Managerial Economics

By

Dr. A.B. MukherjeePh.D., M.Phil., UGC NET, MBA, BBA

Module - 2

Theory of Demand and Demand Forecasting 8 Hours

• Meaning- determinants - demand schedule - demand curve.

• Law of Demand- exceptions- shifts in demand and

movements in demand.

• Elasticity of demand- meaning- types.

2

Determinants of Demand

A host of factors that determine the demand for a Product are:

1. Price of the Product.

2. Price of related goods – substitutes, complements and supplements.

3. Level of Consumer’s Income.

4. Consumer’s taste and preference.

5. Advertisement of the product.

6. Consumer’s expectation about future price and supply position.

7. Demonstration effect and ‘band-wagon effect’’.

8. Consumer-credit facility.

9. Population of the country (for the goods of mass consumption)

10. Distribution pattern of national income, etc.

3

Price of the Product

• The price of the product is one the most important determinants of its

demand in the long run and the only determinant in the short run.

• The price of a product and its quantity demanded are inversely related.

4

Price of Related Goods – Substitutes, Complements & Supplements

• The demand for a commodity is also affected by the changes in the price of

its related goods.

• Related goods may be substitutes and complementary goods.

Substitutes: Two commodities are deemed to be substitutes for one

another if change in the price of one affects the demand for the other in

the same direction.

For Example: Commodities X and Y are considered as substitutes for one

another if a rise in the price of X increases demand for Y and vice versa.

Tea and Coffee, hamburgers and hot-dog, alcohol and drugs are some

examples of substitutes in the case of consumer goods.

5

Price of Related Goods – Substitutes, Complements & Supplements

Complements: A commodity is deemed to be a complement for another

when its complements the use of the other or when the use of two goods go

together so that their demand changes simultaneously.

For Example: Petrol is complement to cars and scooters, butter and jam to

bread, milk and sugar to tea and coffee, mattress to cot, etc.

6

Level of Consumer’s Income

• Income is the basic determinant of quantity of a product demanded since

it determines the purchasing power of the consumer.

• Income-demand relationship is of a more varied nature than that between

demand and its other determinants.

• Income as a determinant of demand is equally important in both short run

and long run.

• For the purpose of Income- Demand analysis, consumer goods and

services may be grouped under four broad categories:

(a) Essential Consumer Goods (ECG)

(b) Inferior Goods (IG)

(c) Normal Goods (NG)

(d) Prestige or Luxury Goods (LG)

7

Essential Consumer Goods (ECG)

• The goods and services in this category are called ‘basic needs’ and are

consumed by all the persons in the society.

For Example: Food Grains, salt, vegetable oil, matches, cooking fuel,

minimum clothing and housing.

• Quantity demanded of this category of goods increases with increase in

consumer’s income but only upto a certain limit, even though the total

expenditure may increase in accordance with the quality of goods

consumed other factors remaining the same.

8

Inferior Goods (IG)

• Inferior goods and superior goods are widely known to both consumers

and sellers.

For Example: Millet is inferior to wheat and rice,, co Bidi is inferior to

cigarette, coarse textiles are inferior to refined ones, kerosene is inferior to

cooking gas, travelling by bus is inferior to travelling by aeroplane.

• In economic sense a commodity is deemed to be inferior if its demand

decreases with the increase in consumer’s income, beyond a certain level

of income.

Note:

• Demand for such goods rises only upto a certain level of income and

declines as income increases beyond this level.

9

Normal Goods (NG)

• Normal goods are those goods which are demanded in increasing

quantities as consumer’s income rises.

For Example: Clothing, household furniture and automobiles are some of

the important examples of this category of goods.

• Demand for normal goods increases rapidly with the increase in

consumer’s income but slows down with further increase in income.

10

Prestige or Luxury Goods (LG)

Luxury Goods:

• All such goods that add to the pleasure and prestige of the consumer without

enhancing his earning fall in the category of luxury goods.

