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Unit I
Definition, Nature and Scope of Managerial Economics, Managerial Economics, Micro Economics and
Macro Economics, Managerial Economics and decision making, Definitions of Basic Concepts: Positive
and Normative Approach, Optimization, Marginal Analysis, Opportunity Cost, Economic Model: Static &
Dynamics, Meaning and Determinant of Demand, Demand Function, Law of Demand, Market Demand,
Elasticity of Demand, Types of Elasticity, Measurement of Elasticity, Significance and uses of Elasticity,
Method of Demand Estimation, Demand Forecasting, Forecasting of an established product, Forecasting
of a new product

ECONOMICS: INTRODUCTION

The word Economics is derived from the Greek words OKIOS NEMEIN meaning household
management .Father of Economics Adam Smith in his book Wealth of Nations 1776 defined
economics is the study of wealth (Wealth Definition). Alfred Marshall in his book Principles of
Economic Science-1890 defined Economics is the study of mankind in the ordinary business of life
(Welfare Definition). Lionel Robbins gave us the most accepted scarcity-oriented definition of
Economics. He says Economics is a social science which studies human behavior as a relationship
between unlimited wants and scarce means which have alternative uses (Scarcity Definition).
Economics Noble prize winner (1970) Paul Samuelson proposes a dynamic definition in his book
Economics (1948). Economics is the study of how people and society end up choosing with or without
money to employ scarce productive resources that could have alternative uses to produce various
commodities and distribute them for consumption, now or in the future among various persons and
groups in society. Economic analysis is the cost and benefits of improving patterns of resources use
(Growth Definition).
MICRO- MACRO ECONOMICS:
Economic theory can be broadly divided into micro economics and macroeconomics. Economics noble
prize winner (1969), Ragner Frisch was the first to use the terms micro and macro in economics in
1933.
The terms micro and macro derived from Greek. Mikros means small and makros means large. In
terms of economic study Micro means individualistic and macro aggregative.
Micro Economics
Micro economics is the study of particular firms, households, individual prices and particular
commodity. Micro economics is based on the assumption of full employment and ceteris paribus
(other things remain constant).
Macro economics
Macro economics is the study of economic system as a whole. Macro economics studies aggregates
values like National Income, National output, general price level, total consumption, saving and
investment of a country.

An Example of a microeconomic issue could be the effects of raising wages within a business. If a
large business raises its wages by 10 percent across the board, what is the effect of this policy on
the pricing of its products going to be?
Since the cost of producing products has increased, the price of these products for consumers is
likely to follow suit. Likewise, what will happen if a company raises wages for its most productive
employees but fires its least productive workers? Likewise, what will happen if a company raises
wages for its most productive employees but fires its least productive workers?

An Example of Macroeconomic issue would be to observe the effects that low interest rates have
on the national housing market or the unemployment rate. Another common focus of
macroeconomics is the way taxes affect the economics of a nation. A macroeconomist would look at
the effects of a decrease in income taxes using measures like GDP and national income, rather than
individual factors.

DEFINITION OF MANAGERIAL ECONOMICS

FEW DEFINITONS
Prof. Evan J Douglas - Managerial economics is concerned with the application of economic
principles and methodologies to the decision-making process within the firm or organization.

By Pashupati Nath Verma

Spencer and Siegleman defined

managerial
Economics
as
the
integration of economic theory
with business practice for the
purpose of facilitating decision
making and forward planning of
management.

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MGT 105: MANAGERIAL ECONOMICS: UNIT-I

Pappas & Hirschey - Managerial

economics applies economic theory
and methods to business and
administrative decision-making.
From the above definitions Nature of
Managerial economics can be traced
easily.

NATURE OF
MANAGERIAL ECONOMICS

1. Managerial Economics is application oriented and uses the body of economic concepts and
principles. Thus, we can say managerial economics is Pragmatic (i.e. practical) in approach.
2. Managerial Economics is mainly used for managerial decision making and forward planning.
3. Managerial economics is deep rooted with micro-economics but it also uses macroeconomics
concept also as both are equally important for decision making and business analysis. Further,
Managerial economics heavily depends on mathematical and optimization techniques. Thus, we
can say managerial economics is Eclectic (i.e. diverse).
4. Managerial Economics is more Normative (i.e. focuses on prescriptive statement and help
establishing rule aimed at attaining the specified goal of business) than Positive (i.e. describing
the phenomenon). It is positive when it is confined to statements about causes and effects and to
functional relationships of economic variables. It is normative when it involves norms and standards,
mixing them with cause and effect analysis.
5. Managerial Economics is a Management Oriented Tool.

SCOPE OF MANAGERIAL ECONOMICS

All the economic theories, tools, and concepts are covered under the scope of managerial economics to
analyze the business environment. Scope of managerial economics is widening day by day with its
continuous development.
Demand analysis and forecasting, Production, Supply and Cost Analysis, Pricing policy,
Profit Policy, and Capital Management is the major areas considered under the scope of
managerial economics.
Demand Analysis and Forecasting: A business firm is an economic organisation which transforms
productive resources into goods to be sold in the market. A major part of business decision making
depends on accurate estimates of demand. Demand analysis and forecasting provided the essential
basis for business planning and occupies a strategic place in managerial economic. The Demand
Analysis and Forecasting mainly covers: Demand Determinants, Demand Distinctions and Demand
Forecast.
Cost and Production Analysis: A study of economic costs, combined with the data drawn from the
firms accounting records, can yield significant cost estimates which are useful for management
decisions. Production analysis frequently proceeds in physical terms while cost analysis proceeds in
monetary terms. The Cost and Production Analysis mainly covers : Cost concepts and classification,
Cost-output Relationships, Economics and Dis-economics of scale, Production function and Cost control.
Pricing Decisions, Policies and Practices: The success of a firm largely depends on how correctly
the pricing decisions are taken. The important aspects dealt with under pricing includes: Price
Determination in Various Market Forms, Pricing Method, Differential Pricing, Product-line Pricing and
Price Forecasting.
Profit Management: In a world of uncertainty, expectations are not always realized so the profit
planning and measurement constitute a difficult area of managerial economic. The important aspects
covered under this area are: Nature and Measurement of profit, Profit policies and Technique of Profit
Planning like Break-Even Analysis.

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Capital Management: Among the various types business problems, the most complex and
troublesome for the business manager are those relating to a firms capital investments. Capital
management implies planning and control of capital expenditure. The important aspects covered under
this area are: Cost of capital Rate of Return and Selection of Projects.

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MICRO, MACRO, AND MANAGERIAL ECONOMICS

RELATIONSHIP

Microeconomics studies the actions of individual consumers and firms; managerial economics is an
applied specialty of this branch. Macroeconomics deals with the performance, structure, and behavior
of an economy as a whole.
Managerial economics applies microeconomic theories and techniques to management decisions. It is
more limited in scope as compared to microeconomics.
Macroeconomists study aggregate indicators such as GDP, unemployment rates to understand the
functions of the whole economy. Macroeconomics models and their estimates are used by the
government to assist in the development of economic policy.
Microeconomics and managerial economics both encourage the use of quantitative methods to analyze
economic data. Managerial economic principles can aid management decisions in allocating these
resources efficiently.
MICROECONOMICS
1. It is the study of individual
economic units of an economy

MACROECONOMICS
It is the study of economy as a
whole and its aggregates.

2. It deals with individual income,

It deals with aggregates like
individual prices and individual
national income, general price
output, etc.
level and national output, etc.
3. Its Central problem is price
Its central problem is
determination and allocation of determination of level of income
resources.
and employment.
4. Its main tools are demand and
Its main tools are aggregate
supply of a particular
demand and aggregate supply of
commodity/factor.
economy as a whole.
5. It helps to solve the central
problem of what, how and for
whom to produce in the economy

It helps to solve the central

problem of full employment of
resources in the economy.

