Unit II:

Utility & Demand

Analysis

DR. UMESH S. KOLLIMATH

ASSOCIATE PROFESSOR

APIMR, Landewadi, Ambegaon, Pune

 Concept of Utility
Meaning
▪Utility is the basis of the consumer demand

▪Specific meaning and use in consumer demand analysis

Absolute
• Ingrained in the commodity;
Product • Want satisfying property of a • Ethically Neutral
Angle commodity
▪Two angles
Consumer • Consumer’s satisfying feeling derive
Angle by consumption, use or possession
Subjective / Relative
• Need not be useful to all
• Varies from person to person
• Varies from time to time
 Total Utility Vs. Marginal Utility
Total Utility:

The Sum of the utility derived by a consumer from the various units of a good or
service he consumers at a point or over a period of time.

Suppose a consumer consumes four units of a good X, at a time and derives

utility from successive units of X as u1, u2, u3 and u4. His total utility (Ux)

can be measured as Ux = u1+u2+u3+u4

Marginal Utility:

The utility derived from the marginal or one additional unit consumed. It is the
addition to the total utility (TUx) resulting from consumption of one additional
unit.

Thus, it refers to the change in the total utility ∆TUx / ∆Qx where,

∆TUx = Change in Total Utility i.e., TUx with a change in Quantity (Qx) i.e.,

∆Qx
 Utility Analysis

A subset of consumer demand theory that analyses consumer behavior and market demand using total
utility and marginal utility. The key principle of utility analysis is the law of diminishing marginal utility,
which explains the law of demand and the negative slope of the demand curve.

The primary focus of utility analysis is on the satisfaction of wants and needs obtained by the consumption
of goods. This is technically termed utility. The utility generated from consumption affects the decision to
purchase and consume a good.

The specific economic use of the term utility in the study of consumer behavior means the satisfaction of
wants and needs obtained from the consumption of a commodity. The good consumed need not be "useful"
in the everyday sense of the term. It only needs to provide satisfaction.
 Law of Diminishing Marginal Utility

The first unit of consumption of a good or service yields

more utility than the second and subsequent units, with a
continuing reduction for greater amounts. Therefore, the fall
in marginal utility as consumption increases is known as
diminishing marginal utility. This concept is used by
economists to determine how much of a good a consumer is
willing to purchase.
 The Concept of Demand
What is Demand?
Demand is an economic principle referring to a consumer's desire to
purchase goods and services and willingness to pay a price for a
specific good or service. Holding all other factors constant, an
increase in the price of a good or service will decrease the quantity
demanded, and vice versa. Market demand is the total quantity
demanded across all consumers in a market for a given good. Aggregate
demand is the total demand for all goods and services in an economy.
 Law of Diminishing Marginal Utility
Definitions:

“The additional benefit which a person derives from a given increase in his stock
of a thing diminishes with every increase in the stock that he already has.” -
Alfred Marshal

“For any individual consumer, the value that he attaches to successive units of a
particular commodity will diminish steadily as his total consumption of that
commodity increases” – Prof. Richard G. Lipsey

Thus, more the consumption of a commodity, lesser will be the total utility
derived thereby!
Assumptions:

1. various units of a commodity are homogeneous.

2. There is no time gap between the consumption of different units.
3. Every consumer wants to maximize utility.
4. The tastes and preferences of the consumer remain the same during
the period of consumption.
5. Marginal Utility of the money remains the same.
For instance:

Units of Total Marginal

Commodity Utility Utility
(Apple)
1 20 20
2 37 17
3 51 14
4 62 11
5 68 6
6 68 0
7 64 -4
8 50 -14
• Total utility (TU) increases up
to 5th Unit

• Increase in diminishing rate

• Total Utility is Max. at 6th Unit

• Marginal Utility (MU) is

decreasing

• MU is zero for 6th Unit.

• Therefore, MU curve cuts X

axis at the 6th Unit.

• MU curve slopes downwards.

Source: A Reddy & Shanthi, 2013

 Why MU curve slopes downwards?

