UNIT 2

Demand Analysis and

Forecasting
Dr. Nidhi Tewatia
Understanding the Demand
Function
• The demand function represents the mathematical
relationship between the quantity demanded of a product and
its determinants, such as price, income, prices of related
goods, and consumer preferences. It is typically expressed as:
• Q = f(P, Y, PR, T, O)
• Q: Quantity demanded of the product
• P: Price of the product
• Y: Consumer income
• PR: Prices of related goods (substitutes and complements)
• T: Tastes and preferences of consumers
• O: Other factors influencing demand (e.g., demographics,
advertising)
Factors Affecting Demand

[Link]: As the price of a product increases, the quantity demanded tends to decrease, assuming other
factors remain constant. This relationship is known as the law of demand.
[Link]: Changes in consumer income affect the demand for different goods. For normal goods, an
increase in income leads to an increase in the quantity demanded, while for inferior goods, the
opposite is true.
[Link] of Related Goods: The prices of substitutes and complements impact the demand for a
product. If the price of a substitute increases, the demand for the product may increase as consumers
switch to the cheaper alternative. Conversely, if the price of a complement increases, the demand for
the product may decrease.
A substitute good is a good that serves the same purpose as another good for consumers.
A complementary good is a good that adds value to another good when they are consumed together.
Pepsi and Coke are a typical example of substitute goods, whereas fries and ketchup may be considered
complements of each other.
4. Tastes and Preferences: Consumer preferences, influenced by factors like trends, advertising, and
cultural influences, play a significant role in shaping demand. Changes in tastes and preferences can
lead to shifts in the demand curve.
5. Other Factors: Various other factors, such as demographics, seasonality, technological
advancements, and government policies, can influence demand. For instance, changes in population
demographics may affect the demand for certain products or services.
 Law of Demand
• The law of demand states that the quantity demanded
of a good shows an inverse relationship with the price of
a good when other factors are held constant (cetris
peribus). It means that as the price increases, demand
decreases.
• The law of demand is a fundamental principle in
macroeconomics. It is used together with the
law of supply to determine the efficient allocation of
resources in an economy and find the optimal price and
quantity of goods.
Graphical Representation of the Law of Demand
• The law of demand is usually represented as a
graph. The graphical representation of the law of
demand is a curve that establishes the
relationship between the quantity demanded
and the price of a good.
• The shape of the demand curve can vary among
different types of goods. Most frequently, the
demand curve shows a concave shape..
• The demand curve is drawn against the quantity
demanded on the x-axis and the price on the y-
axis. The definition of the law of demand
indicates that the demand curve is downward
sloping.
• It is important to distinguish the difference
between the demand and the quantity
demanded. The quantity demanded is the
number of goods that the consumers are
willing to buy at a given price point. On the
other hand, the demand represents all the
available relationships between the good’s
 Types of Demand
Demand can be classified into different types based on various
factors. Here are a few common types of demand:
[Link] Demand: Price demand refers to the quantity of a product
that consumers are willing and able to purchase at different price
levels, holding other factors constant.
[Link] Demand: Income demand refers to the quantity of a
product that consumers are willing and able to purchase at
different income levels, assuming other factors remain the same.
[Link] Demand: Cross demand refers to the quantity of one
product that is demanded due to a change in the price of another
related product, either as a substitute or a complement.
[Link] Demand: Derived demand occurs when the demand for
one product is influenced by the demand for another product that
it helps produce. For example, the demand for steel is derived
from the demand for automobiles or construction.
[Link] Demand: Elastic demand refers to a situation
where a change in price leads to a relatively larger
change in quantity demanded. In elastic demand,
consumers are highly responsive to price changes.