For Example: Stone Studded Jewellery, Costly Brands of Cosmetics, Luxury

Cars, Accommodation in Five Star Hotel, Upper Class Air Travel can be treated

as luxury goods.

Prestige Goods:

• A special category of luxurious goods is that of prestige goods.

For Example: Precious Stones, Ostentatious decoration of buildings, rare

paintings and antiques, diamond studded jewellery and watches, prestigious

schools, etc.

Note: The demand for such goods arises beyond a certain level of

consumer’s income, i.e. Consumption enters the area of luxury goods.

11

Consumer’s Taste and Preference

• Taste and preference generally depend, on life style, social customs,

religious values attached to a commodity, habit of the people, the general

levels of living of the society and age and sex of the consumers.

• Change in these factors changes consumer’s taste and preferences.

• As a result, consumers give up the consumption of some goods and add

new ones in their consumption pattern.

12

Consumer’s expectation about Future price and Supply position

• Consumer’s expectation regarding the future prices, income and supply

position of goods, etc. play an important role in determining the demand

for goods and services in the short run.

• If consumers expect a high rise in the price of a storable commodity, they

would buy more of it at its high current price with a view of avoiding the

pinch of a high price rise in future.

• On the contrary, If consumers expect a fall in the price of certain goods,

they postpone their purchase of such goods with a view of taking

advantage of lower prices in future.

• Similarly an expected increase in income increases demand.

13

Demonstration Effect and ‘Band-Wagon Effect’

• Some people buy goods or new models of goods because they have a genuine

need for them or have excess buying power.

• Some others do so because they want to exhibit their affluence.

• Once the commodity is in vogue, many households buy then not because they

have a genuine need for them but because their neighbours have bought these

goods.

• Such purchases arise because of jealousy, competition and equality in the peer

group, social inferiority and the desire to raise their social status.

• Purchase on account of these factors is what economist call as

‘Demonstration Effect’ or ‘The Band Wagon Effect.’

14

Snob Effect

• On the contrary, when a commodity becomes the thing of common use,

some people, mostly rich, decrease or give up the consumption of such

goods.

• This is known as ‘Snob Effect’.

• It has a negative effect on the demand of the related goods.

15

Consumer Credit Facility

• Availability of credit to the consumers from the sellers, banks, relations

and friends, or from other sources encourage the consumers to buy more

than what they would buy in the absence of credit facility.

• Credit facility mostly affects the demand for durable goods, particularly

which require bulk payment at the time of purchase.

16

Population of the Country

• The total domestic demand for a product of mass consumption depends

also on the size of the population.

• Given the price, per capita income, taste and preference etc., the larger the

population, the larger the demand for a product.

17

Distribution Pattern of National Income

• The distribution pattern of national income is also an important

determinant of a product.

• If national income is unevenly distributed, i.e. If majority of the

population belongs to the lower income groups, market demand for

essential goods including inferior ones, will be the largest whereas the

demand for other kinds of goods will be relatively lower.

18

Exercise

Q1. Which one is example of Substitutes:

a) Tea & Sugar

b) Tea & Coffee

c) Pen & Ink

d) Shirt & Pant

19

Exercise

Q2. In case of Inferior goods, price effect is:

a) 0

b) Positive

c) Negative

d) None

20

Exercise

Q3. The fall in price of one commodity leads to fall in demand

for other commodity & vice-versa for:

(a) Substitutes

(b) Complimentary goods

(c) Giffen goods

(d) Veblen goods

21

Why the Demand Curve Slope Downwards?

1. Diminishing Marginal Utility

2. Substitution Effect

3. Income Effect

4. Change in Consumer’s Number

5. Different Uses

22

Diminishing Marginal Utility

• Law of Demand is based on Diminishing Marginal Utility concept.

• A consumer does not want to pay for a commodity more than its marginal

utility.

• As more and more units of a commodity are purchased the utility

acquired by these units decreases.

• Therefore with the decrease in prices, more and more quantity is

purchased.

