Demand & Elasticity Session 3&4 PDF

Demand Analysis & Elasticity of Demand Demand is defined as desire backed by ability and capacity to pay for the commodity. If a person desires to buy a bike but do not have enough money to buy the bike, then it remains just a desire and cannot be called as demand. Similarly a person...

Demand Analysis & Elasticity of Demand Demand is defined as desire backed by ability and capacity to pay for the commodity. If a person desires to buy a bike but do not have enough money to buy the bike, then it remains just a desire and cannot be called as demand. Similarly a person desires to consume a pizza, does have sufficient money to buy the pizza but feels that he should not buy it at the said price. It means the person has desire, ability to pay the price but do not have willingness to pay the price, it is not demand but just a desire. The term demand is relative term; it is related to price, time, place etc. It also is a subjective term that is subject to a person’s preferences. Thus one needs to know various factors affecting demand Factors affecting demand: For forming successful business strategy, businessman needs to consider all the factors affecting demand for the goods & services that he is producing. 1. Price(P): With increase in price demand falls and vice a versa. Thus there is inverse relationship between price and demand. For example, it is observed that people will demand more loans if bank reduces interest rate which is price of the loan 2. Income (Y): With increase in income, consumers buy more goods and services and with fall in income demand falls. Thus there is direct relationship between income & demand. With increase in income people will have income in excess that they would like to invest in financial instruments. Thus increase in income will lead to increase in demand for insurance products, equities and bonds. 3. Taste & Preferences (T): Consumers will buy goods and services as per their own taste & preferences. For example some people may prefer Chinese food over Indian. Thus preferences of majority residents of each area need to be taken in to consideration by the producer. For a bank or finance company, they need to understand preferences of people, that is what kind of financial products they want so that such products can be designed. 4. Price of related goods In the first point we have discussed how demand for a good or service is affected by its own price. However in today’s complex and competitive world, demand for a product is also affected by the price of some other good that is related to this product. One good can be related to another in two ways, either they are substitutes or complementary of each other a) Substitutes (Ps): If two goods X & Y are substitutes of each other, if price of X falls, then it appears cheaper than Y thus demand for Y will fall. In short, in case of two substitutes, price of one good and demand for another good are directly related. For example if bank A offers low interest on home loans, bank B which has not reduced its interest will experience less demand for loan. b) Complementary goods (Pc): In case of complementary goods, price of one good and demand for another are inversely related. For example, if country’s central bank adopts dear Dr. Sucheta Pawar’s notes on Managerial Economics Page 1  money policy and increases prices of home loans, demand for houses as well as demand for household furniture will fall. 5. Customs & traditions (Cu): Influences demand of people up to a greater extends. During festival it is customary to prepare sweet dish. So demand for sugar is more. 6. Habit (H): If a person is habitual to consume particular good, he will demand the good irrespective of its price and income of the person. 7. Advertisement (A): can change mind set of people and thus alter their tastes & preferences and thus influence demand. For example advertisements presented by ‘Cadbury’s India have changed mind set of people towards chocolate consumption. Chocolate that was earlier perceived as to be consumed only by children is now perceived as something that can be used as nice gift to be cherished, act as a sweet dish at dinner table and something that can be used for celebrations. 8. Quality (Q): Often demand is more for goods & services which are of good quality thus showing positive relationship between demand and quality. For service industry quality of service can be the most important factor affecting demand for the service. Private banks are gaining more popularity in India due to the better service they provide in comparison with nationalized banks. 9. Population (Pop): there will be positive relationship between population and demand. Higher population increases demand for various goods and services. That is why often more populated countries become favorite destination for many foreign companies who want to take advantage of the big market created by greater populated countries. 10.Composition of population (Cop): Refers to age-wise distribution of country’s population. If child population is more, then demand for baby food, diapers etc. will be higher. Favorable composition of population helps the entire economy to grow fast. For example, older people are seen to prefer safe and secure investment options like post office deposits or fixed deposit of the banks. Whereas young people have appetite for risky investment options with better returns. If country has more young people, demand for equities will be more. Demand Function On the basis of this information, demand function can be created – as Dx = f ( P,Y,T,Ps,Pc,Cu,H,A,Q,Pop,Cop…..) Demand function is basically mathematical expression of factors affecting demand. However this function just describes all the factors that influence demand. But it does not describe in what way these factors affect demand. Thus according to relationship that every variable has with demand, we will