[Link] Demand: In contrast to elastic demand,

inelastic demand refers to a situation where a change in
price leads to a relatively smaller change in quantity
demanded. In this case, consumers are less responsive to
price changes.
 Exceptions to the Law of
Demand
• Unlike the laws of mathematics or physics, the laws of economics are not universal. For
example, the law of demand comes with a few exceptions. Some goods do not show an inverse
relationship between the price and the quantity. Therefore, the demand curve for these goods
is upward-sloping.
1. Giffen goods
• These are inferior goods that lack close substitutes that represent a large portion of the
consumer’s income. Scottish economist Sir Robert Giffen proposed the existence of such
goods in the 19th century. Giffen goods violate the law of demand because the prices of these
goods increase with the increase in the quantity demanded. However, Giffen goods remain
mostly a theoretical concept as there is limited empirical evidence of their existence in the
real world.
2. Veblen goods
• Certain types of luxury goods violate the law of demand. Veblen goods are named after
American economist Thorstein Veblen. Generally, they are luxury goods that indicate the
economic and social status of the owner. Therefore, consumers are willing to consume Veblen
goods even more when the price increases. Some examples of Veblen goods include luxury
cars, expensive wines, and designer clothes.
Movement of the Demand Curve

• When there is a change in the quantity demanded of a particular

commodity, because of a change in price, with other factors
remaining constant, there is a movement of the quantity demanded
along the same curve.

• The important aspect to remember is that other factors like the

consumer’s income and tastes along with the prices of other goods,
etc. remain constant and only the price of the commodity changes.

• In such a scenario, the change in price affects the quantity

demanded but the demand follows the same curve as before the
price changes. This is Movement of the Demand Curve. The
movement can occur either in an upward or downward direction
along the demand curve.
In Fig. 1 above, we can see that when the price of
a commodity is OP, its demand is OM (provided
other factors are constant). Now, let’s look at the
effect of an increase and decrease in price on the
demand:

•When the price increases from OP to OP”, the

quantity demanded falls to OL. Also, the demand
curve moves UPWARD.
•When the price decreases from OP to OP’, the
quantity demanded rises to ON. Also, the demand
curve moves DOWNWARD.

Therefore, we can see that a change in price, with

other factors remaining constant moves the
demand curve either up or down.
 The shift of the Demand Curve

• When there is a change in the quantity demanded of a particular

commodity, at each possible price, due to a change in one or
more other factors, the demand curve shifts. The important
aspect to remember is that other factors like the consumer’s
income and tastes along with the prices of other goods, etc.,
which were expected to remain constant, changed.

• In such a scenario, the change in price, along with a change in

one/more other factors, affects the quantity demanded. Therefore,
the demand follows a different curve for every price change.

• This is the Shift of the Demand Curve. The demand curve can shift
either to the left or the right, depending on the factors affecting it.
 Let’s look at an example which captures the effect of a change in consumer’s income on the quantity demanded .
The demanded quantities are plotted as demand
Price (Rs.) Quantity Quantity curves DD and D’D’ as shown below:
demanded demanded
when the when the
average average
household household
income is income is
Rs. 4000 Rs. 5000
5 10 (A) 15 (A1)

4 15 (B) 20 (B1)

3 20 (C) 25 (C1)

2 35 (D) 40 (D1)

1 60 (E) 65 (E1)
• From Fig. 2 above, we can
clearly see that if the income
changes, then a change in
price shifts the demand
curve. In this case, the shift
is to the right which indicates
that there is an increase in
the desire to purchase the
commodity at all prices.

• Hence, we can conclude that

with an increase in income
the demand curve shifts to
the right. On the other hand,
if the income falls, then the
demand curve will shift to
the left decreasing the desire
to purchase the commodity.
 Elasticity of Demand
• Elasticity of demand is a
measure of the responsiveness
of quantity demanded to
changes in price or income. It
indicates how sensitive the
quantity demanded is to
changes in these factors. The
concept of elasticity helps in
understanding the degree of
responsiveness of demand and
its impact on consumer
behavior and market
outcomes.
 Elastic Demand
• Elasticity of demand is illustrated in Figure 1. Note
that a change in price results in a large change in
quantity demanded. An example of products with an
elastic demand is consumer durables. These are
items that are purchased infrequently, like a
washing machine or an automobile, and can be
postponed if price rises. For example, automobile
rebates have been very successful in increasing
automobile sales by reducing price.
• Close substitutes for a product affect the elasticity
of demand. If another product can easily be
substituted for your product, consumers will quickly
switch to the other product if the price of your
product rises or the price of the other product
declines. For example, beef, pork and poultry are all
meat products. The declining price of poultry in
recent years has caused the consumption of poultry
to increase, at the expense of beef and pork. So
products with close substitutes tend to have elastic
demand.
 Inelastic Demand

• Inelastic demand is shown in Figure 2.

