MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS

UNIT-I
INTRODUCTION TO MANAGERIAL ECONOMICS & DEMAND ANALYSIS
ECONOMICS
Economics is a study of human activity both at individual and national level. The economists of
early age treated economics merely as the science of wealth. The reason for this is clear. Every
one of us in involved in efforts aimed at earning money and spending this money to satisfy our
wants such as food, Clothing, shelter, and others. Such activities of earning and spending money
are called “Economic activities”.

According to Adam Smith- “Economics as the study of nature and uses of national wealth”.

According to Dr. Alfred Marshall- “Economics is a study of man’s actions in the ordinary
business of life: it enquires how he gets his income and how he uses it”.
MICRO AND MACRO ECONOMICS
Micro Economics
 The study of an individual consumer or a firm is called Micro Economics. It is also called
the theory of Firm.
 Micro means one millionth. Micro Economics deals with behaviour and problems of
single individual and of micro organisation. Managerial Economics
 Managerial Economics has its roots in micro economics and it deals with the micro or
individual enterprises.
 It is concerned with the application of concepts such as Price Theory, Law of Demand
and Theories of market structure and so on. Macro Economics
 The study of aggregate or total level of economic activity in a country is called Macro
Economics.
 It studies the flow of economic resources or factors of production (such as land, labour,
capital, organisation and technology) from the resource owner to the business firms and
then from the business firms to the households.
 It deals with the total aggregates. For instance, total national income, total employment,
total output and total investment.
 It studies the interrelations among various aggregates and examines their nature and
behaviour, their determination and causes of their fluctuations in them.
 It deals with the price level in general, instead of studying the prices of individual
commodities.
 It is concerned with the level of employment in the economy.
 It discusses aggregate consumption, aggregate investment, price level and national
income.
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  The important tools of macroeconomics include national income analysis, balance of
payments and theories of employment and so on.
INTRODUCTION TO MANAGERIAL ECONOMICS
 Managerial Economics as a subject gained popularity in USA after the publication of
book
“Managerial Economics” by Joel Dean in 1951.
 Managerial Economics refers to the firm’s decision making process.
 It could be also interpreted as “Economics of Management”.
 Managerial Economics is also called as “Industrial Economics” or “Business
Economics”.
 Joel Dean observes managerial economics shows how economic analysis can be used in
formulating policies.
DEFINITIONS OF MANAGERIAL ECONOMICS
 M.H. SPENCER AND L. SIEGELMAN-Managerial Economics defined as “the
integration of economic theory with business practice for the purpose of facilitating
decision making and forward planning by management”.
 BRIGHAMANDPAPPAS believe that managerial economics is -The application of
economic theory and methodology to business administration practice”.
 C.I. SAVAGE AND T.R. SMALL therefore believes that managerial economics is
concerned with business efficiency.
 HAGUE observes that- “Managerial Economics is a fundamental academic subject
which seeks to understand and to analyse the problems of business decision-making.
 In the words of PAPPAS AND HIRSHEY-“Managerial Economics applies economic
theory and methods to business and administrative decision-making. Because it uses the
tools and techniques of economic analysis to solve managerial problems, managerial
economics links traditional economics with decision sciences to develop important tools
for managerial decision-making”.
 MICHAEL R. BAYE defines-Managerial Economics as “the study of how to direct
scarce resources in a way that most efficiently achieves a managerial goal”.
 HAYNES, MOTE AND PAUL define-Managerial Economics as “economics applied in
decision-making. They consider this as a bridge between the abstract theory and the
managerial practice”.
Managerial Economics, therefore, focuses on those tools and techniques, which are useful in
decision-making
MANAGERIAL ECONOMICS:
Managerial Economics refers to the firm’s decision making process. It could be also interpreted
as “Economics of Management”. Managerial Economics is also called as “Industrial Economics”
or “Business Economics”.
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Managerial Economics bridges the gap between traditional economics theory and real business
practices in two days. First it provides a number of tools and techniques to enable the manager to
become more competent to take decisions in real and practical situations. Secondly it serves as an
integrating course to show the interaction between various areas in which the firm operates.
NATURE / CHARACTERISTICS OF MANAGERIAL ECONOMICS:
1) Close to microeconomics: Managerial economics is concerned with finding the solutions
for different managerial problems of a particular firm. Thus, it is more close to
microeconomics.
2) Operates against the backdrop of macroeconomics: The macroeconomics conditions
of the economy are also seen as limiting factors for the firm to operate. In other words,
the managerial economist has to be aware of the limits set by the macroeconomics
conditions such as government industrial policy, inflation and so on.
3) Normative statements: A normative statement usually includes or implies the words
‘ought’ or ‘should’. They reflect people’s moral attitudes and are expressions of what a
team of people ought to do. For instance, it deals with statements such as ‘Government of
India should open up the economy. Such statement is based on value judgments and
express views of what is ‘good’ or ‘bad’, ‘right’ or ‘wrong’. One problem with normative
statements is that they cannot to verify by looking at the facts, because they mostly deal
with the future. Disagreements about such statements are usually settled by voting on
them.
4) Prescriptive actions: Prescriptive action is goal oriented. Given a problem and the
objectives of the firm, it suggests the course of action from the available alternatives for
optimal solution. If does not merely mention the concept, it also explains whether the
concept can be applied in a given context on not. For instance, the fact that variable costs
are marginal costs can be used to judge the feasibility of an export order.
5) Applied in nature: ‘Models’ are built to reflect the real life complex business situations
and these models are of immense help to managers for decision-making. The different
areas where models are extensively used include inventory control, optimization, project
management etc. In managerial economics, we also employ case study methods to
conceptualize the problem, identify that alternative and determine the best course of
action.
6) Offers scope to evaluate each alternative: Managerial economics provides an
opportunity to evaluate each alternative in terms of its costs and revenue. The managerial
economist can decide which is the better alternative to maximize the profits for the firm.
7) Interdisciplinary: The contents, tools and techniques of managerial economics are
drawn from different subjects such as economics, management, mathematics, statistics,
accountancy, psychology, organizational behaviour, sociology and etc.
8) Assumptions and limitations: Every concept and theory of managerial economics is
based on certain assumption and as such their validity is not universal. Where there is
change in assumptions, the theory may not hold good at all.

