Demand and Forecesting Economics MBS First Year

8/8/2019 Demand and Forecesting Economics MBS First Year

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Applications of the P rice Elasticity of Demand

The concept of elasticity of demand plays a crucial role in the pricing

decisions of the business firms and the Government when it regulates prices.

The concept of price elasticity is also important in judging the effect ofdevaluation of a currency on its export earnings. If has also a great use in

fiscal policy because the Finance Minister has to keep in view the elasticity of

demand when it considers to impose taxes on various commodities. We shall

explain below the various uses, applications and importance of the elasticity

of demand.

Elasticity of demand is mainly useful in Pricing Decisions by Business Firms.

The business firms take into account the price elasticity of demand when

they take decisions regarding pricing of the goods. This is because change inthe price of a product will bring about a change in the quantity demanded

depending upon the coefficient of price elasticity. This change in quantity

demanded as a result of, say a rise in price by a firm, will affect the total

consumers expenditure and will therefore, and affect the revenue of the

firm. If the demand for a product of the firm happens to be elastic, then any

attempt on the part of the firm to raise the price of its product will bring

about a fall in its total revenue. Thus, instead of gaining from the increase in

price, it will lose if the demand for its product happens to be elastic. On the

other hand, if the demand for the product of a firm happens to be inelastic,then the increase in price by it will raise total revenue. Therefore, for fixing a

profit maximizing price, the firm cannot ignore the price elasticity of demand

for its product.

Price elasticity of demand can be used to answer the following types of

questions:

1. What will be the effect on sales if a firm decides to raise the price of itsproduct, say by 5 percent?

2. How large a reduction in price of a product is required to increasesales, say by 25 percent.

It has been found by some empirical studies that business firms often fail to

take elasticity into account while taking decisions regarding prices, or they

give insufficient attention to the coefficient of price elasticity. No doubt, the


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main reason for this is that they dont have means to calculate price

elasticity for their product, since sufficient data regarding past prices and

quantity demanded at those prices are not available. Even if such data are

available, there are difficulties of interpretation of it because it is not clear

whether the changes in quantity demanded were the result of changes inprice alone or changes in some other factors determining the demand.

However, recently big corporate business firms have established their

research departments which estimate the coefficient of price elasticity from

the data concerning past prices and quantities demanded. Further, they are

also using statistical techniques to isolate the price effect of the quantity

demanded from the effects of other factors.


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Applications of Cross Elasticity of Demand for

Business Decision Making

The concept of cross elasticity of demand is of great importance in

managerial decision making for formulating proper price strategy.

Multiproduct firms often use this concept to measure the effect of change in

price of one product on the demand for other products. For example, Maruti

Udyog decides to lower the price of Maruti-800; it will significantly affect the

demand for Maruti Vans and Maruti Esteem. So it will formulate a proper

price strategy fixing appropriate price for its various products. Further,

Gillete Company produces both razors and razor blades which are

complements with high cross elasticity of demand. If it decides to lower the

price of razor, it will greatly increase the demand for razor blades. Thus

there is need for adopting a proper price strategy when it produces products

with high positive or negative cross price elasticity of demand.

Second, the concept of cross elasticity of demand is frequently used in

defining the boundaries of an industry and in measuring interrelationship

between industries. An industry is defined as a group of firms producing

similar products (that is, products with a high positive cross elasticity of

demand. For example cross elasticity of demand between Maruti Esteem,

Dawoo Ceilo, and Opel Astra is positive and quite high. They thereforebelong to the same industry (i.e., automobiles). It should be noted that

because of interrelationship of firms and industries between which cross

price-elasticity of demand is positive and high, any one cannot raise the

price of its product without losing sales to other firms in related industries.

Further, the concept of cross elasticity of demand is extremely used in the

United States in deciding cases relating to antitrust laws and monopolistic

practices used by firms. If so happens that in order to reduce competition

that one dominant firm try to merge with each other to form a cartel to

enjoy monopolistic profits. These actions are held illegal by Antitrust or anti-

monopoly laws. An interesting attempt was made in India by Casa-Cola and

it further made efforts to take over Pure Drinks, venture it could have

significantly reduced competition. With this its competition would have been

with other multinational rival firm Pepsi-Cola.


