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Unit 2
Unit 2
Demand Analysis
Structure:
2.1 Introduction
Case Let
Objectives
2.2 Meaning and Law of Demand
2.3 Elasticity of Demand
2.4 Summary
2.5 Glossary
2.6 Terminal Questions
2.7 Answers
2.8 Case Study
Reference/E-reference
2.1 Introduction
In the previous unit, we learnt about the scope and importance of
managerial economics. We learnt that managerial economics helps
managers to arrive at decisions that effectively use the firms resources, and
thereby leading the firm to grow profitably. In this unit, we will study about
demand analysis. The sustenance and growth of a business firm is greatly
influenced by the demand for a firms offerings (goods or/and services). In
this unit, we shall explore the importance of demand and supply in business
decisions/processes like pricing and forecasting. We begin our in-depth
understanding of the subject with a foundation on demand.
Demand and supply are the two main concepts in economics. Some experts
are of the opinion that the entire subject of economics can be summarised in
terms of these two basic concepts.
Case Let
Ramesh, a fresh MBA graduate, had recently joined a small firm that was
involved in the manufacture and marketing of traverse rods that were
used to suspend window curtains. One week into his job, Rameshs
superior asked him to submit a report on the demand for traverse rods in
India. Ramesh was also expected to comment on the factors that
influenced the demand for traverse rods as well as the relative
importance of those factors. Rameshs report was expected to guide the
marketing/sales team in its activities.
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Objectives:
After studying this unit, you should be able to:
describe the concept of demand and its features
define and interpret the demand schedule, law of demand and pricequantity relationships and exceptions to the law of demand
categorise the various factors which influence the demand for goods and
services
apply the concept of elasticity of demand and different kinds of elasticity
of demand
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5.00
200
4.00
300
3.00
400
2.00
500
1.00
600
Total Market
Demand
5.00
100
200
300
600
4.00
200
300
400
900
3.00
300
400
500
1200
2.00
400
500
600
1500
1.00
500
600
700
1800
Demand function
The demand for a product or service is affected by its price, the income of
the individual, the price of other substitutes, population, habit, etc. Thus, we
can say that demand is a function of the price of the product and other
factors, as mentioned above.
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Price
10
8
6
4
Demand
Figure 2.1: Demand Curve
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Price
5.00
4.00
Demand
10
20
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Some examples that favour the unusual demand curve are as follows:
1. Giffens paradox A paradox is an inconsistency or contrary. Sir
Robert Giffen, an Irish Economist, with the help of his own example
(inferior goods) disproved the law of demand. The Giffens paradox
holds that Demand is strengthened with a rise in price or weakened
with a fall in price. He gave the example of poor people of Ireland who
were using potatoes and meat as daily food articles. When price of
potatoes declined, customers instead of buying larger quantities of
potatoes started buying more of meat (superior goods). Thus, the
demand for potatoes declined in spite of fall in its price.
2. Veblens effect Thorstein Veblen, a noted American economist
contends that there are certain commodities which are purchased by
rich people not for their direct satisfaction, but for their snob-appeal or
ostentation. Veblens effect states that demand for status symbol goods
would go up with a rise in price and vice-versa. In case of such status
symbol commodities, it is not the price which is important but the
prestige conferred by that commodity on a person makes him to go for it.
More commonly cited examples of such goods are diamonds and
precious stones, world famous paintings, commodities used by world
famous personalities, etc. Therefore, commodities having snob-appeal
are to be considered as exceptions to the law of demand.
3. Fear of shortage When serious shortages are anticipated by the
people, (e.g., during the war period) they purchase more goods at
present even though the current price is higher.
4. Fear of future rise in price If people expect future hike in prices,
they buy more even though they feel that current prices are higher.
Otherwise, they have to pay a still high price for the same product.
5. Speculation Speculation implies purchase or sale of an asset with the
hope that its price may rise or fall and make speculative profit. Normally,
speculation is witnessed in the stock exchange market. People buy
more shares only when their prices show a rising trend. This is because
they get more profit, if they sell their shares when the prices actually
rise. Thus, speculation becomes an exception to the law of demand.
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D
D
2
Price
Forward
Shift
1
Backward
Shift
D
2
Demand
Figure 2.3: Shifts in Demand
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Ep
D P 40
6
Symbolically, Ep = P D 2 20 6
Original demand = 20 units
original price = 6 00
New demand
New price
= 60 units
= 4 00
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Y
Price
ED =
D
Quantity
Price
10.0
ED = 0
2.00
0
D
10
Quantity
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Y
D
ED > 1
Price
9% / 3% = -3
3%
9%
0
Demand
Price
D
8%
ED < 1
4% / 8% = 0.5
4%
Demand
Figure 2.7: Relatively Inelastic Demand
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Y
D
Price
ED = 1
5%
5% / 5% = 1
5%
0
D
X
Demand
Figure 2.8: Unitary Elastic Demand
Out of five different degrees, the first two are theoretical and the last one is
a rare possibility. Hence, in all our general discussions, we make reference
only to two terms: relatively elastic demand and relatively inelastic demand.
