Demand Estimation

Lecture 8
 DEMAND ANALYSIS
(a) To elaborate DA, we take the example of groundnut demand case. The
selected estimated demand function is as follows:

DGN = −20 − 0.67 PGN + 0.24 Y + 1.18 Pv + 0. 50 Pg − 0.66 Pe

where DGN = groundnut demand in tens of thousand tons, Y = real GDP in rupees
billions, and PGN, Pv , Pg and Pe are price indices (base=100 in 2011-12) of
groundnut oil, vanaspati, ghee and price of eggs, fish and meat, respectively.

(b) The function indicates the following:

Demand for groundnut oil depends positively on consumers’ income (real
GDP), and prices of vanaspati and ghee, and negatively on its own (groundnut
oil) price and price of egg, fish and meat.
( c) Suppose the magnitudes of the various independent
variables in the current period were the following:

Y = 400, PGN = 150, Pv = 130, Pg = 140, and Pe = 120

then the estimate for the groundnut demand

Ans) The groundnut demand is equal (substitute these values

in the estimated function and solve) 119.7 tens of
thousand tons = 1197,000 tons.
(d)The estimates for various demand elasticities at the current
values of the variables would be as follows:
 Price elasticity = (−0.67)(150/119.7) = −0.84
As the magnitude is negative, groundnut demand obeys the
law of demand (non-Giffen good) and as the magnitude is
less than unity the demand is relatively price inelastic.

 Income elasticity = (0.24)(400/119.7) = 0.80

As the magnitude is positive and less than unity,
groundnut oil is a superior and necessary product.
 Cross price elasticities: These are three, one with respect to
each of the three cross price variables. They are as follows:

With vanaspati price: (1.18)(130/119.7) = 1.28

With ghee price: (0.50) (140/119.7) = 0.58
With egg, fish and meat price: (−0.66)(120/119.7) = −0.66

The first two cross-elasticities are positive and the third is

negative. This means groundnut oil is a substitute to vanaspati
and ghee and complement to egg, fish and meat. Further, all
the three elasticities are less than or close to unity, and thus
the relationship between groundnut oil and its three related
goods are weak.
(e)Equation of the Engel curve can be obtained by inserting
the current values of all cause variables but income in the
estimated demand function:
DGN = 23.7 + 0.24 Y

(f)Equation of the demand curve for groundnut oil can be

obtained by inserting the current values of all variables but
own (groundnut oil) price in the estimated function:

D = 220.2 − 0.67 P
(g)Demand curve equation can be used to derive the total revenue (TR) and
marginal revenue equations:
Inverting demand equation yields

PGN = 329 − 1.5 DGN or P = 329 − 1.5 Q

TR = PQ = 329 Q − 1.5 Q2
At what quantity TR is Maximum?

=0
Or, MR = 329 − 3 Q=0
Or, Q=109.67

Here, it must be noted that since MR is the derivative of TR with respect to output (Q), demand
equation must be expressed in terms of P as a function of Q to get the TR and then MR equation. Also,
note that the intercept of demand (P) equation is same as that of MR equation and the slope of the
former is half of that of the latter. This is, however, true only if the demand equation is linear.
(h)Estimated demand function can be used to formulate policies.
 Note that for making policies, one must have objectives and instruments,
and the number of these two must be equal to generate an unique policy. To
proceed further, assume that at demand equals 119.7, there is excess
capacity in the ground nut oil industry and accordingly objective is DGN =
140. Assume that the industry can control groundnut oil price only and
hence the rest of the determinants are non-policy exogenous variables.

 If so, put target at DGN = 140, insert values of all but own price determinants
in the estimated demand equation, and get the following:
140 = 220.2 − 0.67 PGN, solution of which gives
PGN = 120
Thus, the industry must set the price of its product at 120 to meet its sales
target of 140. In other words, to increase sales from 119.7 units to 140 units
* If the number of instruments is more than the number of targets, the policy makers have
alternative policies to achieve the target. The economy has a greater leverage than a
particular industry. Assume the economy’s target at DGN = 140 and its instruments are two,
viz. income and groundnut oil price. If so, the policy equation becomes:
140 = 124.2 + 0.24 Y − 0.67 PGN
or, 0.24 Y − 0.67 PGN = 15.8

Any set of values of Y and PGN which satisfy this equation would meet with the target. A few alternatives
would be as follows:
Policy Alternatives Y Po
1 400 120
2 450 138
3 471 145
4 485 150
Depending on the relative feasibility, the policy makers could choose any one of these or similarly generated
alternative to achieve the target.
(i) The last but perhaps the most significant application of the estimated
function is to generate forecasts for future demands for the product.
For this purpose, one needs forecasts of the independent variables,
which hopefully are relatively easy as they often are macro-economic
variables and their forecasts are usually made systematically.
Assuming, the forecasts for 2025 are as follows:

Y = 500, PGN = 180, Pv = 160, Pg = 150 and Pe = 150

Inserting the above values in the estimated demand function gives

the forecast for groundnut oil demand in 2025. This comes equal to
144.2 units.
 Problem 1

A market consist of two individuals. The demand

equations are Q1=16-4p and Q2=20-2p
A) What is the market demand equation?
B) At price Rs 2, what is the point price elasticity for
each person and for the market?
 Problem 2
• The Hind book Ltd is a publisher of Novels, the corporation hire
economist to determine the demand for its product. After months the
analyst tells the company the demand for the firms novels is:
Qx=1200-5000Px +5Y + 500 Pc
Assume that the initial values of Px, I, Pc are Rs 5, Rs 10000 and
Rs 6 respectively.

1) Determine what effect a price increase would have on total revenues.

2) Evaluate how sales of the novels would change during a period of
rising incomes
3) Assess the probable impact if competing publishers raise their prices.
 Problem 3
The demand equation faced by Sandeep electronics for its
washing machines is given by P=10000-4Q.
A) Write the Marginal revenue equation
B) At what price and quantity, marginal revenue will be
zero?
C) At what price and quantity, total revenue will be
maximum?
D) If price increased from Rs 6000 to Rs 7000, what will be
the effect on total revenue?