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Applications of Income Elasticity for Business Firms

The concept of income elasticity is important for decision making both by

business firms and industries. First, the firms producing products which have

high income elasticity have great potential for growth in an expanding

economy. For example, if for a firms product income elasticity of demand is

greater than one; it means that it will gain more than proportionately to the

increase in national income. Thus firms which are producing products having

high income elasticity are more interested in forecasting the level of

aggregate economic activity (i.e., level of national income) because the

demand for their products will greatly depend on the level of overalleconomic activity. Further, as seen above, the demand for luxuries is highly

income elastic. Therefore, the demands for luxuries increase very much, and

decline sharply during recessionary periods.

On the other hand, the demand for products with low income elasticity will

not be greatly affected by the fluctuations in aggregate economic activity.

During booms the demand for their products will not increase much and

during recessions it will not decrease sharply. Therefore, the firms with low

income elasticity for their products would not be much interested in

forecasting future business activity. Remember it is generally necessities for

which demand is not much income elastic. However, there is one good thing

for the firms which face low income elasticity. They are to a good extent

recession-proof. In the periods of recession, their incomes do not fall to the

extent of decline in aggregate income. Of course, to share the benefits of

increasing national income firms currently producing products with low

income elasticity would try to enter the industries demand for whose

products is highly income elastic as this would ensure better growth

opportunities.

The knowledge of income elasticity of demand also plays a significant role in

designing marketing strategies of the firms. If income of people is an

important determinant of demand for a product, the firms producing product

with high income elasticity of demand will be located in those areas or set up

their sales outlets in those cities or regions where incomes are increasing

rapidly. Besides, the firms will direct their advertising campaigns and other


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sales production activities to those segments of people whose income is high

and also increasing rapidly. This is to ensure higher growth of sales of their

products.

The concept of income elasticity of demand shows clearly why farmers

income do not rise equal to that of urban people engaged in manufacturing

industries. Income elasticity of demand for agriculture products such as food

grains is less than one. This implies that it is difficult for the farmers income

from agriculture to increase in production to the expanding national income.

Thus farmers cannot keep up with the urban people who derive their

incomes from industries producing goods with high income elasticity of

demand.

Demand Forecasting

Forecasting is like trying to drive a car blind-folded and following direction

given by a person who is looking out of the back-window. Philip Kotler

Introduction

The area of production planning and control is one in which the firm

concerns itself with means for the attainment of two objectives: the

production of required quantities of a given product and the production of

these quantities at appropriate times. This means that the producer must

anticipate the future demand for his product and, on this basis, provide the

production capacity which will be required. This call for forecasting the future

demand of a given product, translating this forecast into the demand it

generates for various production facilities and arranging for the procurement

of these facilities.

The discussion of demand forecasting is divided into seven sections. The first

describes the meaning, nature and the vital role played by demand forecasts

in the operations of business. The second deals with the types of forecastingwhich arise out of the planning needs of business firms. The third explores

the various approaches to demand forecasting. The fourth explains the

major determinants of demand. The fifth deals with the major methods

adopted in estimating future demand. The sixth explains the forecasting

methods for new products. The last discusses how forecasts and forecasting

methods can be evaluated in terms of their accuracy and costs.


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1.Meaning, Nature and the Role Played by Demand Forecasts in theOperations of Business

Estimates of expected future conditions are called forecasts and estimates of

expected future demand conditions are called demand forecasts.

Precise forecasts of future developments are clearly impossible. Expectations

depend on the assumptions made. The reliability of the forecasts, hence,

depends on the reliability of the assumptions.

The assumptions and methods employed in forecasting depend upon the

nature of the planning required. There are two major types of planning

which require the use of forecasts. They are short term planning and long

term planning. In industrially well developed countries, these grow out of the

need to predict short-term and long-term changes in demand conditions

facing industries. This has been so because demand conditions were always

more uncertain than supply in industrially advanced countries.

In recent times forecasting has come to play an important role in business

decision-making. A company is in business to serve its customers needs in

some way or the other. Its survival and prosperity depend on its ability and

willingness to adapt its operations to customers needs, to create or

stimulate the need, and serve it adequately and efficiently when the need

arises. Demand forecast serves as the link between the evaluation of

external factors in the economy which influence the business and themanagement of the companys internal affairs. The very term planning is

intimately connected with forecasting because it is concerned with the

future.

