LESSON 4

DEMAND THEORY
4.1 Introduction

1.2 Objectives
The lesson identifies and analyzes the forces that determine the demand for a firm’s product.
The concept of elasticity is introduced as a tool for measuring the responsiveness of quantity
demanded to changes in forces that determine demand.

4.2 Expected Learning Outcomes

By the end of the lesson the learners should be able:-

1. To define and identify the factors determining demand function
2. To explain the concept elasticity of demand
3. To identify and explain different types of elasticities

4.3 Market Demand

The demand for a good or service arises from the consumers’ willingness and ability to purchase
the commodity. The market demand for a good or service is the sum of all individual demands.
The first two panels of figure 4.1 represent the demand curves for two consumers.

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Price

15 15 15

10 10 10

D2 DT
D1
0 4 5 0 2 8 0 6 13

Quantity Quantity Quantity

Per Per period Per period
period
Individual 1 Individual 2 Total\Market Demand
Figure 4.1 The Market Demand Curve

At a price of 10, the individual quantities demanded are 5 and 8 units, respectively. Hence the total
market demand at the price of 10 (as shown in the third panel) is 13 units. Graphically, the market
demand curve is the horizontal summation of individual demand curves.

4.4 Determinants of Market Demand

Demand curve shows the relationship between price and the quantity demanded of a good or
service. The effect of changes in price is depicted as movement from one point to another along a
particular demand curve. Movements along the demand curve in response to changes in the price
of a good or service are referred to as changes in quantity demanded.
In plotting a demand curve, it is assumed that other factors which affect demand are held constant.
When these factors are allowed to vary, the demand curve may shift. Such shifts are referred to as
changes in demand. A shift to the right is called an increase in demand, while a leftward shift
indicates a decrease in demand.
Among the most important factors that determine market demand includes:
Price: There is an inverse relationship between the quantity demanded and the price of the good
Income: Demand is affected by the amount of income that consumers have available to spend. For
most goods, an increase in consumer income would cause the demand curve for the product to
shift to the right.
Price of Other Goods: The demand for a good is often influenced by changes in the prices of
other goods. The nature of the impact depends on whether the goods are substitutes or
complements. Substitutes are goods that have essentially the same use. A rise in the price of a
good is likely to lead to an increase in the demand for its substitutes. For example, an increase in
the price of chicken would cause people to purchase less of it and consume more beef. Thus, the
demand curve for beef would shift to the right from DD to D’D’ as shown in figure 4.2a
Goods that are often used together are called complements. An increase in the price of one such
good will cause the demand for its complement to decrease (e.g., fuel and motor vehicle). A rise
in the price of fuel would lead to a fall in demand of motor vehicles (holding other factors constant)
as can be shown in figure 4.2b by a leftward shift of the demand curve from DD TO D’D’.

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 Price of Chicken rises Price of Fuel price rises
Price of
Beef D’ Vehicle D

D
D’

D’
D
D D’
0 0 Quantity of
Quantity of Beef vehicles per period
per period
(a) Substitutes (b) Complements
Figure 4.2 Demand Curves and Prices of Substitute andComplements.
Consumer Preferences: Preferences of consumers can change rapidly in response to advertising,
fashion, and customs. If consumers show an increasing preference for a product, the demand curve
shifts to the right; that is, at each price, consumers want to buy more than they did previously.
Size of the Population in the Relevant Market: The position of a good’s market demand curve
is also affected by the population in the relevant market. If the population increases, one would
expect that, if all other factors were held equal, the quantity of goods demanded would increase.
Population generally changes slowly so this factor often has little effect in the very short run.
The Advertisement Expenditure (A)
Advertisement helps in increasing demand for the product in at least four ways:
By informing the potential consumers about the availability of the product;
By showing its superiority to the rival product;
By influencing consumers’ choice against the rival products; and
By setting fashions and changing tastes.
Other factors remaining the same, as expenditure on advertisement increase, volume of sale
increases to an extent as can be shown in figure 4.3.

