MBA503 - Session 9 - Elasticity of Demand and Supply

Module Code: MBA503
Module Title: Managerial Accounting and Economics
Session 9-Introduction to Economics
Prof. Usha J C
E mail : usha.ms.mc@msruas.ac.in
Prof. Reshma K.J.
E mail : reshma.ms.mc@msruas.ac.in
Prof. Savitha K
E mail : savitha.ms.mc@msruas.ac.in
Prof. Rakesh C
E mail : rakeshc.co.mc@msruas.ac.in
1
Faculty of Management and Commerce ©Ramaiah University of Applied Sciences
Session Contents
• Explanation of elasticity of demand
• Methods of demand forecasting
2
2
Faculty of Management and Commerce ©Ramaiah
©Ramaiah University
University ofSciences
of Applied Applied Sciences
Learning Objectives
At the end of this session, student will be able to:
• Discuss elasticity of demand
• Describe the concept of demand forecasting
• Forecast the demand
3
Elasticity of Demand
• Law of demand explains the directions of changes in demand
• The degree of responsiveness in quantity demanded to a change in

price
• A fall in price leads to an increase in quantity demanded and vice

versa
• But it does not tell us the rate at which demand changes to change
in price
• It represents the rate of change in quantity demanded due to a

change in price
4
Types of elasticity of demand
1. Price Elasticity of Demand
2. Income Elasticity of Demand
3. Cross Elasticity of Demand
5
Price Elasticity of Demand
• Price Elasticity of demand measures the change in quantity

demanded to a change in price
• It is the ratio of percentage change in quantity demanded to a

percentage change in price
6
Price Elasticity of Demand cont.…
7
Types of Price Elasticity of Demand
8
Perfectly elastic demand (infinitely elastic)
• A small change in price leads to infinite change in quantity
demanded
• In this case the demand curve is a horizontal straight line
• EP= ∞
9
Perfectly Inelastic Demand
• large change in price fails to bring about a change in quantity
demanded
• the change in price will not affect the quantity demanded and quantity
remains the same whatever the change in price
• Demand curve will be vertical line
• EP= 0
10
Relatively Elastic Demand
• Here a small change in price leads to very big change in quantity
demanded
• This case demand curve will be fatter one and EP=>1
11
Relatively Inelastic Demand
• Quantity demanded changes less than proportionate to changes in
price
• A large change in price leads to small change in demand
• demand curve will be steeper and EP=<1
12
Unit elasticity of demand ( unitary elastic)
• Change in demand is exactly equal to the change in price
• EP= 1, the elasticity is said to be unitary
13
Summary of types of elasticity
14
Relationship between Price Elasticity and Total
Revenue
Elasticity For Price Increase For Price Decrease
│Ɛp│ > 1 Revenue decreases Revenue increases
│Ɛp│ = 1 Revenue unchanged Revenue unchanged
│Ɛp│ < 1 Revenue increases Revenue decreases
15
Factors affecting price elasticity of demand
16
The Relationship Between Price Elasticity of
Demand & Total Revenue
17
Income Elasticity of Demand
• Income elasticity of demand shows the change in quantity demanded

as a result of a change in consumers’ income
18
Income Elasticity of Demand
• Concept of income elasticity can be utilized for the purpose of taking vital business
decision
• If income elasticity is greater than Zero, but less than one, sales of the product will
increase but slower than the general economic growth
• If income elasticity is greater than one, sales of his product will increase more
rapidly than the general economic growth
• Firms whose demand functions have high income elasticity have good growth
opportunities in an expanding economy
• Helps manager to take correct decision during business cycle
• Helps in forecasting the effect of changes in income on demand
19
Types of Income Elasticity of Demand
• Zero income Elasticity: quantity demanded remain the same, even

though money income increases. Ey = 0
• Negative income Elasticity: when income increases, quantity

demanded falls. Ey = < 0
• Positive income Elasticity: an increase in income may lad to an

increase in the quantity demanded. Ey =>0
20
Types of Income Elasticity of Demand
• Zero income Elasticity: quantity demanded remain the same, even

though money income increases. Ey = 0
• Negative income Elasticity: when income increases, quantity