Even though the human wants (in aggregate) are unlimited, yet, a particular want can be fully satisfied.
Therefore, when a person consumes more units of a given commodity, his want is satisfied and at a stage, he
doesn’t want any more of the commodity.

Thus, Marginal Utility (MU) decreases with the increase in the consumption units.

Suppose, a commodity could be substituted for different commodities, it’s Marginal Utility increases.
Limitations of Law of DMU:

(1) Homogeneity

(2) No Time Gap

(3) No change in the Tastes / Preferences

(4) Normal Persons

(5) Constant income

Applications:

1. Price Decisions

2. Water – Diamond Paradox

3. Downward slope of Demand Curve

4. Direct Tax Policy

Exceptions:

1. Alcoholics

2. Misers

3. Money

4. Reading

5. Hobbies / Rare Collections

6. Fine Arts (Music, Literature, etc.)

 Cardinal Utility & Ordinal Utility
Distinguishing Point Cardinal Utility Ordinal Utility
Who proposed the idea Classical Economists: Jeremy Bentham, Modern Economist: J.R. Hicks,
Leon Walrus, carl Menger, etc. R.G.D. Allen,
Neo Classical Economists: Alfred
Marshal,

Belief Utility can be cardinally measured Utility can only be expressed

quantitatively like height, Weight, etc. ordinally

Measure Util (1 Util = 1 Unit of Money) No Measure possible.

Assumed that Utility of Money remains Ordinal expression like ‘less
constant than’ or ‘more than’
 Indifference curve
Meaning:
▪The Utility analysis has a serious shortcoming by believing in Cardinal Utility
▪Marginal Utility Analysis boasts too much and explains too little.
▪Prof. Hicks & Allen proposed “Indifference Curve Analysis” alternatively
An indifference Curve may be defined as the locus of points each representing a
different combination of two substitute goods, which yield the same utility or
level of satisfaction to the consumer. So, consumer is indifferent between any two
combinations of the two goods, when it is required to make choice between them.
An indifference curve can also be defined as a graphic representation of the
various quantities of two goods that will yield equal satisfaction.
 Indifference
curve Analysis
Combination Commodi Commodi Total
Indifference Schedule ty Y ty X Utility
a 25 3 U
Let’s suppose that a b 15 5 U
consumer consumes two
goods, X and Y. The last c 8 9 U
column in the
d 4 17 U
Indifference Schedule
gives undefined utility e 2 30 U
(U) derived from various
combinations of X and Y
(i.e., a, b, c, d, e).
 Indifference
curve Analysis
The consumer derives same
level of satisfaction from the
combinations.
When these combinations are
plotted and joined by a smooth
curve, Indifference Curve is
formed. By definition, any point
on this curve shows
combinations of X and Y that
yield same level of satisfaction.
So, the consumer is indifferent
between the points located on
this curve.
It is to be noted that the points along the
indifference curve by no means are the only
combinations of commodities X and Y. The
consumer may make many other
combinations with less or more of one of the
both commodities, yielding same level of
satisfaction but less than that indicated by
the curve IC.
Let’s say, if we have f, g, h as the
combinations below IC, then we would have
another indifference curve indicating lesser
satisfaction
On the other hand, indifference curve drawn
by joining j, k, l may derive satisfaction
greater than IC.
This process can be repeated several times
to generate a set of indifferent cuves giving
different levels of satisfaction, such as IC1,
IC2, IC3, IC4,…..so on.
This is called Indifference Map.
 Properties of Indifference Curves
1. Indifference Curves have a negative slope
2. Indifference Curves of imperfect substitutes are convex to the origin
3. Indifference Curves do not intersect nor are they tangents to each other.
4. Upper Indifference Curve indicates higher level of satisfaction.
Thus, indifference Curves can reveal consumer behavior, his choices, and
preferences and therefore, very important in the business decision-making.
 Budget line
Budget line (also called as Price
Line or Income line) represents:
Maximum quantities of two given
commodities (e.g., Apple and
Mango) at a given level of income
and prices.
It shows all the possible
combinations of two goods that
the consumer can buy at a given
level of income and prices of two
goods.
AB in the diagram depicts
budget line that indicates all
possible combinations of Apple
and Mango.
 Consumer Surplus
First proposed by Dupuit in 1844

Further developed by Alfred Marshal in 1879 – “Pure Theories of Domestic Values”

Used to indicate consumer gains by means his / her purchases.

