all direct demands may loosely be called autonomous. In context of econometric estimates of demand, this distinction is used to identify the determinants of demands. For example in Dx = a-bPx, a represents the autonomous part which captures the effect of all non-price factors, whereas b represents the induced part as Dx is induced by Px, given the size of b. 4. Perishable and Durable Goods Demand Both consumers goods and producers goods are further classified into perishable/ non-durable/single use goods and durable/non-perishable/repeated use goods. The former refers to final output like bread or raw material like cement which can be used only once. The latter refers to items like shirt, car or machines which can be used repeatedly. 5. New and Replacement Demand If the purchase or acquisition of an item is meant as an addition to stock, it is new demand. It the purchase of an item is meant for maintaining the old stock of capital/ asset intact, it is replacement demand. 6. Final and Intermediate Demand

The demand for semi-finished products, industrial raw materials and similar intermediate goods are all intermediate demands. The demand for goods that is made by consumer for final consumption is final demand. Like demand for car is a final demand while demand for steel by car industry is an intermediate demand. 7. Individual and Market Demand This distinction is often employed by the economist to study the size of buyers demand, individual as well as collective. A market is visited by different consumers, consumer differences depending upon factors like income, sex etc. they all react differently to the prevailing market price of a commodity. For example, when the price is very high, a low -income buyer may not buy anything though a high-income buyer may buy something. In case we distinguish between demand of an individual buyer and that of market, which is the aggregate of individual demands. 8. Company (Firm) and Industry Demand An industry is the aggregate of firms (companies). Thus, the companys demand is similar to an individual demand, whereas the industrys demand is similar to the aggregate total demand. Demand for engineers by automobile industry is an industry demand, while demand for engineers by Hero Honda is company demand. Elasticity of Demand Economists and businessmen often concerned with the responsiveness of one variable to change in some other variable. The law of demand states that a change in the price of a commodity causes a change in the quantity demanded. The change is in the reverse direction. This inverse relationship indicated by the law of demand is a qualitative one as it only indicates the direction in which the change would take place. It does not provide us the precise information about the degree of change. The concept of elasticity of demand explains degree of change in quantity demanded due to change in price. The concept of elasticity in economics is borrowed from physics. In physics, it is supposed to show the reaction of one variable with respect to change in other variables on which it is dependent. The elasticity may be defined as the percentage change in some dependent variable given a one per cent change in independent variables, ceteris paribus. There are as many elasticities of demand as its determinants. The most important of these elasticities are: (1) price elasticity, (2) income elasticity, and (3) cross elasticity. Price Elasticity It is a measure of the responsiveness of demand to changes in the commoditys own price. If the change in the price is very small, we use as a measure of the responsiveness of the demand the point elasticity of demand. If the changes in the price are not small we use the arc elasticity of demand as the relevant measure. Ep = proportional change in demand / proportional change in price

Ep = - Q/P. P/Q Where: Ep = price elasticity, p = initial price, Q = initial quantity demanded, and = change. Three points must be noted at this stage: 1. Price elasticity is a ratio of marginal demand (Q/P) to average demand (Q/P). 2. Elasticity is a unitless or dimensionless concept. It is just a pure number. Consider the relative variation of the quantity Q/Q. we can not alter the ratio simply by changing the unit of measure as both the numerator and denominator are expressed in the same unit. The same is true to P/P. 3. The coefficient of elasticity is ordered according to absolute value as opposed to algebraic value. Hence, an elasticity of 2 is greater than an elasticity of 1 even though algebraically the opposite would be true. Thus, ep = - Q/P. P/Q If demand curve is linear, then Q = a - bP Its lope is Q/P = -b, substituting it in the formula of elasticity, we get ep = -b. P/Q, which implies that elasticity changes at the various points of demand curve. Graphically, the point elasticity of linear demand curve is shown by the ratio of the segment of the line to the right and to the left of the particular point. Thus, ep = lower segment/ upper segment. This formula is used when ep is measured at a particular point. When ep is measured on an arc, the following formula would be usedEp = - Q/P. (P1 + P2) / (Q1+Q2) Where, P1 is initial price and P2 is new price and Q1 is initial quantity and Q2 is new quantity. Degrees of Price Elasticity of Demand Following are the degrees of price elasticity of demand: 1. Perfectly elastic demand 2. Perfectly inelastic demand 3. Highly elastic demand 4. Unitary elastic demand 5. Less elastic or inelastic demand (ep = ) (ep = 0) (ep > 1) (ep = 1) (ep < 1)

