Embed Size (px)
Citation preview
Managerial Economics
1
Session I
Demand: Concept and Types2
The process to satisfy human wants/ needs/desires.Want: having a strong desire for somethingNeed: lack of means of subsistenceDesire: an aspiration to acquire something
Demand: effective desireDemand is that desire which backed by willingness and ability to buy a particular commodity. Things necessary for demand:TimePrice of the commodity Amount (or quantity) of the commodity consumers are willing to purchase at the price
3
Type
s of
Dem
and
Direct or Autonomous and Derived DemandDirect demand is for the goods as they are such as Consumer goodsDerived demand is for the goods which are demanded to produce some other
commodities; e.g. Capital goodsRecurring and Replacement DemandRecurring demand is for goods which are consumed at frequent intervals such
as food items, clothes.Durables are purchased to be used for a long period of time
4
Type
s of
Dem
and
Complementary and Competing DemandSome goods are jointly demanded hence are complementary in
nature, e.g. software and hardware, car and petrol.Some goods compete with each other for demand because they are
substitutes to each other, e.g. soft drinks and juices.Demand for Perishable and Durable Goods Durables: Last for a relatively long time and can be consumed
multiple times Demand can be postponed
Non-durables: Perishable, Non-perishable.Individual and Market DemandIndividual demand: Demand for an individual consumerMarket demand: Demand by all consumers
5
Session II Demand: Determinants6
Det
erm
inan
ts o
f Dem
and
Price of the product Single most important determinantNegative effect on demand
Income of the consumer Normal goods: demand increases with increase in consumer’s income Inferior goods: demand falls as income rises
Price of related goods Substitutes If the price of a commodity increases, demand for its substitute rises.
Complements If the price of a commodity increases, quantity demanded of its complement falls.
7
Det
erm
inan
ts o
f Dem
and
Tastes and preferencesVery significant in case of consumer goods
Expectation of future price changes Gives rise to tendency of hoarding of durable goods
PopulationSize, composition and distribution of population will influence demand
AdvertisingVery important in case of competitive markets
Contd…
8
Session III Demand: Function9
Dem
and
Func
tion
Interdependence between demand for a product and its determinants can be shown in a mathematical functional form
Dx = f(Px, Y, Py, T, A, N) …….. [Multivariate fx] Independent variables: Px, Y, Py, T, A, N Dependent variable: Dx
Px: Price of x Y: Income of consumerPy: Price of other commodityT: Taste and preference of consumerA: AdvertisementN: Macro variable like inflation, population growth, economic growth
10
Law
of D
eman
d A special case of demand function which shows relation between price and demand of the commodity
Dx = f(Px) Dx = f(Px)
Reasons Substitution Effect Income Effect
11
Dem
and
Sch
edul
e an
d In
divi
dual
D
eman
d C
urve
Point on Demand Curve
Price (Rs per cup)
Demand (‘000 cups)
a 15 50b 20 40c 25 30d 30 20e 35 10
e
b
a
c
10 20 30
15
20
30
35
5040
25
Quantity of coffee
Pric
e of
Cof
fee
O
d
12
Mar
ket D
eman
dMarket: interaction between sellers and buyers of a good (or service) at a mutually agreed upon price.
Market demand Sum total of the quantities of a commodity that all buyers in the market are
willing to buy at a given price and at a particular point of time (ceteris paribus)
Market demand curve: horizontal summation of individual demand curves
13
Session IVShifting Demand & Exceptions 14
Change in DemandOr Demand Shifting
D1
D2
D0
Price
Quantity0
Shift in demand curve from D0 to D1 More is demanded at same price
(Q1>Q)
Increase in demand caused by: A rise in the price of a substitute A fall in the price of a complement A rise in income A change in tastes that favours the
commodity
Shift in demand curve from D0 to D2 Less is demanded at each price (Q2<Q)
P
Q1QQ2
15
Exc
eptio
ns to
the
Law
of D
eman
d
Law of demand may not operate due to the following reasons: Giffen Goods: Sir Robert Giffen, IrelandSnob Appeal: Veblen Goods, Thorstein VeblenDemonstration Effect: FashionFuture Expectation of Prices (Panic buying)AddictionNeutral goods Life saving drugsSalt
16
Goods with no substituteAmount of income spent
Match box
Session V Elasticity of Demand17
Elas
ticity
of D
eman
d “Elasticity” is a standard measure of the degree of responsiveness (or sensitivity) of one variable to changes in another variable.
price of the commodity, price of the other commodities, income, taste, preferences of the consumer and other factors.