Determinants of price elasticity of demand
You may observe that the elasticity of demand depends on several factors
of which the following are some of the important ones:
1. Nature of the commodity Commodities coming under the category
of necessaries and essentials tend to be inelastic, because people buy
them whatever may be the price. For example, rice, wheat, sugar,
milk, vegetables, etc.; on the other hand, for comforts and luxuries,
demand tends to be elastic, e.g., TV sets, refrigerators, etc.
2. Existence of substitutes Substitute goods are those that are
considered to be economically interchangeable by buyers. If a
commodity has no substitutes in the market, demand tends to be
inelastic because people have to pay higher price for such articles.
For example, salt, onions, garlic, ginger, etc. In case of commodities
having different substitutes, demand tends to be elastic. For example,
blades, tooth pastes, soaps, etc.
3. Number of uses for the commodity Single-use goods are those,
which can be used for only one purpose and multiple-use goods can
be used for a variety of purposes. If a commodity has only one use
(singe use product), demand tends to be inelastic because people
have to pay more prices if they have to use that product for only one
use, for example, all kinds of eatables, seeds, fertilizers, pesticides,
etc. On the contrary, for commodities having several uses, [multipleSikkim Manipal University
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I Case
II Case
III Case
Price in
(Rs.)
Qty.
Demanded
Total
Expenditure
5.00
2000
10000
4.00
3000
12000
2.00
7000
14000
5.00
2000
10000
4.00
2500
10000
2.00
5000
10000
5.00
2000
10000
4.00
2200
8000
2.00
4200
8400
Nature of
PED
>1
=1
<1
Note:
Variation in the value of ED can be summarised as:
1. When new outlay is greater than the original outlay, then ED > 1.
2. When new outlay is equal to the original outlay then ED = 1.
3. When new outlay is less than the original outlay then ED < 1.
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Graphical representation
Y
A
E>1
B
Price
E=1
C
0
E<1
X
Total Expenditure
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Mathematical illustrations
Table 2.4: Price-Demand in Point Method
Points
Price in Rs.
Demand in units
10 - 00
40
09 - 00
46
PED
Change in demand
100
Original demand
In order to find out percentage change in price, the following formula is
employed
Change in price
100
Original price
At Point A, Ep =
change in demand
original demand
6
600
100
15%
40
40
Change in price
1
100
100
100
10%
Original price
10
10
Ep
At point B, ED =
15
1 .5
10
Change in demand 6
600
100
13.04%
Original demand 46
46
Change in price 1
100
100
11.11%
Original price 9
9
Ep
13.04
1.17
11.11
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Price
A 1.5
B 1.17
D
Demand
Figure 2.10: Demand Curve
Figure 2.10 depicts the demand curve for the considered case. It is clear
that on any straight line demand curve, price elasticity will be different at
different points since the demand curve represents the demand schedule
and the demand schedule has different elasticity at various alternative
prices.
Graphical representation
The simplest way of explaining the point method is to consider a linear or
straight line demand curve. Let the straight-line demand curve be extended
to meet the two axis X and Y when a point is plotted on the demand curve, it
divides the curve into two segments. The point elasticity is measured by the
ratio of lower segment of the demand curve below the given point to the
upper segment of the curve above the point. Hence,
Price elasticity =
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Y
D
Upper Segment
Price
Price
P
Lower
Segment
P
D
Demand
Demand
(a)
(b)
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Q2 Q1 P2 P1
Q2 Q1 P2 P1
Illustration
P1 = original price 10 00.
P2 = New price
05 00
By substituting the values in to the equation, we can find out Arc elasticity of
demand.
0 .6
300 200 5 10 500 5 5 1 5
Y
D
Price
P1
D P
82
P
%
404
D
Q1
Q2
Demand
8
Figure 2.12 depicts the demand
curve for the arc method. In the diagram, in
%
order to measure arc elasticity between two points M & N on the demand
=
curve, we have to take the average of prices OP1 and OP2 and also the
average quantities of Q1 &0.Q2.
5
Practical application of price elasticity of demand
Few examples on the practical application of price elasticity of demand are
%
as follows:
1. Production planning It helps a producer to decide about the volume
of production. If the demand for his products is inelastic, specific
quantities can be produced while he has to produce different quantities,
if the demand is elastic.
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3.
4.
5.
6.
7.
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Ey
Symbolically Ey
D Y
Y D
300
4000
1 .5
2000
400
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Symbolically, Ec =
Py
Dx
Py
Dx
40 4
1 .6
2 50
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Ea =
Unit 2
Symbolically,
Ea =
D or Sales
A
40,000
800
2.67
A
Demand or sales 1200
10,000
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Es
Unit 2
Symbolically Es =
Dx / Dy
Px / Py
Dx / Dy
Px / Py
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2.4 Summary
Let us recapitulate the important concepts discussed in this unit:
Demand is created by consumers. Consumers can create demand only
when they have adequate purchasing power and willingness to buy
different goods and services. There is a direct relationship between
utility and demand. Law of demand tells us that there is an inverse
relationship between price and demand in general. Sometimes,
customers buy more in spite of rise in the prices of some commodities.
