Managerial Economics PDF

Module-1: Theory of Demand and Supply Notes e Learning Objective:...

Module-1: Theory of Demand and Supply Notes e Learning Objective: in In this module, you will be able to Explain that the interaction of supply and demand determining price and quantity nl Define market equilibrium Compare a market in equilibrium with a market in disequilibrium O Describe what happens to price when there is a surplus or shortage in the market Demonstrate how changes in the determinants of supply and demand affect the equilibrium price and quantity of a good or service ity Explain that a market reacts to changes in supply and demand by moving to a new equilibrium Use graphs to illustrate shifts in supply and demand and changes in equilibrium price and quantity s Learning Outcome: er In this module, we have discussed about Relation between demand and supply as represented by functions to demand and supply as represented by diagrams v Demand and supply analysis to work out the effects of restrictions on market prices ni Demand and supply analysis to work out changes in equilibrium price and quantity in a market U Various elasticities of demand to forecast changes in revenues, prices, and/or units sold Relationship between elasticity and marginal and total revenue ity How to use elasticities to estimate linear demand and supply functions “Economics as a study of mankind in the ordinary business of life.” Alfred Marshall- m 1.1.1 Nature of Economics Analysis Economics is the science dealing with the production, exchange and consumption )A of various commodities in economic systems. It shows how scarce resources can be used to increase wealth as well as human welfare. The prime focus of economics is on the scarcity of resources and choices among their alternative uses. The resources or inputs available to produce goods are limited or scarce, and this scarcity induces people to make choices among the alternatives. The economic knowledge of (c economics is used to compare the alternatives for choosing the best among them. For example, a farmer can grow sugarcane, banana, paddy or cotton etc. in his farm, but he needs to choose a crop depending upon the availability of irrigation water. Amity Directorate of Distance & Online Education  2 Managerial Economics Two major factors are responsible for the emergence of economic problems. They Notes e are: The existence of unlimited human wants and in The scarcity of available resources. The numerous human wants are to be satisfied through the scarce resources available in nature. Economics deals with how the numerous human wants are to be nl satisfied with limited resources. Thus, the science of economics centers on want - effort - satisfaction. Economics not only cover the decision making behavior of individuals but also the macro variables of economies like national income, public finance, international O trade and so on. Adam smith (1723 - 1790), in his book An Inquiry into Nature and Causes of Wealth of Nations. (1776) defined economics as the science of wealth. He ity explained how a nation wealth is created. He considered that the individual in the society wants to promote only his own gain and in this, he is led by an invisible hand to promote the interests of the society though he has no real intention to promote the society’s interests. s Criticism: Smith defined economics only in terms of wealth and not in terms of human welfare. Ruskin and Carlyle condemned economics as a.dismal science, er as it taught selfishness which was against ethics. However, now, wealth is considered only to be a mean to end, the end being the human welfare. Hence, wealth definition was rejected and the emphasis was shifted from wealth to welfare. v Alfred Marshall (1842 - 1924) wrote a book, Principles of Economics. (1890) in ni which he defined economics as a study of mankind in the ordinary business of life. It examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requisites of well- being. The important features of Marshall’s definition are as follows: U a) According to Marshall, economics is a study of mankind in the ordinary business of life, i.e., economic aspect of human life. b) Economics studies both individual and social actions aimed at promoting ity economic welfare of people. c) Marshall makes a distinction between two types of things, the material things and immaterial things. Material things are those that can be seen, felt and touched, ex: book, rice etc. Immaterial things are those that cannot be seen, m felt and touched, ex: skill in the operation of a thrasher, a tractor etc., cultivation of hybrid cotton variety and so on. In his definition, Marshall considered only the material things that are capable of promoting welfare of people. )A Criticism: a) Marshall considered only material things. But immaterial things, such as the services of a doctor, a teacher and so on, also promote welfare of the people. (c b) Marshall makes a distinction between (i) Those things that are capable of promoting welfare of people and Amity Directorate of Distance & Online Education  Managerial Economics 3 (ii) Those things which are not capable of promoting welfare of people. But Notes e anything, ex: liquor, that is not capable of promoting welfare but commands a price, comes under the purview of economics. in c) Marshall’s definition is based on the concept of welfare. But there is no clear- cut definition of welfare. The meaning of welfare varies from person to person, country to country and one period to another. However, generally, welfare nl means happiness or comfortable living conditions of an individual or group of people. The welfare of an individual or nation is dependent not only on the stock of wealth possessed but also on political, social and cultural activities of the nation. O 1.1.2 Scope of Economics Analysis Scope means province or field of study. In discussing the scope of economics, we ity have to indicate whether it is a science or an art and a positive science or a normative science. It also covers the subject matter of economics. i) Economics - A Science and an Art s a) Economics is a science: Science is a systematized body of information that tracks the cause-effect relation. A further characteristic of science is that its er processes should be measurable. By applying these characteristics, we find that economics is a branch of science that systematically gathers, classifies and analyzes the various facts that are important to it. Economics investigates how generalizations can be deduced with respect to human economic motives. v Individual motivations and business enterprises can easily be measured in money terms. Thus, economics is a science. ni b) Economics is also an art: An art is a system of rules designed to achieve a given end. A science teaches us knowledge; an art shows us how to do it. Using this description we find that economics provides us with practical guidance in U solving economic problems. Science and art are mutually complementary and economics is both a science and an art. ii) Positive and Normative Economics ity Economics is both positive and normative science. a) Positive science: It only describes what it is and normative science prescribes what it ought to be. Positive science does not indicate what is good or what m is bad to the society. It will simply