Module 2

Demand Analysis

Meaning of Demand
The concept demands refers to the quantity of a good or service that consumers are willing and
able to purchase at various prices dealing a period of time. The demand in economics is something
more than desire to purchase through desire is one element of it. A beggar for instance, may desire
food, but due to lack of means to purchase it, his demand is not effective. In economics, demands
refer to effective demand, which implies three things:
 Desire
 Means to purchase
 On willingness to use those means for that purchase. The demand for a commodity at a
given price is the amount of it, which will be bought per unit of time at that price.

Meaning of Demand Analysis

There are a large number of factors, which have a direct impact on the demand of a commodity
or service. Demand analysis means the study of factors, which influence the demand of a
commodity or service. It is only on the basis of these factors or determinants of demand one can
forecast demand. Under demand analysis we study elasticity of demand and methods of its
measurement, sales forecasts and different methods to forecast sales or demand, manipulating
demand and appropriate change in allocation of resources. Analysis of demand enables the
producer to adjust his production to the demand to maximize the objective function.

Objectives of Demand Analysis

1) To study and analyze the determinants of demand.
2) To measure the elasticity of demand.
3) To prepare sales or demand forecasts.
4) Manipulating demand.
5) To make appropriate changes in allocation of resources.

Types of Demand

1. Individual and Market Demand: The quantity of a commodity which an individual is

 willing to buy at a particular price of the commodity during a specific time period, given
his money income, his taste, and. prices of other commodities (particularly substitutes and
complements), is known as 'individual's demand' for a commodity.The total quantity which
all the consumers of a commodity are willing to buy at a given price per time unit, given their
money income, taste, and prices of other commodities (mainly substitutes) is known .as 'market
demand' for the commodity. In other words, the market demand for a commodity is the sum of
individual demands by, the consumers (or buyers) of the commodity, over a time period, and at a
given price, other factors remaining the same.

2. Demand for Firm's Product and Industry's Products: The quantity of a firm's produce
that can be disposed of at a given price over a time period denotes the demand for the 'firm's
product', The aggregate of demand for the product of all the firms of an industry is known as the
market demand for `industry's products.

3. Autonomous and Derived Demand: Autonomous Demand for a commodity is one

that , arises independent of the demand for any other commodity whereas derived demand is
one that is tied to the demand for some 'parent product'. Demand for food, clothes, shelter etc. is
autonomous demand. Demand for land, fertilizers, and agricultural tools and implements are a
derived demand, for these goods are demanded because food is demanded.

4. Demand for Durable and Non-durable Goods: Demand is often classified also under
demand for durable and non-durable gas. Durable goods are those, whose total utility (or use)
is not exhausted by a single use. Such goods can be used repeatedly or continuously over a
period. Durable goods may be consumer as well as producer products. Durable consumer
goods include clothes, shoes; owners occupied residential` houses, furniture, utensils,
refrigerators, scooters, cars, etc. The durable producer goods include mainly the items under
'fixed assets', such as building, plant, machinery, etc. Nondurable goods on the other hand, are
those, which can be used or consumed' only once (e.g., food items) and their total utility is
exhausted in a single use.

5. Short-term and Long-term Demand: Short-term demand refers to the' demand for such
goods as are demanded over a short period. In this category fall mostly the fashion consumer
goods, goods of seasonal use, and inferior substitutes during the scarcity period of superior
goods, etc.
6. The long-term demand, on the other hand, refers to the demand, which exists over a long
period. The change in long-term demand is perceptible only after a long period. Most
generic goods have long-term demand. For example, demand for consumer and
producer goods, durable and non-durable goods, is long-term demand, though their
different varieties or brands may have only short-term demand.