More often than not, one finds forecasting decisions which have an important

influence on production planning operations being made by store-keepers or

stockroom clerks with little or no procedural or policy guidance.

Determination of the types of forecast required and establishment of

procedures governing generation of these forecasts are fundamental steps in

the organization of a well-conceived production control system.

For production planning purposes it is particularly important to distinguish

between forecasts of demand and forecasts of sales. While forecasts of sales

may be important for estimating revenue, cash requirements and expenses,

a production planning system is designed primarily to react to customer

demand. Demand may differ from sales for a variety of reasons. For


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example, there may be substantial lag between customer orders and billings.

Or sales may understate demand to the extent that the manufacturing and

distribution system is unable to cope up with the volume of customer

demand. The particular characteristics of demand forecasts which are

pertinent to production and inventory control are the timing; detail andreliability of forecasts, and the assignment within the organization of the

responsibility for making forecasts and controlling or improving the quality of

forecasts.

2.Types of Demand ForecastingFrom the point of the view of the time span and from the planning

requirements of business firms, demand forecasting can be classified under

two headings: short-term demand forecasting and long-term demand

forecasting.

Short-term ForecastingShort-term forecasting is limited to short periods, usually not exceeding an

year. It relates to policies regarding sales, purchasing pricing and finances.

Here the reference is only to the existing production capacity of the firm.

In most companies, knowledge of conditions in the immediate future is

essential for formulating a suitable sales policy. Production schedules have

to be geared to expected rather than actual sales. Often, by assuming that

prevailing conditions will continue, a firm may find itself faced with a

problem of over production or short supply. An understanding of near future

prospects would make it possible to avoid some of the violent fluctuations

which occur in production scheduling and sales planning.

Knowledge of immediate future conditions is important in pricing. If prices of

materials are expected to go up or shortages are expected, businessmen

may take advantage of the rise by earlier buying. Proper price forecasting

may, thus, help the firm in reducing the costs of operation.

Demand forecasting is also useful to the businessman in determining his

price policy. An increase of prices is avoided when future market conditions

are not expected to be good and the lowering of prices is avoided when

costs or sales levels are likely to rise considerably.


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Many companies use forecasting for setting sales targets and for establishing

controls and incentives. Sales targets will not accomplish their objectives if

not geared meaningfully to the sales levels likely to be achieved. If set too

high, the targets will be discouraging to those who have to meet them. If the

targets are very low, they will be met very easily and incentives will provemeaningless.

Above all, demand forecasting of the type mentioned above will be of

considerable assistance in short-term financial forecasting also. Cash

requirements will depend upon the levels of sales and production scale.

Some prior information is usually needed to procure additional funds on

reasonable terms. Neglect of demand forecasting will complicate financial

planning through its repercussions on production scheduling and inventory

accumulation. In the preparation of budgets, therefore, short-term forecasts

have come to play an important part.

Long-term ForecastingIn short-term forecasting a company is concerned only about the use of its

existing production capacity. But when questions of long-term planning are

involved the businessman must know something about the long-term

demand for his products. Thus the planning of a new production unit or the

expansion of an existing unit must start with an analysis of the long-term

demand potential of the products in question. A multi-product firm must

ascertain not only the total demand situation, but also the demand for

different items. This will involve the study of consumer preferences and

trends, the economy, and technological developments and trends. Once the

demand potential is assessed, it will be easier for the company to engage in

long-term financial planning. Again, manpower planning for existing as well

as new firms must be based on long-term forecasts of the companys

growth.

When forecasts covering long periods are made, the probability of error is

high. Competent forecasts predict the conditions that are likely to prevail in

the near future with comparative confidence, and with a relatively highdegree of accuracy; the results are much less reliable when they attempt to

forecast conditions over longer periods. This is because; as the period

becomes longer certain factors that forecasters take into account in making

their estimates become more volatile. It is very difficult to predict over

extended periods such items as the probable costs of production, the trend

of prices and the changing nature of competition. Moreover, the longer the


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term covered by the prediction, the more likely it is that unanticipated

events such as international conflicts including wars, periods of major

depression and prosperity and inventions and technological advances will

upset the calculations.