provide results of economic analysis of a problem. b) Normative science: It makes distinction between good and bad. It prescribes )A what should be done to promote human welfare. A positive statement is based on the facts. A normative statement involves ethical values. For example, 12% of the labour force in India was unemployed last year. This rate of unemployment is too high; it is normative statement comparing the fact of 12% unemployment with a standard of what is unreasonable. It also suggests how it can be rectified. (c Therefore, economics is a positive as well as normative science. Amity Directorate of Distance & Online Education  4 Managerial Economics iii) Methodology of Economics Notes e Economics as a science adopts two methods for the discovery of its laws and principles, the (a) deductive method and (b) inductive method. in a) Deductive method – In this method it is descended from the general to particular, i.e., a start is made from certain principles that are self-evident or based on strict observations. Then, it is carried down as a process of pure nl reasoning to the consequences that they implicitly contain. For instance, traders earn profit in their businesses is a general statement which is accepted even without verifying it with the traders. The deductive method is useful in O analyzing the complex economic phenomenon where the cause and effect are inextricably mixed up. However, the deductive method is useful only if certain assumptions are valid. b) Inductive method - This method mounts up from particular to general. I.e. it ity begins with the observation of particular facts and then proceeds with the help of reasoning found on experience so as to formulate laws and particulars on the basis of observed facts. E.g. Data on consumption of poor, middle and high income groups of people are collected, classified, analyzed and important s conclusions are drawn out from the results. er 1.1.3 Relevance of Managerial Economics in Decision Making Business firms are a mixture of personnel, financial and physical resources that aid in managerial decision making. It is possible to divide communities into two major v categories − output and consumption. Companies are economic bodies that are on the production side while customers are on the distribution side. ni Company efficiency is measured as part of an economic model. A firm’s business model is called the company theory. Business decisions include other important decisions such as whether a company should conduct a research and development U plan, whether a company should launch a new product, and so on. Managerial economics helps the decision-making process in the following ways: 1. Managerial economics presents various aspects of traditional economics, relevant ity for business decision-making in real life. It derives the ideas, principles and techniques of analysis from economic theory, which have a impact on the decision- making process. Those are adopted or changed to allow the manager to take better decisions when appropriate. Therefore, the goal of constructing a suitable package from conventional economics was achieved by managerial economy. m 2. Managerial economics also incorporates important ideas from other disciplines such as psychology, sociology, etc.; if they are found relevant for decision-making. In addition, managerial economics takes advantage of other academic disciplines )A which have a bearing on a manager’s business decisions in view of the various explicit and implicit constraints within which resource allocation is to be optimised. 3. Managerial economics helps in formulating variety of business decisions in a complicated environment like what commodities should be produced? What inputs (c and production techniques should be used? How much output should be produced and at what prices it should be sold? What are the best sizes and locations of new plants? Etc. Amity Directorate of Distance & Online Education  Managerial Economics 5 4. Managerial economics transforms a boss into a more professional model maker. Notes e Therefore, he can capture the important relationship that characterizes a situation while leaving out the peripheral relationships and cluttering details. in 5. At the firm level, where for various functional areas, exist, such as finance, marketing, HR, production, etc. Managerial economics serves as an integrating agent by coordinating the different areas and brings together the decisions of each department. nl This also makes corporate decision-making not in watertight compartments but in an integrated context, the essence of which lies in the fact that functional divisions or experts frequently enjoy tremendous flexibility and accomplish competing goals. O 6. Managerial economics takes a cognizance of the interaction between the firm and society and accomplishes the key role of business as an agent in the attainment of social and economic welfare. It has come to be recognized that business has other social responsibilities besides its responsibilities to shareholders. Management ity economics focuses emphasis on such social commitments as constraints that are subject to business decisions. It acts as an instrument for the development of society’s economic wellbeing through socially motivated business decisions. 1.1.4 Demand Analysis Meaning of Demand s er Demand is the amount of specific economic goods or services a consumer or group of consumers will want to buy at a given price at a given time. Therefore, demand means the desire supported by an adequate purchasing power to pay for the product v when requested and the willingness to spend the money to satisfy that desire. ni Demand = Desire to buy + Ability to pay + Willingness to pay. Definitions of Demand U According to Melvin and Boyes, “Demand is a relationship between two variables, price and quantity demanded, with all other factors that could affect demand being held constant”. According to Prof. Bober, “Demand means the various quantities of a given ity commodity or service which consumers would buy in one market in given period of time at various prices or at various income or at various prices of related goods”. According to Ferguson, “Demand refers to the quantities of commodity that the consumers are able to buy at each possible price during a given period of time, other m things being equal”. According to B. R. Schiller defines, “Demand is the ability and willingness to buy )A specific quantity of a good at alternative prices in a given time period”. 