7. Joint Demand and Composite Demand: When two or more goods are jointly demanded at
the same time to satisfy a single want it is called joint or complementary demand. There
is joint demand for cars and petrol, pens and ink, tea and sugar, etc. 'A commodity is said to
have composite demand when it can be put to several alternative uses. This is not only
peculiar to commodities like leather, steel, coal, paper, etc. but also to factors of production
like land, labor and capital. For example, coal is demanded by railways, by factories, by
households, etc.
8. Direct and indirect Demand: Demand for goods that are directly used for consumption by
the ultimate consumer is known as direct demand. Since such goods are used for final
consumption, such demand is also called consumer's goods demand. Demand for all
consumers' goods such as bread, tea, readymade shirts, scooters, houses is direct demand.
Indirect demand is the demand for goods that are not used by consumers directly. They are
used by producers for producing other goods. So indirect demand is also known as producer's
goods demand.
9. Total Market and Market Segment Demand: The total market demand will be aggregate
demand for the product from all the segments while market segment demand would refer
demand for the product in that specific market segment. Demand analysis requires not only
the total demand for a product .but also a breakup of the demand for the product in different
parts of the market. The market may be segmented on the basis of age, sex, geographical
region, etc. Thus, while the demand for Vadilal ice cream in India is total. market demand,
demand for Vadilal ice cream in Rajasthan or demand for Vadilal ice cream by women is a
market segment demand.
Determinants of Demand
The main demand determinants are price, income, price of related good and advertising. Therefore,
demand is a multivariate relationship, i.e. it is 'determined by many factors simultaneously.
1. Price of the Commodity: The law of demand states that if other things remain the same the
demand of the commodity is inversely related to its Price. It implies that a rite in price of a
 commodity brings about a fall in its purchase and vice-versa. This happens because of income
and substitution effects.
2. Income of the Consumer: The income of the consumer is another important variable which
influences demand. The ability to buy a commodity depends upon the income' of the consumer.
When the income of the consumers increases, they buy more and when income falls they buy
less. A rich consumer demands more and more goods because his purchasing power is high.
3. Tastes and Preferences: The demand for a product depends upon tastes and preferences of
the consumers. If the consumers develop taste for a commodity they buy whatever may be
the price. A favorable change in consumer preference will cause the demand to increase.
Likewise an unfavorable change in consumer preferences will cause the demand to decrease.
4. Prices of Related Goods: The related goods are generally substitutes and complementary
goods. The demand for a product is also influenced by the prices of substitutes and
complements,: When a want can be satisfied by alternative similar goods they are called
substitutes, such as coffee and tea: When commodities are complement, 'a fall in the price
of one (other things being equal) will cause the demand of the other to rise such as car and
petrol. Thus, the price of one good and the demand for another are inversely related.
5. Advertisement and Sales Propaganda: In modern times, the preferences of consumers
can be altered by advertisement and sales propaganda. Advertisement helps in
increasing demand by informing the potential consumers about the availability of the
product, by showing the superiority of the product, and by influencing consumer choice
against the rival products. The demand for products like detergents and cosmetics is mainly
caused by advertisement.
6. Consumer's Expectation: A consumer's expectation about the future changes in price and
income may also affect his demand. If a consumer expects a rise in prices he may buy large
quantities of that particular commodity. Similarly, if he expects its prices to fall in future,
he will tend to buy less at present. Similarly, expectation of rising income may induce to
increase his current consumption.
7. Growth of Population: The growth of population is also another important factor that
affects the market demand. With the increase in population, people naturally demand more
goods for their survival.
8. Weather Conditions: Seasonal factors also affect the demand. The demand for certain items
purely depends on climatic and weather conditions. For example, the growing demands for
 cold drinks during the summer season and the demand for sweaters during the winter season.
9. Tax Rate: The tax rate also affects the demand. High tax rate would generally mean a low
demand for the goods. At certain times the government restricts the consumption of a
commodity and uses the tax as a weapon. A highly taxed commodity will have a lower
demand.
10. Availability of Credit: The purchasing power is influenced by the availability of credit.
If there is availability of cheap credit, the consumers try to spend more on consumer
durables thereby the demand for certain products increase.
11. Pattern of Saving: Demand is also influenced by the pattern of saving. If people begin to
save more, their demand will decrease. It means the disposable income will be less to
purchase the goods and services. On the contrary, if saving is less their demand will increase.
12. Circulation of Money: An expansion or a contraction in the quantity of money will affect
demand. When more money circulates among the people, more of a thing is demanded by the
people because they have more purchasing power, and vice versa.

Demand Function

The demand function is an algebraic expression of the relationship between demand for a
commodity and its various determinants that affect this quantity.

There are two types of demand functions:

1. Individual Demand Function: An individual's demand function refers to the quantities of a

commodity demanded at various prices, given his income, prices of related goods and tastes.
It is expressed as: D=f(P)

2. Market Demand Function: An individual demand function is the basis of demand

theory. But it is the market demand function that is main interest to managers. It refers to the
total demand for a good or service of all the buyers taken together. The market demand
function may be expressed mathematically thus,

Dx = f ( Px, Pr, M, T, A, U)

Where, Dx = Quantity demanded for commodity x

f = functional relation
Px = Price of commodity x
 Pr = Prices of related commodities, i.e., substitutes and complementaries
M = the money income of the consumer
T = the taste of the consumer
A = the advertisement effect
U = Unknown variables

Law of Demand
Law of demand explains the relationship between change in quantity demanded and change in price. It
states that higher the price, the lower would be the quantity demanded in the market; and the lower
the price, the higher would be the quantity demanded in the market. In other words, the law of demand
says that the price and the quantity demanded are inversely related, all other things being equal.
According to Marshall, "the amount demanded increases with a fall in price, and diminishes with a
rise in price". Thus it expresses an inverse relation between price and demand. The law refers to the
direction in which quantity demanded changes with a change in price.

