F.Y.B.COM. Business Economics - 1 Syllabus PDF

31 F.Y.B.COM. BUSINESS ECONOMICS - 1 SEMESTER - I SUBJECT CODE : UBCOMFSI.3 (Revised Syllabus from Academic Year 2019-20 to IDOL Students) © UNIVERSITY OF MUMBAI Dr. Suhas Pednekar Vice-Chancellor Universityof Mumbai, Mumbai Dr. Kavita Laghate Anil R Bankar Director, IDOL, Associate Prof. of History & Asst. Director & University of Mumbai, Mumbai Incharge Study Material Section, IDOL, University of Mumbai, Mumbai Course and Programme : Ms. Rajashri Pandit Co-ordinator Asst. Prof-cum-Asst. Director, IDOL, University of Mumbai, Mumbai-400 098 Course Writer : Mr. Dandekar Rahul Prakash Priya Asst. Prof. Department of Economics, SES's L.S. Raheja College of Arts & Commerce Santacruz (W), Mumbai - 400054 : Mr. Prashant Shelar Asst. Prof. Department of Economics, Cosmopolitian's Valia C.L. College of Commerce Andheri (W), Mumbai - 400053 : Ms. Shalaka S. Bhadsawle Asst. Prof. Department of Economics, Sathye College, Vile Parle (E), Mumbai - 400057 December 2020, F.Y.B.COM., Business Economics - 1 ISBN No. 978-81-929557-1-3 Published by : Director Incharge, Institute of Distance and Open Learning , University of Mumbai, Vidyanagari, Mumbai - 400 098. DTP Composed : Ashwini Arts Gurukripa Chawl, M.C. Chagla Marg, Bamanwada, Vile Parle (E), Mumbai Printed by : CONTENTS Unit No. Title Page No. SEMESTER - I UNIT 1 1. Introduction to Business Economics 1 1A. Market Demand and Market Supply 8 UNIT 2 2. Demand Analysis 17 2A. Demand Estimation and Forecasting 43 UNIT 3 3. Supply and Production Decisions 53 3A. Economies of Scale and Diseconomies of Scale 79 UNIT 4 4. Cost Concepts 85 4A. Extension of Cost Analysis 100  I SYLLABUS FYBCOM - BUSINESS ECONOMICS -I SEMESTER - I Unit 1: Introduction Scope and Importance of Business Economics - basic tools- Opportunity Cost principle-Incremental and Marginal Concepts. Basic economic relations - functional relations: equations- Total, Average and Marginal relations- Use of Marginal analysis in decision making. The basics of market demand, market supply and equilibrium price- shifts in the demand and supply curves and equilibrium Unit 2: Demand Analysis Demand Function - nature of demand curve under different markets Meaning, significance, types and measurement of elasticity of demand (Price, income cross and promotional) - relationship between price elasticity of demand and revenue concepts Demand Estimation and forecasting: Meaning and significance - methods of demand estimation- survey and statistical methods (numerical examples on trend analysis and simple linear regression) Unit 3: Supply and Production Decisions: Production function: short run analysis with Law of Variable Proportions- Production function with two variable inputs- isoquants, ridge lines and least cost combination of inputs-Long run production function and Laws of Returns to Scale - expansion path - Economies and diseconomies of Scale and economies of scope Unit 4: Cost of Production: Cost concepts: accounting cost and economic cost, implicit and explicit cost, social and private cost, historical cost and replacement cost, sunk cost and incremental cost -fixed and variable cost - total, average and marginal cost - Cost Output Relationship in the Short Run and Long Run- (hypothetical numerical problems to be discussed) Extension of cost analysis: Cost reduction through experience- LAC and Learning curve and Break Even Analysis (with business application) II Additional References: 1) Mehta, P.L.: Managerial Economics – Analysis, Problem and Cases (S. Chand & Sons, N. Delhi, 2000) 2) Hirchey.M., Managerial Economics, Thomson South western (2003) 3) Salvatore, D.: Managerial Economics in a global economy (Thomson South Western Singapore, 2001) 4) Frank R.H, Bernanke. B.S., Principles of Economics (Tata McGraw Hill (ed.3) 5) Gregory Mankiw., Principles of Economics, Thomson South western (2002 ) 6) Samuelson & Nordhas.: Economics (Tata McGraw Hills, New Delhi, 2002) 7) Pal Sumitra, Managerial Economics cases and concepts (Macmillan, New Delhi,2004)     1 UNIT 1 Unit - 1 INTRODUCTION TO BUSINESS ECONOMICS Unit Structure : 1.0 Objectives 1.1 Scope and Importance of Business Economics 1.2 Basic tools- Opportunity Cost principle- Incremental and Marginal Concepts and Use of Marginal analysis in decision making 1.3 Basic economic relations - functional relations: equations- 1.4 Total, Average and Marginal relations 1.5 Summary 1.6 Questions 1.0 OBJECTIVES  To understand Scope and Importance of Business Economics.  To study the basic tools of Economics.  To explore Basic economic and functional relations.  To understand use of Marginal analysis in decision making. 1.1 MEANING, SCOPE AND IMPORTANCE OF BUSINESS ECONOMICS 1.1.1 MEANING Business Economics is also called as Managerial Economics. It involves application of economic theory and practice to business. In business, decision making is very important. Decision making is a process of selecting one course of action out of available alternatives. Thus business economics serves as a link between economic theory and decision-making in the context of business. Following are few definitions of Business Economics. Spencer and Siegelman: It is “the integration of economic theory with business practice for the purpose of facilitating decision making and forward planning by management.” 2 Henry and Hayne: “Business Economics is economics applied in decision making. It is a special branch of economics. That bridges the gap between abstract theory and managerial practice.” Salvatore: “Business Economics refers to the application of economic theory and the tools of analysis of decision science to examine how an organisation can achieve its objectives most effectively.” 1.1.2 SCOPE OF BUSINESS ECONOMICS Scope is nothing but the subject matter of business economics. Scope of Business Economics is very wide. 1) Market Demand and Supply In economics both demand and supply are the important forces through which market economy functions. Individual demand for a product is based on an individual’s choice / Preferences among different products, price of the product, income etc. Individual demand is nothing but desire backed by individual’s ability and willingness to pay. By summing up the demand of all the consumers or individuals for the product we get market demand for that particular product. Individual Supply is the amount of a product that producer is willing to sell at given prices. By summing up the supply of all the producers for the product we get market supply for that particular product. The market price where the quantity of goods supplied is equal to the quantity of goods demanded is called as equilibrium price. Existence, growth and future of business or firm depends on what price market determines for its product. 2) Production and Cost Analysis Knowledge of business economics helps manager to do production and cost analysis. Production analysis helps to understand process of production and to make optimum utilisation of available resources. Cost analysis on the other hand helps firm to identify various costs and plan budget accordingly. Both production and cost analysis will help firm to maximize profit. 3) Market structure and Pricing Techniques Markets are very important in business economics. Study of markets such as perfect completion, monopoly, oligopoly, monopolistic market etc. is very significant for producers. It is very imperative for manager or producer to identify type of market that will be there for their products. Knowledge of markets and competition will help them to take better decision regarding pricing of the product, marketing strategies etc. Pricing techniques, on the other hand, helps the firms to decide best remunerative price at different kinds of markets. 3 4) Forecasting and coverage of risk and uncertainty. Knowledge of business economics helps manager to forecast future. For example Demand forecasting. It means estimation of demand for the product for a future period. Demand forecasting enables an organization to take various decisions in business, such as planning about production process, purchasing of raw materials, managing funds in the business, and determining the price of the commodity. Likewise forecasting future helps firm to take important decisions and cover risk and uncertainty associated with those decisions. 5) Inventory Management Knowledge of business economics will help producer to reduce costs associated with maintenance of inventory such as raw materials, finished goods etc. 6) Allocation of resources Business Economics provides advanced tools such as linear programming which helps to achieve optimal utilisation of available resources. 7) Capital Budgeting Capital budgeting or investment appraisal is an official procedure used by firms for assessing and evaluating possible expenses or investments. It is a process of planning of expenditure which involves current expenditure on fixed/durable assets in return for estimated flow of benefits in the long run. Investment appraisal is the procedure which involves planning for determining whether firm’s long term investments such as heavy machinery, new plant, research and development projects are worth the funding or not. Knowledge of business economics helps producer to take appropriate investment decisions with the help of capital budgeting. 1.1.3 IMPORTANCE OF BUSINESS ECONOMICS 1. Knowledge of business economics helps business organization to take important decisions as it deals with application of economics in real life situation. 2. It helps manager or owner of firm to design policies suitable for their firm or business. 3. Business economics is useful in planning future course of action. 4. It helps to control cost and monitor profit by doing cost benefit analysis. 5. It helps in forecasting future for taking important decisions in present. 4 6. It helps to set appropriate prices for various products by using available pricing techniques. 7. It helps to analyse effects of various government policies on business and take appropriate decision. 8. It helps to degree of efficiency of firms by using various economic tools. 