Unit- II

Elasticity of Demand and

Demand Forecasting and Its
Application
Presented by
Dr. Chintamani Prasad Patnaik
Associate Professor, MBA
Department, AITAM

.
Elasticity – The concept
 The responsiveness of one variable to
changes in another
 When price rises what happens to
demand?
 Demand falls
 BUT!
 How much does demand fall?

.
Elasticity – The concept
 If price rises by 10% - what happens to
demand?
 We know demand will fall
 By more than 10%?
 By less than 10%?
 Elasticity measures the extent to which
demand will change

.
 Elasticity . . .

… is a measure of how much buyers and

sellers respond to changes in market
conditions

… allows us to analyze supply and

demand with greater precision.

.
Types of Elasticity of Demand

1. Price Elasticity of Demand

2. Income Elasticity of Demand
3. Cross Elasticity of Demand
4. Advertisement and Promotion Elasticity
of Demand

.
 Price Elasticity of Demand

 Price elasticity of demand is the

percentage change in quantity demanded
given a percent change in the price.

 It is a measure of how much the quantity

demanded of a good responds to a change
in the price of that good.

.
Factors Affecting Price Elasticity Of
Demand
 Nature of the Commodity
 Availability of Substitutes
 Variety of uses of commodity
 Postponement
 Influence of habits
 Proportion of Income spent on a commodity
 Range of prices

.
Factors Affecting Price Elasticity Of
Demand

 Income Groups
 Elements of time
 Pattern of income distribution

.
 Determinants of
Price Elasticity of Demand

 Necessities versus Luxuries

 Availability of Close Substitutes
 Definition of the Market
 Time Horizon

.
 Determinants of
Price Elasticity of Demand
Demand tends to be more elastic :
 ifthe good is a luxury.
 the longer the time period.
 the larger the number of close
substitutes.
 the more narrowly defined the market.

.
 Determinants of Price Elasticity of Demand
Demand tends to be more elastic:
 if the good is a luxury;
 the longer the time period; and
 the greater the number of close substitutes.
Demand tends to be more inelastic:
 if the good is a necessity;
 the shorter the adjustment time; and
 if there are few good substitutes.
(Necessity Good: If income elasticity is positive and less than one. When
income rises, quantity demanded rises but less than proportionately.
Luxury goods: If income elasticity of demand exceeds one)
.
 Ranges of Elasticity
Inelastic Demand
Quantity demanded does not respond strongly to
price changes.
 Price elasticity of demand is less than one.
Elastic Demand
Quantity demanded responds strongly to changes
in price.
 Price elasticity of demand is greater than one.

.
 Ranges of Elasticity
 Perfectly Inelastic
Quantity demanded does not respond to price
changes.
 Perfectly Elastic
Quantity demanded changes infinitely with any
change in price.
 Unit Elastic
Quantity demanded changes by the same
percentage as the price.

.
A Variety of Demand Curves

Because the price elasticity

of demand measures how
much quantity demanded
responds to the price, it is
closely related to the slope of
the demand curve.

.
 Perfectly Inelastic Demand
- Elasticity equals 0
Pric Dema
e nd

1. An 5
increas
e in 4
price...

10 Quanti
0 quantity demandedty
2. ...leaves the
unchanged.
.
 Relatively Inelastic Demand
- Elasticity is less than 1
Pric
e

1. A 25%
5
increase 4
in price...

90100 Quanti
2. ...leads to a 10% decrease in ty
quantity.
.
Demand is inelastic
Price ( in Rs.) Quantity demanded Total expenditure
4.50 4 18
4 4.25 17
3 5 15

As price falls, the quantity demanded increases,

but the total outlay decreases.
Hence, demand is inelastic. ( Lesser than unity)

.
 Unit Elastic Demand
- Elasticity equals 1
Pric
e

1. A 25%
5
increase 4
in price...

75 100 Quanti
2. ...leads to a 25% decrease in ty
quantity.
.
Demand is Unitary elastic
Price ( in Rs.) Quantity demanded Total expenditure
4.50 4 18
4.00 4.5 18
3.00 6 18

As price falls, the quantity demanded increases,

But the total outlay remains constant.
Hence, elasticity of demand is equal to unity.