1.1.5 Individual Demand vs. Market Demand Individual demand is individual or business demand. This reflects the quantity of a product that a single customer can purchase at a given point in time at a specific price (c point. Although the term is rather ambiguous, individual demand may be interpreted from one person’s point of view, a single family or a single household. Amity Directorate of Distance & Online Education  6 Managerial Economics Market demand offers the total quantity that customers are seeking. In other words, Notes e it represents the sum of any single demand. Market demand is an significant economic marker as it represents a marketplace ‘s competition, a consumer’s willingness in to purchase those goods and a company’s ability to exploit itself in a competitive environment. There is a difference between the concepts of individual demand and market nl demand. Below are the differences: In individual demand, all the individuals face the same prices, which means they are price-accepting. Individual demand is dependent on the income of every O consumer. All consumers face the same prices, but each person’s income is different. The individual demand for a good is the alternative and maximum quantities that each individual wants to acquire at different prices and times. ity Instead, the market demand or the aggregate demand for a good is the sum of the demands of all the consumers. Total market revenue equals the average unit price of the product multiplied by the average quantity of the product purchased by each buyer multiplied by the number of buyers. s Market demand can be defined as the number of goods and services required by a group of people in a given market, which is influenced by interests, needs, and er trends. Thus, this demand will depend a lot on the region where it manifests itself since firms and industries will determine what type of marketing strategies are best suited to consumers in a region. v Market demand is one of the main factors used by companies to set the prices of their products. Price and demand are closely related: the lower the price, the greater ni the demand and vice versa. 1.1.6 Demand by Market Segmentation U Demand Segmentation process is the method of separating a large collection of data into different small sets of data that have more or less similar or related characteristics based on multiple dimensions or dimensional combinations. ity Market segmentation is the process of dividing the overall market into relatively distinct homogeneous sub-groups of customers with specific needs or features that lead them to respond to a particular marketing campaign in similar ways. A market segment is a part of a larger market where individuals, groups, or organisations share one or more characteristics that cause them to have relatively similar product needs. m Segmentation is often necessary in both consumer and industrial markets. In each case, the marketer must decide on one or more useful segmentation variables, that is, dimensions that divide the total market into fairly homogenous groups, each with )A different needs and preferences. The different ways in which the customers can be approached by organizations include: a. Mass Marketing - In mass marketing seller engages in mass production, mass distribution, and mass promotion of one product for all buyers. For Example, Pepsi (c sold only one kind of flavor in a 6.5 ounce bottle in the olden time. It leads to lowest costs that result in lower prices or higher margins. Amity Directorate of Distance & Online Education  Managerial Economics 7 b. Segment Marketing - A market segment consists of a large identifiable group within Notes e a market with similar wants, purchasing power, geographical location, or buying behavior. For Example, Pepsi’s market could be divided into segments consisting of in diet Pepsi drinkers and regular Pepsi drinkers. It enables the product or service and also its price to be more adapted for the target audience. It facilitates the choice of distribution and even communications channels. nl c. Niche Marketing - A niche is a more narrowly defined smaller group whose needs are not currently being well served. This involves segmenting a segment into two or more sub segments, each of which has its own specialization of product or service being offered. It has fewer competitors. It enables the adoption of premium pricing O clue to its specialization in product or the service offered. d. Micromarketing - Micro marketing is the practice of tailoring products and marketing programs to suit the tastes of specific individuals and locations. Micromarketing ity includes local marketing and individual marketing. Local Marketing - Involves tailoring brands and promotions to the needs and wants of local customer groups—cities, neighborhoods, and even specific stores. Example, ICICI bank provides different mixes of banking services in its s branches depending on neighborhood demographics. Individual Marketing - Tailoring the products and marketing programs to er the needs and preferences of individual customers also labeled “one to one marketing”, “markets of one marketing” and “customized marketing”. Example, the tailor custom made the clothes or the cabinet maker made furniture to order. Mass customization is “the process through which firms interact one-to- v one with masses of customers to create customer-unique value by designing products and services tailor made to individual needs. Examples, Dell ni computers delivers computers to individual customers loaded with customer specified hardware and software U 1.1.7 Determinants of Demand The several determinants of demand for different goods and services are as follows ity a. Determinants of Individual Demand Price: Price is a basic factor and a consumer generally decides to buy a commodity with consideration of price. More quantity is demanded at low prices and less is purchased at high prices. Hence, demand is a function of m price and the relationship is expressed as D = f (P). In this equation, demand is the dependent variable and price is an independent variable. Income: A buyer’s income determines their purchasing capacity. Income is an )A important determinant of demand, as with the increase in income a person can buy more goods. Consumers having a greater income usually demand more goods than poor customers. The demand for luxurious and expensive goods is also related to income. Tastes, habits and preferences: Demand for various goods depends on the (c person’s tastes, habits and preferences. Demand for several products like chocolates, ice- cream, beverages etc. depend on individual’s tastes. Demand for tea, cigarettes, tobacco, etc. is a matter of habits. The preferences of Amity Directorate of Distance & Online Education  8 Managerial Economics consumers also changes from time to time. For example consumers prefer Notes e diesel car rather than petrol car because of price factor of fuel. Complementary and Substitutes: Complementary goods are the ones that in are required to satisfy the other demand and are consumed together. For example, Bike and Petrol. If the demand for bikes increases, the demand for petrol will also increase. On the other hand substitutes are the goods, which nl can be used as an alternative to some other goods. For example: Tea and Coffee. If the price of coffee rises, the demand for tea increases. People with different tastes and habits have distinct preferences for O goods: A strict vegetarian will have no demand for meat at any price, whereas a non-vegetarian who has liking for chicken may demand it even at a high price. Similar is the case with demand for cigarettes by nonsmokers and smokers. ity Consumer’s expectation: A consumer’s expectation about the future changes in the prices of a given commodity may also affect its demand. When consumers expect its prices to fall in future, they will buy less at present. Similarly, if they expect the price to rise in future, they will buy more at present. s Advertisement effect: In modern times, the preferences of a consumer can be altered by advertisement and sales propaganda, to only a certain extent. er In fact, demand