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SCOPE OF MANAGERIAL ECONOMICS
The main focus in managerial economics is to find an optimal solution to a given managerial
problem, the problem may have related to production, reduction or control of cost, determination
of price of a given product or service, make or decisions, inventory decisions, capital
management or profit planning and management, investment decisions or human resource
management. While all these are the problems, the managerial economics makes use of the
concepts, tools and techniques of economics and other related discipline to find an optimal
solution to a given managerial problem.
The main Areas of Managerial Economics
Demand Decision:
 The analysis and forecasting of demand for a given product and service is the first task of
the managerial economist.
 The behavioural implications such as the needs of the customers’ responses to a given
change in the price or supply are analysed in a scientific manner.
 The impact of changes in prices, income levels and prices of alternative products /
services are assessed and accordingly the decisions are taken to maximise the profits.
 Demand at different price levels at different points of time is forecast to plan the supply
accordingly and initiate changes in price, if necessary, to enlarge the customer base and
gain more profits.
 Determination elasticity of demand and demand forecasting constitute the strategic issues
that the managerial economist handles in a scientific way.
Input-Output Decision:
 Here, the costs of inputs in relation to output are studied to optimise the profits.
 Production function and cost function are estimated given certain parameters.
 The behaviour of costs at different levels of production is assessed here.
 some costs are fixed, some are semi-variable and others are perfectly variable.
 The quantity of production increases remains constant or decreases with additional
increase in outputs.
 This decision deals with changes in the production following changes in inputs which
could be substitutes or complementary.
 The entire focus of this decision is to optimise(maximise) the output at minimum cost.
 If it is necessary for the manager to know the relationship between the cost and output
both in the short-run and long-run to position his products amidst the competitive
environment. Price-Output Decision:
 Here, the production is ready and the task is to determine the price these in different
market situations such as perfect market and imperfect markets ranging from monopoly,
monopolistic competition, duopoly and oligopoly.
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  The features of these markets and how price is determined in each of these competitive
situations is studied here.
 The pricing policies, methods, strategies and practices constitute crucial part of the study
of managerial economics.
Profit -related Decisions:
 Here we employ the techniques such as Break even analysis, cost reduction and cost
control and ratio analysis to ascertain the level of profits.
 We determine break-even point beyond which firm start getting profits.
 In other words, if the firm produces less than break- even point, it loses.
 We can also plan the production needed to attain a given level of profits in short-run.
 Cost reduction and cost control deal with the strategies to reduce the wastage and thereby
reduce the costs.
 These indirectly enhance the level of profits.
 Ratio analysis helps to determine the liquidity, solvency, profitability of the activities of
the firm. There are certain ratios used to analyse and interpret the profitability of the firm
given a set of accounting data.
Investment Decisions:
 Investment decisions are also called capital budgeting decisions.
 These involve commitment of large funds, which determine the fate of the firm.
 These decisions are irreversible.
 Hence the manager needs to be more attentive while committing his scarce funds, which
have alternative uses.
 The allocation and utilisation of investments is paramount importance.
 Capital has a cost. It is expensive. Hence, it is to be utilised in such a way as to maximise
the return on capital invested.
 It is necessary to study the cost of capital structure and investment projects before the
funds are committed.
Economic Forecasting and Forward Planning:
 Economic forecasting leads to forward planning.
 The firm operates in an environment which is dominated by the external and internal
factors.
 The external factors include major forces such as government policy, competition,
employment, labour, price and income levels and so on.
 These influence its decision relating to production, human resources, finance and
marketing.
 The internal factors include its policies and procedures relating to finance, people, market
and products.