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Thus, the law of demand has certain exceptions. Demand for a product
not only depends on price but also on a number of other factors. In
order to know the quantitative changes in both price and demand, one
has to study elasticity of demand.
2.5 Glossary
Demand: It is the total or given quantity of a commodity or a service that is
purchased by the consumer in the market at a particular price and at a
particular time.
Demand curve: A locus of points showing various alternative price-quantity
combinations.
Demand function: A comprehensive formulation which specifies the factors
that influence the demand for a product.
Elasticity of demand: Responsiveness or sensitiveness of demand to a
given change in the price or non-price determinant of a commodity.
Law of Demand: Keeping other factors that affect demand constant, a fall
in price of a product leads to increase in quantity demanded and a rise in
price leads to decrease in quantity demanded for the product.
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2.7 Answers
Self Assessment Questions
1. Inversely
2. Same / upward
3. Expansion, contraction
4. Qualitative
5. Comprehensive / wider
6. Fall
7. Direction percentage
8. Price Elasticity of Demand
9. Flatter
10. Positive; negative
11. Advertisement Elasticity of Demand
12. Small, large
True or False
i) False
ii) True
iii) True
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iv) False
v) False
vi) False
vii) True
viii) True
ix) False
x) False
Terminal Questions
1. The term demand refers to total or given quantity of a commodity or a
service that is purchased by the consumer in the market at a particular
price and at a particular time. Refer to Section 2.2.
2. Exceptions to law of demand states that with a fall in price, demand also
falls and with a rise in price demand also rises. Refer to Section 2.2 for
more details.
3. If demand increases, there would be forward shift in the demand curve
to the right and if demand decreases, then there would be backward
shift in the demand cure. Refer to Section 2.2.
4. Elasticity of demand shows the reaction of one variable with respect to a
change in other variables on which it is dependent. Refer to Section 2.3.
5. The elasticity of demand depends on several factors Refer to
Sections 2.3.
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Maruti Suzuki, which specialises in small models, sold 1.27 million cars in
the fiscal year that ended in March, with an increase of 25 percent. "So, it
might even be slightly less than last year. There are still four months to
go. Let's see how it goes but I doubt if we'll have any growth this year,"
he said. Bhargava had said in August that he expected Maruti, 54.2
percent-owned by Japan's Suzuki Motor Corp, to post single-digit sales
growth this fiscal year.
He said on Monday he expects the Indian automobile industry to grow 23 percent this fiscal year, compared with the record 30 percent growth it
had clocked a year ago. Slowing economic growth, rising interest rates
and fuel prices, as well as falling stock markets have dampened
sentiment in the Indian auto market.
"While first-time car buyers...have continued to buy cars, the people who
used to replace cars or buy a second or a third car in their family, those
people have deferred buying decisions this year," Bhargava said. He
remained optimistic for a demand revival, but said it was difficult to give a
time frame.
Maruti, which until last year sold nearly every other car in India, faces a
tough competition from the global car makers such as: Hyundai Motor
Co, Ford Motor Co, General Motors Co and Honda Motor Co; and it has
seen its market share slide to just over 40 percent.
Bhargava said it was "a little bit unfair" to calculate this year's market
share as Maruti has been hit by one-off factors such as labour unrest and
inadequate capacity to meet a surge in demand for cars that run on lessexpensive diesel fuel. "Realistically, we would expect to keep around 4243 percent of the market," said Bhargava.
Maruti was hit by a labour strike at a key plant in the northern state of
Haryana, where workers wanted to leave their existing union to form one
of their own. The unrest led to a production loss of about 83,000 cars, or
almost half a billion dollars in output, while buyers were made to wait
longer for the cars they ordered.
Bhargava said recent rises in petrol prices have boosted demand for
diesel cars, but Maruti did not have capacity to meet the demand. "We
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have a waiting list of diesel cars and we have surplus capacity of petrol
cars," he said. Maruti is in advanced talks with Italian automaker Fiat SpA
to source diesel engines to boost its production and expects to receive
supplies starting in January, he said.
Europe has traditionally been the biggest export market for Maruti, but
the company is now trying to build the export market beyond the debt
crisis-racked continent, focusing on Southeast Asia, Africa and Latin
America, Bhargava said.
Discussion Questions:
1. How do macroeconomic conditions (such as slowing economic
growth) affect the demand for products such as cars?
2. What are the various segments that contribute to demand for cars?
3. What could be the relationship between petrol cars and diesel cars?
4. How can international economic conditions impact the export markets
for cars?
5. What steps could Maruti Suzuki take to increase its market share?
(Source: The Economic Times, Nov 21, 2011)
Hint: With the help of the theoretical concepts build your views in this
case study.
References:
E-Reference:
www.Economictimes.com retrieved on 21st November 2011
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