Elasticity of Demand
Mathematically, it is the percentage change in quantity demanded of a commodity to a percentage change in any of the (independent) variables that determine demand for the commodity.
Four major types of elasticity:◦ Price elasticity,
◦ Income elasticity,
◦ Cross elasticity
◦ Advertising (or promotional) elasticity.
ceteris paribus
Price Elasticity of Demand
Price is most important among all the independent variables that affect the demand for any commodity.
Hence price elasticity of demand (“ep”) is considered to be the most important of all types of elasticity of demand.
Perfectly elastic demand ep=∞ (in absolute terms). Horizontal demand curve Unlimited quantities of the commodity can be sold at the prevailing price
A negligible increase in price would result in zero quantity demanded
Perfectly inelastic demand ep=0 (in absolute terms) Vertical demand curve Quantity demanded of a commodity remains the same, irrespective of any change in the price
Such goods are termed neutral.
Degrees of Price Elasticity Price
Quantity O
P D
Q1 Q2
Price
Quantity O
P1
P2
D
Q1
Degrees of Price ElasticityHighly elastic demand
Proportionate change in quantity demanded is more than a given change in price
ep >1 (in absolute terms) Demand curve is flatter
Unitary elastic demand Proportionate change in price brings about an equal proportionate change in quantity demanded
ep =1 (in absolute terms). Demand curves are shaped like a rectangular hyperbola, asymptotic to the axes
Relatively inelastic demand Proportionate change in quantity demanded is less than a proportionate change in price
ep <1 (in absolute terms) | Demand curve is steep
Price
Quantity O
D
D
Q2
P2
Q1
P1
Price
Quantity O
D
D
Q1
P1
Q2
P2
Price
Quantity O
Q1
P1
Q2
P2
D
D
Contd.
Ratio (or Percentage) Method◦ The most popular method used to measure elasticity◦ Elasticity of demand is expressed as the ratio of proportionate change
in quantity demanded and proportionate change in the price of the commodity
◦ It allows comparison of changes in two qualitatively different variables◦ It helps in deciding how big a change in price or quantity is
ep=
◦ where Q1= original quantity demanded, Q2= new quantity demanded, P1= original price level, P2= new price level
Met
hods
of M
easu
ring
Elas
ticity
Xcommodity of pricein change ateProportionXcommodity of demandedquantity in change ateProportion=ep
112
112
/)(/)(PPPQQQ
Point Elasticity Method◦ Elasticity measured at a point of demand curve is referred as point
elasticity of demand.
For nonlinear demand curve we need to apply calculus to calculate point elasticity. As changes in price become smaller and approach zero, the ratio becomes equivalent to the first order derivative of the demand function with respect to price
Point elasticity can be expressed as:
ep = =
PdPQdQ
//
dPdQ
QP.
dPdQ
PQ
Met
hods
of M
easu
ring
Ela
stic
ity
Arc Elasticity Method ◦ Used when the available figures on price and quantity
are discrete, and it is possible to isolate and calculate the incremental changes.
◦ It is used to find the elasticity at the midpoint of an arc between any two points on a demand curve, by taking the average of the prices and quantities.
◦ This method finds wider applications, as it reflects a movement along a portion (arc) of a demand curve
ep = /
=
2/)( 21
12
QQQQ
2/)( 21
12
PPPP
21
12
QQQQ
.
12
21
PPPP
Met
hods
of M
easu
ring
Ela
stic
ity
Total Outlay Method (Marshall)
◦ Elasticity is measured by comparing expenditure levels before and after any change in price, i.e. whether the new expenditure is more than, or less than, or equal to the initial expenditure level.
◦ Helps a seller in taking a decision to raise price only if:◦ Reduction in quantity demanded does not reduce total revenue or◦ Reduction in price increases the quantity demanded to the extent that total revenue also increases.
