Chapter 2 2.

Theory of demand Definition of demand

Demand refers to the various amounts of a commodity that consumers are willing and able to buy at each price in a series of possible prices during a given period of time, all other factors held constant. The term demand used in economics in not a fixed number. It shows how the quantity that buyers purchases vary with prices, other influences had constant. Demand is an effective desire which is backed by: Willingness and ability of the consumer to purchase the desires commodity and Availability of the desired commodity in the market. So effective demand is a want with desire to buy, willingness to pay and ability to pay. Law of demand Law of demand is a principle which states that, other things being constant, the lower the price of a good /service, the greater the quantity of that good/ service buyers are willing and able to purchase over a given period. If prices increase, quantity demand decreases and if price decreases, quantity demand increases. Individuals demand for a commodity may be expressed by i. ii. iii. Demand schedule Demand curve Demand function

i. Demand schedule Demand schedule is a table that shows how an items quantity demanded would vary with prices other things held constant. For example, the following table shows the demand schedule for meat (kg) per week.

Price (Birr) (y) Quantity demanded (X) 10 9 8 7 6 ii) Demand curve Demand curve is anther way of expressing demand for a commodity using diagram. Thus demand curve is a graph of the data comprising demand schedule. It shows how quantity demanded varies with price graphically. The following graph shows the demand curve for the above schedule Price 10 (1, 10) Individual demand curve 8 7 6 (4, 8) 1 2 4 7 12

8 9

12

QX quantity /

It is down ward sloping curve, indicating that as price of meat decreases, the demand for meat will increases and vice versa.

iii) Demand function Demand function is the relation ship between quantity demand for a product and the corresponding prices; expressed in mathematical equation form. If QX is quantity demand for product X and PX is corresponding price, the demand function for X is written as: QX= f (PX)

In general the demand function is stated as Qd = Q P (linear r/ship) Ex Y =1, P1=10 P2 = 8 Equation Y =4 M= y2-y2 x2-x2 M= 8-10 = -2 4-1 3 y-y1=m(x-x1) y-10=m(x-1) y-10=2/3(x-1) y-10=2/3x+2/3 y=-2/3x+2/3+10 Y=-2/3x+32/3
or

- This is an inverse demand function

P=-2/3Qx+32/3 The corresponding demand function is: P= - 2/3Qd +32/2 -3/2x-2/3Qd (p-32/3)-3/2 Qd=-3/2p+16 Qd =16-3/2p or Qd=36-1.5p Is demand function.

Interpretation
-3/2 is the slope of demand function -3/2(slope) implies that when the price of a kg of meant increases by one birr quantity demand decrease by 1.5kg per weak. Negative sign of the slope show the inverse relation ship between price and quantity demand.

Market demand
Market demand is the sum of individual demand obtained by horizontal summation for n number of consumers of a commodity. The market demand is Dc = D1+D2+D3+ -------+ Dn. Example; Price per kg (birr 3 4 5 6 Quantity demand by individual households HH A HH B HH C HH D HH E 3 7 6 8 5 2 5 4 6 3 1 3 2 4 2 0 1 0 2 1 Market demand MD= A+B+C+D+E 29 20 12 4

Determinants of Demand
The following are factors which determine (affect) the market demand for a product. 1. Price of the product 2. Price of related products 3. bevel of consumers income 4. Taste & preference of consumers 5. Advertisement of the product 6. Consumers expectation about future price.

1. Price of the product

The price of a product is one of the determinants of demand. Price of a product and is quantity demand are inversely related. Change in the own price of a product affects quantity demand of that product and causes a movement along the same demand cure. Change in quantity demand should not be confused with change in demand. change in quantity demand for a

product is caused by the price of that product and it do not require a shift in demand curve. Where as, change in demand involves shift in demand curve and occurs as a result of factors other than price.

2. Price of related products

Related goods are commodities which are interdependent. The substitutes complementary goods are the two types of related goods. A. Substitute good is a good which can be used in the place of another good. when two goods are substitutes, the price of one and the demand for the other move in the same direction. EX: - Coffee and tee, butter and Oil, Coca and Pepsi are substitutes. When the price of coffee declines the consumer will buy more coffee and less tea; it implies that the demand for coffee increases. B. Complementary goods are those goods used in conjunction with another. When two goods are complementary, the price of one and the demand of the other move in opposite direction.