Assumptions of the Law of Demand

1. Income Level should Remain Constant: The law of demand operates only when the income
level of the buyer remains constant. If the income rises while the price of the commodity in
question does not fall, it is quite likely that the demand may increase. Therefore, stability in
income is an essential condition for the operation of the law of demand.
2. Tastes of the Buyer Should .not Change: Any change that takes place in the tastes of the
consumers will in all probability prevent the working of the law of demand. It often happens
that when tastes or fashions change people revise their preferences.
3. Prices of Other Goods Should Remain Constant: Changes in the prices of other goods often
affect the demand for a particular commodity. If prices of commodities for which demand is
inelastic rise, the demand for a commodity other than these in all probability will decline even
though there may not be any change in its price. Therefore, for the law of demand to operate it is
very necessary that prices of other goods do not change.
4. No New Substitutes for the Commodity: If some new substitutes for a commodity appear in
the market, its demand generally decline. This is quite natural, because with the availability of
new substitutes some buyers will be attracted towards new product and the demand for the
older product will fall even though price remains unchanged. Hence, the law of demand operates
 only when the market for a commodity is not threatened by new substitutes.
5. Price Rise in Future should not be expected: If the buyers of a commodity expect that its price
will rise in future they raise its demand in response to an initial price rise. This behavior of
buyers violates the law of demand. Therefore, for the operation of the law of demand it is
necessary that there must not be any expectations of price rise in future.
Given these assumptions, the law of demand is explained in terms of demand schedule and a demand
curve.
Demand Schedule and Demand Curve

Demand Schedule: Demand Schedule is a table or a chart which shows the relationship between
price and demand of commodity or service unit of time. If we list the different, quantities of a
commodity demanded at different prices in the form of row and. column, the resulting format is:
demand Schedule. In other words, demand schedule establishes a functional relationship between
independent variable price and dependent variable demand.
Demand Schedule
Commodity Price (Rs.) Quantity Demanded
P 5 100 Units
Q 4 200 Units
R 3 300 Units
S 2 400 Units
T 1 600 Units

D e m a n d C u r v e : The graphical representation of the demand schedule is the demand curve.

Individual demand curve indicates the quantity of the commodity that an individual will buy at different
prices. It is customary in economics to measure a price along 'Y' axis and quantity demanded on 'X' axis.
The curve slopes downward. Any point on the graph indicates a single price quantity relation. The whole
demand curve DD1 shows the quantity of commodity, say Orange that would be bought by an
individual at different prices.
In the figure, point' P of the demand curve DD1 shows demand for 100 units at the Rs. 5. As the
price falls to Rs. 4, Rs. 3, Rs. 2 and Re. 1, the demand rises to 200, 300, 400 and 600 units respectively.
This is clear from points Q, R, S, and T. Thus, the demand curves DD1 shows increase in demand of
orange when its price falls. This indicates the inverse relation between price and demand.

