Scope of Managerial Economics
Demand Theory
Scope of Managerial
Economics
•
•
•
•
•
Demand decision
Cost and production decision
Pricing decisions
Proft decisions
Capital decision
Demand Analysis
Demand
Analysis
Proft
Planning
Sales
Forecasti
ng
Business
Strategi
es
What is Demand?
the desire
to have
possession
the
willingness
to pay for
that
possession
Type of Demand
•
•
•
•
•
•
•
•
Individual vs Market demand.
Market demand vs Total market demand.
Company vs Industry demand.
Domestic vs National demand.
Direct vs Derived demand.
New vs Replacement demand.
Short run vs Long run demand.
Household vs Corporate vs Government
demand
Individual demand vs market
demand
• The consumer's choice to buy a
product that maximizes their
personal satisfaction refects the
individual demand.
• The market demand for goods or
service is the sum of all individual
demands.
Market demand vs Total market
demand
• An aggregate of individual's demand
from high income, middle income
and low-income group yields the
market demand.
• An aggregate of various market
segments yields the total market
demand.
Company vs Industry
demand
• The demand of an individual
company is the company's demand
and the aggregate of various
company's demand yields the
industry's demand.
Direct demand vs Derived
demand
• The demand for an item in response
to its own price is called 'direct
demand' whereas the demand for an
item is called 'derived demand'.
• For example, demand for coal leads
to derived demand for mining, as
coal must be mined for coal to be
consumed.
Law of Demand
• There is an inverse relationship between the price of a
good and the quantity of the good demanded per time
period.
• Income and Substitution Efect
• Assumptions of Law of demand:
– This law assumes the income of the consumer to be constant.
– Preference of the consumer is constant and he is ready to spend
for it even if it is expensive.
– A change in government policies will infuence demand for the
product hence this law assumes a constant government policy.
– No change in size, composition and sex ratio of population.
– Change in weather conditions is also likely to afect the demand
for a product. Therefore this law assumes a stable weather
condition.
Exceptions to the law of
demand
• Gifen's goods (normal goods vs inferior goods)
Symbol of luxury e.g. diamonds, crystal etc
• Consumer's psychology e.g. the higher the price
the better the quality according to this view
• Sale during offseason e.g. reduction ofers yet
demand is low
• Uncertain future e.g. product is uncertain in
future, people may buy more of it even in the face
of rising prices
• Expectations of consumers e.g. When prices fall,
people expect it to fall further and vice-versa
Determinants of Demand
•
•
•
•
Consumer's income.
Price of the product.
Consumer's preferences.
Prices of related goods (substitution
and complementary)
• Population and its distribution.
• Consumer's expectations about the
prices and incomes.
Demand Function
• Describes the relationship between
the demand for a commodity or
service and its determinants.
Change in Demand
• The demand function yields an Engel
curve if income is allowed to vary
while all other variables are held
constant.
• Thus a change in the factors other
than price leads to an increase or
decrease in demand and this is
called change in demand.
Contraction in Demand
• This refers to an upward movement
along the demand curve, indicating a
lowering in the quantity demand for
a given increase in the price of the
commodity.
• Thus extension and contraction
refers to downward or upward
movement along the same demand
curve.
Elasticity of Demand
• The demand function is useful for managers as
it identifes the causal variables for and the
direction of their efects on the demand for
their products.
• However, this knowledge is not enough. The
manager must know the quantitative
relationship between the demand for his
product and its determinants for taking certain
managerial decisions.
• This leads to the concept of 'elasticity of
demand'.
Elasticity of Demand
Demand for a commodity will be more elastic if:
• It has many close substitutes
• It is narrowly defned
• More time is available to adjust to a price
change
Demand for a commodity will be less elastic if:
• It has few substitutes
• It is broadly defned
• Less time is available to adjust to a price change
Types of Elasticity
•
•
•
•
Price elasticity of demand.
Income elasticity of demand.
Cross elasticity of demand.
Advertising elasticity of demand.
Price Elasticity
• It refers to the quantity demanded of a
commodity in response to a given
change in the price of the commodity.
• Importance of Price Elasticity
– A knowledge of price elasticity helps to
guide a frm whether its sales proceeds,
decrease or remain invariable under
conditions of price variations.
– It also helps the frm to estimate the likely
demand for its product at diferent prices.
Price Elasticity
The demand is said to be elastic with respect to price if the change in
quantity
demanded is more than the change in price. This implies that the
elasticity is more
than one (e > I).
The demand is said to be inelastic with respect to price when the
change in quantity
demanded is less than the proportionate change in price. This implies
that the elasticity
is less than one (e < 1).