.
 Perfectly Elastic Demand
- Elasticity equals infinity
Pric
e
1. At any price
above 4,
quantity
demanded is
4 zero. Dema
nd
2. At exactly
4, consumers
will buy any
quantity.
3. At a price below 4, Quanti
quantity demanded is ty
infinite. .
 Relatively Elastic Demand
- Elasticity is greater than 1
Pric
e

1. A 25%
5
increase
4
in price...

50 100 Quanti
2. ...leads to a 50% decrease in ty
quantity.
.
Demand is Elastic
Price ( in Rs.) Quantity demanded Total expenditure
4.50 6 27
4 7 28
3 10 30

As price falls, the quantity demanded increases,

And the total outlay also increases.
Hence, demand is elastic. ( Greater than unity)

.
ALL KINDS OF DEMAND CAN BE SHOWN IN
ONE DIAGRAM AS FOLLOW

WHERE
P D1) Perfectly elastic
demand
RD D1D2)Relatively elastic
I demand
D2 D3)Elasticity of demand
C D equal to utility
D4 3 D4)Relatively inelastic
E
0 D5 X demand
DEMAND D5)Perfectly inelastic
demand
.
 Computing the Price Elasticity
of Demand
(Q2  Q1 )/[(Q2  Q1 )/2]
Price Elasticity of Demand=
(P2  P1 )/[(P2 P1 )/2]
Example: If the price of an ice cream cone increases
from 2.00 to 2.20 and the amount you buy falls from 10
to 8 cones the your elasticity of demand, using the
midpoint formula, would be calculated as:
(10 8)
(10  8) / 2  22 percent  2.32
(2.20 2.00) 9.5 percent
(2.20  2.00) / 2
.
Ranges of Elasticity
 Perfectly Elastic infinite
 Relatively Elastic >1
 Unitary Elastic =1
 Relatively Inelastic <1
 Perfectly Inelastic =0

.
Practical Importance of the Concept of
Price Elasticity Of Demand

 The concept is helpful in taking Business

Decisions
 Importance of the concept in formatting
Tax Policy of the government
 For determining the rewards of the
Factors of Production
 To determine the Terms of Trades
Between the Two Countries
.
Practical Importance of the
Concept of Price Elasticity Of
Demand
 Determination of Rates of Foreign
Exchange
 For Nationalization of Certain Industries
 In economic Analysis ,the concept of
price elasticity of demand helps in
explaining the irony of poverty in the
midst of plenty.

.
Income Elasticity of Demand

.
Income Elasticity of Demand

 Income elasticity of demand measures

how much the quantity demanded of a
good responds to a change in consumers’
income.
 It is computed as the percentage change
in the quantity demanded divided by the
percentage change in income.

.
Income Elasticity

 Types of Goods
 N o r m a l Goods
 I n f e r i o r Goods
 Higher income raises the quantity
demanded for normal goods but lowers
the quantity demanded for inferior
goods.

.
Types Of Income Elasticity Of
Demand

 PositiveIncome elasticity of demand

 Negative Income elasticity of demand
 Zero Income elasticity of demand

.
Positive Income elasticity of demand
Y
D

P
A

D
Income

B S
O Quantity Demanded
.
X
Positive Income elasticity of demand

 Income Elasticity Equal to Unity or

One
 Income Elasticity Greater Than
Unity Or One
 Income Elasticity Less Than Unity
or One

.
Negative Income elasticity of demand
Price

Total Revenue
B S

Quantity Demanded (000s)

.
Zero Income elasticity of demand
Y
D
Income

O X
D

Quantity Demanded

.
 All Income Graphical Representation

Y
F E

D
Income

C
B
A

O X
.
Quantity Demanded
Measurement Of Income Elasticity
Of Demand

Proportionate change in Demand

Income Elasticity Of Demand =
Proportionate change in Income
i.e. ∆q ∆y
Income Elasticity of Demand = +
Q Y

.
Measurement Of Income Elasticity
Of Demand
 Here , ∆q = Change in the quantity
demanded.
q = Original quantity demanded.
∆y = Change in income.
y = Original income.
 For e.g. ,when Income of the consumer =
2,500/- , he purchases 20 units of X, when
income = 3,000/- he purchases 25 units of X

.
Measurement Of Income Elasticity
Of Demand

 Thus
Income Elasticity of Demand
= ∆q ∆y
+
Q Y

= (5/20) + (500/2500)
= 1.5
therefore here the IED is 1.5 which is more
than one.
.
 Factors Affecting Income Of Demand

 Income Itself Only.