Exception to the Law of Demand

According to law of demand, more of a commodity will be demanded at lower prices, than at
higher prices, other things being equal. The law of demand is valid in most of the cases; however
there are certain cases where this law does not hold good. The following are the important exceptions to
the law of demand:
1. Conspicuous Goods: Some consumers measure the utility of a commodity by its price,
i.e., if the commodity is expensive they think that it has got more utilities. As such, they buy
less of this commodity at low price and more of it at high price. Diamonds are often given as
example of this case. Higher the price of diamonds, higher is the prestige value attached to them
and hence higher is the demand for them.
2. Giffen Goods: Sir Robert Giffen, an economist, was surprised to find out that as the price
of bread increased, the British worker purchased more bread and not less of it. This was
something against the law of demand. Why did this happend? The reason given for this is that
when the price of bread went up, it caused such a large decline in the purchasing power of the
poor people that• they were forced to cut down the• consumption of meat and other more
expensive foods'. Since bread even when its price was higher than before was still the cheapest
food article, people consumed more of it and not less when its price went up. Such goods, which
exhibit direct price-demand relationship, are called `Giffen goods'. Generally those goods which
are considered inferior by the consumers and which occupy a substantial place in consumer's budget
are called 'Giffen goods'. Examples of such goods are coarse grains like bajra, low quality of rice
and wheat, etc.
 3. Necessities of Life: Normally, the law of demand does not apply on necessities of life such as
food, cloth etc. Even the price of these goods increases, the consumer 'does not reduce their
demand. Rather, he purchases them even the prices of these goods increase often by reducing
the demand for comfortable goods. This is also a reason that the demand curve slopes upwards
to the right.
4. Conspicuous Necessities: The demand for certain goods is affected by the demonstration
effect of the consumption pattern of a social group to which an individual belongs. These goods, due
to their constant usage, have become necessities of life. For example, in spite of the fact that the
prices of television sets, refrigerators, coolers, cooking gas etc. have been continuously rising, their
demand does not show any tendency to fall.
5. Future Expectations about Prices: It has been observed that when the prices are rising,
households expecting that the prices in the future will be still higher tend to buy larger
quantities of the commodities. For example, when there is wide-spread drought, people
expect that prices of food grains would rise in future. They demand greater quantities of food
grains as their price rise.
6. Impulsive Purchases: At times consumers tend to make impulsive purchases without
any cool calculations about price and usefulness of the product and in. such contexts the law of
demand fails.
7. Ignorance Effect: Generally, it is assumed that households have perfect knowledge about price
and quality of goods. However, in practice, a household may demand larger quantity of a
commodity even at a higher price because it may be ignorant of the ruling price of the
commodity.
8. Outdated Goods: Goods that go out of use due to advancements in the underlying
technology are called outdated, goods. These are generally durable goods such as radio,
telephone, etc. With the launch of light push button type telephones the demand for the heavy
dial telephones will fall even though they may be available at lower prices. Seasonal goods,
which are not used during the off-season, will also be subject to similar demand behavior. For
Example the sale of air coolers may go down in winters even if they are sold at reduced prices.
Elasticity of Demand

Price elasticity of demand expresses the response of quantity demanded of goods, to a change in
its price, given the consumers income, his tastes and prices of all other goods.
Meaning of Elasticity of Demand

The term elasticity of demand is used to denote a measure of the rate at which demand changes in
response to the change in prices. We can say that it is the percentage change in quantity
demanded divided by the percentage in one of the variables on. Which demand depends. In other
words, it is price elasticity of demand, which is usually referred to. as elasticity of demand.

Types of Elasticity of Demand

There are various elasticities of demand. However, the important ones are given below:
1. Price elasticity of demand
2. Income elasticity of demand
3. Cross elasticity of demand
4. Promotional elasticity of demand.

Elasticity of Demand

Price elasticity of demand expresses the response of quantity demanded of goods, to a change in
its price, given the consumers income, his tastes and prices of all other goods.

According to Prof. Lipsey, "Elasticity of demand may be defined as the ratio of the percentage
change in demand to the percentage change in price."

According to Mrs. Robinson's, "The elasticity of demand at any price.... is the proportional change
of amount purchased in response to a small change in price, divided by the proportional change
of price." Thus, price elasticity of demand is the ratio of percentage change in amount demanded to
a percentage change in price. It may be written as:
Types/Degrees of Price Elasticity

1. Perfectly Elastic Demand (E = ∞ ): In case of perfectly elastic demand, the demand for
a commodity changes even though there is no change in price. It also implies that with
a very small percentage change in price, the quantity demanded would change
indefinitely and so the seller would not change the price. As such, this is also an extreme
case of elasticity, which is very rarely found in practice.
In the figure, we can see a straight-line demand curve parallel to X-axis. The diagram
shows that at the ruling price any amount of the commodity can be sold which is a case
of perfectly elastic demand or E = ∞ .

2. Perfectly Inelastic Demand (E = 0): If the demand for a commodity does not change in
spite of an increase or decrease in its price, the demand is perfectly inelastic. The
examples of perfectly inelastic demand are rarely found in real life. If suppose, the price of
product increases by 50% but change in demand is 0, then it is said to be a perfectly inelastic
 demand.

In the figure, a rise in the price of a commodity is followed by absolutely no increase in the
quantity demanded. Thus elasticity becomes zero i.e. E = 0.

3. Unitary Elastic Demand (E = 1) : Price elasticity of demand is unity when the change in
demand is exactly proportionate to the change in price. The demand curve in this case is
a rectangular hyperbola. For example, when the price is Rs. 10 and the quantity demanded
is 100 units, the total outlay is Rs. 1000. If price increases to Rs. 20, and the quantity demanded
declines to 50 units, the total outlay remains at Rs.1000.