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 Volume of sales
Sales curve

0
Advertisement Expenditure (Ksh)

Figure 4.3: Advertisement and Sale

The relationship between demand and advertisement cost shown in figure 4.3 is based on the
following assumptions.
Consumers are fairly sensitive and responsive to various modes of advertisement.
The rival firms do not react to the advertisements made by a firm.
The level of demand has not already reached the saturation point. Advertisement beyond this point
will make only marginal impact on demand.
Per unit cost of advertisement added to the price does not make the price prohibitive for consumers,
compared particularly to the price of substitutes.
Other determinants of demand, e.g., income and tastes, etc. are not operating in the reverse
direction.
In the absence of these conditions, the advertisement effect on sales may be unpredictable.
Consumer-Credit Facility
Availability of credit to the consumers from the sellers, banks or from any other source encourages
the consumers to buy more than what they would buy in the absence of credit availability. Credit
facility affects mostly the demand for durable goods, particularly those which require bulk
payment at the time of purchase.

4.5 The Market Demand Equation

Building on the results of the previous section, we can define the market demand function for a
product, which is the relationship between the quantity demanded of the product and the various
factors that influence this quantity.
QD  f ( P, Y , Po , N , T , A, C )...................................................(4.1)
where QD equals the quantity of the commodity demanded in the market per time period, P is the
price of the commodity in question, Y is consumers’ incomes, P o is the price of related (i.e.,
substitute and complementary) commodities, N is the number of consumers in the market, T is a
measure of consumer tastes and preferences, A is the advertising expenditure and C is the credit
facility.
A linear form demand equation is given as

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QD  a1  a p P  a y Y  a o Po  at T  aA  acC...................................(4.2)
The coefficients ap, ay, ao, and at indicate the impact on quantity demanded of 1-unit changes in
associated variables. The interpretation of the price coefficient a p is that, holding the other three
variables constant, quantity demanded changes by a p units for each 1-unit change in price.
Economic theory predicts that
dQd
 a p  0 (i.e., it is negative)
dP
For example, if ap = -2 and price is measured in dollars, a 1 increase in price would be associated
with a 2-unit decrease in quantity demanded, holding all other factors constant.
dQd
 ay  0
dY
A 1 increase in consumers’ income would be associated with ay-unit increase in quantity
demanded, holding all other factors constant.
dQd
 ao  0
dPo
This is the case if the other commodity is a substitute. A 1 increase in price of other related goods
would lead to increase in demand of the commodity under investigation by a o, holding other factors
constant.
If instead, the other commodity is a complementary good,
dQd
 ao  0
dPo
This implies that a rise in the price of other related commodity by 1 would lead to a fall in demand
of the commodity under consideration by ao, holding all other factors constant.

The Demand Faced by a Firm

Since the analysis of the firm is central to managerial economics, we are primarily interested in
the demand for a commodity faced by a firm.
Where a firm is the only seller in a market (monopoly), the demand curve facing that firm is the
market demand curve. As such, the firm will bear the entire impact of changes in incomes,
consumer preferences, and prices of other goods.
At the opposite extreme is the form of market organization called perfect competition. Here, there
are a large number of firms producing identical product, and each firm is too small to affect the
price of the commodity by its own actions. In such a case, each firm is a price taker and faces a
horizontal demand curve for the commodity.
The two extremes are rare in the real world. A vast majority of firms fall under oligopoly or
monopolistic competition. Under Oligopoly, there are only a few firms in the industry producing
either homogeneous or standardized product (e.g., cement, steel, and chemicals) or differentiated
product (e.g., automobiles, cigarettes, and soft drinks). The implication of this is that the pricing,
advertising, and other promotional behavior of each firm greatly affect the other firms in the
industry and evoke imitation and retaliation.
The other very common form of market organization is monopolistic competition, which is
characterized by having many firms producing products that are close substitutes. As a result, the
degree of control that a firm has over the price of the product it sells is very limited. That is, each

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firm faces a demand curve which, though negatively sloped, is fairly flat, so that any increase in
price would lead to a very large decline in sales.
When considering the demand functions of other firms apart from perfect competition, other more
specific factors that may affect the firm’s demand in a particular industry are considered. They
include price expectations, the level of advertising and other promotional efforts on the part of the
firm, the pricing and promotional policies of other firms in the industry (especially in oligopoly),
availability of credit, the type of good that the firm sells, and so on.
The demand curve for a product faced by a firm will shift to the right (so that the firm’s sales
increase at a given price) if consumers expect prices to rise in the future, if the firm mounts a
successful advertising campaign of their own, or if the firm introduces or increases credit
incentives to stimulate the purchase of its product.