 Price Of the Commodity

.
Importance Of the Concept of
Income Elasticity Of Demand
 In production planning and management
 In forecasting demand when change in
consumers income is expected
 In classifying goods as normal and inferior
 In expansion and contraction of the firm by
the figure of income elasticity of demand
 Markets situations could be studied with
the help of IED
.
Cross Elasticity
 The responsiveness of demand
of one good to changes in the price of a
related good – either
a substitute or a complement

_%__Δ__Q_d__of__g_o_od__t____
Xed =
% Δ Price of good y

.
Cross Elasticity of Demand

 Cross elasticity of demand express a

relationship between the change in the
demand for a given product in response to a
change in the price of some other product
 E.g. if the X tea demand reduces
tremendously than it effect could be seen in
demand of sugar and milk.

.
Types of Cross Elasticity of
Demand
 Cross Elasticity of Demand Equal to Unity
or One
 Cross Elasticity of Demand Greater than
Unity or one
 Cross Elasticity of demand less than unity
or one

.
Measurement Cross Elasticity of
Demand
Proportionate change in Demand
for product X
Cross Elasticity of Demand
= Proportionate change in Price of
i.e. product Y

Cross Elasticity of Demand ∆qx +

∆p y
= Qx Py

.
Cross Elasticity of Demand For
SuYbstitutes
D
Price of Y

O X
.
Demand for Y
Cross Elasticity of Demand For
CoYmplementary Products
D
Price of Y

D
O X
.
Demand for Y
Cross Elasticity of Demand For
Neutral Products
Y
D
Price of Y

O X
Demand for Y
.
 Importance of Cross Elasticity Of Demand
 The concept is of very great importance in
changing the price of the products having
substitutes and complementary goods .
 In demand forecasting
 Helps in measuring interdependence of
price of commodity .
 Multiproduct firms use these concept to
measure the effect of change in price of one
product on the demand of their other
product .
Advertising Elasticity of Demand

 Advertising elasticity of demand is the

measure of the rate of change in demand
due to change in advertising expenditure
 The amount of change in demand of goods
due to advertisement is known as
Advertisement Elasticity of Demand .

.
Advertising Elasticity of Demand

Proportionate change in Demand

for product
Advertising Elasticity of Demand
= Proportionate change in
i.e. Advertising expenditure

∆qx ∆a
Advertising Elasticity of Demand
Q
÷
= A

.
Relationship Between Advertising
Expenditure
Y
and Sales
S
Sales

O X
Advertising Expenditure
.
Factors Affecting Advertising
Elasticity Of Demand
 The stage of the Product’s Market
Development .
 Reaction of market Rival Firms.
 Cumulative Effect of Past Advertisement.
 Influence of Other Factors.

.
Importance of the Advertising
Elasticity Of Demand in Business
Decisions
 It is useful in competitive industries.
 Though advertisement shifts the demand
curve to right path but it also increases the
fixed cost of the firm.

.
Limitation of Advertising
Elasticity of the Demand
 The impact of advertising on sales is
different under different conditions, even if
other demand determinants are constant.
 Like wise, it is difficult to establish any co-
relationship between advertising
expenditure and volume of sales when there
counter advertisements by rival firm in the
market . The effect on sales depend on what
the rivals are doing.
.
Elasticity
 If demand is price  If demand is price
elastic: inelastic:
 Increasing price  Increasing price
would reduce TR would increase TR
(%Δ Qd > % Δ P) (%Δ Qd < % Δ P)
 Reducing price  Reducing price
would increase TR would reduce TR
(%Δ Qd > % Δ P) (%Δ Qd < % Δ P)

.
Importance of Elasticity
 Relationship between changes in price
and total revenue
 Importance in determining what goods to
tax (tax revenue)
 Importance in analysing time lags in
production
 Influences the behaviour of a firm

.
Importance of Elasticity
Concepts
 For a Businessman : If a businessman finds
that the demand is inelastic, he is free to
increase prices. In case if the demand is elastic,
by slightly reducing the price, the demand will
increase sharply and hence the total revenue
will also increase.
 The better a company can assess future
demand, the better it can plan its resources.
Each company is exposed to three types of
factors influencing demand: company,
competitive and macroeconomic factors.