for many products such as toothpaste, soap, washing powder, processed foods, etc., is partially caused by the advertisement effect in a modern man’s life. v b. Determinants of Market Demand Scale of preferences: The market demand for a product is majorly influenced ni by the scale of preferences of the buyers. For example, when a large section of population shifts its preferences from vegetarian foods to non- vegetarian foods, then the demand for the former will tend to decrease and for the latter U will increase. Community income and wealth distribution: If there is an equal distribution of income and wealth, then the market demand for various products of common consumption tends to be greater than in the case of unequal ity distribution. Product price: At a low market price, the market demand for the product tends to be high and vice versa. It is dependent on the general standards of living and spending habits of the people. When people in general adopt a m high standard of living and are ready to spend more, the demand for many comforts and luxury items will tend to be higher than otherwise. Number of buyers in the market and the growth of population: The size of )A market demand for a product depends on the number of buyers in the market. A large number of buyers will usually constitute a large demand. In general, the growth of population over a period of time tends to imply a rising demand for essential goods and services. Age structure and sex ratio of the population: Age structure of population (c determines the market demand for products in a relative sense. If the population of a country comprises more of children, then the demand for toys, Amity Directorate of Distance & Online Education  Managerial Economics 9 school bags etc., i.e. goods and services required by children will be much Notes e higher. Level of taxation and tax structure: A progressively high tax rate will in generally mean a low demand for goods in general and vice versa. But, a highly taxed commodity will have a lower demand. Inventions and innovations: Introduction of new goods or substitutes as a nl result of inventions and innovations in a dynamic modern economy adversely affect the demand for the existing products, which as a result of innovations become obsolete. O Fashions: The change in fashion also affects the market demand for many products. For example, demand for commodities like jeans, skirts etc., and is based on current fashions. Climatic conditions: Demand for certain products is determined by the ity weather conditions. For example, in summers, there is a greater demand for fans, coolers, cold drinks etc. Similarly, demand for umbrellas and rain coats are seasonal. Culture: Demand for certain goods is determined by social customs, festivals, s etc. For example, during Diwali festival, there is a higher demand for sweets and crackers, and during Christmas, cakes and trees are more in demand. er 1.1.8 Elasticity of Demand In neoclassical economic theory elasticity is an important concept. It is useful in v understanding the incidence of indirect taxation, marginal concepts as they relate to the firm theory and wealth distribution and various types of goods. In any discussion of ni welfare distribution, elasticity is also crucial, in particular consumer surplus, producer surplus or government Meaning of Elasticity of Demand U According to Marshall, “The elasticity or responsiveness of demand in a market is great or small accordingly as the demand changes (rises or falls) much or little for a given change (rise or fall) in price.” ity Elasticity of demand is the responsiveness of demand for a commodity to changes in its determinants. Elasticity of Demand = Percentage change in quantity demanded of commodity / Percentage change in its price m Degrees of Price Elasticity of Demand )A The variation in demand is not uniform with a change in price. In case of some products, a small change in price leads to a relatively larger change in quantity demanded. 1. Perfectly Elastic Demand (c In this case, a very small change in price leads to infinite change in demand. The demand curve is a horizontal curve and is parallel to OX axis, the numerical co-efficient of perfectly elastic demand. Amity Directorate of Distance & Online Education  10 Managerial Economics Notes e in nl O ity 2. Perfectly Inelastic Demand s In this case, whatever may be the change in price quantity demanded will remain perfectly constant. The demand curve is a vertical straight line and is parallel to OY er axis. The numerical co-efficient of perfectly inelastic demand is O (zero). It may be presented through a diagram as follows: v ni U ity m 3. Relatively Elastic Demand In this case a slight change in price leads to more than proportionate change in quantity demanded. This can be represented by a gradually sloping demand curve. The )A numerical co-efficient of relatively elastic demand is > 1. This can be diagrammatically reprsented as follows: (c Amity Directorate of Distance & Online Education  Managerial Economics 11 Notes e in nl O ity 4. Relatively Inelastic Demand In this case, a large change in price leads to less proportionate change in demand. s This can be represented by a steeply sloping demand curve. The numerical co-efficient of relatively inelastic demand is 1, then supply is price elastic O When PES < 1, then supply is price inelastic When PES = 0, supply is perfectly inelastic When PES = infinity, supply is perfectly elastic following a change in demand ity 1.2.6 Use of Supply Elasticities in Business-Decision Making. The supply law demonstrates the course of change — if price goes up, supply must go up. But how much supply will rise in response to price increases from the supply law s cannot be known. To calculate such change we need the principle of supply elasticity that tests the magnitude of the supplied quantities in response to a price change. It can be calculated as - er ES = % change in quantity supplied/% change in price v Symbolically, ES = ∆Q/Q ÷ ∆P/P = ∆Q/∆P × P/Q ni Since price and quantity supplied, in usual cases, move in the same direction, the coefficient of ES is positive. U Types of Elasticity of Supply: For all the commodities, the value of Es cannot be uniform. For some commodities, the value may be greater than or less than one. ity 1. Elastic Supply (ES>1) Supply is said to be elastic when a given percentage change in price leads to a larger change in quantity supplied. Under this situation, the numerical value of Es will m be greater than one but less than infinity. SS1 curve of Fig. exhibits elastic supply. Here quantity supplied changes by a larger magnitude than does price. )A (c Amity Directorate of Distance & Online Education  Managerial Economics 25 Notes e in nl O ity 2. Inelastic Supply (ES< 1) Supply is said to be inelastic when a given percentage change in price causes a smaller change in quantity supplied. Here the numerical value of elasticity of supply is s greater than zero but less than one. Fig. depicts inelastic supply curve where quantity supplied changes by a smaller percentage than does price. v er ni U ity 3. Unit Elasticity of Supply (ES = 1) m If price and quantity supplied change by the same magnitude, then we have unit elasticity of supply. Any straight line supply Curve passing through the origin, such as the one shown