4.6 Elasticity of Demand

4.6.1 Price Elasticity of Demand
The price elasticity of demand measures the responsiveness of quantity demanded of a commodity
to a change in its price. In other words, it is the percentage change in quantity demanded resulting
from a one percent change in the price of the commodity.
%Q
Ep  .....................................................................................4.3
%P
For example, suppose that a firm increases the price of its product by 2% and quantity demanded
subsequently decreases by 3%. The price elasticity would be
 3%
Ep   1.5................................................................................4.4
2%
Ep is negative because of the law of demand, which states that price and quantity demanded are
inversely related. Thus, when the price change is positive, the change in quantity demanded is
negative, and vice versa.
The price elasticity of demand for a product must lie between zero and negative infinity. If the
price elasticity is zero, the demand curve is a vertical line; that is, quantity demanded is unaffected
by price. If the price elasticity is negative infinity, the demand curve is a horizontal line; that is, an
unlimited amount can be sold at a particular price, but nothing can be sold if the price is raised
even slightly.

Price
Demand curve,
price elasticity=0

Demand curve,
15 Price elasticity = -∞
_

0
Quantity (Q)
Figure 4.4 Demand Curves with Zero and Infinity Price Elasticities of demand

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These are two approaches to computing price elasticities. Arc elasticities are appropriate for
analyzing the impact of discrete (i.e., measurable) changes in price. The point elasticities can be
used to evaluate the effect of small price changes.

4.6.2 Point Price Elasticity

The point price elasticity of demand or the elasticity at a given point on the demand curve is given
by the following formula.
%Q Q / Q Q P
Ep    . .........................................................................4.5
%P P / P P Q
where ΔQ/ΔP is the inverse of the slope of the demand curve, and it is negative because quantity
and price move in the opposite directions. In the example presented in figure 4.5 observe that
ΔQ/ΔP = - 10/1 at every point on the demand curve (since the demand curve is linear). In the point
elasticity formula only the price-quantity ratio changes along the demand curve. As can be seen in
the figure, the point price elasticity of demand is different at different points on the demand curve.
For example, at point C,
Q P  10 $4
Ep  .  .  2...........................................................................4.6
P Q $1 20
At point E,
Q P  10 $2
Ep  .  .  0.5.....................................................................................4.7
P Q $1 40

Px

6 A (EP= -∞)
_
(EP=-5)
5 B
C (EP=-2)
4
(EP=-1)
3 D

2 E (EP=-0.5)
F (EP=-0.2)
1
(EP=0)
G
0 10 20 30 40 50 60 Qx
Figure 4.5 The point Price Elasticity of Demand
For a linear demand curve, such as the one in figure 4.5, the price elasticity of demand has an
absolute value (that is |E p|) that is greater than 1 above the geometric midpoint of the demand
curve. That is, the range AD is called the elastic range. A 1% change in price of the commodity
leads to more than proportionate change in quantity demanded. In other words, quantity demand
is highly sensitive to changes in prices.

At the geometric mid point (point D), |E p|=1. A 1% change in price of the commodity leads to
identical percentage change in quantity demanded.

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Below the geometric mid point of the demand curve, |E p| is less than 1. The range DG is called the
inelastic range. A 1% change in price of the commodity leads to less than proportionate change in
quantity demanded. Quantity demanded is less sensitive to changes in prices.
Note that given an estimated equation such as 4.3 above, the value of ΔQ/ΔP is given by a 1 (the
estimated coefficient of Px). Therefore, the formula for point price elasticity of demand can be
rewritten as
P
E p  a1 . .......................................................................4.8
Q
where a1 is the estimated coefficient of P in the linear regression of Q on P and other explanatory
variables.
4.6.3 Arc Price Elasticity of Demand
If the changes in price and quantity are large, the point price elasticity may vary considerably
depending on which value of P and Q is used in the elasticity equation. Note also that different
elasticity values would be obtained depending on whether the price rose or fell. For example, using
the point price elasticity formula to measure arc elasticity for a movement from point C to point F
(i.e., a price decline) on demand curve in figure 4.5, we would obtain
Q P  50  20  4
Ep  .  .  2..............................................................4.9
P Q  1  4  20
On the other hand, arc elasticity of a price rise within the same price range (from point F to point
C) equals,
Q p  20  50  1
Ep  .  .  0.5..............................................................4.10
P Q  4  1  20
To avoid this, we use average values for price and quantity in the calculations. Thus arc price
elasticity is defined as
Q ( P2  P1 ) / 2 Q2  Q1 P2  P1
Ep  .  . ......................................................4.11
P (Q2  Q1 ) / 2 P2  P1 Q2  Q1
where the subscripts 1 and 2 refer to the original and to the new values, respectively, of price and
quantity.
Therefore, arc price elasticity for movement from point C to point F equals,
Q  Q1 P2  P1  50  20   1  4 
Ep  2 .  .   0.714.....................................4.12
P2  P1 Q2  Q1  1  4   50  20 
The same result is obtained for the reverse movement from point F to point C:
Q  Q1 P2  P1  20  50   1  4 
Ep  2 .  .   0.714......................................4.13
P2  P1 Q2  Q1  4  1   50  20 
This means that between points C and F on the demand curve in figure 4.5, a 1 percent change in
price results, on the average, in a -0.714 percent opposite change in the quantity demanded of
commodity x.