.
Demand Forecasting
 A forecast is a prediction or anticipation
of any event which is likely to happen in
future.
 Demand forecast is the prediction of the
future demand for a firm’s product.
 It can either be made through experience
or by statistical methods.

.
Forecasts are necessary for :

 Fulfillment of the objectives.

 Preparations of budgets.
 Stabilization of employment and
production.
 Decisions about expansion of a firm.
 Other decisions like long term investment
plans, warehousing and inventory
decisions.

.
Types of Demand Forecasting
1)Short Time Forecast-:
 Are prepared for one year & reviewed
monthly or half yearly.
 Used for marketing activities such as
selling or advertising.
2) Long Time Forecast-:
 For long term planning, like investment
decision for a new unit or during expansion
of existing unit.
 Though they help in planning, the margin
of error is higher.
.
 A forecast is important for at least five reasons:
1. A forecast becomes a basis for setting and maintaining a
production schedule – manufacturing.
2. It determines the quantity and timing of needs for
labor, equipment, tools, parts, and raw materials –
purchasing, personnel.
3. It influences the amount of borrowed capital needed to finance
the production and the necessary cash flow to operate the
business – controller.
4. It provides a basis for sales quota assignments to various
segments of the sales force – sales management.
5. It is the overall base that determines the company’s business and
marketing plans, which are further broken down into specific
goals – marketing offer.

.
Methods of Demand
forecasting
 There are two different sets of methods
for demand forecasting :
 Interview & survey methods ( for short
term forecasts )
 Projection Approach ( for long term
forecasts )

.
Interview and Survey approach

 To anticipate the demand for a product,

information needs to be collected about
the expected expenditure patterns of
consumers. Depending on the various
approaches to collect this information,
different sub – methods are formulated.
 We will study them one by one.

.
Interview and Survey approach

 Executive Opinion :
 In small companies, usually the owner
takes the responsibility of forecasting.
 As a result of the experience and
knowledge he is expected to have, he can
predict what would be the course of
activities in future and plan his own
activities accordingly.

.
Interview and Survey approach

 Opinion polling method : Information

about the consumer’s expenditure can be
collected either by the market research
department or through the wholesalers
and retailers.
 As a result of technological
advancements, it is now possible to collect
this information by the means of internet.

.
Interview and Survey approach

 Collective opinion method :

 J u r y is a group of individuals, usually the top
bosses or sales, production, marketing
managers having experience in different fields.
 T h e advantage of this method is that instead
of basing the forecast on the opinion of one
single individual, a more accurate forecast can
be drawn.

.
Interview and Survey approach

 Sample survey method :

 The total number of customers of a
company is called as its population.
When this number is more, it is not
possible to collect information for all the
customers. When only a few customers
are contacted, it is called as a Sample
Survey.

.
User’s Expectations

Consumer and industrial companies

often poll their actual or potential
customers.
Some Industrial manufacturers ask
about the quantities of products
their customers may purchase in
future and take this as their forecast.

.
Delphi Method

Administering a series of questionnaires to

panels of experts. This method gathers
information from all experts and the opinion of
all the experts is shared by all other experts.
In case if an expert finds that his own forecast
is unrealistic, after going through the opinion
of other experts, there is a chance for
corrections.

.
Projection Approach
 In this method, the past experience is
projected for the future. This can be done
by tow methods :
 Correlation or regression analysis.
 Time series analysis.