Consumer expectation : Dissatisfaction of paying money < satisfaction of having the product

Thus, Consumer Surplus can be measured as the difference between maximum price the consumer is
willing to pay for a commodity and the actual market price charged for it.
 Consumer
Surplus
If OP is the price, OQ is the quantity
purchased, the Marginal Utility (MU) of
OQ would be the price OP.
Then, total money paid =OP X OQ
= OPTQ
But Total Utility (TU) = OMTQ
i.e., price, the consumer is ready to
pay)
Therefore, Consumer Surplus
C.S= OMTQ- OPTQ = MTP
 Unit of Marginal Market Consumer’s
Consumer Commodity
A
Utility
MU
Price
Rupees
Surplus = Price
Prepared to Pay
Surplus (MU) – Actual
Market Price
The excess of price which 1 70 20 70-20 = 50
a consumer would be
willing to pay for a 2 60 20 60-20 = 40
quantity of a commodity 3 44 20 44-20 = 24
and the amount he
actually had to pay for it. 4 20 20 20-20 = 00
This concept is based on Total 4 TU=194 80 194-80=114
the law of diminishing Units
marginal utility (DMU)-
Alfred Marshal
Thus, from the above table,

Consumer Surplus

C.S.= Total Utility – Actual (Market) Price

= 194 – 80

= 114
 Assumptions of Consumer Surplus
1. It is assumed that utility to gain from the purchase can be measured numerically (Cardinally).

2. The concept is based on the law of diminishing marginal utility. Thus, includes citeris paribus
assumptions.

3. It is also assumed that the Marginal Utility of money is constant.

4. The concept assumes that the commodity in question doesn’t have any substitutes.

5. Each commodity is assumed as an independent of other goods.

 Consumer Equilibrium
In Utility Analysis, consumer attains equilibrium whenever utility of
commodity = price i.e., Marginal Utility = Price
We need a different approach in Indifference Curve Analysis to arrive
at Consumer Equilibrium.
There are four indifference curves in the diagram
Price line AB indicates expenditure on two commodities
Any point on AB indicates combination of two commodities leading to
maximum satisfaction.
Therefore, any point of an indifference curve lying on AB must be leading
to maximum satisfaction and is said to be the point of Consumer
Equilibrium.
In the diagram R is a point the consumer has a combination of (ON)
Apples and (OM) Mangoes leading to consumer equilibrium.
 Conditions for Consumer Equilibrium

▪Marginal Rate of substitution and the ratio between the prices of two commodities must be equal

▪The Marginal Rate of Substitution (MRS) must be falling, indifference curve must be convex to

origin

▪The slope of the Price Line and that of the Indifference Curve must coincide.
 Concept of Demand
Meaning:

▪Attitude of Consumers towards the product

▪Attitude gives rise to actions

▪Thus, demand for a commodity is the amount of it that a consumer purchase or will be ready to takeoff
from the market at various prices at a given time.

▪Demand in economics is….

Desire + Ability to Pay + Willingness to Pay

 Types of Demand,

1. Producers’ goods and consumer goods,

2. Durable and non-durable goods,

3. Derived Demand & Autonomous Demand

4. Industry Demand & Company Demand

5. Short-run demand & & Long-term demand

Determinants of Demand
 Law of Demand
Background & Statement:

▪Based on the Law of Diminishing Marginal Utility

▪Establishes relationship between the quantity demanded and price

▪The general experience in the marketplace is that as the price of a commodity falls, quantity demanded goes
up and vice versa.

“The amount demanded increases with a fall in price and diminishes with a rise in price”

-Alfred Marshal

“The law of demand states that often things being equal, the quantity demanded per unit of time will be greater,
lower is the price; and smaller, higher is the price.”