A good or service is considered to be highly elastic if a slight change in price leads to a sharp change in the quantity demanded. Usually these kinds of products are readily available in the market and a person may not necessarily need them in his or her daily life. On the other hand, an inelastic good or service is one whose changes in price

witness only modest changes in the quantity demanded, if any at all. These goods tend to be things that are more of a necessity to the consumer in his or her daily life. Interpretation of Elasticity Coefficients The sign of the coefficient shows the directional change. The negative sign shows inverse relationship between the price and the quantity demanded. As already stated, for interpretation point of view, coefficient value is considered in absolute figure. The interpretation of ep = -1.5 would be that a 1 percent increase in price would lead to a 1.5% decline in quantity demanded. Or if the price falls by 1 percent, quantity demanded would increase by 1.5%. If the elasticity coefficient is less than one, the demand is less elastic or inelastic. If it is equal to one, demand is unitary elastic. If ep > one, the demand is more elastic. On the basis of estimated coefficient of price elasticity, nature of a commodity or a service can be identified. For instance, if a commodity is price-inelastic, it would be an essential commodity. For luxury products, ep would be greater than one. Measurement of Price Elasticity of Demand 1. Total Outlay/ Expenditure Method This method to measure the elasticity of demand was used by Marshall. In this method we compare the change in the total expenditure incurred by a consumer before and after the variation in price. The elasticity of demand is expressed in ways: (i) unity; (ii) greater than unity; and (iii) less than unity. Elasticity is considered unity when the total expenditure remains the same even after a change in price. Elasticity of demand is said to be greater than unity when with the fall in price the expenditure increases or as the price increases, the expenditure falls. Elasticity is considered to be less than unity when the amount spent increases with the rise in price and decreases with the fall in price. These three categories of elasticity have been shown in the following table. Case No. 1 2 3 Price (Px in Rs.) 10 5 10 5 10 5 Demand (Qx in Unit) 4 12 4 8 4 6 Total Outlay (Px.Qx in Rs.) 40 60 40 40 40 30 Elasticity (ep) ep > 1 ep = 1 ep < 1

2. Geometrical Method When elasticity is measured at a point on a demand curve, it is called point elasticity. It is measured at the point by the ratio of the lower part of the linear demand curve to the upper part. If demand curve is non-linear, a tangent is to be drawn at the point on demand curve where elasticity is to be measured. Then, Ep is measured by dividing the lower segment of the tangent line from its upper segment. 3. Percentage Method

When calculating elasticity of demand with the help of percentage method, we compare percentage change in quantity to the percentage change in price. The elasticity, according to this method, is the percentage change in the quantity demanded to the percentage change in the price changed. Thus, the price elasticity becomes ratio of a relative change in the quantity to a relative change in price. Ep = -Q/P. P/Q 4. Arc Method The measurement of price elasticity of demand between any two points on a demand curve is known as arc elasticity. When elasticity is to be measured not on a point but on an arc, instead of initial price and initial quantity, average of both the prices and both the quantities is considered. Ep = -Q/P. (P1 + P2) / (Q1+Q2) Determinants of Price Elasticity 1. Availability of substitutes If the commodity has many close substitutes, its demand will be highly priceelastic. The reason is that if the price of such a commodity goes up, consumers will start consuming other substitutable goods. 2. Nature of Goods Price elasticity also depends on the nature of goods. Essential goods have inelastic or relatively less elastic demand, while luxury products have relatively more elastic demand. 3. Position of a commodity in the budget Budget position means the fraction of total expenditure devoted to a single commodity. The elasticity of a commodity on which a small percentage of income is spent is relatively lower. 4. Number of uses of a commodity The more uses a commodity can be put to, the more elastic its demand would be. If the price of such a commodity increases, consumers will use it only in a few applications. 5. Postponement of Use The goods the purchase and use of which can be deferred have a high elastic demand. When price has risen and demand cannot be postpone, that will make demand less responsive to price rise than when demand can be postpone. 6. Price expectation of Buyers When the price of a product has fallen and the buyers expect it to fall further, then they will postpone buying the good and this will make demand less responsive.