3. Level of consumers income

The effect of change in consumers money income to the demand for a product depends up on the type of the product. We have two types of products normal goods and inferior goods. Normal goods are those goods which the consumer will buy more as his income rises. For most goods arise income will cause an increase in demand. Inferior goods are those goods, which the consumer will buy less and less as his income rise.

4. Consumers Taste and Preference

Other factors remaining constant, a change in consumers taste or preference favorable to a product will mean that, more will be demanded shifting the curve to the right. Unfavorable changes in consumer preference will on the otherand make the product less desirable and decrease the demand.

5. Advertisement of the product

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Advertisement costs are incurred with the objective of promoting sales of the product. Advertisement increases the demand for the product in at least the following four ways. 1. By informing the consumers about the availability of the product. 2. By showing its superiority /quality over the rivals product. 3. By influencing the consumers choice against the rival product. 4. By setting new fashions and changing styles and tastes. The impact of such effect shifts the demand up wards to the right.

6. Consumers expectation.
Consumers expectations regarding the future prices, income and supply position of goods play an important role in determining the demand for goods & services. If consumers expect a high rise in the price of the product, they walled buy more of it at it high current price with a view to avoid increasing price of the future.

3.1.3 Elasticties of Demand

We have discussed the nature of relationship between demand and its determinants. From managerial point of view, however the knowledge of the nature of relationship alone is not sufficient. What is more important is the extent of relationship or the degree of responsiveness of demand to the changes in its determinants. The degree of responsiveness of demand to the changes in determinant is called elasticity of demand. Thus elasticity of demand refers to the responsiveness in the amount of commodity purchased to a change in any one of the factors affecting demand while other factors being constant. The most elasticitys of demand that we will discuss are:1. Price elasticity of demand 2. Cross price elasticity of demand 3. Income elasticity of demand

How the concept of elasticity of demand plays a critical role in business decision making? Take an example of increase in cost of production. When cost of production is increasing, the firm would want to pass the rising cost on to the consumer by raising the prices. But whether raising prices proves beneficial to a firm depends on. i. The price elasticity of demand for the product i.e. how high or low is the proportionate change in its demand in response to a certain percentage change in price and ii. Price elasticity of demand for substitute because when the price of a product increases, the demand for its substitute increases automatically even if their prices remain unchanged.

Therefore raising the price will be beneficial only if: A). demand for a product is less elastic and B). demand for its substitute is much less elastic.

1. Price elasticity of demand

Price elasticity of demand is defined as the responsiveness or sensitiveness of demand for a commodity to the changes in its price. More specifically, it is the percentage change in demand as a result of one percentage change in the price of the commodity. It is given as: Ep = % change in Qd % change in price Ep = Q P = QX P Q P Q P 7

Ep = Q P P Q This is arc formula to find coefficient of price elasticity of demand. Where Q = Original quantity demanded P = Original Price Q= Change in quantity demand P = change in price Arc elasticity: - measures elasticity of demand between any two points on demand curve. Price X 25 20 15 10 5 K J Are elasticity between J and K shows fall in price from 20 to 5, and increases in quantity from 25 to 75 units

Qdx 25 75

Ep = Q . P (with minus) P Q Ep = 75-25. 20 20-5 25

Ep = 50 20 15 25 Ep = 8/3 = 2.67 Interpretation: This means that a one percent decreases in price of commodity X results in a 2.67% increase in demand for it. Thus the demand is elastic, b/c 1% decrease in prices results on a grater than 1% increase in quantity demand. Point elasticity: this is elasticity at a finite point on the demand curve ex at a point P or B. 8

Price P

Demand function will be given and we use the derivative concept to find slope at that given point and substitute Ep = P dQ Qty Q dp

Ex. Q = 100 5P is the demand function for the above diagram. Measure elasticity at P = 10? Slope = dQ = -5 hence at P = 10 dP Q = 100 5 (10) Q = 50 Ep = P dQ Q Dp Ep = 10 (-5) 50 Ep = -1 Similarly at P = 8 Q = 100 5(8) = 60 eP = -5(8%) = -40/60 = - 0.67

Ranges and Interpretations of elasticity of demand

Price elasticity is classified in to 3 based on the degree of responsiveness. 1. Elastic demand 2. Inelastic demand 3. Unitary elastic demand 1. Elastic demand: if a 1% change in price results in amore than 1% change in quantity demand. In this case Pe > 1.