-Richard A Bilas

Other things being equal, demand varies inversely with price

 Law of Demand-Assumptions
According to Stigler & Boulding……

1. There should be perfect competition in the market

2. There should be no change in the income of the consumers

3. There should be no change in the tastes and preferences of the consumers

4. Price of the related commodities should remain unchanged

5. The commodity should be a normal one

6. The size of population should not change

7. There should be no expectation of rise in price of related goods.

 Demand Schedule
TABLE I TABLE II

Price Individual Demand Price Market Demand

Schedule Schedule
Rs. 10 1 Unit Rs. 10 10,000 Units
Rs. 8 2 Units Rs. 8 20,000 Units
Rs. 6 4 Units Rs. 6 40,000 Units
Rs. 4 8 Units Rs. 4 80,000 Units
Rs. 2 14 Units Rs. 2 14,00,000 Units
 Law of Demand

The Demand Curve (DD) simply shows the

relationship between the price, and the
quantity of the commodity demanded. The
demand curve slopes left to right
downwards, indicating that when price rises,
lower amount of the commodity is purchased
and when price falls, more of the commodity
is demanded. The slope of the demand curve is
negative because as the price declines, more
quantity is demanded.
As a convention, Quantity demanded is shown
on X axis and Price on the Y axis.
Demand Curve is also known as Average
Revenue (AR) Curve
Chief Characteristics of Law of Demand:

1. The Law states that demand varies inversely with price, not necessarily
proportionately.

2. Price is an independent variable while the quantity demanded is a dependent

variable.

3. The law depends upon certain conditions such as constancy in tastes and
preferences, income of individuals, prices of substitutes, etc. If they change,
demand may also change.
 Giffen Paradox

Fear of shortage

Veblen Effect

Ignorance of buyers

Expectation of price rise

Exceptions to the Law of Demand

 Giffen Paradox

(i) Sir Robert Giffen observed in 19th Century Ireland,

which was a poor country, that people spent major
portion of their income on bread and a very small
portion on meat.
When the price of bread rose, they increased the
spending on bread and almost stopped buying meat!
(ii) Giffen Goods – Inferior Goods
a Giffen good is a product that people consume more
of as the price rises and vice versa—violating the
basic law of demand!
 ⮚ There are some commodities which are purchased by upper
sections of the society for their snob appeal or ostentation.
⮚ Some people may buy more of such goods, when the price of
the goods rise!

Veblen ⮚ Conspicuous Consumption

⮚ Veblen Goods: Generally sought after by affluent consumers
Effect who place a premium on the utility of the good.
Some other exception to the law of demand:

Fear of Shortage: When there is a speculation about imminent shortage, people

resort to panic-buying!

Ignorance of buyers: Sometimes people buy goods at a higher price out of

ignorance.

Expectation of Price rise: In the speculative market, a rise in price of shares and
stocks is generally followed by large purchases! Price rises of some commodities
lead to the speculation that, the prices would further rise, thereby inducing them
to rush and buy more!
 Change in
Demand

Expansion & Contraction

Vs.
Increase & Decrease
Reasons for increase / decrease in demand:
▪People’s taste and preferences change for goods

▪Consumers’ income changes

▪Price of substitutes change

▪Price of complimentary goods change

▪Propensity to consume a certain good may change

▪Population increases

▪Transfer of payments
 Elasticity of Demand
❑ The elasticity of demand refers to the degree of responsiveness of quantity demanded to a change in its
price, income of the people, price of related goods, advertising, etc.

❑ “The elasticity (or responsiveness) of demand in a market is great or small according to the amount
demanded increases, much or little for a given fall of in price and diminishes much or little for a given
rise in price” – Alfred Marshal

❑ The term ‘elasticity’ refers to the degree of correlation between price (or other determinants) and
demand.

❑ Thus, ‘elasticity of demand’ of a commodity is the measure of its responsiveness to a change in any of
its market determinants.
 Types of Elasticity of Demand

▪Price Elasticity of Demand

▪Income Elasticity of Demand
▪Cross Elasticity of Demand
▪Advertisement Elasticity of Demand
 Price Elasticity of Demand
It can be defined as “ proportionate change in quantity demanded in response to proportionate
change in price.”

