Unit 2: Demand And Supply Analysis

Theory of Demand

The Theory of Demand explains how the quantity of a product that people want to buy changes with its price. Generally, as prices decrease, demand increases, and as prices increase, demand decreases (law of demand).

'Demand'

Desire to acquire it,
Ability to pay for it, and
willingness to pay for it

LAW OF DEMAND

The law of demand states that "Ceteris paribus (other things remaining the same), higher the price, lower the demand and vice versa."
The quantity demanded is inversely related to its price.

Assumptions of Law of Demand:

The income of the consumer is constant.
There is no change in the availability and price of the related commodities (i.e. complementary and substitutes)
There are no expectations of the consumers about changes in the future price and income.
Consumers' tastes and preferences remain the same.
There is no change in the population and its structure.

Exceptions to the law of Demand

Giffen Goods: These are inferior goods for which demand increases as the price rises, due to the effective decrease in real income for consumers.
Veblen Goods: These luxury items become more desirable as their prices increase because they signal status and exclusivity (e.g., designer handbags).
Essential Goods: For necessities, consumers may continue to buy the same amount or more even if prices rise, as they cannot forgo these items (e.g., basic food items).

Types of Demand

Individual Demand: Quantity demanded by a single consumer.
Market Demand: Total quantity demanded by all consumers in the market.
Elastic Demand: Small price changes lead to large changes in demand (e.g., luxury goods).
Inelastic Demand: Price changes have little effect on demand (e.g., necessities).
Joint Demand: Products used together (e.g., printers and ink).
Composite Demand: Goods with multiple uses (e.g., oil).

Determinants of Demand

Price of the Product: Inversely related to demand.
Income of Consumers: Higher income usually increases demand for normal goods.
Prices of Related Goods:

Substitutes: A higher price of one can increase demand for the other.
Complements: A higher price of one can decrease demand for the other.

Tastes and Preferences: Changes in consumer preferences can shift demand.
Expectations: Anticipated future prices can affect current demand.
Number of Buyers: More buyers typically increase overall demand.

Demand Function

The demand function is a mathematical way to show the relationship between the quantity of a product that consumers want and the factors that influence that demand, primarily its price. For example, it can be represented as:

{ Qd = f(P, I, T, N) }

where ( Qd ) is the quantity demanded,
( P ) is the price of the product,
( I ) is consumer income,
( T ) is tastes and preferences, and
( N ) is the number of buyers.

Demand Schedule

A demand schedule is a table that lists the quantity of a good that consumers are willing to buy at different prices. For example:

Demand Curve

The demand curve is a graphical representation of the demand schedule. It shows the relationship between price and quantity demanded. Typically, it slopes downward, indicating that as price decreases, quantity demanded increases.

Shifts in Demand Curve

The demand curve can shift to the left (decrease in demand) or right (increase in demand) due to factors other than price, such as:

Changes in consumer income (higher income can increase demand).
Changes in tastes and preferences (popular trends can increase demand).
Changes in the number of buyers (more buyers can increase demand).
Changes in the price of related goods (substitutes and complements).

Elasticity of Demand

The elasticity of demand measures how sensitive the quantity demanded is to a change in price. It helps businesses understand how changes in price affect sales.

Elastic demand: A small price change leads to a large change in quantity demanded (e.g., luxury items).
Inelastic demand: A price change leads to a small change in quantity demanded (e.g., essential goods).

Measurement of Elasticity

Elasticity is usually measured using the formula:

If ( Ed > 1 ), demand is elastic;
if ( Ed < 1 ), demand is inelastic;
and if ( Ed = 1 ), demand is unitary elastic.

Types of elasticity of demand

1. Price Elasticity of Demand

Price elasticity measures how much the quantity demanded of a good changes when its price changes. In simple words, If the price of a product goes up, do people buy a lot less of it, or just a little less.

Elastic Demand: If a small price increase causes a big drop in sales (like luxury items), it’s elastic.
Inelastic Demand: If sales hardly change when prices go up (like necessities), it’s inelastic.

It Helps businesses decide on pricing strategies. If demand is elastic, they might avoid raising prices.

2. Income Elasticity of Demand

This measures how much the quantity demanded changes as consumer income changes. In simple words, How does a change in income affect how much of a product people buy.

Normal Goods: If demand increases when income rises (like new cars), they have positive income elasticity.
Inferior Goods: If demand decreases as income increases (like cheap ramen), they have negative income elasticity.

3. Arc Elasticity of Demand

This calculates elasticity over a range of prices, rather than at a single point. In simple words, It looks at how demand changes between two different prices, rather than just one specific price point.
It Helps businesses understand how demand shifts between different price points, making it easier to set prices strategically.

Where,

$P_{1}$ and $P_2$ are the initial and new prices,
$Q_1$ and $Q_2$ are the initial and new quantities demanded.