6. It discusses how equilibrium of

It is concerned with the
a consumer, a producer or an determination of equilibrium level
industry is attained.
of income and employment of the
economy.
7. Price is the main determinant of Income is the major determinant
microeconomic problems.
of macroeconomic problems.
8. Examples are: individual
income, individual savings, price
determination of a commodity,
individual firm's output,
consumer's equilibrium.

Examples are: National income,

national savings, general price
level, aggregate demand,
aggregate supply, poverty,
unemployment etc.

MANAGERIAL ECONOMICS
It is the study of application of
economic theory for business
decision making in individual
economic units of an economy
It deals with individual income,
individual prices and individual
output, etc. wrt a business firm
Its Central problem is optimum
allocation of resources and
decision making
Its main tools are demand and
supply as well as production
economies of a particular
commodity/factor.
. It helps to solve the central
problem of what, how, for whom
and how much to produce in the
economy
It discusses how equilibrium of a
consumer, a producer or an
industry is attained with holding
firms objective.
Firms objective as well as prices
is the main determinant of
microeconomic problems.
Examples are: Pricing Decision,
Make are Buy Decision, Decision
on Production Technique, Decision
on Inventory Policies,
Employment & Training Decision,
Project Selection Decision

By Pashupati Nath Verma

MGT 105: MANAGERIAL ECONOMICS: UNIT-I

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MANAGERIAL ECONOMICS & DECISION MAKING

Decision making is an integral part of modern management. Decision making is the process of selecting
one action from two or more alternative course of actions. Resources such as land, labour and capital
are limited and can be employed in alternative uses, so the question of choice arises. Managers of
business organizations are constantly faced with wide variety of decisions in the areas of pricing,
product selection, cost control, asset management and plant expansion. Manager has to choose best
among the alternatives by which available resources are most efficiently used for achieving the desired
aims.

The steps for decision making like problem description, objective determination, discovering
alternatives, forecasting consequences are described below:
Define the Problem
What is the problem and how does it influence managerial objectives are the main questions. Decisions
are usually made in the firms planning process. Managerial decisions are at times not very well defined
and thus are sometimes source of a problem.
Determine the Objective
The goal of an organization or decision maker is very important. In practice, there may be many
problems while setting the objectives of a firm related to profit maximization and benefit cost analysis.
Are the future benefits worth the present capital? Should a firm make an investment for higher profits
for over 8 to 10 years? These are the questions asked before determining the objectives of a firm.
Discover the Alternatives
For a sound decision framework, there are many questions which are needed to be answered such as:
What are the alternatives? What factors are under the decision makers control? What variables
constrain the choice of options? The manager needs to carefully formulate all such questions in order to
weigh the attractive alternatives.
Forecast the Consequences
Forecasting or predicting the consequences of each alternative should be considered. Conditions could
change by applying each alternative action so it is crucial to decide which alternative action to use
when outcomes are uncertain.
Make a Choice
Once all the analysis and scrutinizing is completed, the preferred course of action is selected. This step
of the process is said to occupy the lions share in analysis. In this step, the objectives and outcomes
are directly quantifiable. It all depends on how the decision maker puts the problem, how he formalizes
the objectives, considers the appropriate alternatives, and finds out the most preferable course of
action.
Following are the important areas of decision making;
Selection of product.
Selection of suitable product mix.
Selection of method of production.
Product line decision.
Determination of price and quantity.
Decision on promotional strategy.
Optimum input combination.
Allocation of resources.
Replacement decision.
Make or buy decision.
Shut down decision.
Decision on export and import.
Location decision.
Capital budgeting.

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SOME DEFINITIONS

POSITIVE & NORMATIVE APPROACH:

Positive Science is a systematic knowledge of a particular subject wherein we study the cause and
effect of an event. In other words, it explains the phenomenon as: What is, what was and what
will be. Under the study of positive science, principles are formulated and they are tested on the
yardstick of truth. Forecasts are made on the basis of them.
From this point of view, managerial economics owns Positive Approach, as it has its own
principles/theories/laws by which cause and effect analysis of business events/activities is done,
forecasts are made and their validities are also examined.
Normative Science studies things as they ought to be. Ethics, for example, is a normative science.
The focus of study is What should be. In other words, it involves value judgment or good and bad
aspects of an event. Therefore, normative science is perspective rather than descriptive.
Managerial economics also has a normative approach as it suggests the best course of an action after
comparing pros and cons of various alternatives available to a firm. It also helps in formulating business
policies after considering all positives and negatives, all good and bad and all favors and disfavors. For
instance, if a firm wants to raise 10% price of its product, it will examine the consequences of it before
raising its price. The hike in price will be made only after ascertaining that 10% rise in price will not
have any adverse impact on the sale of the firm.
On the basis of the above arguments and facts, it can be said that managerial economics is a
blending of positive approach with normative approach. It is positive when it is confined to
statements about causes and effects and to functional relationships of economic variables. It is
normative when it involves norms and standards, mixing them with cause and effect analysis.
Managerial economics is not only a tool making, but also a tool using science. It not only studies facts
of an economic problem, but also suggests its optimum solution.
OPTIMIZATIONS:
Optimization is the process of finding an alternative with the most cost effective or
highest achievable performance under the given constraints, by maximizing desired factors and
minimizing undesired ones. Optimization is very crucial activity in managerial decision making process.
According to the objective of the firm, the manager tries to make the most effective decision out of all
the alternatives available.
The optimal decisions differ from company to company ( Why???), and Practice of optimization
is restricted by the lack of full information, and the lack of time to evaluate what information is
available.
The first step in optimization is to examine the methods to express economic relationship. Expression
may be in the form of Table, Graph, or by some Algebraic Expression. This Expression (Model) is then
analyzed for optimization. We usually depend upon mathematical concepts and operation research for
optimization. In computer simulation (modeling) of business problems, optimization is achieved usually
by using linear programming techniques of operations research.
MARGINAL AND INCREMENTAL PRINCIPLE
Marginal analysis helps to assess the impact of a unit change in one variable on the other variable. The
word marginal is used for small changes say a unit change. According to marginal analysis, as
long as marginal benefit of an activity is greater than its marginal cost, it pays for an organization to
continue increase the activity.
In contrast; incremental concept applies to changes in revenue and cost due to a policy change.
The incremental principle states that a decision is profitable when:
it increases revenue more than costs;
it decreases some costs to a greater extent than it increases others;
it increases some revenues more than it decreases others; and
it reduces costs more than revenues.
Suppose a firm gets an order that brings additional revenue of Rs 3,000. The cost of production from
this order is:
Rs
Labour
800
Materials
1,300
Overheads
1,000
Selling and administration expenses
700
Full cost
3,800
At a glance, the order appears to be unprofitable.
But suppose the firm has some idle capacity that can be utilized to produce output for new order.