◦ Degrees◦ When demand is elastic, a decrease in price will result in an increase in the revenue (sales).◦ When demand is inelastic, a decrease in price will result in a decrease in the revenue (sales).◦ When demand is unit-elastic, an increase (or a decrease) in price will not change the revenue (sales)
Met
hods
of M
easu
ring
Ela
stic
ity
Nature of commodity ◦ Necessities are relatively price inelastic, while luxuries are relatively
price elastic
Availability and proximity of substitutes ◦ Price elasticity of demand of a brand of a product would be quite
high, given availability of other substitute brands
Alternative uses of the commodity◦ If a commodity can be put to more than one use, it would be
relatively price elastic
Determinants of Price Elasticity of Demand
Proportion of income spent on the commodity◦ The greater the proportion of income spent on a commodity, the more sensitive would the
commodity be to price◦ Reason is income effect
Time◦ Demand for any commodity is more price elastic in the long run
Durability of the commodity◦ Perishable commodities like eatables are relatively price inelastic in comparison to durable
items
Items of addiction◦ Items of intoxication and addiction are relatively price inelastic
Determinants of Price Elasticity of Demand
Revenue and Price Elasticity of Demand
For relatively inelastic demand, a change in price would have a greater effect on revenue than a change in quantity demanded AR is same as the price of the product
◦Demand curve is also the AR curve of the firm. Marginal Revenue is the revenue a firm gains in producing one additional unit of a commodity
Till ep>1 MR is positive and TR is rising At the midpoint of the demand curve, ep=1 and MR is equal to 0 and TR is at its peak When ep<1, MR is negative and TR is falling. MR= AR [1- MR= AR [1- eepp] ]
TR
Price, Revenue
OQuantity
MR
Revenue and Price Elasticity of Demand
Income Elasticity of Demand (ey) ey measures the degree of responsiveness of demand for a good to a given change in income, ceteris paribus.
Degrees:◦ Positive income elasticity
◦ Demand rises as income rises and vice versa◦ Normal good
◦ Negative income elasticity◦ Demand falls as income rises and vice versa◦ Inferior good
consumer of incomein change ateProportionXcommodity of demandedquantity in change ateProportion=ey
Y1)/Y1-(Y2Q1)/Q1-(Q2=ey
Zero income elasticityNo impact of incomeNeutral good
Cross Elasticity of Demand ec measures the responsiveness of demand of one good to changes in the price of a related good
Degrees◦ Negative Cross Elasticity◦ Complementary goods
◦ Positive Cross Elasticity ◦ Substitute goods
Ycommodity of pricein change ateProportionXcommodity of demandedquantity in change ateProportion=ec
Promotional/Advertising Elasticity of Demand
Advertising (or promotional) elasticity of demand (ea) measures the effect of incurring an “expenditure” on advertising, vis-à-vis an increase in demand, ceteris paribus. Some goods (like consumer goods) are more responsive to advertising than others (like heavy capital equipment).
Degrees◦ea>1 | Firm should go for heavy expenditure on advertisement. ◦ea <1 | Firm should not spend too much on advertisement
X of eexpenditur gadvertisinin change ateProportionXcommodity of sales)(or demandedquantity in change ateProportion=ea
Importance of Elasticity
Determination of price◦ Elasticity is the basis of determining the price of a product keeping its possible effects on the
demand of the product in perspective
Basis of price discrimination◦ Products having elastic demand may be sold at lower price, while those having inelastic
demand may be sold at high prices
Determination of rewards of factors of production◦ Factors having inelastic demand are rewarded more than factors that have relatively elastic
demand.
Government policies of taxation◦ Goods having relatively elastic demand are taxed less than those having relatively inelastic
demand.
Session VIDemand Forecasting
35
“An estimate of sales in dollars or physical units for a specified future period under a proposed marketing plan.”
- American Marketing Association
Demand forecasting is the scientific and analytical estimation of demand for a product (service) for a particular period of time. It is the process of determining how much of what products is needed when and where.
Meaning of Demand Forecasting
Categorization of Demand Forecasting
By Level of Forecasting Firm (Micro) level: forecasting of demand for its product by an individual firm.