in Fig., has an elasticity of supply equal to 1. This can be verified in this way. )A (c Amity Directorate of Distance & Online Education  26 Managerial Economics Notes e in nl O ity 4. Perfectly Elastic Supply (ES = ∞) The numerical value of elasticity of supply, in exceptional cases, may reach up to infinity. The supply curve PS1 drawn in Fig. has an elasticity of supply equal to infinity. s Here the supply curve has been drawn parallel to the horizontal axis. The economic inter¬pretation of this supply curve is that an unlimited quantity will be offered for sale at er the price OS. If price slightly drops down below OS, nothing will be supplied. v ni U ity m 5. Perfectly Inelastic Supply (ES = 0) Another degree is the completely or perfectly inelastic supply or zero elasticity. The )A S1 curve drawn in Fig. illustrates the case of zero elasticity. This curve describes that whatever the price of the commodity, it may even be zero, quantity supplied remains unchanged at OQ. This sort of supply curve is conceived when we consider the supply curve of land from the viewpoint of a country, or the world as a whole. (c Amity Directorate of Distance & Online Education  Managerial Economics 27 Notes e in nl O ity 1.2.7 Market Equilibrium Price is determined in a free market by the interaction of supply and demand. We can underline three dynamic laws of supply and demand. s 1. When the quantity demanded is greater than the quantity supplied, prices tend to er rise, whereas when the quantity supplied is greater than quantity demanded, prices tend to fall. 2. In a market, larger the difference between quantity supplied and quantity demanded, v greater is the pressure on prices to rise (if there is excess demand) or fall (if there is excess supply). ni 3. When the quantity supplied equals the quantity demanded, prices have no tendency to change. U Shift in demand and supply curves and market equilibrium Since both the supply and demand curves can shift in either of the two directions, we have to consider four cases of changes in demand and supply. These cases are so important and universal in nature that they are often called ‘laws of supply and ity demand’. These laws are derived for free markets that we are considering. Such markets have the following features: The demand curve is downward sloping, The supply curve is upward sloping. m The buyers and sellers are price-takers. The buyers and sellers are maximizes. )A The laws of demand and supply are applicable only when these conditions hold. If anyone these conditions are not applicable the laws may not hold. 1. Shifts in demand In the figure, the original demand curve is D and the supply curve is S. Here p0 is (c the original equilibrium price and q0 is the equilibrium quantity. Amity Directorate of Distance & Online Education  28 Managerial Economics Notes e in nl O ity a. A Rise in Demand s Considering a change in the demand conditions such as the rise in the income of buyers. If the income of the buyers raise then the market demand curve for apples er will shift to right to D’. This implies that consumers will now be willing to buy a larger quantity at every price. Thus at the original price P0 they will now be eager to buy q2 units. So, the excess demand develops in the market. This excess demand q2- v q0 creates market forces which cause the equilibrium price to rise. The process will continue until a new equilibrium is reached as at point F where the new demand ni curve intersects the old supply curve. The net result is a rise in market price to p1. The quantity sold also increase from q0 to q1 in this new equilibrium situation. Thus, first it is considered, the rightward shift of the demand curve (i.e., a rise in the U demand for a commodity) causes an increase in the equilibrium price and quantity (as is shown by the arrows in Fig). b. A Fall in Demand ity Demand may fall due to changes in the conditions of demand. If, for example, there is a fall in the price of a substitute for the commodity under consideration, consumers may want to buy smaller quantities at every price. m In the figure suppose D’ is the original demand curve and the original price and quantity are p1 and q1, respectively. Suppose a fall in demand leads to a leftward shift of the demand curve. The new demand curve is D. So an excess supply q1– q3 (=FG) develops in the market. As a result of the operation of the market forces price falls. )A The new equilibrium price is p0. The new equilibrium quantity is q0. So we reach the second conclusion a leftward shift of the demand curve (i.e., a fall in the demand for a commodity) causes a decrease in the equilibrium price and quantity 2. Shifts in Supply (c In the figure the effect of a shift in the supply curve will be considered. Here S and D are original supply and demand curves. The two curves meet at point E. So p0 and Amity Directorate of Distance & Online Education  Managerial Economics 29 q0 are the original equilibrium price and quantity. We may now examine the effect of a Notes e change in the conditions of supply. Such a change increases the quantities that producers are prepared to offer for in sale at each price. For example, there was a rightward shift of the supply curve due to increase in the productivity of factors of production, caused by technological advance. The Green Revolution which has occurred in India is an example of such a change. nl Techno-logical progress has the effect of reducing the cost of production. As a result a larger quantity (qt instead of q0) is offered for sale at a lower price (p1 instead of p0). This happened in the computer industry in the late 90’s. O s ity v er ni a. An increase in supply U An increase in supply implies that a larger quantity is offered for sale at the same price (q2, instead of q0 at p0) or the same quantity at a lower price (as point G indicates). In other words, an excess of supply of q0 q2 (=EH) develops at the original price p0. It sets in motion market forces which cause the price to fall. ity Since there is not much demand for their product, producers find it difficult to sell the entire output at the original price. They start charging lower price. Consumers know about it and start paying a lower price. Consequently price starts falling and it ultimately reaches the value p1. At this new price the equilibrium quantity is q1. Thus we reach the m third conclusion a rightward shift of the supply curve (i.e., an increase in the supply of a commodity) causes a fall in the equilibrium price and an increase in equilibrium quantity. )A b. A Decrease in Supply Finally, we may examine the effect of a rise in the price of a factor, such as wages in a unionized industry. As a result, total cost will rise and the sellers will be willing to offer a smaller quantity for sale at each price. In this case, the original supply curve is S’. Equilibrium price and quantity are p1 and q1. Now the supply curve shifts to left. The (c new supply curve is S. Amity Directorate of Distance & Online Education  30 Managerial Economics At the original equilibrium price p1, the quantity offered for sale is zero but the Notes e quantity demanded is still q1. So the entire quantity demanded is excess demand. This excess demand sets in motion market forces which tend to raise price. The process in continues until and unless the new equilibrium