Thus, Price Elasticity =

Proportionate Change in quantity demanded / Proportionate change in Price

Therefore,

= Change in quantity demanded / quantity demanded

Change in Price / Price

We can express the above mathematically as..

ep = ∆q / q ÷ ∆p / p

= ∆q / q × p / ∆p

Therefore, ep = ∆q / ∆p × p / q

Where, ep = price elasticity

q = quantity demanded at

P = Price of the commodity

∆ represents change
Price elasticity can also be calculated with the help of following formula:

Price Elasticity =

Percentage change in quantity demanded / Percentage change in the price

Thus, the formula can be re-written as….

ep = % ∆q / % ∆p
Types of Price Elasticity
Perfectly Elastic Demand

▪ When a small percentage change in the price

leads to large percentage change in the
quantity demanded

▪ Shape of the demand curve is horizontal to X

axis

▪ ep = ∞

▪ Applicable only to perfect competition

Perfectly Inelastic Demand

▪ Also called Zero Elasticity

▪ Whatever may be the price rise, demand remains

same

▪ Examples: Table salt, Matchbox, etc.

Relatively Elastic Demand
▪ More realistic Concept
▪ The relatively elastic demand curve
is downward sloping and gradual.
▪ For a relatively smaller price
change, quantity demanded changes
in a large quantity.
▪ Examples: Fashion goods, Luxury
goods, lifestyle goods.
Relatively Inelastic Demand
The relatively inelastic demand curve
is downward sloping and steeper
For a relatively higher price change,
quantity demanded changes in smaller
proportion
Examples: Necessities- Staple food
items, Electricity, Gas, Oil, Water, etc.
 Unitary Elastic Demand
▪ Change in quantity demanded for a
commodity occurs at the same proportion as
change in it’s price.
▪ i.e., for one unit change in the price, there is a
change in quantity demanded by one unit.
▪ ep = 1
▪ The demand curve is a rectangular hyperbola
 Measurement of Price Elasticity
▪For practical purposes, it is not enough to know relativity of the concept ‘elasticity’

▪It is necessary to measure elasticity

▪There are four methods to measure elasticity:

-Total outlay method

-Proportional Method

-Geometric Method (Point method)

-Arc method
 Total Outlay Price of the Quantity Total Outlay
Method commodity Demanded (Revenue)
1 Rs. 10 5 kg 50
According to the method, we e>1
2 Rs. 8 8 kg 64
compare total outlay of the
purchaser (or total revenue 3 Rs. 6 12 kg 72
i.e., total value of sales from e=1
the point of view of the seller) 4 Rs. 4 18 kg 72
before and after the variation 5 Rs. 2 32 kg 64
in price. In this method, it is e<1
possible to find out whether 6 Rs. 1 50 kg 50
elasticity is unity, less than
one or more than one.

-
 Total Outlay
Method
When e = 1
The total amount spent on a
commodity remains the same
even though the price has
changed.
When e >1
Total Outlay (Total Revenue)
It means that money spent on
the purchase of a commodity
increases when price of the
In the above diagram, the curve AB represents elasticity of demand greater
commodity falls and vice-versa.
than unity (ep >1), indicating that, with every fall in the price, both the
When e < 1 quantity demanded, and total outlay would increase.
The curve BC represents no change in the total outlay though there is change
It means that total amount spent in the price and hence ep = 1.
increases with every rise in price The CD represents elasticity of demand les than one (ep < 1). It indicates
and decreases with every fall in that with the fall in price, though the quantity demanded increases, the total
price. outlay falls.
 Geometric /
Point Method
ep > 1
This method measures elasticity
at a given point on a demand
curve. It takes into consideration a
straight-line demand curve and
measures elasticity at different
points on the curve. Elasticity of ep < 1
demand is different at different
points of demand curve, as it is a
relative measure of change. The
formula is: ep =
Lower Segment
Upper Segment
At point C, the elasticity of demand is greater than one. And hence demand is elastic.
i.e., in BC / CA, BC > CA
At the point E the elasticity of demand is equal to unity, because at this point BE=EA
At point D, the elasticity of demand is less than Unity, and hence demand is relatively
inelastic.
i.e., in BD/DA, BD < DA.