23

Substitution Effect

• Another cause of downward slope of demand curve is Substitution Effect.

• When a need is fulfilled by two or more commodities it is called

Substitution Effect.

For Example: If the prices of kerosene comes down and the prices of coal

remains as it is, people would prefer kerosene for their purpose. As a

result the demand for kerosene increases as compared to its earlier

demand. In this way, due to substitution effect, demand for a commodity

is increased, while as price increases the demand for that commodity

increases.

24

Income Effect

• Due to decrease in prices there is increase in the real income of the

consumer or he can buy the same amount at less prices than he used to

purchase earlier.

For Example: Price of oil decreases from Rs. 15/- per litre to Rs. 10/- per

litre. So now if consumer maintains his consumption, he saves Rs. 5/- per litre

but if he wants to spend Rs. 5/- too, he can buy ½ litre resulting increase in the

demand of the commodity.

25

Change in Consumer’s Number

• When prices come down, those consumers who were not able to purchase

the commodity due to high prices, start consuming those product as a

result giving rise in the demand.

26

Different Uses

• Most of the commodities have different uses i.e. more than one use and

all the uses are not of the same importance.

• When prices come down consumers start using the product for less

important purpose also and when prices go up he becomes choosy about

the different uses that means that he uses the commodity on priority

basis.

27

Exercise

Q4. The quantity demanded of Pepsi has decreased. The best

explanation for this is that:

a) The price of Pepsi increased.

b) Pepsi consumers had an increase in income.

c) Pepsi's advertising is not as effective as in the past.

d) The price of Coca Cola has increased.

28

Exercise

Q5. Demand curves are derived while holding constant

a. Income, tastes, and the price of other goods.

b. Tastes and the price of other goods.

c. Income and tastes.

d. Income, tastes, and the price of the good.

29

Exercise

Q6. When the decrease in the price of one good causes the

demand for another good to decrease, the goods are:

a. Normal

b. Inferior

c. Substitutes

d. Complements

30

Exercise

Q7. Suppose the demand for good Z goes up when the price of

good Y goes down. We can say that goods Z and Y are:

a) Substitutes.

b) Complements.

c) Unrelated goods.

d) Perfect substitutes.

31

Elasticity of Demand

• The concept of Elasticity of Demand is associated with Alfred Marshall.

• Earlier we have seen that the Law of Demand was a Qualitative

Statement of Relationship between the Price of a Commodity and its

Quantity Demanded by the consumer.

• The Law of Demand did not specify any Quantitative Relationship

between the two.

For Example: A 10% fall in the prices of various goods shall not result in an

equal increase in their quantities demanded.

Suppose the prices of salt, oranges etc are cut down by 10% it does not mean

that the quantities demanded by consumer is increased by 10%.

If we take the example of salt only, 10% fall in price will result in only 2%

increase in demand.

32

Elasticity of Demand

• “Elasticity of Demand may be defined as the extent to which the quantity

demanded of a commodity changes in response to a given change in price.”

• In case of Elastic Demand the quantity demanded of a commodity is

highly sensitive or responsive to even a small change in price.

• But in case of Inelastic Demand even a drastic change in price may not

affect the quantity demanded.

• In the words of Marshall – “Elasticity of demand in a market is great or

small according as the amount demanded increases much or little for a

given fall in the price and diminishes much or little for a given rise in

price”.

33

Elasticity of Demand

34

Types of Elasticity of Demand

Price Elasticity of Demand

Income Elasticity of Demand

Cross Elasticity of Demand

Substitution Elasticity of Demand

Perfectly Elastic

Perfectly Inelastic

Relative Elastic

Relative Inelastic

Unitary Elastic Demand

Zero Income Elasticity of Demand

Negative Elasticity of

Demand

Unitary Income Elasticity of Demand

Income Elasticity of Demand Greater than

Unity

Income Elasticity of Demand Less than Unity

Infinite Substitution Elasticity

Zero Substitution Elasticity

High or Low Substitution Elasticity

Types of Elasticity of Demand

• Price Elasticity of Demand

• Income Elasticity of Demand

• Cross Elasticity of Demand

• Substitution Elasticity of Demand

35

PRICE ELASTICITY OF DEMAND

36

Price Elasticity of Demand

• It is one of a family of concepts of elasticity.