The demand is said to be unity with respect to price when the change
in quantity
demanded is equal to the change in price (e = I).
The demand elasticity is zero when a change in price causes no
change in quantity
demanded and the demand elasticity is said to be infnity when no
reduction in price
Income elasticity
• Income elasticity refers to the quantity
demanded to the commodity in response to
a given change in income of the consumer.
• Importance of income elasticity :
– A knowledge of income elasticity of demand
helps to estimate the likely change in demand
for a product as a result of changes in national
income.
– It also helps us to know whether a commodity is
a superior good, normal or an inferior good.
Income elasticity
• The income elasticity of demand is
positive for superior goods and
negative for inferior goods.
• The income elasticity of demand is
negative, when an increase in
income leads to decrease in quantity
demanded.
Cross elasticity
• It refers to the quantity demanded for a
commodity in response to a change in the
price of a related good, which may be a
substitute or a complement.
• Importance of cross elasticity :
– It is useful in measuring the inter dependence of
demand for a commodity and the prices of its
related commodities.
– It helps to estimate the likely efect on its sales
of pricing decisions, its competitors and helpers.
Cross elasticity
• Cross elasticity is always positive for
substitute and negative for complements.
• It should be noted that greater the cross
elasticity, the more related the two goods are.
• The cross elasticity will be zero, if the two
goods have no relationship.
Advertising elasticity
• It refers to the measurement of
proportionate change in demand in
response to the proportionate
change in promotional eforts.
• Advertising elasticity is always
positive.
• Importance:
– It helps a decision maker to determine
his advertisement outlay and necessary
amount to be invested for the
Advertising elasticity
• Advertising elasticity of demand is
high when even a small percentage
change in advertising expenditure
results in a large percentage of
change in the level of quantity
demanded.
Factors Governing Elasticity of
Demand
• Nature of the product
• Tastes and preferences of the
consumer
• Time period
• Level of price
• Government policy
Importance of elasticity of
demand
• It helps:
(a)to fx the prices of factors of
production,
(b)to fx the prices of goods or services,
(c) to formulate government policies,
(d)to forecast demand, and
(e)to plan the level of output and price.
Group Assignment
• Do Case Study in e-book
“Fundamental of Managerial
Economics: Economic Application”
Page 164 – 168. Present it next week.
Scope of Managerial
Economics
•
•
•
•
•
Demand decision
Cost and production decision
Pricing decisions
Proft decisions
Capital decision
Demand Analysis
Demand
Analysis
Proft
Planning
Sales
Forecasti
ng
Business
Strategi
es
What is Demand?
the desire
to have
possession
the
willingness
to pay for
that
possession
Type of Demand
•
•
•
•
•
•
•
•
Individual vs Market demand.
Market demand vs Total market demand.
Company vs Industry demand.
Domestic vs National demand.
Direct vs Derived demand.
New vs Replacement demand.
Short run vs Long run demand.
Household vs Corporate vs Government
demand
Individual demand vs market
demand
• The consumer's choice to buy a
product that maximizes their
personal satisfaction refects the
individual demand.
• The market demand for goods or
service is the sum of all individual
demands.
Market demand vs Total market
demand
• An aggregate of individual's demand
from high income, middle income
and low-income group yields the
market demand.
• An aggregate of various market
segments yields the total market
demand.
Company vs Industry
demand
• The demand of an individual
company is the company's demand
and the aggregate of various
company's demand yields the
industry's demand.
Direct demand vs Derived
demand
• The demand for an item in response
to its own price is called 'direct
demand' whereas the demand for an
item is called 'derived demand'.
• For example, demand for coal leads
to derived demand for mining, as
coal must be mined for coal to be
consumed.
Law of Demand
• There is an inverse relationship between the price of a
good and the quantity of the good demanded per time
period.
• Income and Substitution Efect
• Assumptions of Law of demand:
– This law assumes the income of the consumer to be constant.
– Preference of the consumer is constant and he is ready to spend
for it even if it is expensive.
– A change in government policies will infuence demand for the
product hence this law assumes a constant government policy.
– No change in size, composition and sex ratio of population.
– Change in weather conditions is also likely to afect the demand
for a product. Therefore this law assumes a stable weather
condition.
Exceptions to the law of
demand
• Gifen's goods (normal goods vs inferior goods)
Symbol of luxury e.g. diamonds, crystal etc
• Consumer's psychology e.g. the higher the price
the better the quality according to this view
• Sale during offseason e.g. reduction ofers yet
demand is low
• Uncertain future e.g. product is uncertain in
future, people may buy more of it even in the face
of rising prices
• Expectations of consumers e.g. When prices fall,
people expect it to fall further and vice-versa
Determinants of Demand
•
•
•
•
Consumer's income.