By Pashupati Nath Verma

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Then the incremental cost to accept the order will be:

Rs
Labour
600
Materials
1,000
Overheads
800
Total Incremental cost
2,400
Incremental reasoning shows that the firm would earn a net profit of Rs 600 (Rs 3,000 2,400), though
initially it appeared to result in a loss of Rs 800. The order should be accepted.
OPPORTUNITY COST PRINCIPAL
Opportunity Cost is the cost of a decision in terms of the next best alternative not chosen i.e.
Opportunity cost refers to the value forgone in order to make one particular investment instead of
another. Opportunity cost comes into play in any decision that involves a tradeoff between two or more
options. This cost arises because most economic resources have more than one use.
For instance, Let's say you have $15,000 and your choice is to either buy shares of Company XYZ or
leave the money in a FD that earns 8% per year. If the Company XYZ stock returns 10%, you've
benefited from your decision because the alternative would have been less profitable. However, if
Company XYZ returns 2% when you could have had % from the FD, then your opportunity cost is (8% 2% = 6%).
ECONOMIC MODEL
An economic model is a simplified description of reality, designed to yield hypotheses about economic
behavior that can be tested. Theoretical economic models seek to derive verifiable implications about
economic behavior.
Types of Models
1-Visual Models, 2-Mathematical models 3-Empirical models 4-Simulation models
Visual Models
Visual models are simply pictures of an abstract economy; graphs with lines and curves that tell an
economic story. These models are relatively easy to understand, but are somewhat limited in their
scope.
Mathematical Models
These are systems of mathematical equations relating number of economic variables. Some of these
models can be quite large. Even the smallest will have five or six equations and as many unknown
variables. The manipulation and use of these models require a good knowledge of algebra or calculus
and operation research.
Few examples of mathematical model relating to demand and supply may be as follows:
S=a+bP or D=a+bP2, Here S denotes Supply, D denotes Demand and P price.
Empirical Models
Empirical models are mathematical models designed by use of empirical data. Empirical models aim to
verify the qualitative predictions of theoretical models and convert these predictions to precise,
numerical outcomes.
For example, suppose in an economic study the following question is asked: "What will happen to
investment if income rises one percent?" The purely mathematical model might only allow the analyst
to say, "Logically, it should rise. The user of the empirical model, on the other hand, using actual
historical data for investment, income, and the other variables in the model, might be able to say, "By
my best estimate, investment should rise by about two percent.
Simulation Models
A simulation model is a mathematical model that calculates the impact of uncertain inputs and
decisions we make on outcomes that we care about, such as profit and loss, investment returns, and
environmental consequences in an experimental condition. The computerized simulation model can
show the interaction of numerous variables all at once, including hidden feedback and secondary
effects that are not so apparent in purely mathematical or visual models. Such a model can be created
by writing code in a programming language, statements in a simulation modeling language, or formulas
in a Microsoft Excel spreadsheet.

STATIC VS. DYNAMIC MODEL

Economic analysis can be conducted either by using a static framework (static model) or a dynamic
setting (dynamic model). Static and dynamic modes of analysis can be differentiated in more than one
ways.
In a static model (theory) the variables (cause-effect) are not dated i.e. they does not change with time.
The demand-supply model of market behavior is a static model. The model that demand depends on
own price, supply depends on own price, with an equilibrium condition that demand must equal supply,
time does not enter into the picture at all and the variables are all undated.
A dynamic model would be one where the relevant variables are dated i.e. they change with time.
According to this criterion the following would be a dynamic model.

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Dt = f( Pt )
St = g( Pt-1 )
Dt = St
There is no lag in the demand relationship. Demand in periodt depends on own price of the same
period.
However, in the supply relationship a gestation lag exists. Supply in periodt depends on price
prevailing in the previous period (t-1). The price level in previous period (t-1) would have induced the
producers to increase or decrease the supply, full impact of such decisions are visible in time period t
only. For market to attain equilibrium, demand in periodt must equal supply in period t.
It must be noted that if one is concerned with the equilibrium configurations of a market for a good, one
has to take recourse to a static methodology. Equilibrium is a static concept. It describes the
position of a market at rest. In contrast, disequilibrium analysis must pertain to dynamics. In a static
framework, we implicitly assume that market adjustment is instantaneous, and without any loss of
time, equilibrium is or is not restored. How the economic agent behaves in the disequilibrium situation
is not the concern of static analysis. This is where dynamic analysis sets in.

DEMAND: MEANING AND TYPES OF DEMAND

DEMAND: The demand for a commodity is the quantity of the good that is purchased over a specific of
period of time at a certain price.
The following five elements are inclusive in it:
1. Desire to acquire a commodity -willingness to have it,
2. Ability to pay for it-purchasing power to buy it,
3. Willingness to spend on it,
4. Given/particular price, and
5. Given/particular time period.
In demand first three elements i.e. desire to acquire the product, willingness to pay for it along with the
ability to pay creates the demand and last two elements i.e. price and time period decides the quantity
of demand.
Types of Demand:
Individuals Demand and Market Demand
Firm and Industry Demand
Demand by Market Segments and by Total Market
Autonomous and Derived Demand
Domestic and industrial demand:
New and replacement demand
INDIVIDUALS DEMAND AND MARKET DEMAND:
Individual demand refers to demand of a commodity by an individual buyer.: Market demand is the
summation of demand for a good by all individual buyers in the market. For example, if the market of
good x has, say only three buyers then individual and market demand (monthly) could be:

A
firm
would
be
interested in the
market demand for its products while each consumer would be concerned basically with only his own
individual demand.
FIRM AND INDUSTRY DEMAND:
Goods are produced by more than one firm and so there is a difference between the demand facing an
individual firm and that facing an industry. For example, demand for Fiat car alone is a firms demand
and demand for all kinds of cars is industrys demand.
DEMAND BY MARKET SEGMENTS AND BY TOTAL MARKET:
Different market segment may have different price, profit margins, competition, seasonal patterns or
cyclical sensitivity, then it may be worthwhile to distinguish the market by specific segments for a
meaningful analysis. In that case, the total demand would mean the total demand for the product from
all market segments while a particular market segment demand would refer to demand for the product
in that specific market segment.
AUTONOMOUS AND DERIVED DEMAND:

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The goods whose demand is not tied with the demand for some other goods are said to have
autonomous demand, while the rest have derived demand. Thus, the demand for all producer goods
is derived demands as they are needed to obtain consumer goods or producer goods. Though, there
is hardly anything whose demand is totally independent of any other demand. But the degree of this
dependence varies widely from product to product.
DOMESTIC AND INDUSTRIAL DEMAND:
The distinction between domestic and industrial demand is very important from the pricing and
distribution point of view of a product. For instance, the price of water, electricity, coal etc. is
deliberately kept low for domestic use as compared to their price for industrial use.
NEW AND REPLACEMENT DEMAND:
New demand is meant for an addition to stock, while replacement demand is meant for maintaining
the old stock of capital/asset intact. The demand for spare parts of a machine is a good example of
replacement demand, but the demand for new models of a particular item [say computer or machine]
is a fine example of new demand. Generally, new demand is of an autonomous type, while the
replacement demand is induced one-induced by the quantity and quality of existing stock.
However, such distinction is more of a degree than of kind.

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DETERMINANTS OF DEMAND

The demand for a good in a market depends on many factors. Some of the important factors are
1.
Price of the good under consideration
2.
Prices of Substitutes
3.
Prices of Complements
4.
Consumer Income level
5.
Price Expectation
6.
Consumer tastes and preferences
7.
Advertising & Promotion
8.
Socio economic and
9.
Demographic factors
10.
Climate
11.
Government Policies
The impact of these determinants on Demand is:
1. Price effect on demand: Demand for a normal good x is inversely related to its own price
(negative effect).
2. Substitution effect on demand: If y is a substitute of x, then as price of y increases, demand
for x also increases (positive effect).
3. Complementarity effect on demand: If z is a complementary of x, then as price of z
increases, demand for x also decreases (negative effect).
4. Income effect on demand: As income rises, consumers buy more of normal goods (positive
effect) and less of inferior goods (negative effect).
5. Price expectation effect on demand: Here the relation may not be definite as the
psychology of the consumer comes into play.
6. Consumer tastes and preferences effect: Taste, preference and habits of consumers may
also have decisive influence on the pattern of demand. Social customs, traditions and
conventions are Socio psychological determinants of demand these are non-economic
and non-market factors.
7. Advertising & Promotional effect on demand: Advertisement has great influence on
demand. It is in observed fact that sales turnover of firms increases up to a point due to
advertisement.
8. Socio-economic Factor effect: e.g accumulated wealth, band wagon effect also influence the
demand.
9. Demographic Factors effect: Population composition also influences the demand.
10.Climate also influences the demand for different goods. For instance, the demand for coolers
and A.C. Increases in summers, while their demand declines in winters.
11.Government policy on taxes and subsidies also influences the demand of different goods
differently. For instance, increase in tax rates / imposition of new taxes reduces the demand,
while increase in subsidies increases the demand.