price p0 is reached. At this price the quantity supplied and demanded are equated at q0. Thus we reach the fourth and final conclusion a leftward shift in the supply curve (i.e., a decrease in nl the supply of a commodity) leads to an increase in the equilibrium price and a fall in equilibrium quantity. O 1.3.1 Needs of Demand Forecasting Demand forecasting is based on the statistical data about past behavior and empirical relationships of the demand determinants. Demand forecasting is not a speculative exercise into the unknown. It is essentially a reasonable judgment of future ity probabilities of the market events based on scientific background. Demand forecasting is an estimate of the future demand. It cannot be hundred per cent precise. But, it gives a reliable approximation regarding the possible outcome, with a reasonable accuracy. It is based on the mathematical laws of probability. s Meaning of Demand Forecasting er Demand forecasting refers to the expectation about the future course of the market demand for a product. It involves techniques including both informal methods, such as educated guesses, and quantitative methods, the use of historical sales data or current v data from test markets. “Demand forecasting means expectation about the future course of the market ni demand for a product”. Levels of Demand Forecasting U Demand forecasting may be undertaken at the following levels: 1. Micro level: It refers to the demand forecasting by the individual business firm for estimating the demand for its product. ity 2. Industry level: It refers to the demand estimate for the product of the industry as a whole. It is undertaken by an Industrial or Trade Association. It relates to the market demand as a whole. 3. Macro level: It refers to the aggregate demand for the industrial output by the m nation as a whole. It is based on the national income or aggregate expenditure of the country. Country’s consumption function provides an estimate for the demand forecasting at macro level. )A Importance of Demand Forecasting Importance of demand forecasting can be summarized as follows: i) Important for production planning: Demand forecasting is a prerequisite (c for the production planning of a business firm. Expansion of output of the firm should be based on the estimates of likely demand, otherwise there may be overproduction and consequent losses may have to be faced. Amity Directorate of Distance & Online Education  Managerial Economics 31 ii) Sales forecasting: Sales forecasting is based on the demand forecasting. Notes e Promotional efforts of the firm should be based on sales forecasting. iii) Control of business: Demand forecasting is important for controlling the in business on a sound footing, it is essential to have a well-conceived budgeting of costs and profits that is based on the forecast of annual demand/sales and prices. nl iv) Inventory control: A satisfactory control of business inventories, raw materials, intermediate goods, semi-finished product, finished product, spare. v) Growth and long-term investment programmes: Demand forecasting O is necessary for determining the growth rate of the firm and its long-term investment programmes and planning. vi) Stability: Stability in production and employment over a period of time can be made ity effective by the management in the light of the suitable forecasting about market demand and other business variables and smoothening of the business operations through counter-cyclical and seasonally adjusted business programmes. Features of Demand Forecasting s The main features of demand forecasting are the following: er i) It is in terms of specific quantities. ii) It is undertaken in an uncertain atmosphere. iii) A forecast is made for a specific period of time which would be sufficient to take v a decision and put it into action. ni iv) It is based on historical information and the past data. v) It tells us only the approximate demand for a product in the future. vi) It is based on certain assumptions. U vii) It cannot be 100% precise as it deals with future expected demand. Characteristics of Demand Forecasting ity Eight major characteristics can be identified with forecasting methods to identify key characteristics of good demand forecasting methods: i) Time horizon: The length of time over which a decision is being made has a bearing on the appropriate technique to use depending on the time i.e. short m and long demand forecasting can be measured. ii) Level of details: The level of detail needed should match the focus of decision making unit in the forecast. )A iii) Stability: Forecasting in situations that are relatively stable over time requires less attention than those that are in constant flux. iv) Pattern of data: As different forecasting methods vary in their ability to identify different patterns it is useful to make the pattern in the data fit with the method (c that suits it the most. Amity Directorate of Distance & Online Education  32 Managerial Economics v) Type of methods: Other assumptions are also made in each forecasting Notes e method that must fit the situation under consideration vi) Cost: Several costs are associated with adapting forecasting procedure in within an organization like managerial development, storage, operation and opportunity in terms of other techniques that might have been applied. vii) Accuracy: It is measured by the degree of deviation between past forecast and nl current actual performance or present forecast and future performance. viii) Ease of application: Models must be chosen within the abilities of the user to understand them and within the time allowed for using them O Essentials of Demand Forecasting The essentials of demand forecasting method can be summarized as follows: ity 1. Simplicity: A simpler method is always more comprehensive than a complicated one. 2. Economy: It should involve lesser costs as far as possible. Its costs must be compared against the benefits of forecasts. s 3. Quickness: It should yield quick results. A time consuming method may delay the decision making process. er 4. Accuracy: Forecast should be accurate as far as possible. Its accuracy must be judged by examining the past forecasts in the light of the present situation. v 5. Plausibility: It implies management’s understanding of the method used for forecasting. It is essential for a correct interpretation of the results. ni 6. Flexibility: Not only is the forecast to be maintained up to date, there should be possibility of changes to be incorporated in the relationships entailed in forecast procedure from time to time. U Types of Demand Forecasting (on the basis of Time) 1. Short-term Demand Forecasting ity Short-term forecasting relates to a period not exceeding a year. Professor E.J. Douglas prefers to use the term demand estimation for short-term demand forecasting. To him demand estimation refers to the determination of the volume of current demand for a firm’s product, for a short period say over a month or a year. m Short-term forecasts relate to the day-to-day particulars which are concerned with tactical decisions under the given resource constraints; as in the short run, the available resources, scale of operations etc., are fixed or unalterable, by and large. In short-term )A forecasting, a firm is primarily concerned with the optimum