Note that a change in price results in only
a small change in quantity demanded. In
other words, the quantity demanded is
not very responsive to changes in price.
Examples of this are necessities like food
and fuel. Consumers will not reduce their
food purchases if food prices rise,
although there may be shifts in the types
of food they purchase. Also, consumers
will not greatly change their driving
behavior if gasoline prices rise.
 Unitary Elasticity

• If the elasticity coefficient is

equal to one, demand is
unitarily elastic as shown in
Figure 3. For example, a 10%
quantity change divided by a
10% price change is one. This
means that a 1% change in
quantity occurs for every 1%
change in price.
 Numericals

1. Consider the demand for a good. At price Rs 4, the

demand for the good is 25 units. Suppose price of the
good increases to Rs 5, and as a result, the demand
for the good falls to 20 units. Calculate the price
elasticity?

2.

3. Suppose the price elasticity of demand for a good is -0.2. If there is a 5%

increase in the price of the good, by what percentage will the demand for the
good go down?
 Solutions:

1.
2 .
3.
ESTIMATING DEMAND USING REGRESSION ANALYSIS

• Estimating demand is a critical aspect of managerial

economics that helps businesses make informed
decisions about pricing, production, and marketing
strategies. Regression analysis is a widely used
statistical technique that allows businesses to estimate
demand by analyzing the relationship between the
quantity demanded of a product and its key
determinants. In this blog, we will explore how
regression analysis can be employed to estimate
demand, its advantages, and the steps involved in
conducting a demand estimation using regression
analysis.
Estimating Demand Using Regression Analysis
EstimaUnderstanding Regression Analysis
ting Demand Using Regression Analysis

• Regression analysis is a statistical technique that examines

the relationship between a dependent variable and one or
more independent variables. In the context of demand
estimation, the dependent variable is the quantity demanded
of a product, while the independent variables are factors that
influence demand, such as price, income, advertising
expenditure, and competitor’s price.
• By analyzing historical data on the quantity demanded and
the corresponding values of the independent variables,
regression analysis allows businesses to quantify the impact of
these variables on demand and develop an equation that can
be used to estimate future demand.
Advantages of Demand Estimation Using
Regression Analysis

[Link] Analysis: Regression analysis provides a quantitative approach to estimating