◦ decisions related to production and marketing. Industry level: for a product in an industry as a whole.
◦ insight in growth pattern of the industry ◦ in identifying the life cycle stage of the product ◦ relative contribution of the industry in national income.
Economy (Macro) level: forecasting of aggregate demand (or output) in the economy as a whole. ◦ helps in various policy formulations at government level.
Categorization of Demand Forecasting
By nature of goods Capital Goods: Derived demand
◦demand for capital goods depends upon demand of consumer goods which they can produce.
Consumer Goods: Direct demand◦durable consumer goods: new demand or replacement demand◦Non durable consumer goods: FMCG
Techniques of Demand Forecasting Subjective (Qualitative) methods: rely on human judgment and opinion.◦ Buyers’ Opinion◦ Sales Force Composite◦ Market Simulation◦ Test Marketing◦ Experts’ Opinion
◦ Group Discussion◦ Delphi Method
Quantitative methods: use mathematical or simulation models based on historical demand or relationships between variables.Trend ProjectionSmoothing TechniquesBarometric techniquesEconometric
techniques
Subjective Methods of Demand Forecasting
Consumers’ Opinion Survey Buyers are asked about future buying intentions of products, brand preferences and quantities of purchase, response to an increase in the price, or an implied comparison with competitor’s products. ◦ Census Method: Involves contacting each and every buyer◦ Sample Method: Involves only representative sample of buyers
Merits◦ Simple to administer and comprehend.◦ Suitable when no past data available.◦ Suitable for short term decisions regarding product and promotion.
Demerits• Expensive both in terms of resources and time.• Buyers may give incorrect responses.
Subjective Methods of Demand Forecasting
Sales Force Composite Salespersons are in direct contact with the customers. Salespersons are asked about estimated sales targets in their respective sales territories in a given period of time.
Merits◦ Cost effective as no additional cost is incurred on collection of data.◦ Estimated figures are more reliable, as they are based on the notions of salespersons in
direct contact with their customers.
Demerits◦ Results may be conditioned by the bias of optimism (or pessimism) of salespersons.◦ Salespersons may be unaware of the economic environment of the business and may
make wrong estimates.◦ This method is ideal for short term and not for long term forecasting
Contd…
Subjective Methods of Demand Forecasting
Experts’ Opinion Methodi) Group Discussion: (developed by Osborn in 1953) Decisions may be taken with the help of brainstorming sessions or by structured discussions.
ii) Delphi Technique: developed by the Rand Corporation at the beginning of the Cold War, to forecast impact of technology on warfare. ◦ Way of getting repeated opinion of experts without their face to face interaction. ◦ Consolidated opinions of experts is sent for revised views till conclusions converge on a point.
Merits◦ Decisions are enriched with the experience of competent experts.◦ Firm need not spend time, resources in collection of data by survey.◦ Very useful when product is absolutely new to all the markets.
Demerits◦ Experts’ may involve some amount of bias.◦ With external experts, risk of loss of confidential information to rival firms.
Contd…
Subjective Methods of Demand Forecasting
Market Simulation Firms create “artificial market”, consumers are instructed to shop with some money. “Laboratory experiment” ascertains consumers’ reactions to changes in price, packaging, and even location of the product in the shop. ◦ Grabor-Granger test (1960s)
Merits◦ Market experiments provide information on consumer behaviour regarding a change in
any of the determinants of demand.◦ Experiments are very useful in case of an absolutely new product.
Demerits◦ People behave differently when they are being observed.
Contd…..
Subjective Methods of Demand Forecasting
Test Marketing Involves real markets in which consumers actually buy a product without the consciousness of being observed.
Product is actually sold in certain segments of the market, regarded as the “test market”. Choice and number of test market(s) and duration of test are very crucial to the success of the results.
Merits◦ Most reliable among qualitative methods.◦ Very suitable for new products. ◦ Considered less risky than launching the product across a wide region.
Demerits ◦ Very costly as it requires actual production of the product, and in event of failure of the product the entire cost of
test is sunk.◦ Time consuming to observe the actual buying pattern of consumers.
Contd….
Quantitative Methods of Demand Forecasting
Trend ProjectionStatistical tool to predict future values of a variable on the basis of time series data.