utilization of its existing production capacity. Usefulness of Short-term forecasting 1. Evolving a sales policy: A short-term demand forecasting is useful in evolving a (c suitable sales policy in view of the seasonal variation of demand and so as to avoid the problem of short supply or overproduction of the firm’s products in the market. Amity Directorate of Distance & Online Education  Managerial Economics 33 2. Determining price policy: Short-term sales forecasting will help the firm in Notes e determination of a suitable price policy to clear off the stocks during offseason, and to take advantage in the peak season. in 3. Evolving a purchase policy: In view of the short-term forecasting of material prices, a firm can evolve a rational purchase policy for buying raw materials and control its inventory stocks with a greater economy. nl 4. Fixation of sales targets: Demand and sales forecasting in the short-term helps the business firm in setting sales targets and for establishing controls over the business. It is no use fixing high sales targets, when sales forecasting O reveals a decline in a quarter. 5. Determining short-term financial planning: A firm’s short-term financial policy and planning can be suitably determined on the basis of short-term demand forecasting. A firm’s need for cash depends on its production and sales. Without ity sales forecasting a rational financial planning is not possible. 2. Medium-Term Demand Forecasting Medium-Term demand forecasting refers to the forecasts prepared for intermediate s period between long term and short term during which the firm’s scale of operations or the production capacity may continue. Medium-Term demand forecasting is followed by er a firm which is subjected to the medium term variation of the business cycle. Business organization such as cotton industries, garments manufacturers and parts and tools ma nufacturers often practices the medium term demand forecasting. Medium-term forecasts are normally forthe periods of one to three years. v 3. Long-Term Demand Forecasting ni Long-term forecasting refers to the forecasts prepared for long period during which the firm’s scale of operations or the production capacity may be expanded or reduced. U Long-term forecasts are normally for the periods exceeding a year, usually 3-5 years or even a decade or more. Functionally, the long periods which permit alternations in the scale of production differ from industry to industry and firm to firm. ity Usefulness of Long-term forecasting 1. Importance for Business planning: Long-term forecasting is of great assistance to long term business planning. Long-term demand potential will provide the required guidelines for planning of a new business unit or for the m expansion of the existing one. Capital budgeting by a firm is based on the long- term demand forecasting. 2. Manpower planning: It is essential to determine long-term sales forecast for )A an appropriate manpower planning by the firm in view of its long-term growth and progress of the business. 3. Long-term financial planning: Finance is the kingpin of the modern business. In view of the long-term demand and sales forecasting and the production (c planning, it becomes easier for the firm to determine its long-term financial planning and programmes for raising the funds from the capital market. Amity Directorate of Distance & Online Education  34 Managerial Economics Sources of Data Collection for Demand Forecasting Notes e The marker research may be based on two types of sources of data collection, viz.: primary sources and secondary sources, providing primary data and secondary data, in respectively. Secondary Sources of Data nl Secondary data or information’s are those which are obtained from someone else’s records. These data are already in existence in the recorded or published forms. Secondary data are like finished products since they have been processed O statistically in some form or the other. In a market research for the demand analysis, a beginning may be made with the collection of secondary data, which would provide clues for further inquiry. There are sufficient secondary sources for collecting the required information for market and demand analysis. ity The main sources of secondary data are: (i) Official publications of the Central, State and Local governments, such as Plan documents, Census of India, Statistical Abstracts of the Indian Union, Annual Survey s of Industries, Annual Bulletin of Statistics of Exports and Imports, Monthly Studies of Production of Selected Industries, Economic Survey, National Sample Survey er Reports, etc. (ii) Trade and technical or economic journals and publications like the Economic and Political Weekly, Indian Economic Journal, Stock Exchange Directory, Basic Statistics v and other information supplied by the Centre for Monitoring Indian Economy, etc. (iii) Official publications like the Reserve Bank of India, e.g., Annual Report on Currency ni and Finance, Monthly Bulletin of Reserve Bank of India, etc. and of international bodies like the IMF, UNO, World Bank, etc. (iv) Market reports and trade bulletins published by stock exchange, trade associations, U large business houses, chambers of commerce, etc. (v) Publications brought out by research institutions, universities, associations, etc. (vi) Unpublished data such as firm’s account books showing data about sales, profits, ity etc. (vii) Secondary data should not be taken at their face value and are never to be used blindly. m 1.3.2 Techniques of Demand Forecasting The methods of demand forecasting can be broadly classified into two categories such as )A i) Survey method and ii) Statistical method. A. Survey Method of Demand Forecasting (c The Survey method is the method of gathering data by asking questions to people who are thought to have desired information. A formal list of questionnaire is prepared. Amity Directorate of Distance & Online Education  Managerial Economics 35 Generally a non-disguised approach is used. The respondents are asked questions on Notes e their demographic interest opinion. Advantages of Survey Method in i) Surveys are relatively inexpensive especially if they are self-administered surveys. nl ii) Surveys are useful in describing the characteristics of a large population. No other method of observation can provide this general capability. iii) They can be administered from remote locations using mail, email or the O telephone. iv) Consequently, very large samples are feasible, making the results statistically significant even when analyzing multiple variables. ity v) There is flexibility at the creation phase in deciding how the questions will be administered: as face-to-face interviews, by telephone, as group administered written or oral survey, or by electronic means. vi) Standardized questions make measurement more precise by enforcing uniform s definitions upon the participants. vii) Standardization ensures that similar data can be collected from groups then interpreted comparatively er 1. Disadvantages of Survey Method v A methodology relying on standardization forces the researcher to develop questions general enough to be minimally appropriate for all respondents possibly ni missing what is most appropriate to many respondents. i) Surveys are inflexible in that they require the initial study design (the