DEMAND SCHEDULE AND DEMAND CURVE

DEMAND SCHEDULE: Demand schedule is a tabular statement showing how much of a

commodity is demanded at different prices, other factors remaining the same. In Demand Schedule
prices placed in descending (or ascending) order and the corresponding quantities which, consumers
would like to buy per unit of time.
DEMAND CURVE: A demand curve is a locus of points showing various alternative price quantity
combinations. The demand schedule can be converted into a demand curve by plotting curve
between Price & Demand in which prices are kept on vertical axis and quantity on horizontal axis.
Demand curve slopes downwards (negatively).

WHY DOES THE DEMAND CURVE SLOPE DOWNWARDS

(NEGATIVELY)

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The demand curve slopes downwards mainly due to the law of diminishing marginal utility. The law of
diminishing marginal utility, states that an additional unit of a commodity gives a lesser satisfaction.
Whenever price change, consumer starts to compare utility of the commodity with money paid for it.
Thus whenever price increases, commodity's utility goes down in comparison to money paid for it,
consumer starts buying less. Therefore, the consumer buys less at higher price and more at lower price.

DEMAND FUNCTION

The demand for a particular commodity is influenced by so many factors- they together are known as
determinants of demand in technical jargon, it is stated as demand function. A demand function in
mathematical terms expresses the functional relationship between the demand for a product
and its various determining factors. As, Demand function is a comprehensive formulation which
specifies the factors that influence the demand for the product. Hence the demand function can be
written as
DX = f ( Px, Ps, Pc, Yd, T, A, W, C, E, P, G, U)
Here

Dx = Demand for x commodity (say, tea)

Px = Price of x commodity (of tea)
Ps = Price of substitute of x commodity
(coffee)
Pc = Price of complementary goods of x
commodity (sugar, milk)
Yd = Disposable income of the consumer
T = Taste and Preference of the consumer
A = Advertisement of x commodity
W = Wealth of purchaser
C = Climate
E = Price expectation of the consumer
P = Population
G = Govt. policies pertaining to taxes and
subsidies
U = Other factors (unspecified/unidentified)

a p
b
a
q
b
pc
q

a p
b
bp
q ae
A simplest demand function may be
q

linear, otherwise it may be non linear. Some

specific demand functions are

Here a, b and c are constant, p denotes price and

q demand.

By Pashupati Nath Verma

Example of a Linear Demand Function for a

commodity X
Dx =200-7Px
Corresponding Demand Schedule

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MGT 105: MANAGERIAL ECONOMICS: UNIT-I

Example of a Non-Linear Demand Function for
a commodity
D =1280(0.75)P
Corresponding Demand Schedule

CHANGES IN QUANTITY DEMANDED VERSUS CHANGES IN

DEMAND

The changes in quantity demanded relates to the law of demand and referred as extension
(Demand increase due to fall in price) or contraction (Demand decrease due to rising price) of
demand due to change in price of the commodity itself, but the changes in demand (Shift in
Demand) is related to increase or decrease in demand due to due to changes in non-price
factors such as income, taste & preference, price of related goods etc.
In case of the changes in quantity demanded it can be shown on original demand curve by moving
upward or downward on the curve itself. But, in case of change or shift in demand, whole demand
curve shift to the left or right from its previous location.
CHANGES IN QUANTITY DEMANDED

CHANGE OR SHIFT IN DEMAND

P r ic e

C o n tr a c tio n
of Dem and

3
(A )

P r ic e

E x p a n s io n o f
Dem and

Px

D
D

1
10
O

20
Q D

30

D
X

Q .D .

D 1 In c r e a s e in d d
D 2 d e c r e a s e in d d .

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Law of demand:Inverse Relation between Price and Demand
10
8
6
Price

4
2
0
0

200 400 600 800

Demand

LAW OF DEMAND

Law of Demand: Law of demand states that there is a negative or inverse relationship
between the price and quantity demanded of a commodity, other things remaining
constant.
Other things include other determinants of demand, viz., consumers income, price of the substitutes
and complements, taste and preferences of the consumer, etc. But, these factors remain constant only
in the short run. In the long run they tend to change. The law of demand, therefore, holds only in the
short run. Law of demand is an empirical law, i.e., this law is based on observed facts and can be
verified with new empirical data.
FACTORS BEHIND THE LAW OF DEMAND
Substitution Effect
Income Effect
Utility-Maximizing Behavior
Substitution Effect: Consumers substitute their demand from one commodity to another related
commodity in case of change in price of original commodity.
Income Effect: Price changes also effects real income of the consumer, which in turns affect the
demand for the commodity.
Utility-Maximizing Behavior: The utility-maximizing behavior of the consumer under the condition of
diminishing marginal utility is also responsible for increase in demand for a commodity when its price
falls.
EXCEPTIONS TO THE LAW OF DEMAND
Veblen Effect
Giffen Effect
Expectations regarding further prices
Speculative Demand
Veblen Effect:
Veblen has pointed out that there are some goods (known to be Veblen Goods after him) demanded by
very rich people for their social prestige. When price of such goods rise, their use becomes more
attractive and their demand increases. Such goods are termed as Veblen Goods. Examples of Veblen
Goods are Luxury cars(Rolls-Royce phantom), apartments etc.
Giffen Effect:
Sir Robert Giffen discovered that when price of, an inferior good increases, income remaining the same,
poor people cut the consumption of the superior substitute so that they may buy more of the inferior
good in order to meet their basic need. Such Inferior goods is known as Giffen Goods. Example of
Giffen Goods is potato in vegetables.
Expectations regarding further prices
If consumers expect a rise in the price of a storable commodity or durable goods, they would buy more
of it at its current price with a view to avoiding the pinch of price-rise in future.
Speculative Demand:
The law also does not hold true in case of speculative demand. Stock markets are the fine examples
of speculative demand.