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  It is necessary to forecast the trends in the economy to plan for the future in terms of
investments, profits, products and markets. This will minimise the risk and uncertainty
about the future.
DEMAND ANALYSIS
Demand
Demand in common parlance means the desire for an object. But in economics demand is
something more than this. According to Stonier and Hague, “Demand in economics means
demand backed up by enough money to pay for the goods demanded”. This means that the
demand becomes effective only it if is backed by the purchasing power in addition to this there
must be willingness to buy a commodity.

Every want supported by the willingness and ability to but constitutes demand for a particular
product or services. In other words, if I want a car and I cannot pay for it, there is no demand for
the car from my side.
A product or services is said to have demand when three conditions are satisfied:
 Desire on the part of the buyer to buy
 Willingness to pay for it
 Ability to pay the specified price for it.
DETERMINANTS OF DEMAND
 There are so many factors on which the demand for a commodity depends. These factors
are Economic, Social as well as Political factors.
 The effect of all these factors on the amount of demanded for the commodity is called
Demand Function.
 The following are some of the factors that cause a change in demand other than price
factor
PRICE OF THE COMMODITY:
 The most important factor affecting on demand is the price of the commodity.
 The amount of the commodity demanded at a particular price is more popularly called
price demand. The relation between price and demand is called the Law of Demand.
 It is not only the existing price but also expected changes in price, which affect demand.
PRICES OF RELATED GOODS
CHANGE IN THE PRICES OF SUBSTITUTES- In case of substitutes like tea and coffee an
increase in price of one commodity leads to an increase in the demand for other commodity and
vice versa. The rise in price of coffee shall raise the demand for tea.
CHANGE IN THE PRICES OF COMPLEMENTARIES-In case of complementariness like car
and petrol a fall in price of one commodity leads to an increase in the demand for other
commodity and vice versa.
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If the price of pens goes up, their demand is less as a result of which the demand for ink is also
less. The price and demand go in opposite direction. The effect of changes in price a commodity
on amounts demanded of related commodities is called cross demand.
INCOME OF THE CONSUMER:
The third most important factor influencing demand is consumer income.
 In fact, we can establish a relationship between the consumer income and demand at
different levels of income, price and other things remaining same.
 The demand for a normal commodity goes up and falls down when income rises and falls
down. But in case of Giffen goods the relationship is opposite.
 Demand always changes with a change in the incomes of the people.
 When income increases the demand for several commodities increases and vice versa.
TASTES AND FASHIONS OF CONSUMERS:

 The fourth most important factor influencing demand is consumers’ tastes and fashions.
 The demand also depends on consumer's taste. Tastes include fashion, habit, customs etc.
 A customer taste is also affected by advertisement.
 If the taste for a commodity goes up, its amount demanded is more even at the same
price.
 This is called increase in demand. The opposite is called decrease in demand.
 A change in the tastes and fashions brings about a change in demand for a commodity.
 When commodity goes out of fashion, the demand for it will decrease even though the
price remains the same. Demand curve shifts to the left.
AFFECT OF WEALTH:
 The amount demanded of the commodity is also affected by the amount of wealth as well
as its distribution.
 When the wealth of the people is more, demand for the normal commodities is also more.
 If wealth is more equally distributed, the demand for necessaries and comforts is more.
 On the other hand, if some people are rich, while the majorities are poor, the demand for
luxuries is generally higher.
CHANGE IN POPULATION:
 Increase in population increases demand for necessaries of life.
 The compositions of population also affect demand.
 Composition of population means the proportion of young and old and children as well as
the ratio of men and women.
 A change in composition of population has an affect on the nature of demand for different
commodities.
 A change in size as well as composition of population will affect the demand for certain
commodities.