If the value is greater than 1, demand is elastic (sensitive to price changes).
If it's less than 1, demand is inelastic (not sensitive to price changes).
If it equals 1, demand is unit elastic (proportional change in quantity to price).

4. Cross Elasticity of Demand

This measures how the quantity demanded of one good changes when the price of another good changes. In simple words, if the price of one product changes, how does it affect the sales of another product.

Substitutes: If the price of coffee goes up and people buy more tea, those goods are substitutes (positive cross elasticity).
Complements: If the price of printers goes up and people buy fewer ink cartridges, those goods are complements (negative cross elasticity).

It Helps businesses understand competitive dynamics and how changes in one product’s price can affect others.

5. Advertising Elasticity of Demand

This measures how much the quantity demanded changes in response to changes in advertising expenditure. In simple words, How does spending more on advertising affect sales If a company spends more on ads and sales go up significantly, it has high advertising elasticity.

AED > 1: Demand is elastic to advertising, meaning a percentage increase in advertising leads to a more than proportional increase in quantity demanded.
AED < 1: Demand is inelastic to advertising, indicating that increases in advertising have a less than proportional impact on the quantity demanded.
AED = 1: Demand is unit elastic to advertising, meaning changes in advertising result in proportional changes in quantity demanded.

Example:

If a 10% increase in advertising expenditure leads to a 20% increase in sales, the AED would be:

AED = \frac{20 %}{10 %} = 2

This indicates that demand is elastic to advertising.

It Helps companies decide how much to invest in marketing. If elasticity is high, increasing advertising is likely to boost sales.

Degree of Elasticity of Demand

1. Perfectly Elastic Demand

Meaning: Even a tiny change in price will cause consumers to stop buying a product altogether.
Example: Imagine you’re at a market where every vendor sells identical pens for ₹10 each. If one vendor raises the price by even 1 paisa, no one will buy from them because they can get the same pen for ₹10 elsewhere.

Key Point: The demand drops to zero if the price increases even a little.

2. Perfectly Inelastic Demand

Meaning: No matter how much the price changes, the quantity demanded remains the same.
Example: Think about a life-saving medicine for a serious condition. If you need it to survive, you’ll buy it even if the price doubles or triples because there’s no substitute.

Key Point: People will buy the same amount no matter how high the price goes.

3. Unitary Elastic Demand

Meaning: The percentage change in quantity demanded is exactly the same as the percentage change in price.
Example: Suppose the price of a product like movie tickets goes up by 10%, and as a result, 10% fewer people go to the movies. The change in demand matches the price change exactly.

Key Point: A change in price leads to a proportional change in demand.

4. Relatively Elastic Demand

Meaning: A small change in price leads to a larger change in quantity demanded.
Example: Let’s say the price of a brand of soft drinks goes up by 5%, but as a result, 20% fewer people buy it because they can easily switch to other brands.

Key Point: Consumers are sensitive to price changes and will switch if prices increase.

5. Relatively Inelastic Demand

Meaning: A change in price causes a smaller change in quantity demanded.
Example: For example, petrol prices may rise by 10%, but people still need to buy almost the same amount to commute to work. So, demand only drops by 2%.

Degree Of Elasticity of Supply

1. Perfectly Elastic Supply

Meaning: Suppliers are willing to supply an unlimited amount of a product at a particular price. However, if the price drops even slightly, they will supply nothing.
Example: Imagine a factory that can easily produce an unlimited number of T-shirts at ₹500 each. If the price drops to ₹499, the factory stops production completely because they don't find it profitable anymore.

Key Point: Suppliers provide as much as needed at a specific price but won’t supply anything if the price drops even a little.

2. Perfectly Inelastic Supply

Meaning: The quantity supplied is fixed, regardless of the price.
Example: Think about seats in a football stadium. Whether ticket prices go up or down, the number of seats (supply) stays the same because the stadium has a limited number of seats.

Key Point: No matter what the price is, the amount supplied cannot change.

3. Unitary Elastic Supply

Meaning: The percentage change in price leads to an equal percentage change in the quantity supplied.
Example: If the price of laptops goes up by 10%, and laptop manufacturers increase their supply by 10%, this is unitary elastic supply.

Key Point: A proportional change in price leads to the same proportional change in supply.

4. Relatively Elastic Supply

Meaning: A small increase in price causes a large increase in the quantity supplied.
Example: If the price of oranges rises by 5%, farmers may quickly produce and supply 20% more oranges because they have the capacity to produce more in a short time.

Key Point: Suppliers can easily and quickly increase production when the price rises.

5. Relatively Inelastic Supply

Meaning: A price increase leads to only a small increase in the quantity supplied.
Example: Suppose the price of housing goes up by 10%. However, it may take a long time to build new houses, so the supply only increases by 2% in response to the higher price.