By Pashupati Nath Verma

MGT 105: MANAGERIAL ECONOMICS: UNIT-I

Page14

SUMMARY

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MGT 105: MANAGERIAL ECONOMICS: UNIT-I

Page15

ELASTICITY OF DEMAND
The concept of elasticity of demand was introduced by Alfred Marshall. According to him the
elasticity (or responsiveness) of demand in a market is great or small according as the
amount demanded increases much or little for a given fall in price, and diminishes much or
little for a given rise in price.
The law of demand explains that demand will change due to a change in the price of the commodity.
But it does not explain the rate at which demand changes to a change in price. The concept of
elasticity of demand measures the rate of change in demand.
TYPES OF ELASTICITY OF DEMAND
Price elasticity of demand;
Income elasticity of demand; and
Cross-elasticity of demand
PRICE ELASTICITY OF DEMAND
Price elasticity of demand is generally defined as the responsiveness or sensitiveness of
demand for a commodity to the changes in its price. More precisely, elasticity of demand is the
percentage changes in demand as a result of one per cent in the price of the commodity.
Percentage
Change
in QuantityDemanded
Percentage
Change
inPrice
Q / Q
Symbolical
ly,e p
P / P

Priceelasticityof demand

INCOME ELASTICITY OF DEMAND

Income elasticity of demand is the degree of responsiveness of demand to the change in income.
Percentage
Change
in QuantityDemanded
Incomeelasticityof demand
Percentage
Change
inIncome

Symbolical
ly,eY

Q / Q
Y / Y

CROSS-ELASTICITY OF DEMAND
The responsiveness of demand to changes in prices of related goods is called cross-elasticity of demand
(related goods may be substitutes or complementary goods). In other words, it is the responsiveness of
demand for commodity x to the change in the price of commodity y.
Percentage
Change
in QuantityDemanded
of X
Cross- elasticityof demand
Percentage
Change
inPriceofrelatedCommodity
Y
Q X / Q X
Symbolical
ly,ec
PY / PY

Depending on how the demand changes, when price changes we can classify all demand curves in the
following five categories:
Perfectly inelastic demand(ep=0)
Relatively Inelastic demand (ep<1)
Unitary elastic demand (ep=1)
Relatively Elastic demand (ep>1)
Perfectly elastic demand (ep=)
What will be the implication of elasticity of demand on Total Revenue (TR)?
If ep=1 TR will not change with prices
If ep<1 TR will move in same direction with higher rate
If ep>1 TR will move in opposite direction at higher rate

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By Pashupati Nath Verma

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Page19

FACTORS INFLUENCING ELASTICITY OF DEMAND

1. Nature of commodity - These who have no substitute goods will have an inelasticity of demand.
The consumers will buy almost a fixed demand whether the price is higher or lower. Demand for
luxuries, on the other hand, is elastic in nature.
2. Different uses of the commodity- A commodity that has several kinds of uses is apt to be
elastic in demand. For each single use demand may be inelastic so that when price of the
commodity goes down only a little more is purchased for every use.
3. Availability of substitute goods- When there exists a class substitute in the relevant price
range, its demand will tend to be elastic. But in respect of commodities having no substitutes, their
demand will be the same inelastic.
4. Consumers income - Generally larger the income, the overall demand for commodities tends to
be relatively inelastic. The redistribution of income in favour of low income people may tend to
make demand for some goods relatively inelastic.
5. Proportion of expenditure- Items that constitute a smaller amount of expenditure in a
consumers family budget tend to have a relatively inelastic demand, e.g., a person who watches a
film every fort night is not likely to give it up when the ticket rates are raised. But one who watches
a film every alternate day perhaps may cut down his number of films. So is the case with matches,
sugar etc.
6. Durability of the commodity- In the case of durable goods, the demand generally tends to be
inelastic in the short run, e.g., furniture, bicycle radio, etc. In the perishable commodities, on the
other hand, demand is relatively elastic, e.g., milk , vegetables, etc.
7. Influence of habit and customs- There are certain articles which have a demand on account of
conventions, customs or habit and in these cases, elasticity is less, e.g., Mangal Sutra to a Hindu
bride or cigarettes to a smoker have inelasticity of demand.
8. Complementary goods- Goods which are jointly demanded have less elasticity, e.g., ink, petrol
have inelastic demand for this reason.
9. Recurrence of demand- If the demand for a commodity is of a recurring nature, its price
elasticity is higher than that of a commodity which is purchased only once. For instance, bicycle,
tape recorders, radios, etc. are purchased only once, hence their price elasticity will be less. But
the demand for cassettes or tape spools would be more price elastic.
10.Possibility of postponement- When the demand for a product can be postponed, it will tend to
be price elastic. In the case of consumption goods which are urgently and immediately required,
their demand will be inelastic.

IMPORTANCE OF ELASTICITY OF DEMAND

IMPORTANCE TO PRODUCER: A producer has to consider elasticity of demand before fixing the price
of a commodity. The concept of elasticity of demand also influences the determination of the rewards
for factors of production in a private enterprise economy. If the demand for labour on a particular
industry is relatively inelastic, it will be easier for the trade union to get their wages raised. The same
remarks apply to other factors of production whose demands are relatively inelastic.
The concept of elasticity, also, provides a guideline to the producers for the amount to be spent on
advertisement. If the demand for a commodity is elastic, the producers shall have to spend large sums
of money on advertisements for increasing the sales.
IMPORTANCE TO GOVERNMENT: If elasticity of demand of a product is low then government will
impose heavy taxes on the production of that commodity and vice versa. The concept of elasticity of
demand also helps the government in fixing an appropriate foreign rate of exchange for its domestic
currency in relation to the currencies of other countries. Before deciding to devalue or revalue domestic
currency in relation to foreign currencies the government has to study carefully the elasticites of
demand for its imports and exports.
IMPORTANCE IN FOREIGN MARKET: If elasticity of demand of a produce is low in the international
market then exporter can charge higher price and earn more profit. It is possible to calculate the terms
of trade between two countries only by taking into account the mutual elasticities of demand for each
others products.
The rate of foreign exchange is also considered on the elasticity of imports and exports of a country.
IMPORTANCE TO BUSINESSMEN: The concept of elasticity is of great importance to businessmen.
When the demand of a good is elastic, they increases sale by towering its price. In case the demand' is
inelastic, they are then in a position to charge higher price for a commodity.
IMPORTANCE TO TRADE UNION: The trade unions can raise the wages of the labor in an industry
where the demand of the product is relatively inelastic. On the other hand, if the demand, for product is
relatively elastic, the trade unions cannot press for higher wages.

By Pashupati Nath Verma

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MGT 105: MANAGERIAL ECONOMICS: UNIT-I

By Pashupati Nath Verma

MGT 105: MANAGERIAL ECONOMICS: UNIT-I

Page21

MEASUREMENT OF PRICE ELASTICITY OF DEMAND

We may use two measures of elasticity:

(a) Arc elasticity, measures elasticity of demand between any two points on a demand curve. It is
known as arc elasticity.
(b) Point elasticity, measures elasticity of demand for a marginal change at some specific point on
demand curve.
Important methods for calculating price elasticity of demand are
1) Percentage Method
2) Graphical Method
3) Mathematical Method
4) Total outlay Method
5) Arc method
PERCENTAGE METHOD
Prof. Flux tries to measure the price elasticity of demand with the help of percentage. This is measured
as the relative change in demand divided by relative change in price (or) percentage change in demand
divided by percentage change in price.
Percentage
Change
in Quantity
Demanded
Priceelasticityof demand
Percentage
Change
inPrice
% Q
Symbolical
ly,e p
% P
Formula is

Illustration1: Yesterday, the price of envelopes

was $3 a box, and Julie was willing to buy 10
boxes. Today, the price has gone up to $3.75 a
box, and Julie is now willing to buy 8 boxes. Is
Julie's demand for envelopes elastic or inelastic?
What is Julie's elasticity of demand?
Solution:
% Change in Quantity
(%Q) = (8-10)/(10)=-0.20=-20% or 20% (omit
negative sign )
% Change in Price
(%P) = (3.75-3.00)/(3.00) = 0.25 = 25% .
Elasticity (eP) =%Q/%P= (-20%)/(25%) = 0.8
Julie's elasticity of demand is inelastic, since it is
less than 1.