At the top left i.e., at point A on the Y axis, elasticity of demand is infinity (∞) OR
perfectly elastic demand
Likewise, at bottom right, point B on X axis elasticity of demand is zero (0) OR
perfectly inelastic demand.

Note: Often we get demand line as curves and not straight lines; then a tangent can be
drawn (on the point at which elasticity is to be measured).
Arc Method
Point Method is advantageous when changes in price and
quantity demanded (∆P and ∆Q) are small.
For larger ∆P and ∆Q, Arc method is useful.
The formula is as follows:
Arc Elasticity Ea = Change in Demand
Original Demand + New Demand
Change in Price “Arc elasticity is a measure of the average
responsiveness to price change exhibited by a
Original Price + New Price demand curve over some finite stretch of the curve”
– Prof. Baumol
Thus, Arc elasticity can be mathematically expressed as below:

Q – Q1 ÷ P – P1

Q + Q1 P + P1

Where P, Q represent original price and quantity

and P1, Q1 represent new price and quantity respectively

 ▪ Nature of the Commodity
▪ Extent of use
▪ Substitutes
▪ Durability
Factors
▪ Income Spent (Proportion of Expenditure to Income)
determining ▪ Income Group
Price Elasticity ▪ Habits and Conventions
▪ Postponement
▪ Time
 Business Applications
The concept of price elasticity of demand of great importance for business and government :

▪Provides important inputs for managerial decision making

▪Helps in pricing decisions

▪Inputs to the government for framing taxation policies

▪Terms of Trade in International Trade

▪Decisions regarding factor payments

▪Helps labour unions in bargaining for wages / bonus, etc.

▪Guides government on which industries must be kept in its control

▪Foreign Currency Management

▪Explains the “Paradox of Poverty”

 Income Elasticity of Demand
It can be defined as…

“The ratio of proportionate change in the purchase of goods to the proportionate change in income”

Income Elasticity = Proportionate change in purchase of a commodity

◦ Proportionate change in income
For most products, most of the time, the income elasticity of demand is positive: that is, a rise
in income will cause an increase in the quantity demanded. This pattern is common enough that
these goods are referred to as normal goods. However, for a few goods, an increase in income
means that one might purchase less of the good; for example, those with a higher income might
buy lesser foodgrains, because they are buying more dry-fruits, or those with a higher income
might buy branded goods instead of local products. When the income elasticity of demand is
negative, the good is called an inferior good. The concepts of normal and inferior goods were
introduced in the Supply and Demand module. A higher level of income for a normal good
causes a demand curve to shift to the right for a normal good, which means that the income
elasticity of demand is positive. How far the demand shifts depends on the income elasticity of
demand. A higher income elasticity means a larger shift. However, for an inferior good—that is,
when the income elasticity of demand is negative—a higher level of income would cause the
demand curve for that good to shift to the left. Again, how much it shifts depends on how large
the (negative) income elasticity is.
Types of Income Elasticity

There are various types of Income Elasticity :

a. High Income Elasticity
b. Unitary Income Elasticity
c. Low Income Elasticity
d. Zero Income Elasticity
e. Negative Income Elasticity
(a) High Income Elasticity (Ed >1)

▪Other things remaining same,

▪Proportionate change in Quantity(Q) demanded is greater than proportionate

change in Income (Y)

▪Positive relation between ∆Q and ∆Y i.e., as the income increases the

demand for the given commodity increases and vice versa.

▪Demand Curve is flatter

(b) Unitary Income Elasticity (Ed = 1)

▪Proportionate change in the Quantity demanded of a given commodity is equal to

proportionate change in the income.

▪The demand curve forms 45◦ angle with the axes.