assign sign to each variable. For example, price and demand are inversely related so price will be „-P‟ Dr. Sucheta Pawar’s notes on Managerial Economics Page 2 Accordingly the same demand function can be expressed as – Dx = f( -P +Y+T+Ps-Pc+Cu+H+A+Q+Pop+Cop) This demand function gives now two important information a businessman wants to know about consumer’s preferences a) what are the determinants b) what way those will influence demand. However this information still is not complete. All variables are not equally influential. For every product and service some factors are more dominantly affect demand, some has limited influence. A producer needs to know dominant factors affecting demand in order to plan marketing strategies. For instance, for a financial investment product, if investors give more importance to security than interest, the company will design a new product that offers better stability and security. In order to specify relative dominance of factors affecting demand, we need to assign weights to each variable. The weights assigned will be constants called as slopes. For example we write Dx = f ( -aP+bY+cT+dPs-ePc+gCu+iH+jA+kQ+lPop+mCop). In this expression, a,b,c,d,….. are constants which are slopes of particular variable Slope of price is ‘a’ which means change in demand/change in price 2.3.1: Calculating linear demand function Through market survey a firm locates various factors affecting demand for a particular product along with respective variable slopes and demand function is calculated which may help producer in taking price output decision. Let’s discuss it with one example. Given the demand function: Qx = -20P + 0.05Y + 2Pr + 4T; where P=price of x, Y = income = 6000, Pr is price of related good = 30, T is taste = 40 Questions: 1) calculate linear demand function 2) Make a demand schedule 3) Draw demand curve 4) what type of good is the related good? 5) What will happen to the demand curve if T changes to 30. Solution: Substituting the given values in the demand function – Qx = -20P – 0.05(6000)+2(30)+4(40) Qx = -20P + 520 is the linear equation obtained In order to make demand schedule, maximum demand when price is zero and maximum price when demand is zero will be calculated. Thus – let’s assume Dx = zero; so the linear equation can be written as 20P = 520; so P=26 Dr. Sucheta Pawar’s notes on Managerial Economics Page 3 It means if the seller fixes price equal to 26, demand will be zero. Lat’s assume P = zero; Dx = 520. It means if the product if offered free of charge, 520 units will be demanded. Once two extreme values are known, demand schedule can be created by taking various assumed value as prices and demand schedule can be made. Price Qx O 520 10 320 20 120 26 0 On the basis of same schedule, demand curve can be drawn Y (0,26) Price (0,24) Qx = -20P+520 (480,0) (520,0) O demand X Plotting X and Y axis intercepts we can draw demand curve as shown above. Related good : Pr is the variable that signify price of related good which carry +ve sign. It means Price of related good and demand are positively related. Thus both goods X and R must be substitutes of each other. If „T‟ taste changes to 30, linear demand function will change to Qx = -20P + 480 So Both X and Y intercept will change to (480,0) and (0,24). Thus demand curve will shift to left hand side showing decrease in demand as shown in the above diagram Conclusion: On the basis of dominant factors influencing demand for specific good or service, business strategy needs to be planned. Often consumer surveys are conducted by companies to locate product specific factors affecting demand. Policy makers often consider factors affecting demand of people for various goods and services while forming tax, subsidy as well as foreign trade related policies. Law of Demand Introduction: The Law of Demand is an important contribution of micro – economics. Dr. Sucheta Pawar’s notes on Managerial Economics Page 4 Statement of the Law: According to Alfred Marshall, Other things remaining same, increase in price leads to fall in demand and vice verse. There is inverse relationship between demand & price. It also can be expressed as Qx=f(-Px) The law can be explained with the help of following schedule and diagram. Demand Schedule: Demand schedule refers to a tabular statement showing inverse relationship between price and demand. Let’s take a hypothetical example of a bank as a business firm which offers home loans. Borrowers or consumer will demand more loans depending upon price of the loan which is called as price of the loan. Demand Schedule Price of loan (Rate of Total Quantity of loan Demanded interest in %) ( in Rupees in lakh) 13 90 12 120 11 190 10 270 9 400 As shown in the above schedule, when price of loan was 13% demand was very less, only for 90 lakh Rs. units. However it can be seen that with every fall in price or rate of interest, demand had been growing. When rate of interest falls to minimum 9% demand is maximum that is 400 /- lakh. Thus the schedule shows inverse relationship between demand and price. Demand Curve: Demand curve is graphical representation of demand schedule. Demand Curve Demand Curve 12 P 10 r 8 i 6 c 4 2 e 0 0 100 200 300 400 Quantity Demanded Dr. Sucheta Pawar’s notes on Managerial Economics Page 5 As shown in the above diagram, Demand curve is downward sloping curve from left to right. Its negative slope shows inverse relationship between price & demand for loans. The Law of Demand will hold true if only if all the following assumptions hold true Assumptions: 1) Income of individual remains same 2) Taste & preferences of consumer remain same 3) Prices of related goods remain unchanged 4) Population remains unchanged 5) Composition of population will not change 6) Quality of the product is same 7) There is no change in advertisement of the product. Though in reality all these factors will rarely remain constant, in order to develop better understanding of relationship between price and demand these are assumed to be constant. For example, if interest charged by nationalized bank for loan is higher, the demand for loan should fall. However if a person ‘prefers’ to take loan from nationalized bank, his demand for loan will remain same. Elasticity of Demand There are various factors affecting demand as discussed in the earlier section. Degree to which demand responds to the change in each of the factor is elasticity of demand. In short, “Degree of Responsiveness of quantity demanded to changes in price is called as Elasticity of Demand.” There are four types of elasticity of Demand. 