4.6.4 Cross-Price Elasticity of Demand

Demand for a commodity also depends on the price of related (i.e., substitute and complementary)
commodities. The responsiveness of quantity demanded to changes in prices of other goods is
measured by cross elasticity.

48
Cross elasticity of demand is the percentage change in quantity demanded of one good caused by
a 1 percent change in the price of some other good. Point cross-price elasticity of demand is given
by
%Q X Q X / Q X
E XO  
%Po Po / Po
Q X Po
 . .........................................................................................4.14
Po Q X
where ΔQX and ΔPo refer, respectively, to the change in the quantity of commodity X and the
change in the price of other commodity, Po. Given
Q x  a o  a1 Px  a 2 N  a3Y  a 4 Po  a5T  a 6 A  a 7 C  .....................................4.15
The value of ΔQ/ΔPo is computed by taking the derivative of Qx with respect to Po, which equals
a4. Therefore, the formula for the point price elasticity of demand can be rewritten as
P
E XO  a 4 o ..........................................................................................................4.16
QX
For large changes in the prices of other good (P o), arc cross elasticities are appropriate. The arc
elasticity is computed as
Q X ( PO2  Po1 ) / 2 Q X 2  Q X 1 ( PO2  Po1 )
E XO     ...............................................4.17
Po (Q X 2  Q X 1 ) / 2 PO2  Po1 (Q X 2  Q X 1 )
where the subscripts 1 and 2 refer to the original and to the new levels of income and quantity,
respectively.
Substitutes and Complements
If the value of EXO is positive (i.e., EXO> 0), commodity X and Y are substitutes because an increase
in Po leads to an increase in QX as X is substituted for O in consumption. Example of substitute
commodities includes coffee and tea, beef and chicken.
When EXO is negative (i.e., EXO < 0), commodity X and O are complementary because and increase
in Po leads to a reduction in Qoand QX. Example of complementary commodities includes cars and
fuel.
Finally, if E XO is close to zero, X and Y are independent commodities. This may be the case with
books and beer, pencils and potatoes, and so on.
Cross Elasticity and Decision Making
Firms often use the concept of cross-price elasticity of demand to measure the effect of changing
the price of a product they sell on the demand of other related products that the firm also sells. For
example, a manufacturer of both razors and razor blades can use the cross-price elasticity of
demand to measure the increase in the demand for razor blades that would result if the firm reduced
the price of razors.

4.7 Relationship between Price Elasticity, Total Revenue, and Marginal

Revenue
There exists an important relationship between the price elasticity of demand and the firm’s total
revenue and marginal revenue.
TR  P.Q
dTR d ( P.Q)
MR   ...........................................................................4.18
dQ dQ

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Using the rule for differentiating a product (given in lecture 2)1,
dQ dP
MR  P Q .................................................................................4.19
dQ dQ
Because dQ/dQ = 1,
dP
MR  P  Q
dQ
  Q  dP 
 P 1    
  P  dQ 
dQ P
The formula of price elasticity of demand is E p  . , which implies that
dP Q
(Q/P)(dP/dQ) = 1/Ep. Therefore,
 1 
MR  P 1  
 E p 
The equation shows that
If Ep<-1 (the elastic range, -∞ <Ep< -1), marginal revenue must be positive.
For example, at point B of figure 4.5, Ep=-5, which implies that
 1
MR  P 1   P1  0.2  0.8 P
  5 
Every additional increase in output within the elastic range leads to increases in total revenue since
marginal revenue is positive.
If Ep>-1 (the inelastic Range, -1 <Ep< 0), marginal revenue must be negative.
For example, at point E of figure 5.4, E p=-0.5, which implies that
 1 
MR  P 1   P[1  2]  1P
  0.5 
Every additional increase in output within the inelastic range results to a decrease in total revenue
since marginal is negative.
If Ep=-1 (unitary elastic), marginal revenue must be zero.
 1
MR  P 1    P[1  1]  0 P  0
  1
An additional increase in output results to no increase in total revenue since marginal revenue
is zero. In other words, total revenue is maximum when Ep=1.
The relationship between the price elasticity of demand and the total revenue and marginal
revenues of the firm is shown graphically in figure 4.6.