(c) Low Income Elasticity: (Ed < 1)

▪Proportionate change in quantity demanded of a given commodity is less than the

proportionate change in the Income.

▪The demand curve is steeper

(d) Zero Income Elasticity: (Ed = 0)

▪When change in income do not bring about any change in in quantity demanded
of a given commodity i.e., quantity demanded remain the same

▪Demand curve is vertical to X axis.

(e) Negative Income Elasticity

▪If the demand for a commodity decreases with an increase in income.

▪The demand curve will be sloping downward

The following table gives a clear idea regarding different types of Income Elasticity:

Nature of the Type of Income Examples

Goods Elasticity
1. Normal Positive Fruits, Vegetables, etc.
Goods
2. Inferior Negative Millets, public bus service,
Goods etc.
3. Luxury Positive > 1 AC, Cars, etc.
Goods
4. Essential Positive < 1 Food grains, etc.
5. Neutral Zero Salt, Matches, etc.
 Applications of Income Elasticity

1. To classify normal and inferior goods. (refer above slide)

2. To know about stage of trade cycle.

Demand for normal goods increases during prosperity and decreases during
regression. Conversely, demand for inferior goods increases during regression and
decreases during prosperity. However, demands for goods that are necessary for our
day to day lives are not much affected during prosperity as well as during
regression.

3. For forecasting demand

4. To determine price
 Cross Elasticity of Demand
❑Most of the goods the we consumer are related- They have either substitutes or complements

❑Substitutes are replaced by each other (Any Examples?)

❑Complements are consumed / used with each other. (Any Examples?)

❑The concept of elasticity can be extended to the related the goods as the change in price of one
good influences quantity demanded of other goods.

“Cross Elasticity of demand is defined as the ratio of the percentage change in demand for one
good to the percentage change in price of other goods.”
 Applications of Cross Elasticity
Cross elasticity of demand can only be measured between any two goods at a time, and the outcome is
the representation of the relationship shared by those two goods.

❑Cross elasticity is greater than zero when rise in price of commodity Y causes rise in demand of
commodity X. Such type of response can be observed in substitute goods such as fresh juices and soft-
drinks.

❑Cross elasticity is less than zero when rise in price of commodity Y causes fall in demand of commodity
X. Such type of response can be seen in complementary goods such as tea and sugar.

❑Cross elasticity is equal to zero when rise in price of commodity Y does not cause any effect on the
demand of commodity X. This type of response can be seen in goods that are not related to each other such
as sugar and shoe.
 Demand Forecasting
Meaning:
⮚Related to prediction of demand of goods / services for a period.

⮚Scientific and Quantitative guesswork.

⮚Effective for managerial decision-making, planning.

⮚Selecting prominent market determinants of demand, a demand equation can be

built, and demand can be predicted more precisely.

Demand Forecasting refers to the prediction or estimation of a future

situation under given constraints.
 Time Period of Demand Forecasting
Demand Forecasting can be carried out for three
distinct Time Periods:

Short Term (Up to 1 Year)

-Policies regarding sales, purchases, pricing and finances

Short Term
Medium Term

-When a good is influenced by medium term trade cycle

variations. E.g., Garment manufacturers / Engineering
Medium Term
goods.

Long Term (Beyond 1 Year)

-Planning new units / expansion, Issuing IPOs, Shares,

Long Term
debentures, hiring additional workforce, etc.
 Time Period

Levels of Forecasting

Purpose

Methods of Forecasting

Nature of Commodity

Nature of Competition

Factors involved in
Demand Forecasting
 Criteria for Good Demand Forecasting
In order to make demand forecasting realistic, the following criteria must be followed:

(i) Accuracy - data

(ii) Plausibility -

(iii) Durability

(iv) Availability

(v) Economy
Methods of Demand Forecasting

Methods of Demand
Forecasting

Survey Method Statistical Methods

1. Trend Projection
1. Consumer Survey
2. Moving Averages
2. Expert Opinion
3. Regression
3. Controlled Experiments
4. Barometric Method
4. Simulated Market
5. Economic Indicators