tool and administration of the tool) to remain unchanged throughout the data collection. U ii) The researcher must ensure that a large number of the selected sample will reply. iii) It may be hard for participants to recall information or to tell the truth about a ity controversial question. iv) As opposed to direct observation, survey research can seldom deal with “context.” v) Unwillingness of respondents to provide information m vi) The interviewer may assure that the information will be kept secret or apply the technique of offering some presents. )A 2. Consumers Survey Method Consumers Survey is undertaken by questioning consumer’s about what they are planning or intending to buy. A questionnaire may be prepared and mailed to the consumers. Or it may be sent through enumerators. In the questionnaire, the (c respondents may be asked for their reactions to hypothetical changes in demand determinants such as price, income, prices of substitutes, advertising etc. Amity Directorate of Distance & Online Education  36 Managerial Economics Survey methods constitute another important forecasting tool, especially for short- Notes e term projections. The most direct method of estimating demand in the short- run is to conduct the survey of buyers’ intentions. The consumers are directly approached and in are asked to give their opinions about the particular product. The questionnaire must be carefully prepared bearing in mind the qualities of a good questionnaire. 3. Market controlled experiment method nl Under this method the main determinants of demand of a product like price, quality, advertising and packaging, are identified. Here the market divisions must be homogeneous with regard to income, population, caste, religion, sex, age, tastes, O preference. Merits: ity - It is a carefully carried out exercise which helps researcher to come out with a demand function indicating quantities. - This method can be used to check the results of demand forecasting obtained from other methods. s Demerits: - These methods are expensive and time consuming. er - These methods are risky as they might send wrong signals to the consumers, dealers and competitors. - It is difficult to satisfy the conditions of homogeneity. v 4. Delphi Method ni In Delphi Method, an attempt is made to arrive at a consensus of opinion. The participants are supplied with responses to previous questions from others in the group by a leader. The leader provides each expert with opportunity to react to the information U given by others, including reasons advanced, without disclosing the source. Delphi method facilitates anonymity of the respondent’s identity. This enables respondents to be frank and forthright in giving their views. It facilitates posing the ity problem to the experts at one time and has their response nearly as good as pooling the panelists together. 5. Consumer Clinics Method m An artificial market situation is created and “consumer clinics” selected. Consumers are asked to spend time in an artificial departmental store and different prices are set for different buyer groups. The responses to the price changes are observed and )A necessary decisions taken. B. Statistical Methods of Demand Forecasting Statistical methods of demand forecasting include the Time Series Analysis, Moving Averages, Exponential Smoothing, Index Numbers, Regression Analysis as well (c as Econometric Models and Input-Output Analysis. These methods use various types Amity Directorate of Distance & Online Education  Managerial Economics 37 of statistical equations and mathematical models to estimate long term demand for a Notes e product. Types of Statistical Methods in 1. Trend Projection Method Trend projection method is a classical method of business forecasting. This nl method is essentially concerned with the study of movement of variable through time. The use of this method requires a long and reliable time series data. The trend projection method is used under the assumption that the factors responsible for the past O trends in variables to be projected (e.g. sales and demand) will continue to play their part in future in the same manner and to the same extend as they did in the past in determining the magnitude and direction of the variable. ity Advantages of Trend Projection Advantages of trend projection method are as follows: i) Trend projection method is reliable to estimate the future course of action. s ii) This method is popular in business forecasting. iii) It is very simple method. er iv) The marketing manager can understand the future demand in market. Disadvantages of Trend Projection v Disadvantages of trend projection method are as follows: ni i) Trend projection method is quite expensive. ii) This method is not useful for short term forecasting. U iii) Trend projection method does not disclose the information which can be used for formulating various business policies. 2. Economic Indicators ity An economic indicator is a statistic about the economy. Economic indicators allow analysis of economic performance and predictions of future performance. One application of economic indicators is the study of business cycles Economic indicators include various indices, earnings reports, and economic m summaries. Examples: unemployment rate, quits rate, housing starts, Consumer Price Index, Consumer Leverage Ratio, industrial production, bankruptcies, Gross Domestic Product, broadband internet penetration, retail sales, stock market prices, money )A supply changes. Types of Economic Indicators Economic indicators can be classified into three categories according to their usual timing in relation to the business cycle: leading indicators, lagging indicators, and (c coincident indicators. Amity Directorate of Distance & Online Education  38 Managerial Economics i) Leading indicators Notes e Leading indicators are indicators that usually change before the economy as a whole changes. They are therefore useful as short-term predictors of the economy. in Stock market returns are a leading indicator: the stock market usually begins to decline before the economy as a whole declines and usually begins to improve before the general economy begins to recover from a slump. Other leading indicators include the nl index of consumer expectations, building permits, and the money supply. ii) Lagging indicators O Lagging indicators are indicators that usually change after the economy as a whole does. Typically the lag is a few quarters of a year. The unemployment rate is a lagging indicator: employment tends to increase two or three quarters after an upturn in the general economy. ity iii) Coincident indicators Coincident indicators change at approximately the same time as the whole economy, thereby providing information about the current state of the economy. There s are many coincident economic indicators, such as Gross Domestic Product, industrial production, personal income and retail sales. A coincident index may be used to er identify, after the fact, the dates of peaks and troughs in the business cycle. 3. Other Statistical Methods v i) Exponential Smoothing In this technique more recent data are given more weight age. This is based on ni the argument that the more recent the observations, the more its impact on future and therefore is given relatively more weight than the earlier observations.