1
Recall that given Y=U.V, where U=f(X) and V=g(X), then product rule of differentiation states that
dY dV dU
U V
dX dX dX

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 P Ep=-∞
A _
B Ep=-5
C Ep=-2
D Ep=-1 Demand Curve
E Ep=-0.5

G Ep=0
0 Q
MR
TR

TR1

TR2
TR curve

Q
0
Figure 4.6: Relationship between Price Elasticity, Marginal Revenue, and Total Revenue

Information about price elasticities can be extremely useful to managers as they contemplate
pricing decisions. As can be seen in figure 4.6, if demand is elastic at the current price (say at point
B), a price decrease (say to point C) will result in an increase in total revenue since marginal
revenue is positive within the elastic range (i.e., from A up to D). Alternatively, if demand is
inelastic at the current price (say at point E), a price decrease (say towards point G) would cause
total revenue to decrease since marginal revenue is negative within the inelastic range (i.e., beyond
point D to point G). At point D, demand is unitary price elastic, TR is maximum, and MR = 0.

4.8 Price Elasticity and Pricing Policy

We know that marginal revenue equals marginal cost (MC) if a firm is maximizing profit, which
means that
 1 
MR  P 1    MC
 E p 
Solving for P, we obtain
 
 Ep   1 
P  MC   or P  MC 
1  E p  1  1 
 E 
 p 

What the equation says is that the optimal price of a product depends on its marginal cost and its
price elasticity of demand. Suppose that marginal cost of a particular commodity is $15 and its
price elasticity of demand equals -2. Then, the firm’s optimal price is

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  
 1 
P  15   30
1  1 
 2 
Holding the marginal cost constant and varying the price elasticity of demand (E p), we observe
that a product’s optimal price is inversely related to its price elasticity of demand. Therefore, if the
product’s price elasticity of demand were
-5 rather than -2, its optimal price would be
 
 1 
P  15   18.75
1  1 
 5 

4.9 Determinants of Price Elasticity of Demand

Availability of Substitutes: Products for which there are close substitutes tend to have higher price
elasticities than products for which there are fewer adequate substitutes. For example, the demand
for sugar is more price elastic than the demand for table salt because sugar has better and more
substitutes (e.g. honey) than salt. Thus, a given percentage increase in the price of sugar and salt
elicits a larger percentage reduction per time period in the quantity demanded of sugar than salt.
Proportion of Income Spent: Demand tends to be inelastic for goods and services that account for
only a small proportion of total expenditures. For example, a 1-kilogram container of salt will meet
the needs of the typical household for months and costs only a few shillings. If the price of salt
were to double, this change would not have a significant impact on the household purchasing
power, and hence, on its demand for salt.
Time Period: Demand is usually more elastic in the long run than in the short run. The explanation
is that given more time, the consumer has more opportunities to adjust to changes in prices. For
example, in the short run, the price elasticity of demand for fuel may be low because people have
few options. But over a longer period, the price elasticity of demand for fuel may be much greater
than in the short run as people replace their high fuel consuming vehicles with fuel efficient,
compact vehicles, switch to car pools and to public transportation, and take other steps to reduce
fuel consumption.

4.10 The Income Elasticity of Demand

When other factors are held constant, the income elasticity of a good or service is the percentage
change in demand associated with a 1 percent change in income. As with price elasticity, we have
point and arc income elasticity.
Point income elasticity of demand is given by
%Q Q / Q
EY  
%Y Y / Y
Q Y
 .
Y Q
where ΔQ and ΔY refer, respectively, to the change in quantity and the change in income.
Given
Q x  a o  a1 Px  a 2 N  a3Y  a 4 Po  a5T  a 6 A  a 7 C  ... ...................................4.20

52
The value of ΔQ/ΔY is computed by taking the derivative of Qx with respect to Y, which equals
a3. Therefore, the formula for the point price elasticity of demand can be rewritten as
Y
EY  a 3
Q
Arc Income Elasticity
Q (Y2  Y1 ) / 2 Q2  Q1 Y2  Y1
EY    
Y (Q2  Q1 ) / 2 Y2  Y1 Q2  Q1
where the subscripts 1 and 2 refer to the original and to the new levels of income and quantity,
respectively. Thus, arc income elasticity of demand measures the average relative responsiveness
in the demand of the commodity for a change in income in the range between Y1 and Y2.