Illustration2 : If Neil's elasticity of demand for

hot dogs is constantly 0.9, and he buys 4 hot dogs
when the price is $1.50 per hot dog, how many
will he buy when the price is $1.00 per hot dog?
Solution:
In the case of John let the new demand is X,
%Change in Quantity = (X 4)/4.
% Change in Price = (1.00 - 1.50)/(1.50) = -33%
Therefore:
Elasticity = 0.9 =%Q/(%P=(X 4)/4/(33%)
0.9 =(X 4)/4)/(0.33)
((X - 4)/4) = 0.33/.9
(X - 4)/4=0.37
X-4=1.47
X=5.47

GRAPHICAL OR POINT METHOD

LengthofLowertSegment

Priceelasticityof demand

of Tangent
LengthofUpperSegment
of Tangent

We can calculate
demand at a point on a demand curve by drawing a tangent on that
both the axis. Formula to find out ep through point method is,

Illustration3:In the adjacent case ep at point P will be given by

Priceelasticityof demand

the price elasticity of

point
extended
to

PM
PR

MATHEMATICAL METHOD

By Pashupati Nath Verma

MGT 105: MANAGERIAL ECONOMICS: UNIT-I

dQ P

dP Q If we have given Demand function in the form of Q=f(P) then price elasticity will be given
Page22

ep
by

3p , determine the price elasticity of demand

Illustration4: If the equation for an item is Q 18 10 p at p=1.
Solution: At p=1, Q=18+10-3=25,
ep

p
dQ P
6 p 10
dP Q
Q

(6 *1 10) *1 / 25 16 / 25
p 1,Q 25

Further, dQ/dp=-6P+10, thus putting

the value Q=25, p=1 and dQ/dp=6p+10 we will get elasticity at p=1

TOTAL OUTLAY METHOD

Prof. Alfred Marshal tries to measure the price elasticity of demand with the help of total outlay method
and he also says that e=1 and e=0 does not exist in practical life and e>1,e=1 & e<1 have practical
approach. Under this method elasticity will be of three types:I E> 1 elasticity of demand:- When there is inverse relation between price and total outlay it
means that when price increases total outlay decreases and vice versa , it is known as e>1 elasticity of
demand ie elastic demand.
II E=1 elasticity of demand:- Even if price increases or decreases but total outlay is
constant, then it is known as e=1 or a unit elasticity of demand or unitary elastic.
III E<1 elasticity of demand:- When there is positive or direct relationship between price total
outlay it means as the price increase total outlay increase & vice versa is known as E<1 elasticity of
demand or inelastic demand.
Illustration5:
Price Per Unit
Quantity
Total Expenditure / Total
($)
Demanded
Outlay
20
10 Pens
200.0
10
30 Pens
300.0
The figure shows that at price of $20 per pen, the quantity demanded is
10 pens, the total expenditure OABC ($200). When the price falls down
to $10, the quantity demanded of pens is 30. The total expenditure is
OEFG ($300).
Since OEFG is greater than OABC, it implies that change in quantity
demanded is proportionately more than the change in price. Hence the
demand is elastic (more than one) E > 1.
Price Per Pen
Quantity
Total Expenditure/Total
($)
Demanded
Outlay
10
30
300
5
60
300
The figure shows that at price of $10 per pen, the total expenditure is
OABC ($300). At a lower price of $5, the total expenditure is OEFG ($300).
Since OABC = OEFG, it implies that the change in quantity demanded is
proportionately equal to change in price. So the price elasticity of demand
is equal to one, i.e., E = 1.

Price Per Pen

($)
5
2

Quantity
Demanded
60
100

Total Expenditure /Total

Outlay
300
200

In the fig at a price of $5 per pen the quantity demanded is 50 pens. The
total expenditure is OABC ($300). At a lower price of $2, the quantity
demanded is 100 pens.
The total expenditure is OEFG ($200). Since OEFG is smaller than OABC,
this implies that the change in quantity demanded is proportionately less
than the change in price. Hence price elasticity of demand is less than one
or inelastic.

ARC METHOD
When we measure elasticity between any two particular points of the demand curve, it is known as ARC
elasticity of demand. When there is a major change in price or in a demand then ARC elasticity of
demand method is appropriate for the economist.

By Pashupati Nath Verma

MGT 105: MANAGERIAL ECONOMICS: UNIT-I

OriginalQuantity- NewQunatity/O
riginalQuantity NewQunatity
OriginalPrice- NewPrice/Orig
inalPrice NewPrice
Q P1 P2
Symbolical
ly,e p
X
P Q1 Q2
Page23

Priceelasticityof demand

Where P1 & Q1 are price and quantity at first point (say, original price and
quantity) and
P2 & Q2 are price and quantity at second point (say, new price and
quantity)
Illustration6: Given the following Demand Schedule, price elasticity of demand
between prices 9 to 11 will be calculated as follows:
Demand schedule
PRICE
QUANTITY
9
164
10
160
11
156

ep

Q
P P2 164 156 164 156 12 320
X 1

X
202.11
P Q1 Q2
9 10
9 10
1 19
(Ignore Sign)

Example 1: You are given market data that says when the price of pizza is $4, the quantity demanded
of pizza is 60 slices and the quantity demanded of cheese bread is 100 pieces. When the price of pizza
is $2, the quantity demanded of pizza is 80 slices and the quantity demanded of cheese bread is 70
pieces. Can the Price-Elasticity of Demand be calculated for either good? If so, calculate the PED.
Example 2: Consider the markets for widgets and cogs. You study survey data and observe that if
widgets cost $5, then 100 widgets are demanded. You also observe that if widgets cost $3, then 150
cogs are demanded and if widgets cost $4 then 100 cogs are demanded. If cogs cost $2, then 125 cogs
are demanded. Can the Price-Elasticity of Demand be calculated for either good? If so, calculate the
PED.
Example 3: Consider the market for widgets and cogs . You study survey data and observe that if
widgets cost $5, then 100 widgets are demanded and 60 cogs are demanded. You also observe that if
widgets cost $3, then 200 widgets are demanded and 100 cogs are demanded. If cogs cost $2, then
125 cogs are demanded. Can the Price-Elasticity of Demand be calculated for either good? If so,
calculate the PED.
Example4: Calculate the elasticity coefficient from the data above for the interval where price changes
from 8 to 7. Where is the range of unit price elasticity of demand for the following demand curve?
Price
8
7
6
5
4
3
Quantit
3
4
5
6
7
8
y
Example5: If the price of good X decreases by 2.1% and the price elasticity of demand is 0.4, find the
percentage change in quantity demanded and the percentage change in revenue. If you want to
increase revenue should you increase or decrease the price in this case?
Case Study: Problem: Highway Blues
Ratan Sethi opened a petrol-pump cum retail store on Delhi Agra Highway about two-hour drive from
Delhi. His store sells typical items needed by highway travelers like fast foods, cold drink, chocolates,
hot coffee, childrens toys etc. He charges higher price compared to the sellers in Delhi, yet he is able
to maintain brisk sales particularly of Yours Special Pack (YSP) consisting of soft drink in a
disposable plastic bottle and a packer of light snacks. The Highway travellers prefer to stop at his store
because, while their cars wait for with some other item in the store). Each year he could substantially
enhance his sales by providing Special Summer Price on YSP which is almost half of its regular price.
Last year while returning from Delhi, Ratan found that a new, big and modern grocery shop has come
up 15 kms from Delhi on the National Highway. It has affected his sales but only marginally. But last
month another large convenience store has opened just 5 km away from his store. He knows that the

By Pashupati Nath Verma

MGT 105: MANAGERIAL ECONOMICS: UNIT-I

Page24

challenge has come to his doorsteps and he expects to be adversely affected by the existence of these
two stores. He needs to meet this challenge and decides to use the pricing strategy which he has been
using quite effectively till recently. He now permanently reduces the price of YSP to half of its existing
price. But at the end of the year Ratan finds that his sales in general and of YSP in particular had
declined by 20 percent.