Key Point: Even if prices rise, suppliers can’t increase the supply much, often due to time, resources, or production constraints.

Difference Between PED & PES

Uses of Elasticity of Demand for Managerial Decision-Making

The elasticity of Demand measures how much the quantity demanded of a product changes when there is a change in its price or other factors (like income or the price of related goods). It tells businesses how sensitive consumers are to price changes

It help in:

1. Decision-MakingPricing

Understanding Consumer Sensitivity: If a product is price elastic (demand decreases significantly when prices rise), managers need to be careful with price increases. For example, if a restaurant raises the price of its popular dish from $10 to $15 and notices that customers stop ordering it, they may decide to lower the price back to attract customers again.
Setting Discounts: For products with elastic demand, managers can offer discounts to boost sales. For instance, a clothing store may find that a 20% discount increases sales significantly, allowing them to sell more despite lower prices.

2. Revenue Management:

Maximizing Revenue: If demand is elastic, lowering prices might lead to a larger increase in sales, resulting in higher overall revenue. For example, if a software company reduces its subscription fee and gains many new users, the total revenue may increase even though the price is lower.
Price Testing: Managers can experiment with different prices to find the best balance between price and quantity sold, ensuring they maximize income.

3. Product Line Decisions:

Identifying Best Sellers: Managers can analyze which products have more elastic demand and focus on promoting those items. For instance, if a bakery discovers that its cupcakes have elastic demand while bread does not, it might decide to create more cupcake varieties or run promotions for cupcakes.
Discontinuing Products: If a product consistently shows inelastic demand (not affected much by price changes), managers might consider discontinuing it if it doesn’t contribute significantly to profits.

4. Market Entry and Expansion:

Assessing New Markets: Before entering a new market, companies can study the elasticity of demand for their products in that area. For instance, if research shows that people in a new city are price-sensitive, the company might plan a competitive pricing strategy to attract customers.
Planning Promotions: Understanding elasticity can help managers plan effective marketing campaigns. If they know a certain demographic is price-sensitive, they can tailor promotions to that group to increase sales.

5. Inventory Management:

Stock Levels: Knowing the elasticity of demand helps managers decide how much stock to keep. If a product is elastic, managers may avoid overstocking, as they know demand can drop significantly with price changes.
Seasonal Adjustments: Managers can adjust inventory levels based on expected demand elasticity during different seasons. For example, a retailer might stock up on winter clothing when they anticipate high demand, but be cautious about overstocking if prices are expected to rise.

Understanding the elasticity of demand helps managers make informed decisions about pricing, revenue, product focus, market expansion, and inventory management. By knowing how consumers react to price changes, businesses can better align their strategies to meet consumer needs and maximize profits.

Demand Forecasting

Demand Forecasting is the process of predicting how much of a product or service customers will want to buy in the future. This helps businesses plan their operations, manage inventory, and set sales targets.

Significance of Demand Forecasting

Efficient Resource Allocation: Knowing how much product to make helps businesses use their resources efficiently. For example, if a toy company expects high demand for a new toy during the holiday season, it can ensure enough materials and labor are available.
Inventory Management: Accurate forecasts prevent overstocking or understocking products. If a grocery store knows it will sell a lot of milk in the summer, it can order enough stock to avoid running out.
Financial Planning: Forecasting helps in budgeting and financial planning. A company can estimate its revenue based on expected sales, making it easier to plan expenses and investments.
Market Strategy Development: Understanding demand helps businesses create effective marketing strategies. If they know a product will be popular, they can prepare promotional campaigns in advance.

Methods of Demand Forecasting

Qualitative Methods: These rely on opinions and judgments rather than numerical data.Example: Asking salespeople about customer preferences or conducting surveys to gather feedback from customers.
Quantitative Methods: These use historical data to predict future demand.Example: Analyzing past sales data to identify trends and make predictions. Here are a few common quantitative methods:

Time Series Analysis: Uses historical sales data to identify patterns over time (e.g., seasonal sales trends).
Causal Models: Uses relationships between demand and other factors (e.g., price, marketing spending) to make predictions.

Numerical Exercise

Example; Let’s go through a simple numerical exercise to illustrate demand forecasting.
Scenario: A small bakery sells loaves of bread and wants to forecast demand for the next month based on past sales data.
Historical Sales Data:
Week 1: 100 loaves,
Week 2: 120 loaves,
Week 3: 110 loaves,
Week 4: 130 loaves

Step 1: Calculate the Average Weekly Demand To forecast demand, first calculate the average sales over the past four weeks

Step 2: Forecast Demand for the Next MonthAssuming the bakery operates four weeks in a month, the forecasted demand for the next month can be calculated as:

In this example, the bakery forecasts that it will need 460 loaves of bread for the next month based on its historical sales data. Meaning: Demand forecasting helps predict future customer demand.Significance: It aids in resource allocation, inventory management, financial planning, and marketing strategies.Methods: It includes qualitative methods (like surveys) and quantitative methods (like a