demanded falls. Ey = < 0
• Positive income Elasticity: an increase in income may lad to an

increase in the quantity demanded. Ey =>0
21
Cross Elasticity of Demand
• Cross elasticity of demand is the proportionate change in the quantity
demanded of a commodity in response to change in the price of
another related commodity
• If the cross elasticity is positive, the commodities are said to be

substitutes
• If cross elasticity is negative, the commodities are compliments
• Substitute goods have positive cross elasticity because the increase in

the price of one goods may increase the demand of substitute goods
22
Cross Elasticity of Demand
• Complementary goods have negative cross elasticity because increase
in the price of one product will reduce the quantity demanded of
complementary product
• For fixing the price of product which having close substitutes or

compliments, cross elasticity is very useful
23
Uses of Cross-Price Elasticity of Demand
• Informs the multi-product firm to be aware of how demand for one

product is likely to respond to changes in the prices of other goods
• Helps the managers to measure degree of competition in the

market
24
Supply Elasticity
• Suppliers make a profit by selling goods and services at higher
prices than their cost to produce
• The elasticity of supply measures the percentage change in the

quantity of supply compared to the percentage change in a supply
determinant
• Elasticity of supply can be measured against price
25
Supply Elasticity cont.…
• The price elasticity of supply measures the percentage change in

supply quantity compared to the percentage change in the price,
which, in turn, determines the change in total revenue
Quantity Change Percentage

Price Elasticity of Supply =
Price Change Percentage
• There is a wide variation in the price elasticity of supply, which

depends not only on the product or service, but also on price
change
26
Price elasticity of supply
27
Elasticity of Supply
<1 inelastic
If supply elasticity = 1 then supply is unit elastic
>1 elastic
28
Factors affecting price elasticity of supply
29
Importance of Elasticity
• Production
• Price fixation
• Distribution
• International trade
• Public finance
• Nationalization
• Price discrimination
• Others
30
Determinants of Elasticity
• Nature of commodity
• Availability/range of substitutes
• Extent /variety of uses
• Postponement/urgency of demand
• Income level
• Amount of money spend on the commodity
• Durability of commodity
• Purchase frequency of a product/time
• Range of Prices
• Others 31
Demand Estimation and Forecasting
• Business enterprise needs to know the demand for its product
• An existing unit must know current demand for its product in order to
avoid underproduction or over production
• current demand should be known for determining pricing and

promotion policies
• Demand Estimation is the process of finding current values of demand

for various values of prices and other determining variables
32
Steps in Demand Estimation
• Identification of independent variables
• Collection of data on the variables from past records, publications of

various agencies etc.
• Development a mathematical model or equation that indicates the

relationship between independent and dependent variables
• Estimation of the parameters of the model
33
Demand Forecasting
• An estimate of future demand for the product
• It is an objective assessment of the future course of demand
• Demand forecast relate to production inventory control, timing,

reliability of forecast etc.
34
Levels of Demand forecasting
• Macro level
• Industry Level
• Firm/Micro level
35
Types of Demand Forecasting
• Short term Demand forecasting:

– Making a suitable production policy to avoid over production or underproduction
– Helping the firm to reduce the cost of purchasing raw materials and to control
inventory
– Deciding suitable price policy so as to avoid an increase when the demand is low
– Setting correct sales target
– Forecasting short term financial requirements for planned production
– Evolving a suitable advertising and promotion programme
36
Types of Demand Forecasting
• Long term Demand Forecasting :

– Planning of a new unit or expansion of existing
– Planning long term financial requirements
– Planning of manpower requirements
– To forecast future problems of material supply and energy crisis
37
Methods of Demand Forecasting
38
Survey Method
• Survey method is one of the most common and direct methods of

forecasting demand in the short term
• This method encompasses the future purchase plans of consumers

and their intentions
• An organization conducts surveys with consumers to determine the

demand for their existing products and services anticipate the
future demand accordingly
39
Survey Method
• Expert Opinion survey Method
• Delphi Method
• Consumer Interview method
40
Expert Opinion Survey Method
• Experts are requested to provide their opinion about the product
• Sales representatives act as experts who can assess the demand for
the product in different areas, regions, or cities
• Apart from salesmen and consumers, distributors or outside

