Demand and Pricing

Theory of the Consumer

 explains how the consumer’s choices of the goods and
services under different conditions of income, prices,
government policies etc.
 Shows how a consumer attains equilibrium under the given
constraints and the effect of the changes in any of the
determinants on the equilibrium
 broadly two approaches to explain the consumer behavior
1. Cardinal approach-
2. Ordinal approach
(see microeconomics)
Demand function
 Functional relationship between the quantity demand and its
various determinants
Qd=f(own price, income of the consumer, price of related
commodities, advertisement of the product, government
policies, taste and preference, expected market situation
etc.)
 The relationship between price and quantity demand other
things remain same is represented by the demand curve and
so a change in price results into movement along the demand
curve and rest of the other factors shifts the demand curve.
Modeling Consumer Demand
 It is a process of quantifying the relationship between the quantity
demand and its relevant determinants in order to know how a
change in any of the determinants changes the quantity demand of
the product.
 It is a systematic process and the main steps it follows are
- Step I: Specify the objective of the demand modeling
-Step II: Specify the demand function with most important
determinants of the demand of the product
-Step III: Collection of relevant information/data using appropriate
methods/tools
-Step IV: Estimation of the function using appropriate statistical and
econometric methods
Demand Forecasting
 Predicting demand of the product for future based on the
available information
 Based on the appropriate techniques, demand forecasting is a
systematic way of predicting or forecasting demand of a
product due to change in any of the determinant.
 the change in the determinants of demand, changes the
quantity demand of the product and so by estimating the
appropriate model of the demand we can forecast future
demand when there is a change in the determinants.
Process/ Steps Demand Forecasting
 Step I: Specify the objectives of demand forecasting
 Step II: specify appropriate demand function with relevant
determinants
 Step III: Collection of data using appropriate methods/tools
 Step IV: Analysis of the data using appropriate statistical and
econometrics tools
 Step V: Interpretation of the results and forecasting demand
considering the change in relevant determinants or different
scenario
Role/ Importance of demand modeling/
forecasting
 To know the existing status of the demand and its
determinants of the product
 Predicting the sales of the product in future
 Design appropriate business strategies
 Planning for human resources, financial resources,
production and inventory planning
 Minimizing risk and uncertainties
 Efficient use of the scarce resources
 Diversification of the business
 Design government policy
Methods/techniques of demand forecasting
 1. Qualitative Methods:
-generally used when the quantitative information are not available
-can also be used to supplement quantitative forecast
-basically it is used to forecast the demand for a product that the firm
intends to introduce or short-term forecast
-general opinion surveys of the experts, customers, wholesellers / retailers
or sales executives
 2. Quantitative methods
- uses the quantitative information to forecast demand of the product
- -general methods are time series analysis, regression analysis, barometric
method, input-output method
3. Mixed Method: quantitative and qualitative
-
Elasticity of demand
 -proportionate or percentage change in quantity demand due to proportionate
or percentage change in any of the determinants
 1.Price elasticity of demand ( Ep):
 Ep=%change in Qd/% change in P
 Generally Ep is negative but for giffen goods Ep is positive
 If Ep=0, then the product is perfectly inelastic to price which is possible for the
most necessary products ( price increasing strategy for the firm is best choice
while for the government price regulation or price ceiling policy)
 If Ep=∞, the product is perfectly elastic to price( no pricing strategy rather
increasing quantity is better)
 If Ep<1, then, it is relatively inelastic ( price increasing strategy works better)
 If Ep>1, it is relatively elastic, so, price reducing strategy is better to the firm
 If Ep=1, it is called unitary elastic demand and in this case pricing strategy does
not work to increase revenue or profit.
Importance/ significance of Price Elasticity in
Business Decision Making
 1. helps to classify the nature of the product of the firm-
normal or giffen
 2.hepls to take appropriate pricing and production decision
e.g.
 3. helps to make government policy decision e.g. in case of
the product of perfectly inelastic in price, then price
regulation or price ceiling policy
 4.helps to make demand forecasting under different pricing
scenerio
2. Income elasticity of demand (Ei)
 Ei= % change in Qd/% change in Income
 If Ei>0, it is normal product and if Ei<0, it is inferior
 If Ei=0, it is perfectly income inelastic product which can be
a most necessary product ( e.g. salt)
 If Ei=1, it is unitary elastic
 If Ei<1, it is relatively inelastic to income
 If Ei>1, it is relatively elastic product ( luxurious product)
 If Ei= ∞, then, it is perfectly elastic to income
Importance/role of income elasticity
 1. helps to classify the product as normal ( necessary , luxurious)
or inferior
 2. helps to make appropriate production decision based on the
expected change in the income of the consumer –e.g. if Ei>1,
then, the increase in demand of the product is greater than
increased income of the consumer, so the firm should take
production decision accordingly
 3. helps to assess the impact on sales of the product due to
business cycles- e.g. during recession, the demand of the product
with Ei>0, declines while the product with Ei<0 increases
 4.helps to design appropriate government policy –e.g. if Ei>1, it
is a luxurious product and so government can tax accordingly
 5. helps for demand forecasting
Cross-Elasticity Demand (Ec)

 It is the proportionate change in quantity demand of a

commodity due to change in price of other related product.
 i.e. Ec= % change in Qd of X/% change in pricy of Y
 It measures the effect of changes in price of a commodity to
the quantity demand of others
 If Ec>0, then the two products are substitutes
 If Ec<0, then, they are complements
 For e.g. if Ec= -1, it means, both products are complements,
then, if the the price of the related product increases by 1%,
then, demand of the other will fall by the same 1%.
Importance of cross elasticity of demand
 1. it helps to identify the nature or relationship of the products
such as substitutes or complementary or independent ( if Ec=0)
 2. it helps the management for effective pricing and output
decision e.g. if Ec>0, then the other related product is substitute
and so the firm should either reduce price or reduce quantity if
the price of the substitute commodity reduces.
 3. it also helps the government for appropriate policy making for
e.g. if the government wants to discourage the vehicles based on
petroleum products and encourages electric vehicles, then, the
government can increases the custom for petroleum based vehicle
making them more expensive.
Advertisement elasticity of demand ( Ea)
 It shows how the sales or demand of the product changes due
to the changes in advertisement expenditures.
 It is the proportionate change in quantity demand of the
product due to proportionate changes in its own
advertisement expenditure
 i.e. Ea= % change in Qd/% change in Adv. Exp
 Generally, Ea>0 implying the positive impact of the Ad. for
sales
Importance of Advertisement Elasticity
 It helps to assess the effectiveness of advertisement
expenditure on sales. For e.g. if Ea<o, then advertisement is
harmful for sales or demand. Similarly, if Ea<1, then,
increase in sales is less than the increase in advertisement
exp.
 It helps to use the appropriate or most effective
media/channel/ market of advertisement based on the
coefficient of the elasticity. For e.g. if Ea for print media is
1.1, Ea for online media is 1.15, then, advertisement on
online media is more effective
Consumption Decisions in the short
run and long run
 The short-run consumption decisions are inelastic or less elastic
because in the short run the determinants of the consumption /
demand are more or less fixed or given. For e.g. the taste and
preferences, income, availability of other products etc. are not
changed immediately. So, the short run consumption decisions are
not changed easily.
 It means the short run demand curve is steeper or less elastic.
 But in the long run, the more choices are available, taste and
preferences are also changed, income and other factors affecting
consumption or demand are changing
 This makes the long run consumption decisions more sensitive or
more elastic.
 So the long-run demand curve is flatter or more elastic than the
short-run