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  For example: An increase in size of population will increase the demand for food grains.
Similarly, an increase in percentage of women increases the demand for bangles and
sarees.
CHANGES IN CLIMATE AND WEATHER:
 Demand always changes with a change in weather or climate even though price remains
unchanged.
 In summer the demand for cool drinks increases and in winter it decreases.
 The climate of an area and the weather prevailing there has a decisive effect on
consumer’s demand.
 In cold areas woollen cloth is demanded. During hot summer days, ice is very much in
demand. On a rainy day, ice cream is not so much demanded.
CHANGES IN GOVERNMENT POLICY:
 Government policy affects the demand for commodities through taxation.
 Taxing a commodity increases its price and demand goes down.
 Similarly, financial help from government increases the demand for a commodity while
lowering its price.
EXPECTATIONS REGARDING THE FUTURE:
 If consumers expect changes in price of commodity in future, they will change the
demand at present even when the present price remains the same.
 Similarly, if consumers expect their incomes to rise in the near future they may increase
the demand for a commodity just now.
STATE OF BUSINESS:
 The level of demand for different commodities also depends upon the business conditions
in the country.
 If the country is passing through boom conditions, there will be a marked increase in
demand.
 On the other hand, the level of demand goes down during depression conditions.
ADVERTISEMENT:
 Advertisement has become the most popular means in changing the demand for a
commodity in the modern world.
 By a regular advertisement, the preference of the consumers can be influenced.
TECHNICAL PROGRESS:
 Due to technical progress, new commodities will enter into the market and demand for
the old commodities will decrease.
 For example, Due to the introduction of electronic watches the demand for ordinary
watches has decreased.

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 DEMAND FUNCTION
Demand function is a mathematical expression of relation between the quantity demanded and its
determinants. It can be expressed as follows
QD = F( P, I, Psc, T, A)
Where
Qd = quantity demand
F = functional relational between input
P = price of the product
I = income of the consumer
Psc= price of substituted or complementary
T = taste and preference
A = advertisement
LAW OF DEMAND
DEMAND ANALYSIS
INTRODUCTION OF DEMAND:
 Demand in common practice / ordinary language means the desire for an object. Suppose
a person desires to have a car. It is called demand in ordinary usage.
 But in economics demand has a separate meaning which is quite distinct from the above
meaning.
 A mere desire cannot become demand in Economics.
 A desire which is backed up by (i) ability to buy and (ii) willingness to pay the price, is
called demand. Unless the desire is accompanied by ability to buy and willingness to pay,
it cannot be called demand in Economics.
DEFINITIONS OF DEMAND:
According to Stonier and Hague-

 “Demand in economics means demand backed up by enough money to pay for the goods
demanded”.
 This means that the demand becomes effective only if it is backed by purchasing power
in addition to this there must be willingness to buy a commodity.
 Thus, demand in economics means the desire backed by the willingness to buy a
commodity and the purchasing power to pay.

In the words of Benham,

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  “The demand for anything at a given price is the amount of it which will be bought per
unit of time at that price”. (Thus, demand is always at a price for a definite quantity at a
specified time.)
 Thus, demand has three essentials i.e., price, quantity and time. Without these three
demand has no significance in economics.
DEFINITIONS OF LAW OF DEMAND:
ALFRED MARSHALL stated that Law of Demand as-

 “a rise in the price of commodity or service is followed by a reduction in demand and fall
in price is followed by an increase in demand, if the conditions of demand remain
constant.”
 Marshall stated that the Law of Demand basing on the law of Diminishing Marginal
Utility.
In the words of SAMUELSON-
 The Law of Demand may be stated as- “Other things being equal, the quantity demanded
increases with a fall in price and decreases with a rise in price.”
LAW OF DEMAND:
Law of demand states the relationship between price and quantity demanded. As per the law
when price is increased demand will decrease, and similarly, when price is decrease demand will
increase, this law assumed that, other things remaining constant, the change in price will
inversely affect demand, thus the relationship between price and demand is inverse.
A rise in the price of a commodity is followed by a fall in demand and a fall in price is followed
by a rise in demand, if a condition of demand remains constant.
DEMAND SCHEDULE
The Law of Demand may be explained with the help of the following Demand Schedule.
Price of Mangoes (Rs.) Quantity Demanded