experts may also be used for forecast
• Firms in advanced countries like USA, UK etc...make use of outside

experts for estimating future demand
41
Limitations of Expert Opinion Survey Method
• Provides estimates that are dependent on the market skills of

experts and their experience
• Involves subjective judgment of the assessor, which may lead to

over or under-estimation
• Depends on data provided by sales representatives who may have

inadequate information about the market
42
Delphi Method
• It is a sophisticated statistical method to arrive at a consensus
• Panel is selected to give suggestions to solve the problems in hand
• Both internal and external experts can be the members of the panel
• Each expert is provided information regarding the estimates made

by other experts in the group
• Forecasts are cross checked among experts to reach more accurate

decision making
43
Consumer Interview Method
• Involves collecting necessary information regarding the current and future

demand for a product
• This method carries out the studies and experiments on consumer behavior
• Areas of markets are selected with similar features, such as population, income
levels, cultural background, and tastes of consumers
• Market experiments are carried out with the help of changing prices and
expenditure
• These results help in forecasting future demand
44
Consumer Interview Method
Consumer Interview Method may be undertaken in three ways:
• Complete Enumeration
• Sample survey
• End-use method
45
Limitations of Consumer Interview Method
• Refers to an expensive method
• Affects the results of experiments due to various social-economic

conditions, such as strikes, political instability, natural calamities
46
Statistical Methods
• Statistical methods are complex set of methods of demand
forecasting
• These methods are used to forecast demand in the long term
• Demand is forecasted on the basis of historical data and cross-

sectional data
• Historical data refers to the past data obtained from various sources,
such as previous years’ balance sheets and market survey reports
• Cross-sectional data is collected by conducting interviews with

individuals and performing market surveys
47
Statistical Methods
• Trent projection method
• Econometric methods
• Extrapolation
48
Trend Projection Method
• Trend Projection is concerned with the movement of variables through time
• This method requires a long time-series data
• The trend projection method is based on the assumption
• Factors liable for the past trends in the variables to be projected shall continue to
play their role in the future
• A long-standing firm can obtain such data from its departments (such as sales)
and the books of accounts
• new firms can obtain data from the old firms operating in the same industry
49
Econometric methods
• Regression
– Simple Linear Regression
50
Regression Analysis
• In statistical modeling, regression analysis is a statistical process for estimating

the relationships among variables
• It includes many techniques for modeling and analyzing several variables, when
the focus is on the relationship between a dependent variable and one or more
independent variables
• The investigator seeks to ascertain the causal effect of one variable upon another
— the effect of a price increase upon demand
• Regression analysis is used to estimate the strength and the direction of the
relationship between two linearly related variables: X and Y. X is the
“independent” variable and Y is the “dependent” variable
51
Simple Linear Regression
Simple linear regression is a statistical method that allows us to summarize
and study relationships between two continuous (quantitative) variables.
When there is only one predictor variable, the prediction method is called
simple regression
Example, the relationship between crop yields and rainfall

• One variable, denoted x, is regarded as the predictor, explanatory, or
independent variable
• The other variable, denoted y, is regarded as the response, outcome, or

dependent variable
• The predictions of Y when plotted as a function of X form a straight line
52
Simple Linear Regression
Example
• Linear regression consists of finding the best-fitting straight line through the points
• The vertical lines from the points to the regression line represent the errors of
prediction
• The vertical lines between the points and the black line represent errors of prediction
53
Multiple Linear Regression
• Used to estimate the relationship between a dependent variable and

two or more independent variables
• Example, the relationship between the salaries of employees and their

experience and education
54
Moving Average
• Moving average (rolling average or running average) is a calculation to

analyze data points by creating series of averages of different subsets
of the full data set
• Moving average series can be calculated for any time series
• In finance it is most often applied to stock and derivative prices,

percentage returns, yields and trading volumes
55
Moving Average
• Simple moving average
• Weighted moving average
56
Simple Moving Average
• A simple moving average (SMA) is an arithmetic moving average calculated by adding
the closing price of the security for a number of time periods and then dividing this
total by the number of time periods
• The Simple Moving Average is arguably the most popular technical analysis tool used
by traders
• The Simple Moving Average (SMA) is often used to identify trend direction, but can
be used to generate potential buy and sell signals
• Ft =
• Ft = Forecast for the coming period
• N = Number of period to be averaged
• A t-1 = Actual occurrence in the past period for up to “n” periods