Q1.
Q2.

Where has Ratan Sethi gone wrong?

If he was a managerial economist, how do you think he would have handled the situation?

By Pashupati Nath Verma

MGT 105: MANAGERIAL ECONOMICS: UNIT-I

Page25

DEMAND ESTIMATION

Estimation of demand and forecasting of demand both of these sometime misunderstood to be

the same but they are different: Demand estimation attempts to quantify the links between the level of
demand for a product and the variables which determines it whereas demand forecasting simply
attempts to predict the level of sales at some particular future date. For this reason the set
of techniques used may differ, although there will be some overlap between the two.
In general, an estimation technique can be used to forecast demand but a forecasting technique cannot
be used to estimate demand. A manager who wishes to know how high demand is likely to be in two
years time might use a forecasting technique. A manager who wishes to know how the firms pricing
policy could be used to generate a given increase in demand would use an estimation technique
STAGES IN DEMAND ESTIMATION
Demand estimation involves a number of stages. Some of these stages may be omitted in the simpler
methods of estimation, like the first two steps (for simpler estimates). However, with a statistical study,
or econometric analysis there are essentially seven stages:
1. Statement of a theory or hypothesis: Identification of relationship between economic
variables(Usually based on some empirical experience or based on some well established theory)
An example of such a theory might be that the quantity people buy of a particular product might
depend more on the past price than on the current price
2. Model specification: Developing mathematical equation satisfying relationship between
economic variables
Various alternative models may be specified at this stage, since economic theory is often not robust
enough to be definitive regarding the details of the form of model.
3. Collection of Data: Collecting data related to economic variables considered in Model
developed earlier from relevant sources.
4. Estimation of parameters of the Model: On the basis of collected data, parameters
values are estimated (these values parameter defines that how and how much the different
variables are related)
5. Checking goodness of fit. Once a model, or maybe several alternative models, have been
estimated, it is necessary to examine how well the models fit the data and to determine which
model fits best.
6. Hypothesis testing. Having determined the best model, we want to test the hypothesis stated in
the first step; in the example quoted we want to test whether current price or past price has a
greater effect on sales.
7. Development of estimates based best model.

METHODS OF DEMAND ESTIMATION

There are a variety of ways that can be used to estimate demand, each of which has certain
advantages and disadvantages.
CONSUMER SURVEYS: (Questioning the consumer to determining his behavior). These are based
questioning the consumer to determining his consumption behavior using questionnaire, interviews etc.
Advantages:
They give up to date information about the current market scenario.
Much useful information can be obtained that would be difficult to uncover in other ways; for
example, if consumers are ignorant of the relative prices of different brands, it may be
concluded that they are not sensitive to price changes. This can be exploited by the firms for
their best possible interest.
Disadvantages: Validity, Reliability, Sample Bias.
MARKET EXPERIMENTS: (Direct market experiments to understand the changes in demand due to
changes in it s depended variables) Here consumers are studied in an artificial environment. Laboratory
experiments or consumer clinics are used to test consumer reactions to changes in variables in the
demand function in a controlled environment. Experimenter need to be careful in such experiments as
the knowledge of being in the artificial environment can affect the consumer behavior.
Advantages:
Direct observation of the consumers takes place rather than something of a hypothetical theoretical
model.
Disadvantages:

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Page26

There is less control in this case, and greater cost; furthermore, some customers who are lost at this
stage may be difficult to recover.
Experiments need to be long lasting in order to reveal proper result.
STATISTICAL TECHNIQUES: These are various quantitative methods to find the exact relationship
between the dependent variable and the independent variable(s).
The most common method is regression Analysis :
Simple (bivariate) Regression: Y = a + bX
Multiple Regression: Y = a +bX1 + c X2 +dX3 +..

DEMAND FORECASTING

Large numbers of firms produce for a future anticipated demand. Accurate demand forecasting is
necessary in order to produce right quantities at the right time and arrange well in advance for the
various factors of production like raw materials, equipment, machine accessories, labor and building.
These forecasting based decisions will influence current level of production, which is dependent upon
anticipated future demand.
Demand forecasting reduces the uncertainties associated with business. A forecast is a prediction or
estimation of a future event. Accuracy of a forecast is determined by its nearness to the actual value in
future.
NEED FOR FORECASTING
1. Long Range Strategic Planning for corporate objectives such as profit, market share, Return on
Capital Employed (ROCE), strategic acquisitions, international expansion, etc.
2. Annual Budgeting for operating plans such as annual sales, revenues, profits
3. Annual Sales Plans for regional and product specific targets.
4. Resource Needs Planning for HRM, Production, Financing, Marketing, etc
TYPE OF DEMAND FORECASTING
1. LONG TERM DEMAND (forecast are related to the need for capacity expansion or reduction
depending upon the demand in the long run ie more than 5 years)
2. MEDIUM TERM FORECAST (deals with business cycles that usually last for periods from two to
five years.)
3. SHORT TERM DEMAND (forecast is done for production schedules of less than one year; It is done
to deal with annual variations in sales).
APPROACHES TO FORECASTING
1. JUDGMENTAL APPROACHES: the forecast is based upon the judgment and expertise of experts.
2. EXPERIMENTAL APPROACHES: A demand experiment is conducted among a small group of
consumers who are adequately representative of characteristics of general population. This type of
approach is adopted when the product being introduced is new, and there is no pre-existing data
available.
3. RELATIONAL CAUSAL APPROACHES: Interviews and other methods are used to determine the
reasons why consumers purchase a particular product. Once these reasons are clear, the forecast
can be done.
4. TIME SERIES APPROACHES: Sales and other data for different markets, for different periods of
time is analyzed to get a general trend or pattern in sales.

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MGT 105: MANAGERIAL ECONOMICS: UNIT-I

Page28

METHODS FOR DEMAND FORECASTING OF AN ESTABLISHED

PRODUCT

Demand forecasting for an established product is easier than a new product as at least we
have some historical data in case of established product. Various techniques used in this case
are discussed below in some detail.
The methods used may be divided broadly into two categories, qualitative and quantitative. Demand
forecasting is full of uncertainties due to changing conditions. Consumer behavior is unpredictable as it
is motivated and influenced by a multiplicity of forces. Every method developed for forecasting has its
advantages and disadvantages and selection of the right method is crucial to make as accurate as
possible forecast. A right combination of quantitative and qualitative methods is to be used.

QUALITATIVE TECHNIQUES
Qualitative techniques are generally used when there is insufficient data available for quantitative
analysis. They are also known as subjective methods as they are dependent upon intuition based on
experience, intelligence, and judgment. They are also preferred for giving a quick estimate and cost
savings.
Some of these techniques are as follows
OPINION POLE METHODS: As the name suggest, forecast in this method is subjected to opinion of
respondent. Respondents may be either of the Consumers or Sales-force or Experts. On the basis of
respondent we can further classify this category as follows:
1. Consumers Survey or Survey of Buyers Intention
2. Sales force opinion
3. Experts Opinion
CONSUMERS SURVEY OR SURVEY OF BUYERS INTENTION: Under this category consumers are
surveyed (in personal or by phone or by post or using internet) to know the consumers buying
intention about the product during a specific time period. While surveying, there are three main

methods for the interviews.

Complete
Enumeration
method: All the consumers of
the product are interviewed and
their future plans for product is
ascertained.
Advantage: First hand unbiased
information
Disadvantage: High Cost,

Sample Survey Method: A

sample
of
consumers
is
interviewed.
Advantage: Low Cost
Disadvantage:
Requires
expertise.