• Alfred Marshall was the first economist to give a clear formulation of price

elasticity.

• It is the ratio of proportionate changes in the quantity demanded of a

quantity demanded of a commodity to a given proportionate change in

price.

• If Price Elasticity of Demand is Ep then :

Ep = Relative change in Quantity /Relative Change in Price

• In other words elasticity is the percentage change in quantity to the

percentage change in price

37

Types of Price Elasticity of Demand

• Perfectly Elastic Demand

• Perfectly Inelastic Demand

• Relative Elastic Demand

• Relative Inelastic Demand

• Unitary Elastic Demand

38

Perfectly Elastic Demand

39

Perfectly Elastic Demand

• The situation where the slightest rise in the price causes the quantity

demanded to fall to zero and the slightest fall in price causes an infinite

increase in quantity demanded of the commodity is called Perfectly

Elastic Demand situation.

• The demand in such cases is hyper sensitive and elasticity of demand is

infinite.

• In actual life Perfectly Elastic Demand is very rare phenomenon.

40

Perfectly Inelastic Demand

41

Perfectly Inelastic Demand

• It refers to a situation where even substantial change in price leaves the

demand unaffected.

• In other words the price may change but the quantity demanded remains

unchanged.

• The demand in such case is insensitive or non responsive and the elasticity

of demand is zero.

• Like Perfectly Elastic Demand cases of Perfectly Inelastic demand are also

rare in real life.

42

Relative Elastic Demand

43

Relative Elastic Demand

• It refers to that situation where a small proportionate change in the price of

any commodity results in a large proportionate change in its quantity

change.

• In other words – ‘A small proportionate fall in price is followed by a large

proportionate increase in demand and vice-versa.’

44

Relative Inelastic Demand

45

Relative Inelastic Demand

• It refers to that situation where a big proportionate change in the price of a

commodity is accompanied by a smaller proportionate change in its

quantity demanded.

• Elasticity of Demand here is said to be less than unity.

46

Unitary Elastic Demand

47

Unitary Elasticity of Demand

• It refers to that situation where a given proportionate change in price is

accompanied by an equal proportionate change in the quantity demanded.

• Elasticity of demand equal to unity.

48

Review of Price Elasticities of Demand

1. Perfectly Elastic (Ep = ∞)

2. Perfectly Inelastic (Ep = 0)

3. Relative Elastic (Ep > 1)

4. Relative Inelastic (Ep < 1)

5. Unitary Elastic Demand (Ep = 1)

49

EXERCISE

Q1. The price elasticity of demand measures

A) the slope of a budget curve.

B) how often the price of a good changes.

C) the responsiveness of the quantity demanded to changes in

price.

D) how sensitive the quantity demanded is to changes in

demand.

50

EXERCISE

Q2. The Price Elasticity of Demand depends on:

A) the units used to measure price but not the units used to measure

quantity.

B) the units used to measure price and the units used to measure quantity.

C) the units used to measure quantity but not the units used to measure

price.

D) neither the units used to measure price nor the units used to measure

quantity.

51

EXERCISE

Q3. The price elasticity of demand equals:

A) the percentage change in the quantity demanded divided by the

percentage change in the price.

B) the change in the quantity demanded divided by the change in price.

C) the percentage change in the price divided by the percentage change in

the quantity demanded.

D) the change in the price divided by the change in quantity demanded.

52

EXERCISE

Q4. The price elasticity of demand can range between:

A) negative one and one.

B) zero and infinity.

C) zero and one.