1 25

2 20

3 15

4 10

5 5

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  From the above table, it is clear that as price of Mangoes rises from Rs.1 to Rs.2 demand
falls from 25 to 20.
 When the price of Mangoes rises to Rs.5 quantity demand falls to 5 Mangoes.
 In the same way as price rises, quantity demand falls on the basis of demand schedule.
We can draw a demand curve from the above Demand Schedule as follows.
 In the above Diagram, demand is shown on OX –axis and price is shown on OY-axis. DD
is the demand curve.
 The demand curve DD shows the inverse relation between price and quantity demand of
Mangoes.
 The demand curve slopes downward from left to right.
ASSUMPTIONS OF LAW OF DEMAND:
Law of Demand is based on the following assumptions. The Law will hold good only if the
following assumptions are fulfilled.
1. That the tastes and fashions of the people remain unchanged.
2. That the people’s income remains unchanged / constant.
3. That the prices of related goods remain unchanged / same.
4. That there are no substitutes for the commodity in the market.
5. That the commodity is not the one which has prestige value such as diamonds etc.
6. That the demand for the commodity should be continuous.
7. That the people should not expect any change in the price of the commodity.
EXCEPTIONS TO THE LAW OF DEMAND:
Some times in case of some commodities demand curve slopes upwards from left to right. It
shows that when price rises demand also rises and when price falls demand also falls. In this case
the demand curve has a positive slope. We can draw the Exceptional Demand Curve as follows.

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  In the above Diagram, demand is shown on OX –axis and price is shown on OY-axis.
 DD is the demand curve.
 When price increases from OP to OP1 quantity demand also increases from OQ to OQ1
and the price falls down from OP1 to OP quantity demand also falls down from OQ1 to
OQ.
 Hence the exceptional demand curve slopes upwards from left to right in this diagram.
following are the important exceptions to the Law of Demand.
1. Giffen Paradox
2. Prestige goods
3. Speculation
4. Trade Cycles
5. Changes in Expectations.
GIFFEN PARADOX:
 In the early part of the 19th Century, Sir Robbert Giffen, a British Economist observed
that the Low paid British workers were purchasing more bread, when its price increased.
 This is something contrary to the law of demand.
 He observed that the people spend a major portion of their incomes on bread only a small
part on meat. Meat is costlier but less essential that bread.
 When the price of the bread increased, they reduced the expenditure on meat.
 With the money thus saved they purchased more bread to compensate for the loss of
meat.
 Thus, where the price of bread is increases, its demand is also increased. This is the
against law of demand.
 This paradox was stated by Sir Robbert Giffen. Therefore, it is called Giffen Paradox.
 Marshall could not explain this. It appeared to be a paradox to him.
 The Demand Curve for Giffen goods (Inferior goods) goes upward from left to right as
shown in the above diagram.
PRESTIGE GOODS:
 This exception is explained by Veblen. Costly goods like Diamonds, cars etc., are called
prestige goods or as Veblen goods.
 Generally rich people purchase those goods for the sake of prestige.
 The use of such articles increases the prestige of owners.
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  So, rich people may buy more of such goods when their prices rise.
 Thus, the amount demanded rises instead of falling, when the prices fall they do not
purchase them because their value is reduced.
 Therefore, the demand decreases when the price falls.
 This is against to the Law of Demand.
 Since this exception is stated by Veblen, it is called Veblen effect
SPECULATION:
 When the price of a commodity rises and people expect that it will rise still further.
 Hence, they buy more of that commodity.
 Similarly, if they expect that there is going to be a further fall in the price, demand may
not expand. This is contrary to the Law of Demand.
TRADE CYCLES:
 During the periods of economic prosperity, people buy more even when the prices rise.
 This happens because the incomes of the people have gone up.
 During times of depression, people buy less and less even when prices fall.
CHANGES IN EXPECTATIONS:
 When people expect a further rise in prices, people buy more when prices rise.
 They want avoid paying more in future.
 Similarly, when people expect the prices to fall in further, they buy less and less as prices
fall.
 They may be expecting a further in prices.
ELASTICITY OF DEMAND
Elasticity of demand explains the relationship between a change in price and consequent change
in amount demanded. “Marshall” introduced the concept of elasticity of demand. Elasticity of
demand shows the extent of change in quantity demanded to a change in price.
In the words of “Marshall”, “The elasticity of demand in a market is great or small according as
the amount demanded increases much or little for a given fall in the price and diminishes much
or little for a given rise in Price”
Elastic demand: A small change in price may lead to a great change in quantity demanded. In this
case, demand is elastic.
In-elastic demand: If a big change in price is followed by a small change in demanded then the
demand in “inelastic”.
Types of Elasticity of Demand: There are three types of elasticity of demand:
1. Price elasticity of demand
2. Income elasticity of demand
3. Cross elasticity of demand
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 4. Advertising elasticity of demand Price elasticity of demand:
Elasticity of demand in general refers to price elasticity of demand. In other words, it refers to the
quantity demanded of a commodity in response to a given change in price. Price elasticity is
always negative which indicates that the customer tends to buy more with every fall in the price,
the relationship between the price and the demand is inverse.
𝑷𝒓𝒐𝒑𝒐𝒓𝒕𝒊𝒐𝒏𝒂𝒕𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒕𝒉𝒆 𝒒𝒖𝒂𝒏𝒕𝒊𝒕𝒚 𝒅𝒆𝒎𝒂𝒏𝒅 𝒐𝒇 𝒄𝒐𝒎𝒎𝒐𝒅𝒊𝒕𝒚
𝑷𝒓𝒊𝒄𝒆 𝑬𝒍𝒂𝒔𝒕𝒊𝒄𝒊𝒕𝒚 =
𝑷𝒓𝒐𝒑𝒐𝒓𝒕𝒊𝒐𝒏𝒂𝒕𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒕𝒉𝒆 𝒑𝒓𝒊𝒄𝒆 𝒐𝒇 𝒄𝒐𝒎𝒎𝒐𝒅𝒊𝒕𝒚
𝑸𝟐 − 𝑸𝟏/𝑸𝟏
𝒆𝒅𝒑 =
𝑷𝟐 − 𝑷𝟏/𝑷𝟏
Where:

Q1 = quantity demand price before change

Q2 = quantity demand price after change
P1 = price before change
P2 = price after change
Income elasticity of demand: Income elasticity of demand refers to the quantity demand of a
commodity in response to a given change in income of the consumer.
𝑷𝒓𝒐𝒑𝒐𝒓𝒕𝒊𝒐𝒏𝒂𝒕𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒕𝒉𝒆 𝒒𝒖𝒂𝒏𝒕𝒊𝒕𝒚 𝒅𝒆𝒎𝒂𝒏𝒅 𝒐𝒇 𝒄𝒐𝒎𝒎𝒐𝒅𝒊𝒕𝒚
𝑰𝒏𝒄𝒐𝒎𝒆 𝑬𝒍𝒂𝒔𝒕𝒊𝒄𝒊𝒕𝒚 =
𝑷𝒓𝒐𝒑𝒐𝒓𝒕𝒊𝒐𝒏𝒂𝒕𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒕𝒉𝒆 𝑰𝒏𝒄𝒐𝒎𝒆 𝒐𝒇 𝒕𝒉𝒆
𝒑𝒆𝒐𝒑𝒍𝒆
𝑸𝟐 − 𝑸𝟏/𝑸𝟏
𝑬𝒅𝑰 =
𝑰𝟐 − 𝑰𝟏/𝑰𝟏

Where:
Q1 = quantity demand price before change
Q2 = quantity demand price after change
I1 = income before change
I2 = income after change
Cross elasticity of demand: Cross elasticity of demand refers to the quantity demanded of a
commodity in response to a change in the price of a related good, which may be substitute or
complement.
𝑷𝒓𝒐𝒑𝒐𝒓𝒕𝒊𝒐𝒏𝒂𝒕𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒕𝒉𝒆 𝒒𝒖𝒂𝒏𝒕𝒊𝒕𝒚 𝒅𝒆𝒎𝒂𝒏𝒅 𝒐𝒇 𝒄𝒐𝒎𝒎𝒐𝒅𝒊𝒕𝒚 "𝑿"
𝑪𝒓𝒐𝒔𝒔 𝑬𝒍𝒂𝒔𝒕𝒊𝒄𝒊𝒕𝒚 =
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 𝑷𝒓𝒐𝒑𝒐𝒓𝒕𝒊𝒐𝒏𝒂𝒕𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒕𝒉𝒆 𝑷𝒓𝒊𝒄𝒆 𝒐𝒇 𝑪𝒐𝒎𝒎𝒐𝒅𝒊𝒕𝒚
"𝒀"
𝑸𝟐 − 𝑸𝟏/𝑸𝟏
𝑬𝒅𝑰 =
𝑷𝟐 − 𝑷𝟏/𝑷𝟏

Where:
Q1 = quantity demand price before change
Q2 = quantity demand price after change
P1 = price before change
P2 = price after change
Advertising elasticity of demand: It refers to increase in the sales revenue because of change in
the advertising expenditure. In other words, there is a direct relationship between the amount of
money spent on advertising and its impact on sales. Advertising elasticity is always positive.
𝑷𝒓𝒐𝒑𝒐𝒓𝒕𝒊𝒐𝒏𝒂𝒕𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒕𝒉𝒆 𝒒𝒖𝒂𝒏𝒕𝒊𝒕𝒚 𝒅𝒆𝒎𝒂𝒏𝒅 𝒐𝒇 𝑷𝒓𝒐𝒅𝒖𝒄𝒕
𝑪𝒓𝒐𝒔𝒔 𝑬𝒍𝒂𝒔𝒕𝒊𝒄𝒊𝒕𝒚 =
𝑷𝒓𝒐𝒑𝒐𝒓𝒕𝒊𝒐𝒏𝒂𝒕𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑨𝒅𝒗𝒆𝒓𝒕𝒊𝒔𝒆𝒎𝒆𝒏𝒕 𝒄𝒐𝒔𝒕
𝑸𝟐 − 𝑸𝟏/𝑸𝟏
𝑬𝒅𝑨 =
𝑨𝟐 − 𝑨𝟏/𝑨𝟏