Criteria for Good Forecasting:

Accuracy: Forecasts should closely match actual outcomes.
Reliability: The method should produce consistent results over time.
Timeliness: Forecasts must be delivered in time for decision-making.
Flexibility: The method should adapt to changing conditions or new data.
Simplicity: Forecasts should be easy to understand and implement.
Cost-Effectiveness: The benefits of forecasting should outweigh the costs.
Comprehensiveness: All relevant factors affecting demand should be considered.
Objectivity: Relying on data and facts, avoiding personal biases.
Use of Appropriate Data: Utilize relevant, high-quality data sources.
Feedback Mechanism: Include a system for reviewing and improving forecasts based on past performance.

Importance of Forecasting:

Informed Decision-Making: Enables data-driven decisions, reducing guesswork.
Resource Allocation: Helps allocate resources efficiently to meet demand.
Inventory Management: Maintains optimal inventory levels, reducing stockouts and overstocking.
Financial Planning: Assists in budgeting and predicting revenues and expenses.
Market Strategy Development: Informs effective marketing and sales strategies.
Risk Management: Identifies potential risks, allowing for contingency planning.
Performance Evaluation: Compares actual performance against forecasts for adjustments.
Long-Term Planning: Supports strategic planning by highlighting future trends.
Competitive Advantage: Enables quicker responses to market changes.
Customer Satisfaction: Anticipates customer needs for timely delivery of products.

Overall, forecasting is crucial for improving efficiency, reducing costs, and enhancing customer satisfaction.

Supply Analysis

Supply refers to the amount of a product that producers are willing and able to sell at different prices.

Law of Supply:

The Law of Supply states that as the price of a product increases, the quantity supplied also increases, and vice versa. In simple terms, if producers can sell their goods for a higher price, they are more likely to produce and sell more of it. Example: Imagine a lemonade stand. If the price per cup of lemonade goes from $1 to $2, the stand owner will likely make more lemonade to sell, because they can earn more money.

Supply Elasticity

Supply Elasticity measures how responsive the quantity supplied is to a change in price. It helps managers understand how much the supply of a product will change when prices fluctuate.

Types of Supply Elasticity:

Elastic Supply: When a small change in price leads to a large change in quantity supplied. For example, if a local bakery can quickly make more cookies when the price rises, its supply is elastic.
Inelastic Supply: When a change in price results in a small change in quantity supplied. For example, if a farmer can only grow a certain amount of apples in a season, even if the price increases, the supply remains relatively unchanged.

Uses of Supply Elasticity for Managerial Decision Making:

Pricing Strategies: Knowing if supply is elastic or inelastic helps managers set prices effectively. If demand is high and supply is elastic, they can raise prices to maximize profits.
Production Planning: If managers know that supply is elastic, they can quickly adjust production levels to meet changes in demand.
Market Entry Decisions: Understanding supply elasticity can help businesses decide if they should enter a new market. If supply is elastic, it may be easier to compete and meet consumer needs.

Price of a Product under Demand and Supply Forces

The price of a product is determined by the interaction of demand (how much consumers want a product) and supply (how much producers are willing to sell).

Equilibrium Price: The price at which the quantity demanded by consumers equals the quantity supplied by producers is called the equilibrium price. At this price, there is no surplus (excess supply) or shortage (excess demand).Example: If the price of a smartphone is set too high, fewer people will want to buy it (lower demand), while producers may want to make more because of the high price. Conversely, if the price is too low, many people want to buy it (higher demand), but producers might not want to supply as many. The market finds a balance at the equilibrium price.

Supply Function

The supply function is a mathematical representation that describes the relationship between the quantity of a product that producers are willing to sell and various factors that influence that quantity, primarily the price of the product. It expresses how much of a good or service will be supplied at different price levels. Basic Structure of a Supply FunctionThe general form of a supply function can be expressed as:

[ Qs = f(P, C, T, N, E) ]

Where:

(Qs) = Quantity supplied
(P) = Price of the product
(C) = Cost of production (e.g., labor, materials)
(T) = Technology (level of technology affecting production efficiency)
(N) = Number of suppliers in the market
(E) = Expectations of future prices

Factors Affecting the Supply Function

Price of the Product: Generally, as the price increases, the quantity supplied also increases (this reflects the Law of Supply).
Cost of Production: If production costs rise (due to higher wages or raw material prices), the supply may decrease, shifting the supply curve to the left.
Technology: Advancements in technology can make production more efficient, increasing supply at all price levels (shifting the supply curve to the right).
Number of Suppliers: More suppliers entering the market usually increases the total supply.
Expectations: If suppliers expect prices to rise in the future, they may reduce the current supply to sell more later at a higher price.