demand, allowing businesses to obtain numerical estimates of the impact of different factors
on demand. This helps in making more precise and data-driven decisions.
[Link] of Key Determinants: Regression analysis helps identify the key
determinants of demand by examining the relationship between the dependent variable
(quantity demanded) and the independent variables (factors affecting demand). This
understanding allows businesses to focus their efforts on the most influential factors when
developing strategies.
[Link]: Once the demand equation is established using regression analysis, businesses
can utilize it for demand forecasting. By inputting values of the independent variables into
the equation, they can estimate the quantity demanded under different scenarios, aiding in
production planning, resource allocation, and inventory management.
[Link] Analysis: Regression analysis enables businesses to conduct sensitivity analysis
by assessing the responsiveness of demand to changes in independent variables. This
information helps in understanding the elasticity of demand and the potential impact of
pricing, advertising, or other strategic decisions on quantity demanded.
Steps in Conducting Demand
Estimation Using Regression
Analysis
[Link] Collection: Gather historical data on the quantity
demanded and relevant independent variables, such as price,
income, advertising expenditure, and competitor’s price. Ensure
that an adequate amount of data is collected to capture variations
in the variables over time.
[Link] of the Regression Equation: Based on economic
theory and knowledge of the industry, determine the form of the
regression equation. For example, if price is expected to have a
linear relationship with quantity demanded, the equation might
take the form: Quantity Demanded = β0 + β1 * Price + ε, where
β0 and β1 are the coefficients to be estimated, and ε is the error
term.
3. Estimation of Coefficients: Use statistical software
or tools to estimate the coefficients of the regression
equation. The estimation process involves minimizing the
sum of squared differences between the observed
quantity demanded and the values predicted by the
equation.
4. Interpretation of Coefficients: Interpret the
estimated coefficients to understand the impact of each
independent variable on demand. Positive coefficients
indicate a positive relationship with demand, while
negative coefficients indicate an inverse relationship.
5. Evaluation of Model Fit: Assess the goodness of fit
of the regression model using statistical measures such
as the R-squared value, which indicates the proportion of
the variation in the dependent variable explained by the
independent variables.
6. Validation and Testing: Validate the estimated
demand equation by comparing the predicted values with
actual data not used in the estimation process. Conduct
statistical tests, such as the t-test or F-test, to evaluate
the statistical significance of the coefficients.
[Link] and Analysis: Once the demand equation
is validated, utilize it to estimate demand under different
scenarios, conduct sensitivity analysis, and support
decision-making processes related to pricing, production,
and marketing strategies.
 Demand forecasting
• Demand forecasting is a critical aspect of managerial
economics that helps businesses estimate future
consumer demand for their products or services.
Accurate demand forecasting enables businesses to
make informed decisions about production planning,
inventory management, pricing strategies, and resource
allocation. In this blog, we will explore some commonly
used demand forecasting techniques and their
application in business.
 Time Series Analysis

• Time series analysis is a widely used technique for demand forecasting,

especially when historical data is available. It involves analyzing past demand
patterns to identify trends, seasonality, and other recurring patterns that can be
used to make future predictions. Time series analysis techniques include:
[Link] Averages: Moving averages calculate the average demand over a
specified period, smoothing out short-term fluctuations. Simple moving averages
use a fixed time period, while weighted moving averages assign different weights
to each data point based on their significance.
[Link] Smoothing: Exponential smoothing assigns exponentially
declining weights to past demand observations, giving more weight to recent
data. This technique is useful for capturing short-term changes in demand.
[Link] Models: ARIMA (AutoRegressive Integrated Moving Average) models
combine autoregressive and moving average components to model and forecast
time series data. They can capture trends, seasonality, and irregularities in
demand patterns.
 Causal Methods

• Causal methods focus on identifying cause-and-effect relationships

between demand and related factors such as price, income, advertising
expenditure, or competitor’s actions. These methods use historical data on
both the dependent variable (demand) and the independent variables
(factors influencing demand). Common causal methods include:
[Link] Analysis: Regression analysis estimates the relationship
between the dependent variable (demand) and one or more independent
variables. By analyzing historical data, businesses can identify the factors
that significantly affect demand and develop a regression equation for
forecasting.
[Link] Models: Econometric models use statistical techniques to
estimate demand by incorporating economic variables, market dynamics,
and consumer behavior. These models can be complex and involve
multiple equations to capture the relationships among various factors.
 Judgmental Methods

• Judgmental methods rely on expert opinions, market surveys, or qualitative

assessments to forecast demand. These methods are useful when historical data is
limited or when demand is influenced by factors that are difficult to quantify. Some
judgmental methods include:
[Link] Research Surveys: Market research surveys collect data directly from
consumers, allowing businesses to gather insights into their preferences,
intentions, and buying behavior. These surveys can provide valuable information
for demand forecasting.
[Link] Method: The Delphi method involves collecting opinions from a panel of
experts anonymously and iteratively. The experts’ responses are aggregated and
shared with the group, leading to a convergence of opinions over multiple rounds.
This iterative process helps to achieve a consensus forecast.
[Link] Force Composite: Sales force composite involves soliciting input from the
sales team based on their knowledge of the market and customer interactions.
The sales team provides their own estimates of future demand, which are
aggregated to create a forecast.