2. Inelastic demand: - If a 1% change in price results in a less than 1%

change in quantity demand. In this case Pe < 1.

3. Unitary elastic demand: - If 1 % change in Price leads to exactly 1 %

change in quantity demand. Pe =1

Application of price elasticity of demand in Decision making Price elasticity and Total revenue
A firm aiming at enhancing it total revenue would like to know whether increasing or decreasing the price would achieve its goal. To check this we use price elasticity coefficient of demand. In general; i. If Pe >1, then decreasing price will increase revenue and ii. If Pe < 1, then increasing the price will increase the total revenue. To prove this we need to know TR functions. TR = PQ and the information about P and Q is obtained from the demand function. For example let Q = 100 5P, price function con be derived as P = 20 0.2Q . TR = P.Q = (10-0.2Q)Q TR = 10Q 0.2Q2 and find MR MR = d TR = 20 - 0.4Q dQ

Diagrammatically TR 500 400 300 10 M

200 100 TR=P.Q

Qd

Price and 20 MR

>1

15

10

5 O 50

QX Qd

When price elasticity is elastic i.e. Pe > 1 TR is increasing as price decreases .

When Pe = 1 (unitary) as price decreases. When Pe < 1, (inelastic), as price decreases TR will decrease.

Elasticity, marginal revenue and average revenue 1. MR = P (1- 1 ) Pe 2. MR = AR ( 1 - 1 ) or MR = AR AR Pe Pe 3. Pe = AR___ AR MR

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Thus given AR and MR, we can easily find out Pe by using the above formula. Conclusion for the diagram 1. If Pe = 1, MR = O 2. If Pe > 1, MR > O 3. If Pe <1, MR < O

2. Cross price elasticity of demand

Cross price elasticity is the measure of responsiveness of demand for a commodity to the changes in the price of its substitutes and complementary goods. For example, the cross elasticity change in its quantity to % changes in the price of coffee (substitute), the formula is: Et,c = % change in demand for Tea (Qt) % change in price of coffee (Pc) Et,c = Pc Qt Qt Pc is cross price and elasticity of Tea

Use of cross price elasticity

It is used to define substitute goods. If cross price elasticity b/n two goods is positive, the two goods may be considered as substitutes of one another .Similarly if cross elasticity of demand for two goods is negative, the goods are complementary, the higher the negative cross- elasticity, the higher is the degree of complementarily.

3. Income elasticity of demand

Consumers income is one of the determinants of demand for a product. The responsiveness of demand for a product to changes in the income is known as income elasticity of demand. If may be given as: Ey = Y Xq Xq Y

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Ey = Y Xq where Xq = quantity demand of X Xq Y Y= disposable in come X q =Chaney in goutily of X demanded Y = Champ in disposable in come Income elasticity of demand is always positive b/c of positive relation ship between in come and quantity demand.

Use of in come alacrity

Income elasticity has of a great importance in production planning and management in the long run. The concept of income elasticity can be used to estimate future demand provided that the rate of increase in income and income elasticity of demand for the product are known. The knowledge of income elasticity can thus be useful in forecasting demand when change in personal income is expected. It also helps in avoiding over production or under production.

Demand Forecasting
Techniques of fore casting demand

Why demand forecasting?