It is a function of the top management in each firm to make its own decision

regarding the span of time to be covered by demand forecast. It is safer to

forecast for longer periods, when the volume of demand has held fairly

constant from year to year. If demand has been erratic for reasons that are

largely unexplainable, the forecasting period should be shorter.

3.Approach to ForecastingThe following four distinct steps must be kept in view in dealing with anydemand forecasting problems:

i) Identify and clearly state the objectives of the forecasting problem.In certain cases the required forecasts may be of a short term

nature. The approach needed here may be of quite different from

what long-term forecasts will call for. In certain other cases

forecasts of market shares may be required which calls for an

approach different from that needed for a general industry forecast.

ii) Ascertain the determinants of demand for the particular product orproduct group. The factors influencing demand differ widely

depending on the product/s or industry or industries involved.

Economists have a tendency to categorize goods and services into

three broad categories for facilitating demand analysis. These three

categories are:

- Consumers non-durable goods.- Consumers durable goods- Capital goods.We follow here the same kind of categorization for purposes of

demand analysis. The determinants of demand pertaining to these

categories are different. They are discussed in detail in the next

section.


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iii) Select appropriate methods of forecasting. The method selected willdepend upon the purpose or objective of the demand forecasts, the

nature of the product/s involved, the types of data available, etc.

iv) Present the findings in a readable form. This is important becausethe management will be interested only in the actual forecast, itsmeaning and implications for policy.

Once a product forecast for the whole industry is available, it is easy for the

company to estimate its share of the market. Analysis of past data can

indicate the trends in market share among the competitors.

In preparing company forecasts the management may rely of two varying

assumptions:

a) The ratio of company sales to total industry sales will continue as inthe past, or

b)The ratio of company sales to total industry sales will change.Demand forecasts for the company may be made based on either of these

assumptions. And often companies prepare alternative forecasts based on

them.

Forecasting must be a continuing activity. Every forecast is based on a given

set of data and assumptions hold good. As improved information becomes

available, forecasts must be reviewed and revised so that the management

is provided with a better basis for decision making.

4.Determinants of Demandi) Non-durable consumer goods

There are at least three basic factors influencing the demand for non-

durable consumer goods. They are: purchasing power (income), price

and demography.

a) Purchasing PowerOne of the major determinants of demand is the purchasing power

of the consumer and this is determined by the income or rather

disposable personal income (Personal income minus direct taxes

and other deductions, if any) of the consumer. In Nepal, data on


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disposable income is not directly available. The Central Statistical

Organization has not yet started the publication of data on

disposable income. Indirect estimates can, however, be obtained

from the published data.

Use of disposable income for estimating demand has been criticized

by some writers on the plea that it does not constitute free

purchasing power. Hence, they prefer to use the concept

discretionary income in place of disposable income. Discretionary

income can be estimated by deducting three items from disposable

income, viz. imputed income and income in kind, major fixed outlay

payments such as mortgage debt payment, insurance premium

payments and rent and essential expenditures such as food and

clothing and transport expenses based upon consumption in a

normal year. But here it may be pointed out that the disposable

income concept is considered to be equally satisfactory by many

experts.

b)PriceThe importance of price of a particular product and its substitutes in

determining the demand has always been emphasized by

economists. A measure of the price-demand relationship for a

product is given by the concept elasticity of demand. Concepts

such as price elasticity, income elasticity, cross elasticity, etc. of

demand are used in economic analysis.

c) DemographyExperience shows that demand for a product is determined by

certain population characteristics also. For example, a study of the

demand for lipsticks must take into account the number of women

by age. Again, in a study of the demand of tyers, the population

consists of the number of cars, buses, trucks and other motor

vehicles in use. This shows that demography does not necessarily

relate exclusively to human population. In fact, its use is in

differentiating between total market demands on the one hand and

market segments on the other. The segments represent divisions

of the total market into homogenous groups. The idea is to

construct one or more segments that are considered to be


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important elements affecting the demand for the product.

Demographic or population groups can be defined in terms of

educational background, sex, age, income, social status, geographic

location, etc. The segment, if quantified, can be used as an

independent variable affecting the demand for the product inquestion.