1.2 BASIC TOOLS IN BUSINESS ECONOMICS Opportunity cost Individuals face Trade-offs in day to day life. It is a conflicting situation where people have to make decision or make choices among available alternatives. The moment selection takes place, the counterpart becomes opportunity cost. Opportunity lost is nothing but opportunity cost. If you decide to attend lecture, then you have to sacrifice on time that you could have spent otherwise. If you plant potatoes in your field, you must forego the chance of planting another crop because your resources are limited. Opportunity cost plays very important role in decision making. Doing one thing excludes doing something else. In other words, when we select something, we pay a cost, which is the cost of not being able to do the next best thing. Marginalism Rational decision makers will always think in terms of marginal quantities. One should compare the cost of an additional chocolate with the benefits of an extra chocolate in order to decide whether to have it or not. If the additional revenue that the producer is going to get by producing one more car is greater than the cost of producing the extra car, only then the seller will produce an extra car. Let us take one example, an additional car sells for Rs. 10 lacks while it costs only Rs. 8 lakhs to produce the additional car. Clearly, a rational producer will decide to produce the car because he will make profit of Rs. 2 lakhs per car. On the other hand, if the price of car falls to Rs.7 lakhs while the cost of producing it remains Rs. 8 lakh, it will not make sense to produce the additional car since the cost surpasses the revenue to be earned from it. The cost of producing the extra car is called as marginal cost while the revenue obtained from selling an extra car is called as marginal revenue. If marginal revenue exceeds marginal cost, it obviously makes sense to produce the extra car. If the marginal revenue is less than marginal cost, it not advisable to produce the extra car. Let us take another example from your day to day life. Suppose you may score 10 additional marks in economics by 5 studying for entire night. Getting the additional 10 marks is important because it makes you feel happy and proud. But suppose staying up for entire night makes you feel really sleepy in the morning hence makes you feel dull and unhappy. In this case, whether you should study for entire night depends upon whether the happiness that you get from the 10 additional marks in economics overshadows the unhappiness caused by the additional sleeplessness. In this way individuals can make use of marginalism principal in their day to day life for making appropriate decisions. Incrementalism Marginalism represents small unit change in the concerned variables. But many times in real life situations changes takes place in chunks or batches. For example firm producing car will not generally increase its production by one unit, but by a batch of additional units. Here we use concept of incrementalism instead of marginalism and decision will be taken by comparing incremental cost and incremental revenue. Check your progress : 1) What do you mean by Business Economics? 2) Why knowledge of Business Economics is important? 3) Define opportunity cost. 4) Distinguish between Marginalism & Incrementalism. 1.3 BASIC ECONOMIC RELATIONS - FUNCTIONAL RELATIONS: EQUATIONS- TOTAL, AVERAGE AND MARGINAL RELATIONS The Relationship between Total, Average and Marginal can be explained with the help of concepts like utility, cost, revenue etc. Here we will take example of revenue concepts. Where, P = Price & Q = Quantity TR = Total Revenue AR = Average Revenue MR = Marginal Revenue 6 Quantity Price TR AR MR 1 30 30 30 30 2 28 56 28 26 3 26 78 26 22 4 24 96 24 18 5 22 110 22 14 6 20 120 20 10 7 18 126 18 6 8 16 128 16 2 9 14 126 14 -2 10 12 120 12 -6 Table 1.1 Total revenue is calculated by multiplying price and quantity. As quantity increases TR increases initially then it decreases. AR is same as price. MR decreases constantly and becomes negative eventually. Important concepts 1. Variables A variable is magnitude of interest that can be measured. Variables can be endogenous and exogenous variables. Variables can be independent and dependent. 2. Functions Function shows existence of relationship between two or more variables. It indicates how the value of one variable depends on the value of another one. It does not give any direction of relation. 3. Equations An equation specifies the relationship between the dependent and independent variables. It specifies the direction of relation. 4. Graph Graph is a geometric tool used to express the relationship between variables. It is a pictorial representation of data which shows how two or more sets of data or variables are related to one another. 7 5. Curves The functional relationship between the variables specified in the form of equations can be shown by drawing line or outline which gradually deviates from being straight for some or all of its length in the graph. 6. Slopes Slopes show how fast or at what rate, the dependant variable is changing in response to a change in the independent variable. 1.4 SUMMARY In this unit we have seen meaning, scope and importance of business economics. Business Economics is also called as Managerial Economics. It involves application of economic theory and practice to business. In business, decision making is very important. Decision making is a process of selecting one course of action out of available alternatives. Thus business economics serves as a link between economic theory and decision-making in the context of business. Scope of business economics involves Market Demand and Supply, Production and Cost Analysis, Market structure and Pricing Techniques, Forecasting and coverage of risk and uncertainty, Inventory Management, Allocation of resources, Capital Budgeting etc. We have also discussed basic tools in economics such as opportunity cost, marginalism and incrementalism. Business economics deals with many economic relations and various concepts such as variables, functions, equations, graph, curves and slopes. 1.5 QUESTIONS 1) Discuss scope and importance of business economics. 2) Write short note on Opportunity Cost. 3) Write short note on Marginalism 4) Discuss use of marginal analysis in decision making. 5) Write short note on Incrementalism. 6) Explain following concepts- a. Variables b. Functions c. Equations d. Graph e. Curves f. Slopes  8 Unit – 1A MARKET DEMAND AND MARKET SUPPLY Unit Structure : 1A.0 Objectives 1A.1 The basics of market demand, market supply and equilibrium price 1A.2 Shifts in the demand and supply curves and equilibrium 1A.3 Summary 1A.4 Questions 1A.0 OBJECTIVES 1) To study the basics of market demand, market supply and equilibrium price. 2) To study shifts in the demand and supply curves and equilibrium. 1A.1 MARKET DEMAND, MARKET SUPPLY AND EQUILIBRIUM PRICE In economics both demand and supply are the important forces through which market economy functions. Individual’s demand is desire backed by his / her ability and willingness to pay. There is an indirect or negative relationship between price and quantity demanded. Individual Supply is the amount of a product that producer is willing to sell at given prices. There is a direct or positive relationship between price and quantity supplied. Market Demand Individual demand for a product is based on an individual’s choice / Preference among different products, price of the product, income etc. Individual demand is nothing but desire backed by individual’s ability and willingness to pay. By summing up the demand of all the consumers or individuals for the product we get market demand for that particular product. 9 Table 1A.1Market Demand Schedule Price Demand of Demand of Market Demand Individual A Individual (Demand of Individual A + B Demand of Individual B) 10 5 7 12 20 4 6 10 30 3 5 8 40 2 4 6 50 1 3 4 The above table 1A.1 represents demand schedule of individual A, individual B and Market Demand. Same schedule can be represented with the help of a graph. Diagram 1A.1 Market Demand Curve Diagram 1A.1 represents demand curve of individual A, individual B and Market Demand. DA is a demand curve of individual A. DB is the demand curve of individual B. DM is the market demand curve. All curves are downward sloping indicating negative relationship between price and quantity demanded. 10 Market Supply Individual Supply is the amount of a product that producer is willing to sell at given prices. By summing up the supply of all the producers for the product we get market supply for that particular product. Table 1A.2 Market Supply Schedule Price Supply of Supply of Market Supply Producer A Producer B (Supply of Producer A + Supply of Producer B) 10 1 3 4 20 2 4 6 30 3 5 8 40 4 6 10 50 5 7 12 The above table 1A.2 represents supply schedule of producer A, producer B and Market supply. Same schedule can be represented with the help of a graph. Diagram 1A.2 Market Supply Curve 11 Diagram 1A.2 represents supply curve of producer A, producer B and Market supply. SA is a supply curve of producer A. SB is the supply curve of producer B. SM is the market supply curve. All curves are upward sloping indicating positive relationship between price and quantity demanded. Equilibrium Price The market price where the quantity of goods supplied is equal to the quantity of goods demanded is called as equilibrium price. This is the point at which the market demand and market supply curves intersects. Table 1A.3 Equilibrium Price Schedule Price Market Demand Market Supply 10 12 4 20 10 6 30 8 8 40 6 10 50 4 12 The above table 1A.3 represents schedule of equilibrium price. Same schedule can be represented with the help of a graph to locate equilibrium price. Even in the table itself it is very clear that 30 is equilibrium price as at this price, market demand is equal to market supply i.e. 8 units. Diagram 1A.3 Equilibrium Price. 12 Diagram 1A.3 represents Equilibrium Price. DM is the market demand curve. DM is downward sloping curve indicating inverse or negative relationship between price and quantity demanded. SM is the market supply curve. SM is upward sloping curve indicating direct or positive relationship between price and quantity supplied. DM and SM curves intersect each other at point E where equilibrium price is 30 and equilibrium quantity demanded and supplied is 8 units. Check your Progress : 1) What do you mean by Individual Demand & Market Demand? 2) What do you mean by Individual Supply & Market Supply? 3) Define Equilibrium Price. 1A.2 SHIFTS IN DEMAND AND SUPPLY CURVES AND EQUILIBRIUM 1A.2.1 SHIFTS / CHANGES IN DEMAND : Shifts in demand takes place due to changes in non-price factors such as income, population, government policies, tastes, preferences, habits, fashion etc. Whenever there are favourable changes in these factors then the demand curve shifts outward. It is also known as Increase in Demand. Whenever there are unfavourable changes in these factors then the demand curve shifts inward. It is also known as Decrease in demand. Diagram 1A.4 Changes in Demand 13 In the above diagram D is the original demand curve. At price P, OQ quantity is demanded. If there are favourable changes in the non-price factors affecting demand then the demand curve shifts outward and becomes D1. Here we can see that at same price P, now more quantity i.e. OQ1 quantity is demanded. If there are unfavourable changes in the non-price factors affecting demand then the demand curve shifts inward and becomes D2. Here we can see that at same price P, now less quantity i.e. OQ2 quantity is demanded. Shift from D to D1 is known as Increase in Demand and shift from D to D2 is known as Decrease in Demand. 