7. Time factor in adjustment of consumption pattern In short run, it is difficult to change habits. Hence, the short run demand is less responsive to price change. The longer the time allowed for making adjustment in consumption pattern, the greater will be the elasticity. Income Elasticity of Demand Income elasticity of demand measures the degree of responsiveness of quantity demanded of a commodity with respect to the change in the level of income of a consumer, other things remaining constant. Ei = Q/Y. Y/Q Where: Ei = income elasticity, Y =initial income, Q = initial quantity demanded, and = change. If income elasticity is to be measured on an arc, average of both incomes and both the quantities will be considered in place of initial income and initial quantity. Ei = Q/Y. Y1+Y2/Q1+Q2 Unlike Ep which is always negative, Ei is generally positive. However, in case of inferior and Giffen goods, it is negative. The reason is that when income increases, consumers switch over to the consumption of superior substitutes. For all normal goods, Ei is positive though the degree of elasticity varies in accordance with the nature of commodities. Consumer goods of three categories, viz., necessities, comforts and luxury have Ei less than one, equal to one, and more than one, respectively . The income elasticity of demand for different categories of goods may, however, vary from household to household and from time to time, depending upon the choice and preference of the consumers, level of consumption and income, and their susceptibility to demonstration effect. Understanding of Income elasticity of demand is significant in production planning and management in the long run. It is useful in demand forecasting. It is generally believed that the demand for goods and services increases with the increase in GNP depending on the marginal propensity to consume. This may be true in the context of aggregate demand, but not necessary for a particular product. It is quite likely that increase in GNP flows to a section of consumers who do not, or are not in a position to consume the product in which a businessman is interested. For instance, if the major proportion of increased GNP goes to those who can afford a car, the growth rate of GNP can not be used to calculate income elasticity of demand for motorcycles. Cross Elasticity of Demand The cross elasticity is the measure of responsiveness of demand for a commodity to the changes in the price of its substitutes or complementary goods.

Ec = Qx /Py. Py/Qx Where: Ec = cross elasticity, Qx = initial quantity of x commodity, Py = initial price of y commodity, = change. If Ec is to be measured on an arc, above formula is modified as: Ec = Qx /Py. Py1+ Py2 / Qx1+Qx2 Sign of Ec will be negative in case of complementary goods and positive in case of substitutive goods. An important use of Ec is to identify the extent of substitutability between the two goods. Its coefficient helps the businessman in fixing the price of its product. If Ec of a product is greater than 1, it would not be advisable to increase the price; rather reducing the price may prove beneficial. In case of complementary goods, demand projection can be made by calculating the Ec. For instance, if elasticity of demand for car with respect to price of petrol is greater than one, it would suggest that the company has to invest more on R&D to make the car model more fuel-efficient to enhancing the demand. Practical Uses of Elasticity The concept is useful to both business as well as government managers. It helps the sales manager in fixing the price of his product. The concept is also important to the economic planners of the country. In trying to fix the production targets for various goods in a plan, a planner must estimate the likely demand for goods at the end of the plan. This requires the understanding of income elasticity of demand. The price elasticity of demand as well as cross elasticity of demand would determine the substitution between goods and hence useful in fixing the output-mix. The concept is also useful to policy makers in particular determining taxation policy, minimum wage policy, stabilization programmes for agriculture and price policy for various other goods where administered prices are used. The main uses of the concept are: 1. In taxation - if Ep<1, government can increase tax on such commodities to increase tax revenue. But government does not do so because India is a democratic country. 2. In Monopoly Price 3. In International trade 4. In Production 5. In Distribution