Time series data are composed of:◦ Secular trend (T): change occurring consistently over a long time and is relatively
smooth in its path. ◦ Seasonal trend (S): seasonal variations of the data within a year ◦ Cyclical trend (C): cyclical movement in the demand for a product that may have a
tendency to recur in a few years◦ Random events (R): have no trend of occurrence hence they create random
variation in the series.
Quantitative Methods: Methods of Trend Projection
Graphical method◦ Past values of the variable on vertical axis and time on horizontal axis and line is plotted. ◦ Movement of the series is assessed and future values of the variable are forecasted◦ simple but provides a general indication and fails to predict future value of demand
020406080
100120140160180200
2001 2002 2003 2004 2005
Year
Dem
and
for m
obile
s (in
lakh
s)
Contd…
Quantitative Methods : Smoothing Techniques
Moving Average: forecasts on the basis of demand values during the recent past.
Dn= where Di= demand in the ith period, n= number of periods in the moving average
Weighted Moving Average: forecast the future value of sales on the basis of weights given to the most recent observations. The formula for computing weighted moving average is given as:
Dn= where Di= demand in the ith period, wi= weight for the ith period, n= number of periods in the
moving average.
n
Dn
ii
1
n
iiiDw
1
Quantitative Methods : Smoothing Techniques
Exponential Smoothing: assign greater weights to the most recent data, in order to have a more realistic estimate of the fluctuations. Weights usually lay between zero and one
Ft+1=aDt+(1-a)Ft
where Ft+1= forecast for the next period, Dt=actual demand in the present period, Ft=previously determined forecast for the present period, and a=weighting factor, termed as smoothing constant.
New forecast equals old forecast plus an adjustment for the error that had occurred in the last forecast
Ft+1=aDt+ a(1-a)Dt-1+ a(1-a)2Dt-2+ a(1-a)3Dt-3+...+a(1-a)t-1D1+ a(1-a)2Dt-2+ a(1-a)tF1)
Contd…
Quantitative Methods : Barometric Techniques
Barometric Technique alerts businesses to changes in the overall economic conditions.
Helps in predicting future trends on the basis of index of relevant economic indicators especially when the past data do not show a clear tendency of movement in a particular direction.
Indicators may be◦ Leading indicators: economic series that typically go up or down ahead of
other series
◦ Coincident indicators: move up or down simultaneously with the level of economic activities
◦ Lagging series : which moves with economic series after a time lag.
Contd….
Quantitative Methods
Simple (or Bivariate) Regression Analysis: ◦ deals with a single independent variable that determines the value of a dependent variable. ◦ Demand Function: D = a+bP, where b is negative. ◦ If we assume there is a linear relation between D and P, there may also be some random variation
in this relation.
Nonlinear Regression Analysis◦ Log linear function log D =A + B log P + e
where A and B are the parameters to be estimated and e represents errors or disturbances. ◦ Linear form of log linear function D* = a + b P* + e
where D*= log D and P*=log P
Contd…..
Quantitative MethodsMultiple Regression Analysis:D = a1+a2.P+a3.A+e
(where A = advertising expenditure incurred).
D^ = a^1 + a^2P + a^3A,
(where a1, a2 and a3 are the parameters and e is the random error term (or disturbance), having zero mean).
Similar to simple regression analysis, multiple regression analysis would aim at estimation of the parameters a1, a2 and a3.
Choose such values of the coefficients that would minimize the sum of squares of the deviations.
Contd…..
Quantitative MethodsSimultaneous Equations Method Based on the fact that in any economic decision every variable influences every other variable.
Incorporates mutual dependence among variables. It is a simultaneous and two way relationships,
A typical simultaneous equation model may comprise of: ◦ Endogenous variables: included in the model as dependent variables◦ Exogenous variables: given from outside the model◦ Structural equations: which seek to explain the relation between a particular endogenous
variable and other variables ◦ Definitional equations: which specify relationships that are considered to be true by definition
Limitations of Demand Forecasting
Change in Fashion
Consumers’ Psychology
Lack of Experienced Experts
Lack of Past Data◦ Accurate
◦ Reliable
Session VI Supply54
Supply
Indicates the quantities of a good or service that the seller is willing and able to provide at a price, at a given point of time, Ceteris Peribus.