1A.2.2 SHIFTS / CHANGES IN SUPPLY Shifts in supply takes place due to changes in non-price factors such as cost of production, government policies, state of technology etc. Whenever there are favourable changes in these factors then the supply curve shifts outward. It is also known as Increase in supply. Whenever there are unfavourable changes in these factors then the supply curve shifts inward. It is also known as Decrease in supply. Diagram 1A.5 Changes in Supply In the above diagram S is the original supply curve. At price P, OQ quantity is supplied. If there are favourable changes in the non-price factors affecting supply then the supply curve shifts outward and becomes S1. Here we can see that at same price P, now more quantity i.e. OQ1 quantity is Supplied. If there are unfavourable changes in the non-price factors affecting supply then the supply curve shifts inward and becomes S2. Here we can see that at same price P, now less quantity i.e. OQ2 quantity is supplied. Shift from S to S1 is known as Increase in Supply and shift from S to S2 is known as Decrease in Supply. 14 1A.2.3 SHIFTS IN EQUILIBRIUM The market price where the quantity of goods supplied is equal to the quantity of goods demanded is called as equilibrium price. This is the point at which the market demand and market supply curves intersects. Whenever there are changes in demand and supply, position of equilibrium will change. Diagram 1A.6 Effects of Changes in Demand on Equilibrium In the above diagram D is the original demand curve and S is the original Supply curve. At equilibrium E, equilibrium price is P and equilibrium quantity demanded and supplied is OQ. If there are favourable changes in the non-price factors affecting demand then the demand curve will shift outward and become D1. Now the new equilibrium is at E1. At E1, equilibrium price is P1 and equilibrium quantity demanded and supplied is OQ1. If there are unfavourable changes in the non-price factors affecting demand then the demand curve will shift inward and become D2. Now the new equilibrium is at E2. At E2, equilibrium price is P2 and equilibrium quantity demanded and supplied is OQ2. Thus increase in demand leads to higher price and decrease in demand leads to lower prices. 15 Diagram 1A.7 Effects of Changes in Supply on Equilibrium In the above diagram D is the original demand curve and S is the original Supply curve. At equilibrium E, equilibrium price is P and equilibrium quantity demanded and supplied is OQ. If there are favourable changes in the non-price factors affecting supply then the supply curve will shift outward and become S1. Now the new equilibrium is at E1. At E1, equilibrium price is P1 and equilibrium quantity demanded and supplied is OQ1. If there are unfavourable changes in the non-price factors affecting supply then the supply curve will shift inward and become S2. Now the new equilibrium is at E2. At E2, equilibrium price is P2 and equilibrium quantity demanded and supplied is OQ2. Thus increase in supply leads to lower price and decrease in supply leads to higher prices. Check you Progress : 1) List out the factors that lead to changes in demand. 2) List out the factors that lead to changes in supply. 1A.3 SUMMARY In economics both demand and supply are the important forces through which market economy functions. Individual demand for a product is based on an individual’s choice / Preference among different products, price of the product, income etc. Individual demand is nothing but desire backed by individual’s ability and willingness to pay. By summing up the demand of all the 16 consumers or individuals for the product we get market demand for that particular product. Individual Supply is the amount of a product that producer is willing to sell at given prices. By summing up the supply of all the producers for the product we get market supply for that particular product. The market price where the quantity of goods supplied is equal to the quantity of goods demanded is called as equilibrium price. Existence, growth and future of business or firm depend on what price market determines for its product. In this unit we studied derivation of individual and market demand and supply curves along with derivation of equilibrium price and quantity. We have also seen how shifts in demand and supply takes place along with their effect on equilibrium level of price and quantity. 1A.4 QUESTIONS 1) Write short note on Market Demand. 2) Write short note on Market Supply. 3) Write short note on Equilibrium Price. 4) Complete the following table and draw the graph. Price Demand of Individual Demand of Individual Market A B Demand 10 15 10 ? 20 14 9 ? 30 13 8 ? 40 12 7 ? 50 11 6 ? 5) Complete the following table and draw the graph. Price Supply of Producer A Supply of Producer B Market Supply 10 8 6 ? 20 9 7 ? 30 10 8 ? 40 11 9 ? 50 12 10 ? 6) Write short note on changes in Demand. 7) Write short note on changes in supply. 8) What are the effects of changes in Demand on equilibrium? 9) What are the effects of changes in Supply on equilibrium?  17 UNIT 2 Unit - 2 DEMAND ANALYSIS Unit Structure : 2.0 Objectives 2.1 Introduction 2.2 Demand function 2.3 Determinant of demand 2.4 Meaning of demand 2.5 Law of demand 2.6 Nature of demand curve under different markets 2.7 Elasticity of demand 2.8 Price elasticity of demand 2.9 Factors affecting price elasticity 2.10 Measures of price elasticity 2.11 Degrees of price elasticity of demand 2.12 Income elasticity of demand. 2.13 Cross elasticity of demand. 2.14 Promotional elasticity of demand 2.15 Concepts of revenue. 2.16 Summary 2.17 Questions 2.0 OBJECTIVES  To understand the demand and its function.  To study the various factors which determines the demand.  To familiarise with the various concepts of elasticities of demand.  To understand with the concepts of revenue. 2.1INTRODUCTION In economics both demand and supply are the important forces through which market economy functions. The demand function shows the relationship between the quantity demanded and its various determinants. In this chapter we will explain the demand function in detail and the nature of demand curve under different market situation. We will also explain the relationship between elasticity of demand and revenue concepts. 18 2.2 DEMAND FUNCTION Demand function is an arithmetic expression that shows the functional relationship between the demand for a commodity and the various factors affecting it. This includes the income of a consumer and the price of a commodity along with other various determining factors affecting demand. The demand for a commodity is the dependent variable, while its determinants factors are the independent variables. The demand for a commodity depends on various factors which determines the quantity of a commodity demanded by various individuals or a group of individuals. The following equation shows the demand function which expresses the relationship between the quantity demanded of a commodity X and its determinants. Qd x = f  Px ,Y, Py ,T, A  Where, Qd x = Quantity demanded of commodity X. Px = Price of commodity X. Y = income of a consumer. Py = Price of related commodities. T = Taste and Preference of an individual consumer. A = Adverting expenditure made by producer. 2.3 DETERMINANTS OF DEMAND The important determinants of demand for a commodity are explained below: 1. Price of commodity (Px): The price of commodity is very important determinants of demand for any commodity. Other things remaining same, the rise in price of the commodity, the demand for the commodity contracts, and with the fall in price, its demand expands. So, the quantity demanded and price shows an inverse relationship in the case of normal goods. In other word changes in price brings changes in the consumer’s demand for that commodity. 2. Income (Y): Another important determinant of demand for a commodity is consumer’s income. Change in consumer’s income also influences the change in consumer’s demand for a commodities. The demand for normal goods increases with the 19 increasing level of income and vice versa. it shows a direct relationship between income and quantity demanded. 3. Price of related commodities (Py):The demand for a commodity is also affected by the price of other commodities, especially of substitute or complementary goods. A good may have some related goods either substitute or complementary. The relation between two may be different. Substitute Goods: Substitute Goods are those goods which can be substituted from each other. For Instance Tea & Coffee. When the rise in the price of Tea causes rise in demand for Coffee because there is no change in price of coffee such goods are called as substitute goods. In other words the relation between two substitute goods are positive. An incase the price of one commodity increase the demand for other. Complementary Goods: Complementary goods are those goods which one purchased together. For Instance Car & Petrol. when their a rise in price of Petrol leads to fall in demand for Car such goods are called complementary good. In other words, the relation between two complementary goods are negative. An increase in price of one commodity leads to decrease in demand for other. 4. Taste and Preference (T): The demand for a commodity also depends on the consumer’s taste and preferences such as change in fashion, culture, tradition etc. As the consumers taste and preference for a particular commodity changes the demand for that particular commodity also changes. Therefore, Taste and Preference of a consumer plays an important role. 5. Advertising expenditure (A): Advertising expenditure by a firm influence the demand for a commodity. The advertisements by the manufacturer and sellers attract more customers towards the commodity. There exists positive relationship between advertising expenditure and demand for the commodity. 2.4 MEANING OF DEMAND The demand in economics means the desires to purchase the commodity backed by willingness and the ability to pay for it. Demand= Desire + Willingness to buy + Ability to pay 2.5 THE LAW OF DEMAND The law of demand was propounded by the famous economist Alfred Marshall in early 1892. Due to the general 20 observation of law, economists have come to accept the validity of the law under most situations. The law of demand states that other thing being equal the relationship between the price and the quantity demanded of a commodity are inversely related to each other. In other words, when the price of a commodity rises the quantity demand for the commodity falls. The law of demand helps to explain the consumer’s choice behaviour due to change in the price of a commodity. Assumptions: The law of demand is based on the following assumption given below: 1. No change in consumers income: There should not be any change in the consumer income while operating under the law of demand. If income of a consumer increases the consumer may buy more goods at the same price or buy the same quantity even if price increases. The income is assumed to be constant, as it may lead to enticement to the consumer to buy more goods and raise the demand for a commodity despite an increase in the price of commodity. 