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BUSINESS ECONOMICS

Session 1: DEMAND ANALYSIS I

1.

Pre-Work

1.1

Introduction

The primary objective of a business firm is to maximize profits. Profit maximization implies maximizing the difference between Total Revenue (TR) and Total Cost (TC).

Π = TR – TC

Given this objective, the business options which a firm faces would relate to: increasing TR or decreasing TC or both i.e. some combination of TR & TC.

To understand the implications of profit maximization, let us

begin by assuming unchanging TC. This restriction translates into a situation where increase in profits leads to increase in TR.

where increase in prof its leads to increase in TR. ↑ Π = Π = ↑

Π =

Π =

TR,

TR – TC where TR = (P xQ )

How can TR increase? By definition TR is P x Q. If we assume that Prices (P) are unchanging then increases in Q will lead to increases in TR. In other words, if the demand for a product (Q) increases then TR also rises (under the above assumptions).

This

depends on how a firm is able to influence consumers to buy more

How can a firm increase the demand for its Product?

of its product (X) i.e. ↑Q x .

Consider the following two situations. The demand for

washing machines increased significantly in most Indian metros over

the last ten years. Why did this happen? Even while the prices of

washing machines have reduced significantly there have been other

changes as well. With more working women and the associated

difficulties in the availability of domestic help, there has been an

inherent rise in the demand for household appliances.

Compare this situation with the demand for ‘Vaccumizer’ –

which was launched in the 1990s. The product was based on a novel

idea wherein freshness is maintained through vaccumising. This

concept did not pick up in India. Why? With easy access to ‘Kirana’

stores that have a high turnover and availability of fresh fruits &

vegetables ‘at the doorstep’, the perceived consumer utility for the

product would not be high. Therefore, it is not surprising that this

product was not successful in the Indian market.

The above examples indicate that at the firm level, ↑ Q x implies:

Identification of what consumers want

Understanding what factors determine consumer’s demand decisions.

1.2

Understanding Consumer’s demand curve

For an individual consumer, utility perception

is the first step for the buying decision. To

understand how a consumer takes a decision

to buy a product consider a situation where a

person is very hungry. To satisfy his hunger,

the person has to decide on what products to

consume and how much?

Why apples? He likes apples. This would mean demand for a product exists when a consumer perceives ‘utility’ generally defined as tastes and

preferences Utility is defined at

an individual consumer level and is multi-dimensional. For example, a person who drinks tea for its flavour would demand tea leaves. But the person who looks for convenience would demand tea bags. In this case, the utility dimension in former case is taste while in the latter case it

is convenience.

Let’s say he decides to eat apples. How many apples will he decide to eat and

What is the basis for this decision?

Suppose the ‘utility’ derived for consuming apples is assigned a

number where an increase in the number implies utility is increasing and a

decrease would men that utility is decreasing. The following table presents

the utilitiy derived from apples.

Consumption of Apples

Number of Apples

(TU) Total Utility (Cumulative)

MU

0

0

0

1

30

30

2

55

25

3

75

20

4

90

15

5

100

10

6

100

0

7

90

-10

We observe that upto 5 apples, the utility (in this case, satiating hunger) is

increasing.

At the 6 th apple, the utility derived is constant and thereafter it

declines. Given this relationship between consuming apples and utility, how does a consumer decide how much to consume?

For this, we need to see the incremental utility derived by successive units of apples of consumed. This is defined as Marginal utility (MU)

MU

TU

Q

(i.e change in TU (Total utility) due to one unit change in

quantity

consumed)

In the above example, MU in the highest for the first apple and declines for the successive units, reaches zero for the 6 th unit and thereafter turn negative based

Why should a consumer not consume the 7 th apple? The consumer experiences disutility as is reflected in negative MU.

on the law of diminishing marginal utility. This implies that as long as MU is positive (or TU is increasing), a consumer would tend to consume more of that product. Since the objective of a consumer is to maximize TU, consumption will be stopped when TU is maximum or MU = 0 (i.e. at the 6 th apple). Extending this framework to consumer choice i.e. How does a consumer decide when faced with a number of consumption alternatives? Suppose instead of apples, the consumer has the choice of two fruits, namely, apples and oranges. Given the TU and MU of apples and oranges (i.e. defined by tastes of individual consumers) as in the table below, how will the consumer decide?

 

Apples (Rs 5)

 

Oranges (Rs 10)

 

Number

TU A

MU A

MU A

Number

TU O

MU O

MUo

Consumed

P

A

Consumed

P

O

1

30

30

6

1

40

40

4

2

55

25

5

2

75

35

3.5

3

75

20

4

3

100

25

2.5

4

90

15

3

4

115

15

1.5

5

100

10

2

5

125

10

1

6

100

0

 

6

125

0

 

7

90

-10

 

7

115

-10

 

Can a business firm influence these consumption decisions? Yes, if through advertisement or any other method a firm enhances utility perceptions of a consumer, demand or consumption of that product will rise.

The differences in TU values reflects the differences in preferences for the fruits. From the above, it is evident that the consumer likes oranges more than apples. For understanding consumer choice under a set of constraints

assume that the consumer faces a constraint of 5 fruits. In other words, consumer choice has to maximize utility given the restriction of consuming 5 fruits. As such incremental utility (or MU) for successive units of apples and oranges need to be compared. Based on MU, the consumer’s choice of fruits will be as follows: 1 st orange, 2 nd orange, 1 st apple, 2 nd apple and 3 rd orange. If the constraint is relaxed to 8 fruits, then 3 rd and 4 th apples and 4 th orange will also be consumed.