Where:
Q1 = quantity demand price before change
Q2 = quantity demand price after change
A1 = advertising before change
A2 = advertising after change
MEASUREMENT ELASTICITY OF DEMAND
1. Perfectly elasticity of demand
2. Perfectly inelasticity of demand
3. Relatively elasticity of demand
4. Relatively inelasticity of demand
5. Unity elasticity of demand
Perfectly elasticity of demand: When any quantity can be sold at a given price, and when there
is no need to reduce price, the demand is said to be perfectly elastic. In such cases, even a small
increase in price will lead to complete fall in demand.

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Perfectly inelasticity of demand: When a significant degree of change in price leads little or
no change in the quantity demanded, then the elasticity is said to be perfectly inelasticity. In
other words, the demand is said to be perfectly inelasticity when there is no change in the
quantity demanded even though there is a big change in the price.

Relatively elasticity of demand: The demand is said to be relatively elasticity when the change
in demand is more than the change in the price.

Relatively inelasticity of demand: The demand is said to be relatively inelasticity when the
change in demand is less than the change in the price.

Unity elasticity: The elasticity in demand is said to be unity when the change in demand is equal
to the change in price.

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SIGNIFICANCE OF ELASTICITY OF DEMAND
Price of factors of production:
The factors of production are land, labour, capital, organizations and technology. These have a
cost; we have to pay rent, wages, interest, profits and price for these factors of production.

Price fixation:
the manufacturer can decide the amount of price that can be fixed for his product based on the
concept of elasticity, if there is no competition, in other words in the case of a monopoly, the
manufacture is free to fix his price as long as it does not attract the attention of the government,
when there are close substitutes, the product is such that its consumption can be postponed, it
cannot be put to alternative uses and so on, then the price of the product cannot be fixed very
highly.
Government policies
 Tax policies: government extensively depends on this concept to finalize its polices
relating to taxes and revenues. Where the product is such that the people cannot postpone
its consumptions, the government tends to increase its, price, such as petrol and diesel,
cigarettes, and so on.
 Raising bank deposits: if the government wants to mobilize larger deposits from the
consumer it proposes to raise the rates of fixed deposits marginally and vice versa.
 Public utilities: government uses the concept of elasticity in fixing charges for the public
utilities such as elasticity tariff, water charges, ticket fare in case of road or rail transport.

Forecasting demand:
Income elasticity is used to forecast demand for a particular product or services. The demand for
the products can be forecast at a given income level. The trader can estimate the quantity of
goods to be sold at different income levels to realize the targeted revenue.
Planning the levels of output and price:
The knowledge of price elasticity is very useful to producers. The producer can evaluate whether
a change in price will bring in adequate revenue or not. In general, for items whose demand is
elastic, it would benefit him to charge relatively low price. On the other hand, if the demand for

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the product is inelastic, a little higher price may be helpful to him to get huge profits without
losing sales.
DEMAND FORECASTING
Demand forecasting refers to an estimate of future demand for the product. It is an objective
assessment of the future course of demand, in recent times, forecasting plays an important role in
business decision – making. The survival and prosperity of a business firm depend on its ability
to meet the consumer’s needs efficiently and adequately. Demand forecasting has an important
influence on production planning. It is essential for a firm to produce the required quantities at
the right time.
It is also essential to distinguish between forecasting of demand and forecast of sales, sales
forecasts are important for estimating revenue, cash requirements and expenses whereas, demand
forecasting relate to production, inventory control, timing, reliability of forecast etc. however,
there is not much difference between these terms.
METHODS OF DEMAND FORECASTING
1. Survey methods
2. Statistical methods
3. Expert opinion methods
4. Test marketing
5. Controlled experiments
6. Judgmental approach
STATISTICAL METHODS: Statistical method is used for long run forecasting. In this method,
statistical and mathematical techniques are used to forecast demand. This relies on past data.
Trend projection method: these are generally based on analysis of past sales patterns. These
methods dispense with the need for costly market research because the necessary information is
often already available in company files. This method is used in case the sales data of the firm
under consideration relate to different time periods, i.e., it is a time – series data. There are five
main techniques of mechanical extrapolation.
 Trend line by observation: this method of forecasting trend is elementary, easy and
quick. It involves merely the plotting of actual sales data on a chart and them estimating
just by observation where the trend line lies. The line can be extended towards a future
period and corresponding sales forecast is read form the graph.
 Least squares methods: this technique uses statistical formulae to find the trend line
which best fits the available data. The trend line is the estimating equation, which can be
used for forecasting demand by extrapolating the line for future and reading the
corresponding values of sales on the graph.
 Time series analysis: where the surveys or market tests are costly and time – consuming,
statistical and mathematical analysis of past sales data offers another method to prepare
the forecasts, that is, time series analysis.