4.11 Inferior Goods, Necessities, and Luxuries

Income elasticities can be either negative or positive. When they are negative, the interpretation is
that increases in income are associated with decreases in the quantity demanded of the good or
service. Goods that behave this way are called inferior goods. These are inexpensive goods (e.g.,
staple food like milk), which consumers consume when they are on a shoe-string budget, but when
their income improves they abandon the commodity and switch to other better commodities (e.g.
steak, spaghetti etc).
Normal goods and services have positive income elasticities. Examples of normal goods include
food, clothing, housing, jewelry, education, and recreation, just to mention but a few. For the first
three (necessities), EY is positive but low (i.e., 0 < EY ≤1). That is, demand is relatively unaffected
by changes in income. For the last three classes of goods (luxuries), E Y is likely to be well above
1. This means that the change in demand is more than proportionate to change in income. As
individuals become wealthier, expenditures on luxury goods represent a larger share of their
income.
For a giffen good the quantity demanded is grater when the price is higher. It is a good considered
essential by a section of consumers. For example alcoholic drink. As its price increases, the
consumers have to spend a greater portion of their income to maintain the same level of
consumption.
4.12 Income Elasticity and Decision Making
Income elasticity for a firm’s product is an important determinant of the firm’s success during
fluctuations in economic activity. During boom periods, when incomes are rising, firms selling
luxury items will find that the demand for their product will increase at a rate faster than the rate
of income growth. However, the demand for a luxury item may decrease rapidly during a recession.
In the case of necessities, demand is likely to reduce less rapidly in recession period, while it may
increase by less than proportionate increase in income during boom periods.
Knowledge of income elasticity can be useful in targeting marketing efforts. For example, in order
to increase sales of luxury items, a firm should concentrate its sales efforts on media that reach the
wealthier segment of the population.

Advertisement or Promotional Elasticity of Sales

The expenditure on advertisement and on other sales-promotion activities do help in promoting
sales, but not in the same degree at all levels of the total sales. The concept of advertisement
elasticity is useful in determining the optimum level of advertisement expenditure.
Point advertisement elasticity (E A) of sales may be defined as

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 %Q Q / Q
EA  
%A A / A
Q A
 .
A Q
The value of ΔQ/ΔA is computed by taking the derivative of Q x with respect to A, which equals
a6. Therefore, the formula for the point advertisement elasticity of demand or sales can be rewritten
as
A
E A  a6 ....................................................................................4.21
QX
Interpretation of advertisement-elasticity: The advertisement elasticity of sales varies between
EA = 0 and EA = ∞.
Elasticities Interpretation
EA = 0 Sales do not respond to the advertisement expenditure.
0 < EA< 1 Increase in total sales is less than proportionate to the increase in advertisement
expenditure.
EA> 1 Sales increase at higher rate than the rate of increase of advertisement
expenditure.

4.13 Determinants of Advertisement Elasticity

The following factors determine the advertisement elasticity.
Level of the total sales. In the initial stages of sales of a product, particularly of one which is
newly introduced in the market, the advertisement elasticity is greater than unity. As sales increase,
the elasticity decreases.
Advertisement by rival firm. In a highly competitive market, the effectiveness of advertisement
is determined also by the relative effectiveness of advertisement by the competing firms.
Cumulative effect of past advertisement. In case expenditure incurred on advertisement in the
initial stages is not adequate enough to be effective, elasticity may be very low. But over time,
additional doses of advertisement expenditure may have cumulative effect on the promotion of
sales and advertising elasticity may increase considerably.
Advertising elasticity is also affected by other factors affecting demand for product, e.g., change
in products’ price, consumers’ income, growth of substitute and their prices.