2. No change in the price of other goods: The price of substitute goods and complimentary good should remain the same. If any of the price changes may lead to change in the demand for the other commodity and it will change the consumer preference will affect the law of demand. 3. No change in taste and preference: The law assumes that the consumer’s taste and preference for a commodity remains the same. If there is a change in consumer’s taste and preferences there will be a change in the demand for the commodity. 4. No expectation of change in the future price: The law of demand remains valid if there is no change in future expectation about price of commodities. If consumer is expecting rise in price in future, he will buy more quantities even at a higher price in present time and vice-versa. 5. No change in the size and composition of population: The law also assumes that the size and composition of the total population of a country should not change. That means, the population must neither increase nor decrease. Because a rise in the populations would increase the demand for commodities. Along with the size of population, composition of population also matters. If number of senior citizens is more then the demand for medical care will be more. If female population is more then the demand for cosmetics will be more. 6. No change in government polices: The law assumes that there is no change in the government policy which will either increases or decreases the demand for the commodity. 21 Demand Schedule and Demand Curve: The law of demand can be simply explained through a demand schedule and demand curve. The demand schedule is a tabular representation of the law of demand which is shown below: Demand Schedule: Table 2.1 Price (`) Quantity demanded of a commodity ‘X’ (Units) 50 10 40 20 30 30 20 40 10 50 Representation of table: It can be seen from the above table, that when the price of a commodity ‘X’ is `50 per unit, the consumer purchases 10 units of the commodity. Further when the price of the commodity falls to `40, he purchases 20 units of commodity. Similarly, when the price falls further the quantity demand by the consumer goes on increasing by 30 units as so on. This demand schedule shows the inverse relationship between the price and quantity demanded of a commodity. Demand curve: Quantity Demand Diagram 2.1 The demand schedule can also be explained through demand curve in a simpler way. The demand curve is a graphical representation of the quantities of good demanded by the consumer at various possible price in a period of time. The Diagram shows quantity demanded on X-axis and the price of a commodity 22 on Y-axis. If the demand schedule is plotted on the demand curve, we get the various price-quantity combination points and if we join these points, we get the downward slopping demand curve. Thus, the downward sloping demand curve according to law of demand shows, the inverse relationship between price and quantity demanded. Exceptions to the Law of Demand: The law of demand is generally valid in most of the cases but there are few cases where the law is not applicable. Such cases are explained below: 1. Goods having prestige value (Veblen effect): This exception to the law of demand was propounded by an economists Thorstein Veblen in his work ‘conspicuous consumption’. According to him, some consumer measures the utility of a commodity by its price i.e., the higher the price of a commodity, the higher its utility. For example, People sometimes buy certain expensive or prestigious goods like diamonds at high prices not due to their intrinsic value but only because it has snob value. On the other hand, as price falls, they demand less due to the loss of its snob value. This effect is called as Veblen effect or Snob value. 2. Giffen goods: Another exception to the law of demand was put forwarded by the economists Sir Robert Giffen. There is a direct price – demand relationship in case of giffen goods. When with the rise in the price of a giffen goods, its quantity demand increases and with the fall in its price its quantity demand decreases, the demand curve will slope upward to the right hand side and not downward. 3. Price Expectations: When the consumer expects there is rise in price of a commodity in future, he/she may purchase more of commodity at present. Where the law of demand is not applicable. 4. Emergencies: During the time of emergencies such as natural and man-made calamities, the law of demand becomes ineffective. In such circumstances, people often fear the shortage of the necessity goods and hence demand more goods and services even at higher prices. 5. Change in fashion and taste &preferences: The change in taste and preferences of the consumers denies the effect of law of demand. The consumer tends to buy those commodities which are in trends in the market even at higher prices. On the other hand, when a product goes out of fashion, a reduction in the price of the product may not increases the demand for it. 23 Check your Progress : 1) Who propounded the theory of law of demand? 2) What relationship does law of demand state between demand & price? 3) What is Veblen effect? 2.6 NATURE OF DEMAND CURVE UNDER DIFFERENT MARKETS Economist have classified the various markets prevailing in a capitalist economy into (a) perfect competition or pure competition, (b) monopolistic competition, (c) oligopoly and (d) monopoly. According to Cournot, a French economist, “Economist understand by the term market not any particular market place in which things are bought and sold but the whole of any region in which buyers and sellers are in such free interaction with one another that the price of the same good tends to equality easily and quickly’’. The type of different market depends on number of factors. Accordingly, the nature of demand curve is different in different market. The nature of demand curve under various market structure are as follows: Demand Curve in Perfect Competition: Perfect competition is said to prevail when there are large number of producers (firms) producing and selling homogenous product. The maximum output produce by the individual firm is very small relatively to the total demand to the industry product so that firm cannot affect the price by varying its supply of output. The seller is the price taker he accepts the price determined in the market by market demand and market supply. Thus, the individual price under perfect competition is determine by the market demand and market supply. Market Demand Curve: The market demand curve under perfect competition is downward sloping. Because price and quantity demand are inversely related to each other as the price of a commodity increases the demand for that good decreases. The market price at which the firms will sell their commodity is determined by the interaction of market demand and market supply. Once the market determines the price for the commodity all firms will fix their price equals to market price as they are price taker 24 under the perfect competition. Thus, the individual demand curve is equal to the equilibrium price of the market. The Diagram 2.2. shows the market demand curve which is downward sloping and P0 is the equilibrium market price which is followed by all the individual firm and the individual firm is facing the horizontal demand curve. Diagram 2.2 Individual Firm demand curve: Demand curve facing an individual firm working under prefect competition is perfectly elastic i.e. a horizontal straight line parallel to X axis at a given price which is determined by the market demand sand market supply. The Diagram 2.3 shows Qty demanded on X axis and Price of the commodity on Y axis. Where OP1 is the price determined by the interaction of market demand and market supply curve. It shows if firm tries to lower the price, he will get negative profit. Diagram 2.3 Demand Curve under Monopoly: Monopoly is a market where there is single firm producing and selling product which has no close substitute. As being the single seller monopoly has a control on supply and he can also decide the price of a commodity. But however, a rational monopolist who aim at maximum profit will 25 control either price or supply. As monopolists is the only single seller in the market, he constitutes the whole industry. Therefore, the demand curve under monopoly market is downward sloping and has a steeper slope as shown in the Diagram 2.4. below: Diagram 2.4 Thus, in monopoly there is a strong barrier to entry new firm in the industry. If the monopolist firm wants to increases the sale in the market, he has to lower the price of its commodity. Demand curve under Monopolistic competition: In the monopolistic market there is a large number of firms producing or selling somewhat differentiated product which have close substitute. As a result, demand curve facing a firm under monopolistic competition is sloping downward and has a flatter shape which is highly elastic and this indicate that a firm enjoy some control over the price of a commodity. The demand curve facing an individual firm under monopolistic competition is shown in the following Diagram 2.5. Diagram 2.5 26 Demand curve under oligopoly market : Oligopoly is a market where there are few firms or sellers producing or selling differentiated products. The fewness of firm ensures that each of them will have some control over the price of the product and the demand curve facing each other will be downward sloping which indicates the price elasticity of demand for each firm will not be infinite. As there are interdependence of firm. Any decision regarding change in the price of output attracts reaction from the rival firms. Therefore, the demand curve for an oligopoly firm is indeterminate, i.e. it cannot be drawn accurately as exact behaviour pattern of a producer with certainty. The demand curve faced by the firm under oligopoly is shown in the following Diagram 2.6: Diagram 2.6 The demand curve facing an oligopolist is kinked in nature. The kink is formed at a prevailing level the point K because the segment of the demand curve above the prevailing price level i.e. Kd is highly elastic and the segment the segment below the prevailing price level i.e. Kd1 is inelastic. This is due to different reaction of the different firm. 2.7 ELASTICITY OF DEMAND Elasticity of demand helps us to estimate the level of change in demand with respect to a change in any of the determinants of demand. The concept of elasticity of demand helps the firm or manager in decision making with respect to pricing, promotion and production polices. It has a very great importance in economic theory ss well for formulation of suitable economic policy. 