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  Moving average method: this method considers that the average of past events
determine the future events. In other words, this method provides consistent results when
the past events are consistent and unaffected by wide changes.
 Exponential smoothing: this is a more popular technique used for short run forecasts.
This method is an improvement over moving averages method, unlike in moving
averages method, all time periods here are given varying weight, that is, value of the
given variable in the recent times are given higher weight and the values of the given
variable in the distant past are given relatively lower weights for further processing.
 Barometric Technique: Simple trend projections are not capable of forecasting turning
paints. Under Barometric method, present events are used to predict the directions of
change in future. This is done with the help of economics and statistical indicators. Those
are (1) Construction Contracts awarded for building materials (2) Personal income (3)
Agricultural Income. (4) Employment (5) Gross national income (6) Industrial Production
(7) Bank Deposits etc. g. Simultaneous equation method: in this method, all variable is
simultaneously considered, with the conviction that every variable influence the other
variables in an economic environment. Hence, the set of equations equal the number of
dependent variable which is also called endogenous variables.
 Correlation and regression methods: correlation and regression methods are statistical
techniques. Correlation describes the degree of association between two variables such as
sales and advertisement expenditure. When the two variables tend to change together,
then they are said to be correlated.
Expert opinion methods:
Well informed persons are called experts; experts constitute yet another source of information.
These persons are generally the outside experts and they do not have any vested interest in the
results of a particular survey. As expert is good at forecasting and analysis the future trend in a
given product or service at a given level of technology. The service of an expert could be
advantageously used when a firm uses general economic forecasting or special industry fore
casting prepared outside the firm.
Test marketing:
It is likely that opinions given by buyers, salesman or other experts may be, at times, misleading.
This is the reason why most of the manufactures favour to test their product or service in a
limited market as test – run before they launch their product nationwide.
Controlled experiments:
Controlled experiment refers to such exercise where some of the major determinants of demand
are manipulated to suit to the customers with different tastes and preferences, income groups, and
such others, it is further assumed that all other factors remain the same.
Judgmental approach:

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When none of the above methods are directly related to the given product or service, the
management has no alternative other than using its own judgment. Even when the above methods
are used, the forecasting process is supplemented with the factor of judgment for the following
reasons
 Historical data for significantly long period is not available
 Turning point in terms of policies or procedures or causal factors cannot be precisely
determined Sale fluctuation are wide and significant
 The sophisticated statistical techniques such as regression and so on, may not cover all
the signing.

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Factors Governing Demand Forecasting
Functional nature of demand: market demand for a particular product or service is not a single
number but it is a function of a number of factors, for instance, higher volumes of sales can be
realized with higher levels of advertising or promotion efforts.
Types of forecasting: based on the period under forecast, the demand forecast can be of two
types1) short – run forecasting and 2) long – run forecasting. Short run forecasts cover a period
of one year whereas long- run forecasting any period ranging from one year to 20 years.
Forecasting level: the forecasting, at the firm level, industry level, national level or at the global
level.
 Firm level: firm level means estimating the demand for the products and services offered
by a single firm
 Industry level: the aggregate demand estimated for the good and service of all the firms
constitutes the industry level forecast. The total estimate of different trade associations
can also be view as industry level forecast.
 National level: national level forecasting is for the whole economy, national level
forecasts are worked out based on the levels of income, savings of the consumers.
 Global level: globalization and deregulation, the entrepreneurs have started exploring the
foreign markets for which the global level forecasts are utilized.
Degree of orientation: demand forecasts can be worked out based on total sales or product or
service wise sales for a given time period. Forecasting in terms of total sales can be viewed as
general forecast whereas product or service – wise or region or customer segment – wise forecast
is referred is referred to as specific forecast.
New product: it is relatively easy to forecast demand for established products or products which
are currently in use. The new product in consideration can be analyzed as a substitute for some
existing product. Assess the demand through a sampled or total survey of consumers’ intentions
over the new product features and price. f) Nature of good: The goods are classified into
producer goods, consumer goods, consumer durables and services. The patterns of forecasting in
each of these differ. g) Degree of competition: there may be a single trader or a few traders
depending upon the nature of goods and services.

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