57
Weighted Moving Average
• A type of moving average that assigns a higher weighting to recent
price data than does the common simple moving average
• This average is calculated by taking each of the closing prices over a

given time period and multiplying them by its certain position in the
data series
• W t = weight given to time period “t” occurrence
58
Extrapolation
• Extrapolation is a useful statistical tool used to estimate values that

go beyond a set of given data or observations
• Extrapolation is the process of finding a value outside a data set
• Forecasting will be done using historical data
• It implements the principle that recent data should be weighted

more heavily and ‘smoothes’ out cyclical fluctuations to forecast
the trend
59
Summary
• Several forecasting techniques are available, each with strengths and

weaknesses
• Understanding the various drivers of demand data helps management to

forecast future demand
• Time-series methods can be useful when past demand gives some

indication of future demand
• Regression can be effective when one or more independent variables are

linked to demand
• Analysis of forecast error is critical to effective forecast management
60

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Module Code: MBA503

Module Title: Managerial Accounting and Economics

Session 9-Introduction to Economics

• Explanation of elasticity of demand

• Methods of demand forecasting

At the end of this session, student will be able to:

• Discuss elasticity of demand

• Describe the concept of demand forecasting

• Forecast the demand

• Law of demand explains the directions of changes in demand

• The degree of responsiveness in quantity demanded to a change in

• A fall in price leads to an increase in quantity demanded and vice

• It represents the rate of change in quantity demanded due to a

1. Price Elasticity of Demand

2. Income Elasticity of Demand

3. Cross Elasticity of Demand

• Price Elasticity of demand measures the change in quantity

• It is the ratio of percentage change in quantity demanded to a

• In this case the demand curve is a horizontal straight line

• Demand curve will be vertical line

• This case demand curve will be fatter one and EP=>1

• A large change in price leads to small change in demand

• demand curve will be steeper and EP=<1

• EP= 1, the elasticity is said to be unitary

Elasticity For Price Increase For Price Decrease

│Ɛp│ > 1 Revenue decreases Revenue increases

│Ɛp│ = 1 Revenue unchanged Revenue unchanged

│Ɛp│ < 1 Revenue increases Revenue decreases

• Income elasticity of demand shows the change in quantity demanded

• Helps manager to take correct decision during business cycle

• Helps in forecasting the effect of changes in income on demand

• Zero income Elasticity: quantity demanded remain the same, even

• Negative income Elasticity: when income increases, quantity

• Positive income Elasticity: an increase in income may lad to an

• Zero income Elasticity: quantity demanded remain the same, even

• Negative income Elasticity: when income increases, quantity

• Positive income Elasticity: an increase in income may lad to an

• If the cross elasticity is positive, the commodities are said to be

• If cross elasticity is negative, the commodities are compliments

• Substitute goods have positive cross elasticity because the increase in

• For fixing the price of product which having close substitutes or

• Informs the multi-product firm to be aware of how demand for one

• Helps the managers to measure degree of competition in the

• The elasticity of supply measures the percentage change in the

• Elasticity of supply can be measured against price

• The price elasticity of supply measures the percentage change in

Quantity Change Percentage

• There is a wide variation in the price elasticity of supply, which

• Extent /variety of uses

• Amount of money spend on the commodity

• Purchase frequency of a product/time

• Business enterprise needs to know the demand for its product

• current demand should be known for determining pricing and

• Demand Estimation is the process of finding current values of demand

• Identification of independent variables

• Collection of data on the variables from past records, publications of

• Development a mathematical model or equation that indicates the

• Estimation of the parameters of the model

• An estimate of future demand for the product

• It is an objective assessment of the future course of demand

• Demand forecast relate to production inventory control, timing,

• Short term Demand forecasting:

– Setting correct sales target

– Forecasting short term financial requirements for planned production