27 Meaning of elasticity: Elasticity is the measure of the degree of responsiveness of change in one variable to the degree of responsiveness change in another variable. % change in A Thus, Elasticity = % change in B The concept of elasticity of demand therefore refers to the degree of responsiveness of quantity demanded of a good to the change in its price, consumers income and price of related goods. Check your Progress : 1) In which market condition market demand & market supply determines the price of commodity? 2) Why Oligopoly demand Curve is kinked? 3) What is Elasticity? 2.8 PRICE ELASTICITY OF DEMAND Price elasticity of demand shows the degree of responsiveness of quantity demanded of a good to the change in its price, other factors such as income, prices of related commodities that determines demand for the commodity which are held constant. In other words, price elasticity of demand is defined as the ratio of the percentage change in quantity demanded of a commodity to a percentage change in price of the commodity. Thus, ep = Percentage change in quantity demanded Percentage change in price The demand curve for most of the commodities, is downward sloping due to the inverse relationship between quantity demanded and price of the commodity, the value of the price elasticity of demand will always be negative. While interpreting the price elasticity of demand the negative sign is ignored or omitted. This is because we are interested in measuring the magnitude of responsiveness of quantity demanded of a good to changes in its prices. 28 2.9 FACTORS AFFECTING PRICE ELASTICITY OF DEMAND The price elasticity of demand depends upon number of factors which affects its elasticity. They are as follows: a. Nature of goods or commodity: The elasticity of demand for a commodity depends upon the nature of the commodity, i.e., whether the commodity is a necessary, comfort or luxury good. The elasticity of demand for a necessary commodity is relatively small. For example, if the price of such a good rise, its buyers generally are not able to reduce its demand as its necessity commodity. The elasticity of demand for a luxury good is usually high. This is because the consumption of a such good, unlike that of a necessary commodity, can be delayed. That is why if the price of such a commodity increase, the demand for the good can be significantly reduced. b. Availability of Substitute Goods: The price elasticity of demand also depends upon the substitution of goods. If there is a close substitute for a particular commodity in the market, then the demand for such commodity would be relatively more elastic. For example, since tea and coffee are close substitute for each other in the commodity market, a rise in the price of coffee will result in a considerable fall in its demand and a consequent rise in the demand for tea. Therefore, a demand for coffee will be relatively more elastic because of the availability of tea in the market. c. Alternative and Variety of Uses of the Product: as we know that the resources have an alternative use. The demand for such goods has many uses. The more the alternative and variety of uses of a good, the more would be its elasticity of demand. For example, Electricity is used for many purposes such as lighting, heating, cooking, ironing and also use as a source of power in many industries & households. That is why when the price of electricity increases, its demand will decrease and vice versa. d. Role of Habits and custom: if the consumer has a habit of something, he will not reduce his consumption even if the price of such commodity increases the demand for them do not decreases considerably and so their elasticity of demand will be inelastic. Ex; Alcohol, Cigarettes which are injurious for health but people still consume it because of their habit. 29 e. Income Level of the consumer: The elasticity of demand differs due to the change in the income level of the households. Elasticity of demand for a commodity is low for higher income level groups then the people with low incomes. This is because rich people are not influenced much by changes in the price of goods. Poor people are highly affected by the increase or decrease in the price of goods. As a result, demand for the lower income group is highly elastic in demand. f. Postponement of Consumption: if the consumer postponed the consumption of commodity in future the demand is relatively elastic. For example, commodities whose demand is not urgent, have highly elastic demand as their consumption can be postponed if there is an increase in their prices. However, commodities with urgent demand like medicines have inelastic demand because it is an essential commodity whose consumption cannot be post pended. g. Time Period: Price elasticity of demand is related to a period of time. The elasticity of demand varies directly with the time period. In the short run the demand is generally inelastic and in long-run it becomes relatively elastic. This is because consumers find it difficult to change their habits, in the short run, in order to response to the change in the price of the commodity. However, demand is more elastic in long run as their other substitutes available in the market, if the price of the given commodity rises. 2.10 MEASUREMENTS OF PRICE ELASTICITY OF DEMAND There are various methods of measuring price elasticity of demand some of the important methods are explained below: A. Percentage method: This method is associated with the name of Dr Alfred Marshall. This method is known by various names such as Proportionate method, Ratio method, Arithmetic method, and Flux method. The price elasticity of demand in this method is measured by dividing percentage change in quantity demanded by the percentage change in the price. In other it is the ratio of the percentage change in quantity demanded of a commodity by the percentage change in the price of the commodity itself. Thus, Ep= Percentage change in quantity demanded Percentage change in price 30 Symbolically, Ep = ÷ = Where, q = original quantity demanded. p = original price. Δq = change in quantity demanded. Δ p= change in price. As mentioned above, the price elasticity of demand has a negative sign this is due to inverse relationship between price and quantity demanded. But for simplicity in understanding the magnitude or the degree of responsiveness we ignore the negative sign and take only numerical value of elasticity. B. Point method: Prof. Marshall devised a geometrical method for measuring the elasticity of demand at a point on the demand curve. In other word, the point elasticity of demand measures the elasticity of demand at the point on the demand curve. This can be illustrated by the following given example: Table 2.2 Price of Quantity Point commodity X demanded of X 20 60 A 15 90 B The above table is represented in the following Diagram 3.7. Diagram 2.7 31 The elasticity is at point A & B q / q Elasticity at point A = p / p 30 / 60  5 / 20 30 10   5 60  1.10 Elasticity at point B 30 / 90  5/5 30 5   5 90  0.33 C. Arc elasticity of demand: In the above measure we have studied the measurement of elasticity at a point on a demand curve. When elasticity is measured between two points on the same demand curve, it is known as arc elasticity. According to Prof. Baumol, “Arc elasticity is a measure of the average responsiveness to the change in price exhibited by a demand curve over some finite stretch of the demand curve.”. Any two points on the same demand curve make an arc shows the arc elasticity of demand. In other words, arc price elasticity of demand measures elasticity of demand at two points on the demand curve. q p Ep   q1  q2 p1  p2 2 2 q  q p  p1  2 1 2 q2  q1 p2  p1 q2  q1 p2  p1   p2  p1 q2  q1   90  60   15  20  15  20    90  60  30 35   5 150  1.39 D. Geometrical measure of elasticity of demand: If there is a linear demand curve the point elasticity of demand is measured by geometrical method i.e. it is the ratio of lower segment of the 32 demand curve below the point to the upper segment of the demand curve above the point on the demand curve. Symbolically, Ep = Lower segment of the demand curve below the point Upper segment of the demand curve above the point The geometric method can be explained through the Diagram 3.8 given below: Diagram 2.8 2.11 DEGREES OF ELASTICITY OF DEMAND Different commodities have different elasticities of demand. Some commodities have more elastic demand then others, while other commodities have relative elastic demand. The elasticity of demand ranges from zero to infinity (0-∞). It can be equal to zero, one, less than one, greater than one and equal to unity. “The degree of responsiveness to the change in demand in a market for a commodity is great or small, as the amount demanded increases much or little for a given fall in price and diminishes much or little for a given rise in price of the commodity”. The various level or the degree of elasticity of demand is explained in brief below: 1. Perfectly elastic demand (Ep = ∞): The demand is said to be perfectly elastic, if slight change in price leads to infinite change in the quantity demanded of the commodity. In other words, it is the level of responses where the consumer is able to buy all the available commodity at a particular price where the demand is elastic. The demand curve under this situation is horizontal straight line parallel to X axis shown in the Diagram 3.9 below. 33 This type of demand curve is relevant in perfect competition. But in the real world, this case is exceptionally rare and are not of any practical interest. Diagram 2.9 2. Perfectly inelastic demand (Ep = 0): The demand is said to be perfectly inelastic, if the demand for a commodity does not change with a change in price of the commodity. In other words, the perfectly inelastic demand of a commodity is opposite to the perfectly elastic demand. Under the perfectly inelastic demand, a rise or fall in price of a commodity the quantity demanded for a commodity remains the same. The elasticity of demand will be equal to zero. The demand curve is vertical straight line parallel to Y-axis shown in the Diagram 2.10. Diagram 2.10 34 3. Unitary elastic demand (Ep = 1): Demand is said to be unitary elastic when the percentage change in the quantity demanded for a commodity is equal to the percentage change in its price. The numerical value of unitary elastic of demand is exactly equal to one i.e. Marshall calls it as unit elastic. The demand curve is rectangular hyperbola shown in the Diagram 2.11. Diagram 2.11 4. Relatively Elastic demand (Ep> 1): Demand is said to be relatively elastic, when the percentage change in quantity demanded of a commodity is greater than the percentage change in its price. In other words, it refers to a situation in which a small change in price leads to a great change in quantity demanded. The demand curve under this situation is flatter as shown in Diagram 2.12. Such demand curve is seen under monopolistic competition. Diagram 2.12 35 5. Relatively Inelastic demand (Ep< 1): Demand is relatively inelastic when the percentage change in the quantity demanded of a commodity is less than the percentage change in the price of the commodity. The demand curve under this situation is steeper shown in Diagram 2.13. Such demand curve is observed under monopoly market. Diagram 2.13 Check your Progress : 1) What is the nature elasticity of demand for luxurious good? 2) List down the degrees of Elasticity of Demand. 