D) negative infinity and infinity

53

EXERCISE

Q5. Demand is inelastic if :

A) a large change in quantity demanded results in a small change in price.

B) the price elasticity of demand is greater than 1.

C) the quantity demanded is very responsive to changes in price.

D) the price elasticity of demand is less than 1.

54

EXERCISE

Q6. Of the following, demand is likely to be the least elastic for

A) Toyota automobiles.

B) compact disc players.

C) Ford automobiles.

D) toothpicks.

55

INCOME ELASTICITY OF DEMAND

56

Income Elasticity of Demand

• Income Elasticity of Demand for a commodity shows the

extent to which a consumer demands for that commodity as a

result of a change in his income.

• It shows the responsiveness of a consumer purchases of that

commodity to a change in his income.

• Income Elasticity of demand may be defined as the ratio of

proportionate change in the quantity of the commodity to a

given proportionate change in the income of consumer.

57

Types of Income Elasticity of Demand

1. Zero Income Elasticity of Demand.

2. Negative Elasticity of Demand.

3. Unitary Income Elasticity of Demand.

4. Income Elasticity of Demand greater than unity.

5. Income Elasticity of Demand less than unity.

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1. Zero Income Elasticity of Demand

• This situation refers to the situation where a given increase in

the consumer’s money income does not result in any increase

of the quantity demanded of the commodity.

• Thus in Zero Income Elasticity of Demand EI = 0

59

2. Negative Elasticity of Demand

• That refers to the situation where a given increase in the

consumer’s money income is followed by an actual fall in the

quantity demanded of the commodity.

• This happens in the case of inferior goods.

• Thus in Negative Elasticity of Demand EI < 0

60

3. Unitary Income Elasticity of Demand

• This refers to the situation where the proportionate change in

the consumer’s income spend on the commodity is actually

the same both before and after the increase in income.

• The Income Elasticity of Demand is Unity.

• In such case EI = 1

61

4. Income Elasticity of Demand greater than Unity

62

• This refers to the situation where the consumer spends a

greater proportion of his money income on the commodity

when he becomes richer and more prosperous.

• The Income Elasticity of Demand is greater than unity in case

of Luxuries.

• Thus Income Elasticity of Demand Greater than Unity is

represented as EI > 1

5. Income Elasticity of Demand less than Unity

63

• This refers to the situation where the consumer spends a

smaller proportion of his money income when he becomes

richer and more prosperous.

• The Income Elasticity of Demand is less than Unity in the case

of necessaries.

• The expenditure increases in a smaller proportion when the

consumer’s money income goes up.

• Thus Income Elasticity of Demand Less than Unity is

represented as EI < 1.

Factors Affecting Elasticity of Demand

1. Degree of Necessity.

2. Proportion of Consumer’s Income spent on the commodity.

3. Existence of Substitutes.

4. Habit.

5. Several uses of the commodity.

6. Postponement.

7. Time.

8. Range of Price.

64

CROSS ELASTICITY OF DEMAND

65

Cross Elasticity of Demand

• Normally the commodities are seldom completely independent.

• They are surrounded by substitutes and complements.

• The two goods say X and Y can either be substitutes of each other or

complementary to each other.

• In the case of substitute goods and complementary goods the term

Cross Elasticity of Demand may be defined as the ratio of

proportionate change in the quantity demanded of commodity X to a

given proportionate change in the price of the related commodity Y.

• EC = % age change in the quantity demanded of X

% age change in the price of Y

66

SUBSTITUTION ELASTICITY OF DEMAND

67

Substitution Elasticity of Demand

• Substitution Elasticity may be defined as the extent to which

one commodity can be substituted for another as a

consequence of a given change in their price ratio.

• If the consumer continues to enjoy the same amount of

satisfaction the ratio in which the two commodities are

bought naturally changes when the process of substitution

takes place.