4.14 Summary
 Demand curve is downward sloping
 Some of the factors that affect the demand of a commodity or a service include; price,
income, taste and preferences, advertisement, price of the related commodity
 Elasticity is the measure of the responsiveness of the dement to the change in any of the
factors that affect demand
 Elasticity is very useful in the decision making of the firm

4.15 Activities

Suppose that a coffee producing firm estimated54 the following regression of the demand for its
brand of coffee:
Qc  1.5  3.0 Pc  0.8Y  2.0 Pb  0.6 PS  1.2 A
where Qc = sales of coffee brand C, in dollars per pound
 LESSON 5
DEMAND ESTIMATION

5.1 Introduction

1.2 Objectives
Estimation and forecasting of future demand is essential for planning and scheduling
production, purchase of raw materials, acquisition of finance and advertising. It is much
more important where a large-scale production is being planned and production
involves a long gestation period.
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5.2 Expected Learner Outcomes

By the end of the lesson the learners should be able:-

1. To identify and explain various techniques of demand estimation
2. To explain consumer clinics and market experiments as methods of
information collection.
3. To explain the steps involved in demand estimation by regression
analysis.

5.3 Techniques of Demand Estimation

There are two methods of estimating demand of a product or a service ie demand estimation using
market research technique and statistical (regression) method.
Marketing Research Technique
This method is generally used to estimate short-term demand. Under this method, surveys are
conducted to collect information about consumers’ intentions and their future purchase-plans. This
method includes:
The Direct Interview Method
Potential consumers get interviewed either orally or by use of questionnaires. They are asked how
they would respond to particular changes in the price of the commodity, incomes, the price of
related commodities, advertising expenditures, credit incentives, and other determinants of
demand over a given period, say one year.
Direct interview may cover almost all potential consumers (complete enumeration method) or only
selected groups of consumers from different cities (sample survey method). Under this method,
only a few potential consumers and users selected from the relevant market through a sampling
method are surveyed. On the basis of the information obtained, the probable demand may be
estimated through the following formula:
H
DP  R ( H . AD )
HS
where DP = probable demand forecast
H = census number of households from the relevant market
HS = number of households surveyed or sample households
HR = number of households reporting demand for the product
AD = average expected consumption by the reporting households (= total quantity reported to be
consumed by the reporting households ÷ number of households).
This method is simpler, less costly, and less time-consuming than the comprehensive survey
method.
The method, however, has some limitations similar to those of complete enumerations or
exhaustive survey method.

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Expert-Opinion Method
Firms having a good network of sales representatives can ask them to assess the demand for the
product in the areas, regions, and cities they represent.
Since they are in close touch with the consumers of goods, they are supposed to know the future
plans of their customers, their reaction to the market changes, and to the introduction of a new
product and the demand for competing products.
The estimates of demand thus obtained from different regions are added up together to get the
overall probable demand for a product.
Firms that do not have sales representatives may gather similar information about demand for their
products through the professional market experts or consultants, who can, through their experience
and expertise, predict the future demand.

5.4 Consumer Clinics and Market Experiments

Another alternative method of collecting necessary information regarding demand is to carry out
consumer clinics and market experiments in consumer’s behavior under actual, though controlled,
market conditions.
Consumer Clinics or Controlled Laboratory Experiment
Under this method, consumers are given a sum of money and asked to spend it in a simulated store
to see how they react to changes in the commodity price, product packaging, displays, price of
competing products, and other factors affecting demand.
Participants in the experiment can be selected so as to closely represent the socioeconomic
characteristics of the market of interest.
Participants have an incentive to purchase the commodities they want the most because they are
usually allowed to keep the goods purchased. Thus, consumer clinics are more realistic than
consumer surveys.

Market Experiments
Unlike consumer clinics, which are conducted under strict laboratory conditions, market
experiments are conducted in the actual market place.
Under this method, firms first select several markets with similar socioeconomic characteristics,
in terms of population, income levels, cultural and social background, occupational distribution,
choices and preference.
Then, they carry out market experiments by changing the commodity price, packaging,
advertisement expenditure, and other controllable variables in the demand function under the
assumption that other things remain the same. The controlled variables may be changed over time
either simultaneously in all the markets or in the selected markets.
After such changes are introduced in the market, the consequent changes in the demand over a
period of time (a week, a fortnight, or a month) are recorded.
On the basis of data collected, elasticity coefficients are computed. These coefficients are then
used along with the variables of demand function to assess the demand for the product.
By using census data or surveys for various markets, a firm can also determine the effect of age,
sex, level of education, income, family size, etc., on the demand for the commodity.
The advantage of market experiments is that they can be conducted on a large scale to ensure the
validity of the results and consumers are not aware that they are part of an experiment.