Purchasing power(Y), Price(P) and demography(D) can be combined

in an additive relationship in order to get a formula which can be

used for predicting demand(d) for a consumer good. The formula

may take the form

d=Y+P+D

Durable Consumer Goods

Three different purchase characteristics can be distinguished in the case of

durable consumer goods. They are:

i. Time-use characteristics;ii. Use-facilities characteristics; andiii. Demographic characteristics.i. Time-use characteristics

Consumer durables have got extended use and as such they are never

used up in a single act as are match-sticks or ice-cream. This feature

enables the consumers to go on using them by repairing if necessary,

or to scrap them and get new ones. Experience shows that

emergencies such as war or scarcity force people to postpone

replacement of durable goods and thereby to lower the effective

scrapping rate. The decisions to replace goods are influenced also by

considerations such as social prestige and status, income and product

obsolescence.

ii. Use-Facilities characteristicsGenerally durable goods require special facilities for their use. For

example, to use a car, or truck, one needs to have roads and petrol or

diesel stations. Again, to use a refrigerator or a radio, one needs

electricity. The existence and growth of such facilities is an important

variable in determining the volume of sales or quantity demanded of


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the products in question. Hence, due consideration must be given in

choosing the variables influencing the demand for durable consumer

goods.

iii.

Demographic characteristicsThe decision to purchase consumer durables is influenced also by

factors such as size of families, age distribution of adults and children,

population groups in different income strata, price and other

considerations. Demography here includes a study of populations other

than human also. A study of the demand for commercial airliners has

used the number of commercial airports as both a use facilities

characteristics and as demographic characteristics in deriving the

forecasting equation. Hence, the three different purchase

characteristics may be considered independently, or in combination,

depending on the product and the economic judgment of the analyst.

The total demand for durable goods, in fact, is the sum of two

demands: a new owner demand and a replacement demand. The new

owner demand will increase the stock of the goods. Replacement

demand tends to grow with the growth in the total stock with

consumers and at times it may even exceed the new stock with

consumers and at times it may even exceed the new demand. For

certain well established products, life expectancy tables are made

available in advanced countries in order to estimate the average or

near average replacement rates.

The basic demand equation for durables may be stated as follows:

d=N+R

Where, (d) represents total demand, (N) new-order demand and (R)

replacement demand.

Each of these independent variables may be forecast separately. It

must be borne in mind that in the case of most durable goods there is

an upper limit beyond which demand cannot grow. This upper limit

refers to the saturation point. For example, even if income goes up,

there is limit to the number of radios that people will buy. It is to this

level towards which the actual volume of consumer stocks tends to

gravitate. The difference between the saturation point or the


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maximum ownership level and the actual stock shows the growth

potential of the demand for durable goods.

Capital goods

Capital goods are produced means of further production. They are used to

facilitate the production of other goods. Examples are machinery of all kinds,

factor buildings etc. The demand for capital goods is a case of derived

demand. Hence, the demand for capital goods depends upon the

profitability of the industries using the capital goods, the ratio of production

to capacity in user industries, the level of wage rates, the policy of the

Government, business prospects, etc. Where the wage rates go exceptionally

high, the management will have an added tendency to go for labor-saving

equipment.

In the case of particular capital goods, demand will depend on the specific

markets they serve and the end uses for which they are bought. The

demand for textile machinery, for instance, will be determined by the

expansion of textile industry in terms of new units and replacement of

existing machinery. Therefore, demand forecasts for capital goods will have

to take into account new demand as well as replacement demand.

Two types of data are required for forecasting the demand for capital goods,

intermediate or industrial goods. They are

i) The growth prospects of the user industries, andii) The criteria or norm of consumption of the capital goods per unit

of each end use.

The critical assumptions underlying the end-use approach are:

a) The demand estimates for the end-use approach are availableb)The norms of consumption (the technology of the industry) will remain

unchanged during the period under consideration.

c) Norms based on present consumption patterns in industry may, inpart, reflect existing shortages and import restrictions in the economy.


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In building bridges, for example, mild steel might be in use at present

instead of constructional steel (which is more suitable for the purpose.

This might be due to the non-availability or high cost of constructional

steel. But as the pattern of availability changes, the consumption

pattern in the industry may also vary, changing the norms ofconsumption in the process.

Documents

Demand and Forecesting Economics MBS First Year