Supply of a product X (Sx) depends upon:◦ Price of the product (Px)◦ Cost of production (C)◦ State of technology (T)◦ Government policy regarding taxes and subsidies (G)◦ Other factors like number of firms (N)
Hence the supply function is given as:
55
Sx = (Px, C, T, G, N)
Law of Supply Law of Supply states that other things remaining the same, the higher the price of a commodity the greater is the quantity supplied.Price of the product is revenue to the supplier; therefore higher price means greater revenue to the supplier and hence greater is the incentive to supply. Supply bears a positive relation to the price of the commodity.
Point on Supply Curve
Price (Rs. Per cup)
Supply (‘000 cups per month)
a 15 10b 20 20c 25 30d 30 45e 35 60
Supply Schedule
56
c
e
d
Supply Curve
3010 20 605040
1520
30
35
25
Pric
e of
Cof
fee
Quantity of Coffee0
ba
Change in Supply
Shift in the supply curve from S0 to S1 More is supplied at each price
(Q1>Q) Increase in supply caused by:
Improvements in the technology
Fall in the price of inputs Shift in the supply curve from S0
to S2 Less is supplied at each price
(Q2<Q) Decrease in supply caused by:
A rise in the price of inputs Change in government policy
(VAT) 57
S2
S1
S0
Price
Quantity O
Q2
P
Q0 Q1
Equilibrium occurs at the price where the quantity demanded and the quantity supplied are equal to each other.
Market Equilibrium
Price(Rs)
Supply (‘000 cups/
month)
Demand (‘000 cups/
month)
15 10 50
20 15 40
25 30 30
30 45 15
35 70 10
58
D
S
Quantity
Price
O
25 E
30
For prices below the equilibrium◦ Quantity demanded exceeds quantity supplied (D>S) ◦ Price pulled upward
For prices above the equilibrium◦ Quantity demanded is less than quantity supplied (D<S)◦ Price pulled downward.
Market Equilibrium
Price(Rs)
Supply (‘000 cups/
month)
Demand (‘000 cups/
month)
15 10 5020 15 4025 30 3030 45 1535 70 10
59
D
S
Quantity
Price
O
25 E
30
20
30
4515
Changes in Market Equilibrium(Shifts in Supply Curve)
The original point of equilibrium is at E, the point of intersection of curves D1 and S1, at price P and quantity Q
An increase in supply shifts the supply curve to S2
Price falls to P2 and quantity rises to Q2, taking the new equilibrium to E2
A decrease in supply shifts the supply curve to S0. Price rises to P0 and quantity falls to Q0 taking the new equilibrium to E0
Thus an increase in supply raises quantity but lowers price, while a decrease in supply lowers quantity but raises price; demand being unchanged
Q2
P2
E2
S2
S2
Q
PE
D1
D1
S1
S1
Price
QuantityO
E0P0
Q0
S0
S0
60
The original point of equilibrium is at E, the point of intersection of curves D1 and S1, at price P and quantity Q
An increase in demand shifts the demand curve to D2
◦ Price rises to P1 and quantity rises to Q1 taking the new equilibrium to E1
A decrease in demand shifts the demand curve to D0
◦ Price falls to P* and quantity falls to Q* taking the new equilibrium to E2.
Thus, an increase in demand raises both price and quantity, while a decrease in demand lowers both price and quantity; when supply remains same.
Q1
P1E1
D2
D2
Q*
P* E2
Changes in Market Equilibrium(Shifts in Demand Curve)
D0
D0
D1
D1S1
S1
Price
QuantityO
EP
Q
61
Change in Both Demand and Supply
P2
Q2
E2
S2
S2
D1
D1
Quantity
Price
O
S1
S1D2
D2
Q1
P1 E1
Whether price will rise, or remain at the same level, or will fall, will depend on: the magnitude of shift and the shapes of the demand and
supply curves. Therefore, an increase in both supply
and demand will cause the sales to rise, but the effect on price can be: Positive (D increases more than S) Negative (S increases more than
D) No change (increase in
D=increase in S) 62