68

Example of Substitution Elasticity

Commodities Price per Kg Consumer

Purchase

Qty Ratio Price Ratio

Margarine Rs. 5/- per Kg 3 Kgs3:2 1:2Butter Rs. 10/- per Kg 2 Kgs

69

Commodities Price per Kg Consumer

Purchase

Qty Ratio Price Ratio

Margarine Rs. 5/- per Kg 5Kgs5:1 1:3Butter Rs. 15/- per Kg 1Kg

Example of Substitution Elasticity

• The original Margarine and Butter ratio was 3:2 while the new ratio is

5:1.

• The proportionate change in the margarine butter ratio is

3/2 – 5/1 = - 7/2 / 3/2 = -7/3

• The original price ratio was ½ while the new price ratio is 1/3.

• The proportionate change in price ratio is (1:2 – 1:3) / 1:2 = 1:3

• Elasticity of Substitution

Es = Proportionate change in the combination ratio of goods X and Y

Proportionate change in the price ratio of goods X and Y.

• In the above Example Es will be -7/3 /1/3 = -7 or = + 7

70

Infinite Substitution Elasticity

• The Substitution Elasticity will be infinite if two commodities are perfect

substitutes of each other.

• A fall in price of one commodity assuming the price of the other to be

constant will lead the consumer to substitute the former completely for the

latter.

• The Elasticity of Substitution then will be infinite but in actual life we

rarely come across two commodities which are perfect substitutes of each

other.

71

Zero Substitution Elasticity

• The Elasticity of Substitution will be zero if two commodities are no

substitutes for each other.

• In such a case the rate of substitution between them will be zero or we can

say that their will be no possibility of substitution between the two

commodities.

• Even if the price ratio of two commodities changes the consumer will not

be able to substitute one commodity for the other.

• Hence Elasticity of Substitution will be Zero.

72

High or Low Substitution Elasticity

• Between the other two extremes limits of infinite and zero elasticities, we

can have high or low substitution elasticities depending on whether the

rate of substitution between the two commodities falls gradually or rapidly.

• If the rate of substitution falls gradually the elasticity of substitution will

be high.

• On the contrary, if the rate of substitution falls rapidly the Elasticity of

Substitution will be low.

73

Points to Remember

Elasticity, Price-Change and Change in TR

74

Elasticity Coefficient Change in Price Change in TR

e = 0 IncreaseDecrease

IncreaseDecrease

e < 1 Increase Decrease

IncreaseDecrease

e = 1 Increase Decrease

No Change No Change

e > 1 IncreaseDecrease

DecreaseIncrease

e = OO IncreaseDecrease

Decrease to ZeroInfinite increase*

Points to Remember

Income Elasticities

75

Consumer Goods Elasticity Coefficient Change in TR

1. Essential Goods Less than one (ey < 1) Less thanproportionate change

in sale

2. Comforts Almost equal to unity (ey = 1)

Almost proportionate change in sale

3. Luxuries Greater than unity(e > 1)

More than proportionate increase

in sale

EXERCISE

Q7. If a price decrease results in your expenditure on a good

decreasing, your demand must be:

A) unit.

B) inelastic.

C) linear.

D) elastic.

76

EXERCISE

Q8. If the demand for a good is unit elastic,

A) A 5 percent increase in price results in a 5 percent increase in

total revenue.

B) the demand curve is a straight line with slope of -1.

C) a 5 percent increase in price results in a 5 percent decrease in

total revenue.

D) a 5 percent increase in price does not change total revenue.

77

EXERCISE

Q9. Suppose that the quantity of root beer demanded declines

from 103,000 gallons per week to 97,000 gallons per week as a

consequence of a 10 percent increase in the price of root beer.

The price elasticity of demand is:

A) 1.66

B) 6.00

C) 0.60

D) 1.40.

78

EXERCISE

Q10. When the quantity of coal supplied is measured in

kilograms instead of pounds, the demand for coal becomes:

A) more elastic.

B) neither more nor less elastic.

C) less elastic.

D) undefined.

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THANK YOU

HAVE A GREAT DAY AHEAD!!!

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