Demand forecasting is predicting future demand for product. Information regarding future demand is essential for: 13

Planning and scheduling production Purchase of raw manorial Acquiring of finance and advertising Avoiding under or over production

The techniques for forecasting demand that we are going discoed in this chapter are classified as: 1- Survey methods 2- Statistical methods

Survey Methods
This method is generally used when the purpose is to make short term forecast of demand. Under this method consumer surveys are conducted to collect the information about their intensions and future purchase plan. This method includes: Survey of potential consumers Opinion polling of experts i.e. opinion survey of market experts and sales representatives. The following techniques are used to conduct the survey of consumers and experts. a. Complete enumeration b. Sample survey c. End use methods

The most direct and simple way of assessing future demand for a product is to interview of potential consumers and to ask them what quantity they would be willing to purchase. When all consumers are interviewed we call it complete enumeration survey and when only a few selected representatives are interviewed it is known as sample survey method. The quantities indicated by all consumers are added to obtain the probable demand for the

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product. If m number of consumers in a city report to purchasing of a product: total probable demand (DP) will be: DP = q1+q2+q3+-- qn

Limitations of this method

1. In case of widely dispersed markets the method may not be physically possible or may be costly. 2. Demand forecasted many not be reliable b/c of the following reasons. Consumers themselves may not know their actual demand in the future Their answers to hypothetical question may not be real or may be hypnotically. Consumers response may be biased according to their expectation about the market condition Their plans may change with changes in factors not included in the questioner

Sample survey Method

In this case only a few potential consumers will be selected from the relevant market and interviewed. On the basis of information obtained the probable demand (DP) may be estimated using the formula: DP = HR (H.AD) where DP = probable demand HS H = census number of house holds from the relevant market HS = number of sample house holds HR = number of house holds reporting demand for the product. AD = average expected consumption by the reporting house holds. This method is generally simpler, less costly and less time consuming than the complete enumeration method. The end -use method

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This method has four stages 1st. Identifying and listing all possible users of the product 2nd. Fixing suitable technical norm of consumption of the product under the study 3rd. Application of the norm 4th. Aggregate the product wise content of the item for which the demand is to be forecasted.

Advantages
Future demand can be estimated in details by types and size. It is possible to trace and pinpoint variations in consumption at any time in the future.

Opinion Poll Methods

This aims at collecting opinions of those who have information and knowledge of the market i.e. sales representatives, sales executive professional marketing experts.

2. Statistical Methods
Statistical methods use historical and cross -section date for estimating long term demand. It is superior to survey methods for the following reasons:1. Element of subjectivity is minimum 2. Methods of estimation are scientific 3. Estimates are very more reliable 4. Estimation requires less cost The statistical methods of demand projection includes the following 1. Trend projection methods 2. Barometric methods 3. Econometric method

Trend projection method

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This method is concerned with the study of movement of variable throng time. It requires the use of long and reliable time services data. But cause effect relation ship is not revealed in the method. It can be applied in time series date on sales.

Barometric Method of forecasting

This method is similar to the method meteorologists use to forecast weather. They use barometer to forecast weather conditions on the basis of movement of mercury. Similarly, economist use economic indicators as barometers to forecast trend in economic activities. Thus, the basic approach of this technique is to construct an index of relevant economic indicators and to forecast future trends on the basis of movements in the index of economic indicators.

Econometric Methods
Econometric methods use statistical fools and economic theories to estimate economic variable and forecast the intended economic variable. The forecasts made under this method are more reliable than any other methods and thus it is the widely used method for estimating future demand for a product. Econometric methods use the following two techniques. Regression method This combines economic theory and statistical techniques for estimation. Economic theory is used to specify the determinant of demand and the nature of relationship between demand for a product and its determinants. In short it establishes the general form of demand function. Statistical techniques are employed to estimate the values of parameters in the estimated equation. Simultaneous equation technique It involves forecasting several simultaneous equations, which are generally behavioral equations, mathematically identities and market clearing equation. The method uses sophisticated mathematical and statistically tools which are beyond your scope. The basic features of these methods are:-

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 First to complete the model and specify behavioral assumptions regarding the variable included in the model. The variables included are: - endogenous and exogenous variables. Second stet is to collect relevant data on endogenous and exogenous variable Third the data colleted will be analyzed using relevant techniques Finally the model is solve for each variable

Concluding remark
There are several methods and techniques available for forecasting demand for a product. All the methods discussed have their own advantages and disadvantages. The applicability and usefulness of a method depends on the purpose of forecasting and availability of reliable and relevant data. The analysis should therefore, choose a method or a technique of forecasting that is relevant to the purpose, continent to handle, applicable to available data and also inexpensive.

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