1) Price Elasticity of Demand 2) Income Elasticity of Demand 3) Cross Elasticity of Demand 4) Promotional Elasticity of Demand Price Elasticity of Demand It can be symbolically expressed as ‘Ep’. Price Elasticity of Demand refers to ‘degree of responsiveness of quantity demanded to changes in price.’ To calculate price elasticity of demand, following formula can be used. Price Elasticity of Demand = Proportionate change in Demand - (1) Proportionate change in Price The basic formula can be developed as – Dr. Sucheta Pawar’s notes on Managerial Economics Page 6 Ep = Q2-Q1/Q1 x 100 P2-P1/P1 x100 - (2) Where Q2 = New quantity demanded, Q1 = Original demand, P2 = New price, P1 = Original price. The formula can further be developed as Ep = Q2-Q1 × P1 P2-P1 Q1 Measuring Price Elasticity of Demand Illustration: ‘Jatin Cycles’, use to sell 100 tri-cycles per day at the price of 2000/- At Diwali the shop offered 10% discount on tri-cycles for five days. With new price of 1800/- the shop sold 150 tri-cycles per day for five days. Calculate price elasticity of demand? Was it a correct strategy of the shop for increasing its revenue? Solution: Proportionate change in Price is Rs.-200 (Rs.1800 – Rs2000) Proportionate change in Demand is Rs.250 (750 - 500) Price Elasticity of Demand = Proportionate change in Demand (1) Proportionate change in Price Price Elasticity of Demand (Ep) = 250 =-5 -5 Interpretation: Elasticity coefficient is ‘5’, the ‘-‘sign represents negative relationship between price and demand. So elasticity is ‘5’, which is greater than 1. Thus demand for tri-cycle is relatively elastic. It means 1% fall in price will lead to 5% increase in demand. Thus price discount was absolutely correct strategy of the cycle mart. Types of Price Elasticity of Demand: can be explained as follows 1) Perfectly Elastic Demand ( Ep = ∞) : Refers to the situation in which at a particular price any quantity is demanded. Thus Ep = ∞ Perfectly elastic demand can also be described with the help of following diagram Dr. Sucheta Pawar’s notes on Managerial Economics Page 7  As shown in the above diagram, D1 is a horizontal straight line demand curve parallel to X - axis which shows infinite elastic demand. However this is an extreme type of elasticity and thus found very rarely. 2) Perfectly Inelastic Demand (Ep=0): Refers to the situation in which whatever is the change in price, demand remains same. As shown in the diagram, D2 is a demand curve which is a vertical straight line parallel to Y axis. In case of commodity like salt, demand is perfectly inelastic. 3) Unitary Elastic ( Ep = 1): refers to the situation in which percentage change in demand is equal to percentage change in price. Change in price Rs.6 Rs.5 10 11 Change in Demand As shown in the above diagram, ‘D’ is unitary elastic demand curve. 4) Relatively Elastic Demand (Ep > 1): refers to the situation in which proportionate change in demand is greater than proportionate change in price. Commodities like bags, soaps generally have relative elastic demand. In case of goods having elastic demand, generally price is reduced slightly to expand sales by the company Dr. Sucheta Pawar’s notes on Managerial Economics Page 8 5) Relatively Inelastic Demand ( Ep < 1): Refers to the situation in which proportionate change in demand is less than proportionate change in price. Necessary commodities like food, medicines generally have inelastic demand. Both types can be shown with the help of following diagram – Change in price Change in Demand As shown in the diagram flatter demand curve shows relatively elastic demand where as the steeper curve shows inelastic demand. Relatively Elastic and Relatively Inelastic demand are the two types of price elasticities which are found more in the practical world which are known as ‘Elastic Demand’ and “Inelastic Demand’ respectively. Other three types are uncommon. Income Elasticity of Demand Income elasticity of demand refers to degree of responsiveness of quantity demanded to changes in income. It can be symbolically expressed as ‘Ey’. Income elasticity can be calculated with the help of following formula Income Elasticity of Demand = Proportionate change in Demand (1) Proportionate change in Income Therefore Ey = Q2-Q1 × Y1 Y2-Y1 Q1 Dr. Sucheta Pawar’s notes on Managerial Economics Page 9  Measuring Income Elasticity of Demand Illustration: Sam who was working in an IT firm got 20% salary increment. As a result he increased his grocery expenses by 15%. Calculate income elasticity coefficient Solution: Proportionate change in Income is 20 per cent, Proportionate change in Demand is 15 per cent Price Elasticity of Demand = Proportionate change in Demand (1) Proportionate change in Price Price Elasticity of Demand (Ep) = 15% = 75% or 0.75 20% Interpretation: Since 0.75 < 1, Sam’s demand for grocery is income inelastic. It means 1% change in income leads to.75% increase in demand for grocery Types of Income Elasticity Types of income Elasticity of Demand can be explained as follows There are five types of income elasticity of demand: 1) Negative Income Elasticity of Demand ( Ey1): Is the situation in which proportionate change in demand is greater than proportionate change in income. 5) Income elasticity less than one ( Ey