1.3 Deriving the demand curve (Price & Quantity relationship)

Suppose apples are priced at Rs 5 per piece and oranges at Rs 10 per piece, and the budget for the purchase of fruits is Rs 20. How does this change the earlier choice of fruits?

Suppose price of apples increase to Rs 10 per piece and that of oranges to Rs 5 per piece, how would the choice of fruit undergo a change

When the MU for successive units of apples and oranges are compared to their respective prices, the choice of fruits for consumption is not same as indicated earlier. For example, assume the income

(or budget of a consumer is Rs. 20). Given a budget of Rs 20, two apples and one orange would be bought by the consumer. Thus, in the absence of prices, consumer choice is based on MU of individual products. With prices included, the choice will be determined by the comparison of MU relative to respective prices.

Assuming unchanging tastes (or unchanging

MU schedules), a price reduction of product X

will lead to an increase in the value of the ratio

What would be the implications of a firm reducing the prices of a product?

MU x P x
MU x
P
x

thereby increasing the demand for Product X relative to other MU x

products.

.

Following from this, we have Qx = f

When

x

P x

MU

P

x

MU X is constant, then P x will lead to Q x and as such the ratio

increases. And, the converse holds true for an increase in price. Hence,

Q x = f (P x , T ). This is the demand curve for product X. The changes in

quantity demanded due to changes in prices would vary between products

depending on consumer’s tastes and preferences.

1.4 Understanding Quantity & Income relationship

In the above example, suppose if

consumer’s budget increases from Rs 20 to

35 and the relative prices are unchanging.

What would be the implications on the demand

for Apples and Oranges?

Instead of 2 apples and 1 orange, the

consumer would now demand 3 apples

and 2 oranges. In other words, changes in

incomes, influences the demand for

products. The extent of change in demand

for a product would depend on the nature

of the product.

How do we identify normal and inferior goods? For example, some consumers will move from scooters to cars. For this group of consumers, scooters are inferior goods and cars are normal or superior goods. Alternatively, if another group of consumers shift from Segment ‘A’ to Segment ‘B’ due to rise in incomes, then Segment ‘A’ cars will be inferior goods while Segment ‘B’ will be superior goods.

How can a firm define the market demand for inferior and superior goods?

Given that normal or inferior goods vary between consumers, from the perspective of a firm these goods are defined at the average market demand level Market demand level. This can be explained by the following example. Suppose a market

6

is defined by 3 Consumers, viz; A, B and C.

By definition, if income increases and the demand for product X increases, we call these products normal or superior goods. Alternatively, when demand for products decrease with increase in income, we call these products inferior goods.

Their

Income

-

demand

schedules

are

as

follows:

 

Q

x

I

A

B

C

Market

 

10

10

10

20

40

15

12

8

18

38

20

14

2

15

31

25

18

1

10

29

Q X : demand for scooter (in ‘000)

 

I

: Average Income (Rs ‘000 per

month)

 

At the market level, as income increases from 10 to 25; demand for scooters decreases from 40 to 29. Hence, scooters are defined as inferior good. Note: there may be some consumer in the market for whom demand increases as income increases.

1.5 Understanding the Relative Price & Quantity relationship

Suppose in the above example, relative prices change i.e. price of orange decreases to Rs 5 per piece while the price of apples continues to be at Rs 5 per piece. What would be the implications on the demand for apples and oranges?

Given a budget of Rs 25, 3 oranges and 2 apples will be purchased by the

consumer. In other words, when relative prices change or prices of other products

(P Y ) relative to product X change, the demand for X or (Q X ) will change. On the

basis of the direction of influence of P Y on Q X , we broadly categorize the products into Substitute and Complementary goods. For example,

(i) Assume that if Maruti reduces the price of Zen (P z ), the demand for Santro (Q s ) decreases.

P z
P
z

Q Z

Q s
Q s

7

Here, Zen and Santro are substitute goods and the sign of coefficient P Y on Q X

will be positive (+).

(ii) Assume that if prices of tyres (P t ) rise, and the demand for scooters (Q s )

decreases.

P t
P t
P t Q t

Q

t

P t Q t
P t
P t
P t Q t

Q t

Q t
Q s
Q
s

Q s t s t

Here,

Complementary goods.

P t

and

Q s

are

negatively

related.

Thus,

tyres

and

scooters

are

1.6

Deriving the Demand Function

Why

demand factors?

does

a

firm

need

to

identify

A firm can respond to changes in market condition effectively if the firm identifies the demand factors for its products. For example, if there is an expectation that per capital incomes are going to rise by 10%. How should a firm respond to this trend? If a firm produces normal or if a firm superior goods, rise in income will lead to an increase in the demand for these products. Alternatively, if the firm produces inferior goods, then rise in income will result in decline in demand and therefore, the firm would look into the option of reducing production.

Similarly, identifying substitute and complementory products is respond to price changes of competitors.

From

the

above,

it

is

evident

that

Q x = f (P x , I, P y ,T ). This would mean

changes in the above demand factors would

lead to a change in Q x . The direction of

change would depend on whether the

individual demand factors have a positive

(move in the same direction) or negative

(move in the opposite direction) impact.

From the above discussion on demand

factors, P x is Endogenous and I and P y are

Exogenous factors. P x is Endogenous because

the firm can induce a change in the variable.

For example, when a firm is a late extrant into a market, a firm has the option

to price its product below its competitors and change the same according to

its strategies. Thus, changes in P x are induced by the firm in accordance to its strategic objectives. As against this, the firm cannot influence the changes in I and P y . Thus, a firm reacts to the changes in exogenous variables. For example, when a competitor decides to reduce the price, a firm can only respond to this change rather than influence the competitor’s decision (unless both firms are colluding).