2.12 INCOME ELASTICITY OF DEMAND As we have discussed earlier the factor which determines elasticity of demand for a commodity. The consumer’s income is one of the important determinants of demand for a commodity. The demand for a commodity and consumer’s income is directly related to each other, unlike price-demand relationship. Income elasticity of demand shows the degree of responsiveness of quantity demanded of a commodity to a small change in the income of a consumer. In other words, the degree of responsiveness of quantity demanded to a change in income is measured by dividing the proportionate change in quantity 36 demanded of a commodity by the proportionate change in the income of a consumer. Percentage change in purchases of a commodity Income Elasticity = Percentage change in income 2.12.1 MEASUREMENT OF INCOME ELASTICITY OF DEMAND The income elasticity of demand can be calculated by either point method or arc method. Point income elasticity of demand is measured by following Q / Q formula: E y  Y / Y Q Y   Y Q Q Y   Y Q Where, Q = Original Quantity Demanded. Y= Original Income. ΔQ= Change in Quantity Demanded. ΔY= Change in Income. Arc income elasticity of demand is measured by following formula: Q2  Q1  Y2  Y1  Ey   Y2  Y1  Q2  Q1  Income elasticity of demand being zero is a great significance. It implies that a given increase in the income of a consumer does not at all lead to any increase in quantity demanded of a commodity or expenditure on it. Classification of goods based on income elasticity of demand: We can broadly classify the various goods on the basis of value of income elasticity of demand. 1. Normal Goods: Normal goods are those goods which are usually purchased by consumer as his income increases. In other words, normal good means an increase in income causes an increase in the demand for a commodity. It has a positive income elasticity of demand. Normal goods are further classified as: a. Necessity goods: A good with an income elasticity less than one and which claims declining proportion of consumers income as he becomes richer is called a necessity good. Necessity goods are those goods where an 37 increase in income of a consumer leads to less than proportionate increases in the demand for a commodity. For example, daily used goods, basic goods etc. the income elasticity of demand for such goods positive and less then unity. i.e. Ey< 1. b. Luxuries goods: A good having income elasticity more than one and which therefore bulks larger in consumers budget as he becomes richer is called a luxury good. Luxuries goods are those goods where a change in income leads to direct and more than proportionate change in quantity demand for a commodity. For example, diamonds, expensive cars, etc. Thus, income elasticity of demand for such goods is positive and greater than one i.e. Ey > 1. c. Comfort goods: Comfort goods are those goods where change in income leads to direct and proportionate change in quantity demanded. For example, semi-luxury goods and comfort items. Income elasticity of such goods are positive and unity. i.e. Ey = 1. 2. Inferior goods: Inferior goods are those goods are where consumer buys less of goods as his income increases. Goods having negative income elasticity are known as inferior goods. As income of a consumer increases his demand for goods shifts from inferior to superior. The income elasticity for such goods are E y  0. 3. Neutral goods: when a change in income of a consumer brings no change in the quantity demanded of a commodity. For example, salt, rice, pulses etc. elasticity for such goods are Ey  0. 2.13 CROSS ELASTICITY OF DEMAND Sometimes we find two goods are inter-related to each other either they are substitute goods or commentary goods. Cross elasticity of demand measures the degree of responsiveness of demand for one good in responsive to the change in the price of another good. Percentage change in quantity demanded of commodity 'X' Ec = Percentage change in the price of commodity 'Y' Classification of goods based on value of cross elasticity of demand: 38 a. Substitution: If the value of elasticity between two goods are positive the goods are said to be substitute to each other. For example, Tea and coffee, if the price of tea increases the demand for coffee increases. b. Complementary: if the value of elasticity between two goods are negative the goods are said to be complementary. For example, car and petrol, if the price of petrol increases the demand for car decreases. c. Unrelated: if the value of elasticity between two goods are zero then the goods are said to be unrelated to each other. For example, table and car, if the price of table increases there is no change in the demand for car. 2.14 PROMOTIONAL ELASTICITY OF DEMAND It is also known as ‘Advertisement elasticity’. In modern times an increase in expenditure on advertisement or promotion leads to an increase in the demand for a commodity Promotional elasticity of demand is the proportional change in quantity demand due to proportionate change in promotional expenditure. In other words, percentage change in the quantity of demand for a commodity divided by the percentage change in promotional expenditure shows the promotional elasticity of demand. Percentage change in quantity demanded EA  Percentage change in advertisement expenditure The greater the elasticity of demand, its better for a firm to spend more on promotional activities. The promotional elasticity of demand is usually positive. Check your Progress : 1) How income of a Consumer related to the demand of the commodity? 2) If the Consumer income increase. What will be the elasticity of demand for necessity goods? 39 2.15 CONCEPTS OF REVENUE The term revenue refers to the income obtained by a firm or a seller through the sale of commodity at different prices. The revenue is classified as: 1. Total revenue: The total revenue or income earned by a firm or producer from the sale of the output he produced is called the total revenue. Thus, the total revenue is the price multiply the quantity of output. TR = P×Q Where, TR = Total Revenue. P = Price of a commodity. Q = Total Output sold. Thus, Total revenue is the sum of all sales, receipts or income of a firm in the market. 2. Average revenue: The average revenue refers to the revenue obtained by the firm by selling the per unit of output of a commodity. It is obtained by dividing the total revenue by total unit of output sold in the market. AR = TR Q Or AR = P Where, AR= Average revenue. The average revenue curve shows that the price of the firm’s product is the same at each level of output. In other words, the average revenue curve of a firm is also the demand curve of the consumer. 3. Marginal revenue: Marginal revenue is the additional revenue earned by selling an additional unit of the commodity. In other words, Marginal revenue is the change in total revenue due to the sale of one additional unit of output. Thus, marginal revenue is the addition commodity made to the total revenue by selling one more unit of the commodity. In algebraic terms, marginal revenue is the net addition to the total revenue by selling n units of a commodity instead of n – 1. Thus, MRn = TRn - TRn-1 Or MR = ΔTR ΔQ 40 Relationship between price elasticity and total revenue: Elasticities of demand can be divided into three broad categories: elastic, inelastic, and unitary. An elastic demand is one in which the elasticity is greater than one, indicating a high responsiveness to changes in price. Elasticities that are less than one indicates low responsiveness to price changes and correspond to inelastic demand. Unitary elasticities indicate proportional responsiveness of either demand or supply, as summarized in the following table: Total Change in Elasticity Reasons revenue price Increase Fall Ep > 1 Percentage Decrease Rise change in quantity demanded is greater than the percentage change in price. Decrease Fall Ep < 1 Percentage Increase Rise change in quantity demanded is smaller than percentage change in price. Unchanged Fall Ep = 1 Percentage Unchanged Rise change in quantity demanded is equal to percentage change in price. Table 2.3 The relationship between the price elasticity and total revenue shows the following analysis from the above table. A. When demand is elastic, price and total revenue move in opposite directions. B. When demand is inelastic, price and total revenue moves in same direction. C. When demand is unitary elastic, total revenue remains unchanged with the price changes. This relationship can be easily understood by the following diagram: 2.14 41 Relationship between price elasticity and Average revenue and Marginal revenue: The relationship between AR, MR and elasticity of demand is very useful to understand at any level of output. This relationship is also very useful to understand the price- determination under different market conditions. It has been discussed that average revenue curve of a firm is the same thing as the demand curve of the consumer for the product of the firm under market. This relationship can be explained with the following diagram: 2.14 Diagram 2.14 2.16 SUMMARY In this unit we have analysed the demand concept and its various function along with the law of demand. In economics both demand and supply are the important forces through which market economy functions. But in this unit, we will focus more on demand side. The demand function shows the relationship between the quantity demanded and its various determinants. In this chapter we will explain the demand function in detail. Demand function is an arithmetic expression that shows the functional relationship between the demand for a commodity and the various factors affecting it. It has also explained he nature of demand curve under different market situation. We have also discussed the nature of demand curve under different market conditions with the various elasticity concepts and its measures in detail. Elasticity of demand helps us to estimate the level of change in demand with respect to a change in any of the determinants of demand. The concept of elasticity of demand helps the firm or manager in decision making with respect to pricing, promotion and production polices. The 42 elasticity of demand measures the elasticity of four important factors i.e. price, income, cross and promotional with three important measures of point, arc and geometric measures of elasticity. The unit also deals with the various revenue of the firm in business and their relationship in detail. 