.
 a) Trend Projection Method-:
 Trend Projections – Least Squares
 Eyeball fitting is simply a plot of the data with a line drawn through them that
the forecaster feels most accurately fits the linear trend of the data.
 In this method, previous data's on a product considering its sales are
chronologically arranged
 This arrangement is called “Time Series”.
 This time series represents the effective demand for a particular
product .
 Merits-:
It does not require the formal knowledge ofeconomic
theory and the market, it only needs the time seriesdata.
 Demerits-:
It assumes that the past is repeated in future. Also, it is an
appropriate method for long-run forecasts, but inappropriate
for short-run forecasts.

.
  Trend Projection can be either done-:
 Graphically or, Period Year Quarter Sales(In
Millions)
 Statistically.
1. 2011 (I) 1000
1)Graphically-:
2 (II) 1100
Lets take e.g 3. (III) 1400
of sales of a 4. (IV) 1200

company in last 5. 2012 (I) 1300

6. (II) 1500
3 years.
7. (III) 1100
Now, using these 8. (IV) 1400
data's we can predict 9. 2013 (I) 1600

the sale for year 2008. 10. (II) 1800

11. (III) 1700
12. (IV) 1900

.
Graph of sales of the company using
Trend Projection method.
2000

1800

1600

1400

1200

1000

800 Series1

600

400

200

0
(I) (II) (III) (IV) (I) (II) (III) (IV) (I) (II) (III) (IV)

2011 2012 2013

.
Statistically,

 Constant Rate of Change=

“ Y=mx+c”
Here, Y= Sales by the company,
m= Slope,
x= Time Period,
c= Intercept.

.
 Classical approach to time series analysis:
Past sales can be used to forecast future demand.
Past sales are viewed from the angles of trends,
various cycles of business, seasonality and then a
forecast is drawn after checking the possibility of
the same treads, cycles and seasonality factors.

This method is easy to use, it is based on past

behavior and does not include new company,
competitor or macroeconomic developments.

.
Naïve Method

Next Year’s Sales = This Year’s Sales X This Year’s Sales

Last Year’s Sales

.
Moving Average

Moving averages are used to allow for

marketplace factors changing at different
rates and at different times.

.
EXAMPLE OF MOVING-AVERAGE FORECAST

SALES SALES FOR THREE-YEAR

PERIOD VOLUME THREE-YEAR MOVING
PERIOD AVERAGE
1 200
2 250
3 300 750
4 350 900 300
5 450 1100 ( 3) = 366.6
6 ?
Period 6 Forecast = 366.6

.
Categories of New Products
New-To-The-World

New Product Lines

Six
Categories Product Line Additions
of
New Improvements/Revisions
Products
Repositioned Products

Lower-Priced Products
.
Forecasting of New Products

 Evolutionary method : Whenever a new

product has been evolved from an existing
product ( eg. Colour TV from Black & White
TV ), the information of the existing product
may be used for prediction of future for the
new product.
 Substitution method : Many new goods are
purchased by customers for replacing the old
ones. ( Eg. LCD TV’s in place of Colour TV’s).

.
Forecasting of New Products

 Growth pattern methods : To predict the

demand for a new product, the growth pattern
of an established related goods can be
understood.
 Opinion polling method : This method
advocates the direct questioning to the
probable buyers or the influencers of sales of
such products. (Eg. demand for drugs can be
ascertained by asking the doctors )

.
Forecasting of New Products

 Sample survey method : A product is

first introduced in a test market ( small
city having profiles of customers of
metros ). Responses from these markets
are taken as a base for forecasts.
 Indirect opinion polling : Instead of
asking the probable buyers, here, the
resellers are consulted.

.
Significance of Demand Forecasting

 It provides appropriate production

scheduling so as to avoid the problem of over-
production or problem of short supply.
 Helping the firms to reduce the cost for
purchasing raw material.
 Setting sales targets, establishing sales controls
& incentives.
 Manufacturers prefer “Make to Stock” rather
than “Make to Order". Demand Forecasting
helps to plan ahead and provide the finished
goods to their customers as soon as possible.

.
Demand Forecasting
Criteria of a good Forecasting Method:
 Accuracy
 Plausibility (Mgt must have confidence and
understanding)
 Durability
 Availability
 Economy (Cost Effectiveness)

. DR.CPP ME 2013
ThankYou!!!