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5.5 Demand Estimation by Regression Analysis
Regression analysis is the most common method of estimating demand in managerial economics.
This method combines economic theory and statistical techniques of estimation. Economic theory
is employed to specify the determinants of demand and to determine the nature of relationship
between the demand for a product and its determinants. Economic theory thus helps in determining
the general form of demand function. Statistical techniques are employed to estimate the values of
parameters in the equation estimated.

The following is a summary of the steps to be taken when estimating demand by regression
analysis.

Step 1: Model Specification

The first step in multiple regression analysis is to specify the variables that are supposed to explain
the variation in the demand for the product under study. These will usually include the price of the
commodity (P X), consumers’ income (Y), the number of consumers in the market (N), the price of
related (i.e., substitute and complementary) commodities (P o), consumers’ tastes and preferences
(T), and all the other variables such as the level of advertising (A), the availability and level of
credit incentives (C), and consumers’ price expectations, that are thought to be important
determinants of the demand for the particular commodity under study.
It is important to note the following:
The demand function for expensive durable goods, such as automobiles and houses, which are
usually purchased by borrowing money, must include credit terms or interest rates among the
explanatory variables.
Demand function for seasonal products such as cold beverages, umbrellas, and air conditioners
will have to include weather conditions.
For estimating demand for capital goods (e.g., machinery and equipments), the relevant variables
are rates of profit, additional corporate investment, rate of depreciation, cost of capital goods, cost
of other inputs (e.g., labor and raw materials), market rate of interest, etc.

Thus, we can specify the following general function of the demand for the commodity (Q X),
measured in physical units, where the dots at the end of equation 7.4 refer to the other determinants
of demand that are specific to the particular firm and commodity:
Q X  f ( PX ,Y , N , P0 , T ,...) (5.1)
Step 2: Collecting Data on the Variables
Data can be collected for each variable over time (i.e., yearly, quarterly, monthly, etc.) or for
different economic units (individuals, households, etc.). The former is called time-series data,
while the latter is called cross-sectional data.
The type of data actually utilized in demand estimation is often dictated by availability. Proxy for
some variables for which data are not available could be used. For example, a proxy for consumers’
price expectations in each period might be the actual price changes from the previous period. Since
it is usually very difficult to find reliable quantitative measures of tastes, a researcher may have to
make sure (possibly by consumer surveys) that they have not changed during the period of the
analysis, so that tastes can be dropped as an explicit explanatory variable from the actual estimation
of the demand equation.

Step 3: Specifying the Form of the Demand Equation

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The reliability of the demand forecast depends to a large extent on the functional form of equation
and the degree of consistency of the explanatory variables in the estimated demand function.
Some common forms of multi-variate demand functions include are given below.
Linear Function
Where the relationship between demand and its determinants is given by a straight line, the most
common form of equation for estimating demand is:
Q X  a o  a1 PX  a 2Y  a 3 Po  a 4 A  ...  e (5.2)
The a’s are the parameters (coefficients) to be estimated, and e is the error term. In such a linear
model, the estimated parameters are constant regardless of the level of the particular variable or
other variables included in the demand equation. This leads to easy interpretation of the estimated
coefficients of the regression.

Power Function
By plotting on a scatter diagram the dependent variable against each of the independent variables,
we might observe that relationship between these variables is nonlinear. The most common
nonlinear specification of the demand equation is the power function.
Q X  a o PXa1 Y a2 Poa3 A a4 (5.3)
In order to estimate the parameters (i.e., coefficients a o… a4) of demand equation 5.3, we must
first transform it into a log-linear from, and then run the regression on the log of the variables.
ln Q X  ln a 0  a1 ln PX  a 2 ln Y  a 3 ln Po  a 4 ln A (5.4)
The estimated slope coefficients (i.e., a1, a2, a3 and a4) in equation 5.4 represent elasticities.
Specifically, a1 is the price elasticity of demand (EP), a2 is the income elasticity of demand (Ey), a3
is the cross-price elasticity (EXO), and a4 is the advertisement elasticity of demand (E A)

Step 4: Estimate the Parameters in the Chosen Equation

The multivariate equation is finally estimated using the ordinary least square method.

5.6 Summary
 Demand estimation is the process of determining the future level of demand of a good
 Marketing survey is a method of demand estimation by interviewing the consumers
 Regression is a statistical method of demand forecasting
 Various stages are involved during this estimation

5.7 Activities

1. Explain the limitations of direct interview method

2. Briefly explain the various steps involved in estimating demand by regression analysis.
3. Clearly distinguish between consumer clinic and market experiments

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