2.17 QUESTIONS 1. Explain the law of demand and the factors with determines the demand. 2. Explain the nature of demand curve under different markets. 3. What is demand function? Explain in detail. 4. What is elasticity? Explain price elasticity of demand in detail. 5. Explain the measurements of price elasticity of demand. 6. Discuss the different degrees of elasticity of demand. 7. What are the factors affecting price elasticity of demand? 8. Write a note on: a) Income elasticity of demand. b) Cross elasticity of demand. c) Promotional elasticity of demand. 9. Explain the concepts of revenue in detail.  43 Unit – 2A DEMAND ESTIMATION AND FORECASTING Unit structure: 2A.0 Objectives 2A.1 Introduction 2A.2 Meaning 2A.3 Significance of demand forecasting 2A.4 Steps in demand forecasting 2A.5 Methods in demand forecasting 2A.6 Summary 2A.7 Question 2A.0 OBJECTIVES  To understand the meaning and significance of demand forecasting  To learn the steps, involve in estimating demand forecasting  To understand the methods of demand forecasting 2A.1 INTRODUCTION Business is a serious job. Manager or the business firms has to take certain decision to run their business smoothly without any disturbance in his business. Demand forecasting play a vital role in business planning. Business enterprises need to plan their activities. Most of the business decisions of a firm under an organization are made under the conditions of risk and uncertainty. Demand forecasting is a systematic process that involves anticipating the demand for the product and services of an organization in future under a set of uncontrollable and competitive forces in the economy. Demand forecasting helps the business firms to take appropriate decision about the production and the use of factors of production to fulfil the future demand of the commodity. 44 2A.2 MEANING Demand forecasting means estimation of demand for the product for a future period. Demand forecasting enables an organization to take various decisions in business, such as planning about production process, purchasing of raw materials, managing funds in the business, and determining the price of the commodity. A business organization can forecast demand for his product by making own estimations called guess or by taking the help of specialized consultants or market research agencies. 2A.3 SIGNIFICANCE OF DEMAND FORECASTING Demand forecasting plays an important function in the management of various business decision. Forecasting help the business firm to know what is likely to happened in future and to reduce the degree of risk and uncertainty in business and to make various business policy decision and action of the future. Thus, a demand forecasting is meant to guide business policy decision. The significance of demand forecasting are as follows: 1) Fulfils the sobjective: Demand forecasting implies that every business unit starts with certain pre-determined objectives. Demand forecasting helps in fulfilling these objectives. An organization estimates the current demand for its products and services in the market and move forward to achieve the set goals. For example, an organization has set a target of selling 60, 000 units of its products. In such a case, the organization would make demand forecasting for its products. If the demand for the organization’s products is low, the organization would take remedial actions, so that the set objective can be achieved. 2) Production planning: Demand forecasting is important to forecast the future production plan of business firm. There is a gestation period between production of goods and services and demand for it. Demand forecasting help to eliminate those gaps between demand and supply of goods preventing shortages and surplus. 3) Distribution and avoidance of wastage of resources planning: The business firm has to take decision regarding the distribution of capital, machinery, raw material in the production process. So that if there is any shortage of those resources can be arranged prior through estimation. Making a right and correct estimation of using resources reduces the usage of it. 45 4) Sales distribution policy: Sales of goods and service gives revenue to the firm’s demand. Forecasting is nothing but estimating the sales of the product. To formulate realistic sales targets and to make arrangements for the movement of production for the movement of product region wise, demand forecasting is very essential. This can help to formulate an effective sales policy, and therefore, to increase sales revenue. 5) Price policy: The firm has to make decision regarding the price of goods and services which is a critical job. The firm has to make appropriate price policy so that there is no price fluctuation in the future. 6) Reduce business risk: Every business has certain risk. Demand forecasting help the business firm to make appropriate business decision to reduce such risk and uncertainty to a certain extent. 7) Inventory planning: Inventories are goods and raw materials held by the firm future sale. Demand forecasting helps in devising appropriate inventory management policies. Check your Progress : 1) How demand forecasting health business firm in predicating future demand for his product? 2) List down the factors determining nature of demand forecasting. 2A.4 STEPS IN DEMAND FORECASTING The demand forecasting finds its significance during large- scale production of goods and services. During such period of time firms may often face difficulties in obtaining a fairly accurate estimation of future demand. Thus, it is essential for a firm to forecast demand systematically and scientifically to arrive at desired objective. Therefore, the following steps are to be taken to facilitate a systematic demand forecasting: 1. Determining the objective: The very first step in demand forecasting is to determine its objective of forecasting. The objective for which the demand forecasting is to be done must be clearly specified. The objective of forecasting may be defined in terms of; long-term or short-term demand, the whole or only 46 the segment of a market for a firm’s product, overall demand for a product or only for a firm’s own product, firm’s overall market share in the industry, etc. The objective of the demand must be determined prior in the process of demand forecasting begins as it will give direction to the whole research. 2. Nature of forecast: After determining the objective of forecasting the second important step is to identified the nature of demand forecasting. Its based on the nature of forecasting. 3. Nature of commodity: While forecasting it is important to understand the nature of the product whether it is consumer goods or producer goods, perishable goods or durable goods. If the good is perishable the forecasting is to be done in a short period of time and for durable goods it may be done in long run. 4. Determinants of demand: Determinants of demand play an important role in determining the forecasting as different commodity have different factor determination of demand which depends upon the nature of commodity and nature of forecasting. The important determinants are price of the commodity, price of related goods, income of a consumer etc. 5. Identifying the relevant data: Necessary data for the forecasting are collected, then tabulated, analysed and cross- checked by the firm. The data are interpreted by applying various statistical or graphical techniques, and then to draw necessary deductions there from. The forecaster has to decide whether to choose primary or secondary data. The primary data are the first-hand data which has never been collected before. While the secondary data are the data already available. Often, data required is not available and hence the data are to be adjusted, even manipulated, if necessary, with a purpose to build a data consistent with the data required. Then after collecting the relevant data from different sources and proceed for the further step. 6. Selecting the method: After collecting the relevant data the firm choose the appropriate method of forecasting the demand. Appropriate method of sales forecasting is selected by the company considering the relevant information, purpose of forecasting and the degree of accuracy required. The choice of method has to be appropriate and logical. If the required data is not available toward the method, the forecaster may force to use less reliable method. The forecaster should use a method which should not be too time consuming and it should be reliable for long term. 7. Testing accuracy: After making a choice of method the forecaster needs to test the accuracy of it. There are various 47 methods choose to test the accuracy. This testing helps to reduce the margin of error and thereby helps to improve its validity for the purpose of decision making 8. Evaluation and conclusion: the last and final step are to evaluate the forecasting and to draw a conclusion from it. 2A.5 METHODS OF DEMAND FORECASTING The main challenge to the forecaster while forecasting the demand is to select an effective technique or method. Broadly speaking methods of demand forecasting are classified into Qualitative methods and Quantitative methods. Which can also be classified as Survey method and Statistical method. The forecaster may choose any of the method depending upon the data which is available. Under these two broad categories, there are other specific methods which is been choose to analysis the data. These two methods will be discussed below: A. Survey method: This method is also called as qualitative method of demand forecasting. This method is one of the most common and direct method of demand forecasting in the short run. In this method the future purchase plans of the consumers and their aims are included. An organization conducts these surveys with consumers to determine the demand of their existing products and services and forecast the future demand of their product accordingly. The forecaster may undertake the following survey methods: a) Expert’s opinion: This method is based on the opinion of expert who predict the demand for a product based on his experiences and his knowledge in the particular specialised field. The expert may be from the same organisation or may be hired from outside. They may be salesman, sales manager, marketing expert, market consultant etc they act as experts who can assess the demand for the product in different areas, regions, or cities. This method involves the opinion of three or four experts. Each expert will be asked about his opinion regarding the demand for the product and the expert through his personal experience give his opinion for the product and forecast the demand. This method is very simple to use and it requires less statistical work. Due to expert’s personal views the time for forecasting is short and the cost involve is also low. On the other side as its expert’s personal opinion or guess where its likely to be