End use Method: Information

about the end use of the product
is collected from the industrial
users to calculate the demand in
industries, exports etc.
Advantage: Useful in case of
intermediate product
Disadvantage: Not useful in
case of, too many end uses

SALES FORCE OPINION METHODS: This method is based on gathering opinion of sales personnel
who are closer to customers. Method can be used to forecast competitive technologies that are
emerging in the market.
Advantage: Low Cost, Fast, May be used for new product.
Disadvantage: Not useful for long range forecast, Correction and Adjustment factor needed.
EXPERTS OPINION METHODS: This is a qualitative forecasting technique in which a panel of
experts working together in a meeting arrives at a consensus through discussion & ranking the ideas.
Subjective estimates of experts are identified. Method emphasize on group exercise. It involves key
stakeholders: company executives, dealers, distributors, suppliers, marketing consultants, professional
association members.
Advantage: Easy and Quick method of forecasting
Disadvantage: Too much weight to executives opinions truth telling??
Delphi Method is one of the formalized technique of Experts Opinion Method:
Delphi Method: A qualitative forecasting technique in which panel of experts working separately and
not meeting, arrive at a consensus through the summarizing of idea by a skilled coordinator. This is
similar to jury opinion, but also incorporates a structured process to minimize the undesirable aspects
of group interactions and improve reliability and accuracy, It Reduces group-think and it is effective
method of long-range forecasting, Sometimes there may not be any consensus among experts
Procedure of Delphi Method:

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1. Choose the experts to participate representing a variety of knowledgeable people in different

areas
2. Through a questionnaire (or E-mail), obtain forecasts (and any premises or qualifications for the
forecasts) from all participants
3. Summarize the results and redistribute them to the participants along with appropriate new
questions
4. Summarize again, refining forecasts and conditions, and again develop new questions
5. Repeat Step 4 as necessary and distribute the final results to all participants
QUANTITATIVE TECHNIQUES
TREND PROJECTION: Time series analysis in statistics provides techniques by which all trend
components, cyclic component & Seasonal Component and their effects on demand are isolated and
identified. Techniques used for measuring the trend are:
Graphical
Method of SemiMethod of Moving
Method of Least
Method
Averages
Averages
Square
Annual
Sales Entire set of historical In this method an averaging By the method of least
data is plotted on data is divided in to two period is selected and square
a
functional
paper and trend parts. A trend line is forecast for the next period relation between demand
line
is
drawn drawn
through
the is the arithmetic average of and its determinant is
through
the averages of the two the AP most recent actual developed by the use of
points for making halves
for
making demands.
this functional relation
projection/foreca
forecast.
This technique is useful demand is forecasted.
st.
This technique is useful when there is a cyclic Functional relation by this
This method is only in case of linear variation
the
demand. method
may
be
a
simple and less trend
Sometimes weighted MAs polynomial
or
an
expensive.
also used.
exponential relation.
METHOD OF REGRESSION ANALYSIS: Regression analysis establishes a relationship between a
dependent variable and one or more independent variables. In simple linear regression analysis there is
only one independent variable. Simple linear regression can also be used when the independent
variable X represents a variable other than time. Multiple regression analysis is used when there are
two or more independent variables.
An example of a multiple regression equation is:
Y = 50.0 + 0.05X1 + 0.10X2 0.03X3
where:
Y = firms annual sales ($millions)
X1 = industry sales ($millions)
X2 = regional per capita income ($thousands)
X3 = regional per capita debt ($thousands)
BOX JENKINS METHOD: Box Jenkins Method also known as ARIMA(Auto-Regressive Integrated Moving
Average) models, this is an empirically driven method of systematically identifying, estimating,
analyzing and forecasting time series. This method is used only for short term predictions since it is
suitable only for demand with stationary time series sales data, i.e. the one that does not reveal the
long term trend.
The models are designated by the level of auto regression, integration and moving averages (P,d,q)
where P is the order of regression, d is the order of integration and q is the order of moving average.
There are 3 components of the ARIMA process:
AR(Autoregressive) process.
MA(Moving Average) process.
Integration process.
AR process: Of order p, generates current observations as a weighted average of the past
observations over p periods, together with a random disturbance in the current period.
Yt=+a1Yt-1+a2Yt-2+.+apYt-p+et
MA process: Order q, each observation of Yt is generated by the weighted average of random
disturbances over the past q periods.
Yt= +et-c1et-1-c2et-2+.-cqet-q
Integrated Process: Ensures that the time series used in the analysis is stationary. The previous 2
equations are combined to form:
Yt=a1Yt-1+a2Yt-2+...+apYt-p++et-c1et-1-c2et-2+-cqet-q

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If there are frequent turning points then trend method cannot explain the relationship fully between
time and sales as there is negative relationship sometimes, while at other it is positive. Therefore some
other indictor is used which shows a similar variation as the commodity. It can be GNP, personal
income, bank rate, WPI, Industrial production, Employment Rate etc. There might be some time lag or
lead in case of these indictors affecting the demand of the product. After identifying the product, one
may use the regular least square approach to get the sales forecast. This is also known as barometric
method as indicator is used as a barometer to forecast the demand.

METHODS FOR DEMAND FORECASTING OF AN NEW PRODUCT

To forecast demand for new products, we can use either of the following four methods:
1.
2.
3.
4.

Survey of Buyers Intention

Test Marketing
Life Cycle segment Analysis
Historical Analogy Method

5. Bounding curves Method

SURVEY OF BUYERS INTENTION: Discussed earlier.
LIFE CYCLE SEGMENT ANALYSIS: Sales curve of any commodity
eventually turns out to be S shaped. This is known as product life
cycle. The first stage is Research and Development, where product
is market tested. No sales occur but a lot of expenditure is
incurred. In Introduction stage product is launched and commercial
exploitation and marketing begins. Sales grow in the next two
stages of market development and exploitation. Intensive
advertising and sales promotion is done. At this optimum level of
resource utilization the firm gets maximum profit here. As similar
products by competitors flood the market, growth rate of sales
decline in the maturity stage. Price elasticity is very high, and in
the later saturation stage the high cross elasticity between
different brands makes rate of sales growth zero. Marketing becomes
ineffective, but firms maintain quality, services etc to maintain market share. Eventually this leads to
the phase of decline the product life comes to an end. In this method forecasting is done on the basis
of stage of PLC it is running in the industry.
TEST MARKETING: It involves selecting a test area which can be regarded as true sample of total
market. The product is launched in that area in the same manner in which it is intended to be used
when product is launched nationally. All marketing devices are selected with this in mind. The sales
data of the product in the test area is then used to forecast the demand for the product nationally.
This method is costly and time consuming. Considerable energy and effort goes as all marketing
devices are used for a small area. Selection of an appropriate test area is also difficult. The test needs
to be run for a long period of time, to be sure about the sales data. Also differences in sociological and
psychological characteristics need to be taken into account for this data. The launch if product in a test
area gives competitors to prepare for the imitation of the product or prepare their own strategies to
deal with the product.
HISTORICAL ANALOGY METHOD: This method is used for forecasting demand for a new product or
an existing product when introduced in a new area. When it is an existing product, then its sales data
for a previous place (which has similar socio-economic conditions as the place where the product is
being introduced) is taken for studying and estimating the future demand. In such cases one has to
carefully account for sociological and psychological differences. Generally, places which are as similar
as possible are taken for studying. If the product has not been used anywhere, then the past
consumption pattern of some other similar product is taken as basis for forecasting the demand for the
product.
The process is difficult as it is tough to find very similar locations, account for all the differences or find
a similar product.

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By Pashupati Nath Verma