Price of the product.
Consumer's preferences.
Prices of related goods (substitution
and complementary)
• Population and its distribution.
• Consumer's expectations about the
prices and incomes.
Demand Function
• Describes the relationship between
the demand for a commodity or
service and its determinants.
Change in Demand
• The demand function yields an Engel
curve if income is allowed to vary
while all other variables are held
constant.
• Thus a change in the factors other
than price leads to an increase or
decrease in demand and this is
called change in demand.
Contraction in Demand
• This refers to an upward movement
along the demand curve, indicating a
lowering in the quantity demand for
a given increase in the price of the
commodity.
• Thus extension and contraction
refers to downward or upward
movement along the same demand
curve.
Elasticity of Demand
• The demand function is useful for managers as
it identifes the causal variables for and the
direction of their efects on the demand for
their products.
• However, this knowledge is not enough. The
manager must know the quantitative
relationship between the demand for his
product and its determinants for taking certain
managerial decisions.
• This leads to the concept of 'elasticity of
demand'.
Elasticity of Demand
Demand for a commodity will be more elastic if:
• It has many close substitutes
• It is narrowly defned
• More time is available to adjust to a price
change
Demand for a commodity will be less elastic if:
• It has few substitutes
• It is broadly defned
• Less time is available to adjust to a price change
Types of Elasticity
•
•
•
•
Price elasticity of demand.
Income elasticity of demand.
Cross elasticity of demand.
Advertising elasticity of demand.
Price Elasticity
• It refers to the quantity demanded of a
commodity in response to a given
change in the price of the commodity.
• Importance of Price Elasticity
– A knowledge of price elasticity helps to
guide a frm whether its sales proceeds,
decrease or remain invariable under
conditions of price variations.
– It also helps the frm to estimate the likely
demand for its product at diferent prices.
Price Elasticity
The demand is said to be elastic with respect to price if the change in
quantity
demanded is more than the change in price. This implies that the
elasticity is more
than one (e > I).
The demand is said to be inelastic with respect to price when the
change in quantity
demanded is less than the proportionate change in price. This implies
that the elasticity
is less than one (e < 1).
The demand is said to be unity with respect to price when the change
in quantity
demanded is equal to the change in price (e = I).
The demand elasticity is zero when a change in price causes no
change in quantity
demanded and the demand elasticity is said to be infnity when no
reduction in price
Income elasticity
• Income elasticity refers to the quantity
demanded to the commodity in response to
a given change in income of the consumer.
• Importance of income elasticity :
– A knowledge of income elasticity of demand
helps to estimate the likely change in demand
for a product as a result of changes in national
income.
– It also helps us to know whether a commodity is
a superior good, normal or an inferior good.
Income elasticity
• The income elasticity of demand is
positive for superior goods and
negative for inferior goods.
• The income elasticity of demand is
negative, when an increase in
income leads to decrease in quantity
demanded.
Cross elasticity
• It refers to the quantity demanded for a
commodity in response to a change in the
price of a related good, which may be a
substitute or a complement.
• Importance of cross elasticity :
– It is useful in measuring the inter dependence of
demand for a commodity and the prices of its
related commodities.
– It helps to estimate the likely efect on its sales
of pricing decisions, its competitors and helpers.
Cross elasticity
• Cross elasticity is always positive for
substitute and negative for complements.
• It should be noted that greater the cross
elasticity, the more related the two goods are.
• The cross elasticity will be zero, if the two
goods have no relationship.
Advertising elasticity
• It refers to the measurement of
proportionate change in demand in
response to the proportionate
change in promotional eforts.
• Advertising elasticity is always
positive.
• Importance:
– It helps a decision maker to determine
his advertisement outlay and necessary
amount to be invested for the
Advertising elasticity
• Advertising elasticity of demand is
high when even a small percentage
change in advertising expenditure
results in a large percentage of
change in the level of quantity
demanded.
Factors Governing Elasticity of
Demand
• Nature of the product
• Tastes and preferences of the
consumer
• Time period
• Level of price
• Government policy
Importance of elasticity of
demand
• It helps:
(a)to fx the prices of factors of
production,
(b)to fx the prices of goods or services,
(c) to formulate government policies,
(d)to forecast demand, and
(e)to plan the level of output and price.
Group Assignment
• Do Case Study in e-book
“Fundamental of Managerial
Economics: Economic Application”
Page 164 – 168. Present it next week.