biased. b) Delphi method: Delphi method is a group decision-making technique of forecasting demand. In Delphi method, a group of 48 experts gives their opinion on the demand for the products of individual firm in future based on questions which have been asked by the firm. These questions are repeatedly asked until a result is obtained. In addition, each and every expert is provided information regarding the estimates made by other experts in the group, so that he/she can revise his/her estimations with respect to others’ estimates. In this way, the forecasters cross check among experts to reach more accurate decision making. The main advantage of this method is that it is time and cost effective as a number of experts are approached in a short time without spending much time on other resources. However, this method may lead to appropriate decision making. This method allows the forecaster to solve the problem to the experts at once and have instant response. But the success of this method depends upon the skills, experience, knowledge, and aptitude of the expert. c) Consumer survey method: In this method, the consumers are directly approached to unveil their future purchase plans. This method is the most direct method because forecasting is done by interviewing all consumers or a selected group of consumers out of the relevant population through various other methods of survey. The firm may choose for complete enumeration method, sample survey method and end use method for sample surveys depending upon the nature of forecasting. The following methods are described in brief below: i. Complete enumeration method: Under the Complete Enumeration Survey, the forecaster undertakes the survey of the whole population who demand for the commodity. The firm may go for a door to door survey by making questionnaire to get the data requires. This method has an advantage of first hand data, unbiased information, yet it has its share of disadvantages also. The major limitation of this method is that it requires lot of resources, manpower and time period. There may be a chance where the consumer or the population may give false statement or may deliberately misguide the investigators due to which there may be chance of data error. In this method, consumers may be unwilling to reveal their purchase plans due to personal privacy or commercial secrecy. ii. Sample survey method: This method is also known as test market. In this method the forecaster selects the samples of consumer from the relevant population instead of considering the whole population. If sample is the true representative of data, there is likely to be no significant difference in the results obtained by the survey. Apart from that, this method is less tedious and less costly then the complete enumeration method. A sample survey technique is a variant of test marketing. 49 Product testing basically involves employing the product with a number of users for a set of periods of time. Their reactions to the product are noted after a period of time and an estimate of likely demand is made from the result. These are suitable for new products or for completely modified old products for which there is no prior data available. It is a more scientific method of estimating like demand because it stimulates the national launch in a very closely defined geographical area. Their can be a sampling error in this method as the size of sample is small i.e. smaller the size of sample larger the sampling error. iii. End-use method: This method is quite useful for industries which are mainly producer’s goods and when a product is used for more than one use. In this method, the sale of the product is projected on the basis of demand survey of the industries which are using this product as an intermediate product, that is, the demand for the final product is the end user demand of the intermediate product which are used in the production of this final product is considered. The end use method of demand estimation of an intermediate product may involve many final good industries using this product at home and abroad. It helps us to understand inter-industry’ relations. The major efforts required by this type of method are not in its operation but in the collection and presentation of data. This will help the forecaster to manipulate the future demand. This policy helps the government to frame many of its policies. Its major limitations are that it requires every firm to have a plan of production correctly for the future period. d) Market experiments: This method involves collecting necessary information regarding the current and future demand for a product in the market. This method carries out the studies and experiments on consumer behaviour under actual market conditions. In this method, some areas of markets are selected with similar features, such as income level , population, cultural and political background, and tastes of consumers. The market experiments are carried out with the help of changing prices and expenditure, so that the resultant changes in the demand are recorded. These results help in forecasting future demand. i. Actual market experiment: This method is conducted in the actual market place in several ways. One method is to select several market or stores with similar characteristics. This method is very useful in the process of introducing a product for which no other data exist. ii. Simulated market experiment: This method is also called as consumer clinic or laboratory experiment. Under this method the firm make a set of consumers and give them a 50 sum of money and asked them to shop in a stimulated store. While shopping the consumer reaction towards the change in price of a product, packaging, advertisement etc are taken into consideration. B. Statistical methods: This method is also called as quantitative method. Statistical method is most useful in demand forecasting. In order to key objectivity, that is, by consideration of all implications and viewing the problem from an external point of view, the statistical methods are used to forecast the demand of the product to get the accurate solution to the problems. The following are some statistical methods which are been used now a day: I. Trend method: A firm existing for a long time will have its own data regarding sales for past years. Such data when arranged in a chronologically manner will yield what is referred to as ‘time series. Time series method shows the past sales with effective demand for a particular product under normal conditions. Such data can be given in a tabular or graphic form for further analysis. This is the most popular method among business firms, partly because it is simple and cheap and partly because time series data often show a persistent growth trend. Time series has got four types of components namely, Secular Trend (T), Secular Variation (S), Cyclical Element (C), and an Irregular or Random Variation (I). These time elements are expressed by the equation O = TSCI. Secular trend refers to the long run changes that occur as a result of general tendency. Seasonal variations refer to the changes in the short run weather pattern or the social habits. Cyclical variations refer to the changes that occur in industry during a depression and boom period. Random variation refers to the factors which are generally able such as wars, strikes, natural calamities such as flood, famine and so on. When a prediction is made the seasonal, cyclical and random variations are removed from the observed data. Thus, only the secular trend is left. This trend is then projected. Trend projection fits a trend line into a mathematical equation. The trend can be estimated by using any one of the following methods: (a) The Graphical Method: Graphical method is the simplest technique to determine the trend analysis. All values of output or sale of product for different years are plotted on a graph and a smooth free hand curve is drawn passing through as many points as possible on the graph. 51 The direction of this free hand curve is either upward or downward and shows the possible trend. (b) The Least Square Method: Under the least square method of forecasting, a trend line can be fitted to the time series data with the help of statistical techniques such as least square method of regression. When the trend in sales over time is given by straight line, the equation of this line is in the form of: y = a + bx. Where ‘a’ is the intercept and ‘b’ shows the impact of the independent variable. We have taken two variables i.e. the independent variable x and the dependent variable y. The line of best fit establishes a kind of mathematical relationship between the two variables v and y. This is expressed by the regression у on x. In order to solve the equation v = a + bx, we have to make use of the following normal equations: Σ y = na + b ΣX Σ xy =a Σ x+b Σ x2 II. Regression method: regression methods attempts to assess the relationship between at least two variables (one or more independent and one dependent), the purpose is to predict the value of the dependent variable from the specific value of the independent variable. The foundation of this prediction generally is historical data. This method starts from the assumption that a basic relationship exists between two variables. An interactive statistical analysis computer package is used to formulate this mathematical relationship. Check your Progress : 1) List down the steps of demand forecasting. 2) Define survey method of demand forecasting. 3) Define Delphi method of demand forecasting. 2A.6 SUMMARY This unit study the demand estimation and its forecasting. Demand forecasting play a vital role in business planning. Business enterprises need to plan their activities. Most of the business 52 decisions of a firm under an organization are made under the conditions of risk and uncertainty. Demand forecasting is a systematic process that involves anticipating the demand for the product and services of an organization in future under a set of uncontrollable and competitive forces in the economy. Demand forecasting helps the business firms to take appropriate decision about the production and the use of factors of production to fulfil the future demand of the commodity. It had studied the importance or significance of demand forecasting. Demand forecasting plays an important function in the management of various business decision. Forecasting help the business firm to know what is likely to happened in future and to reduce the degree of risk and uncertainty in business and to make various business policy decision and action of the future. The unit explains the various steps in forecasting demand. It has also explained the two major methods of demand forecasting in detail. 2A.7 QUESTIONS 1. What is demand forecasting? Explain its importance. 2. Discuss the steps to be taken to estimate demand forecasting. 3. Explain the surv

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