4. Elastic Demand (E > 1): If the percentage change quantity demanded is greater than the
percentage change in price, price elasticity of demand is greater than one. This is known as
elastic demand.
 5. Inelastic Demand (E < 1): If the percentage change in quantity demanded is less than the
percentage change in price, price elasticity of demand is less than one. This is known as
inelastic demand.

Income Elasticity of Demand

Income elasticity of demand is defined as the percentage change in the quantity demanded of a
good divided by the percentage change in the income of the consumer. In symbolic form:

EY= Q/ Y*Y/Q

EY= Stands for Income Elasticity

Q= Stands foe Quantity demanded

Y= Stands for Income

Q= Changes in quantity demanded

Y= change in income

Types of Income Elasticity of Demand

1. High Income Elasticity- When the quantity demanded of good increases by a larger
percentage as compared with the income of the consumer, income elasticity of demand is
high.

2. Unitary income Elasticity: When the percentage change in quantity demanded is equal
to the percentage change in income, income elasticity of demand is unitary.
3. Low-Income Elasticity: When the quantity demanded of- good increases by a
smaller percentage as compared with the income of consumer, income elasticity of demand is

low.
 4. Zero Income Elasticity: When the quantity demanded of a good remains unchanged
upon the change of income, income elasticity of demand is zero.

5. Negative Income Elasticity: When the quantity demanded of a good falls in response
to an increase in income, the income elasticity of demand is negative.

Cross Elasticity of Demand

A change in the demand for one good in response to a change in the price of another good represents
cross elasticity of demand of the former good for the latter good. It is defined as:

EC= Percentage Change in quantity demanded of good A= Qx/Py*Py/Qx.

Percentage change in Price of Good B
Where, Ec= stands for cross elasticity
Qx= Stands for original quantity demanded of x
Py= stands for a small change in the price of y.
Py= stands for original price of good y
Qx= stands for change in quantity demanded.

The elasticity coefficients give significant results about the type of goods:
a. Substitute Goods: If cross elasticity of demand is positive, meaning that sales of X move
in the same direction as a change in the price of Y, then X and Y are substitute goods. An
example is Kodak film (X) and Fuji film (Y): An increase in the price of Kodak film causes
consumers to buy more Fuji film, resulting in a positive cross' elasticity. The larger the
positive cross-elasticity coefficient, the greater is the substitutability between the two
products.
b. Complementary Goods: When cross elasticity is negative, we know that X and Y
"go together; an increase in the price of one decreases the demand for the other. So, the two
are complementary goods, For example, an increase in the price of cameras will d3crease the
amount of film purchased. The larger the negative cross-elasticity coefficient, the greater is the
complementarily between the two goods.
c. Independent Goods: A zero or near-zero cross elasticity suggests that the two products
 being considered are unrelated .or independent goods. An example is walnuts and film; we
would not expect a change in the price of walnuts to have any effect on purchases of film, and
vice versa.
The concept is used to anticipate the effect on the sales of a firm to a change in price of their
rivals. For example, the MUL can measure the effect of a change in the prices of Santro or Matiz on
the demand-for Zen.

Advertising and Promotional Elasticity of Demand

The promotional elasticity of demand is a measure of the responsiveness of demand for a

commodity to the change in outlay on advertisements and other promotional efforts.

Ea= Percentage change in demand

Percentage change in expenditure on advertisement and other promotional efforts

Ea= Dx/Dx
A/A
The greater' the promotional elasticity, the more will be the incentive to go in for advertising. The
advertisement elasticity of sales varies between zeros to infinity.
1. If EA = 0, then sales do not respond to the advertisement expenditure.
2. When EA < 1 is positive, then sales increase in proportionately lesser degree than the increase in
advertisement outlay.
3. Sales increase in equal proportion to advertisement outlay if EA = 1.
4. When EA > 1 then sales increase more than proportionately to the increase in advertisement
budget.
Example: Advertisements happen to be a very important factor for pushing up the demand for
any product A company presently sells 6200 units of shoe polish at a once of Rs. 30 per unit. In
view of sluggish demand, it decides to increase its outlay on advertising from Rs. 12 lakh to Rs.
20 lakh. If the promotional elasticity of demand for shoe polish is 1.4, find out the new demand
for shoe polish.
Uses of Elasticity of Demand for Managerial Decision Making

The concept of price elasticity of demand (elasticity of demand) is of great significance to the
producers or sellers, workers and government in formulating their policies. It has practical
implications in managerial decision-making. The practical importance of this concept will be clear from
the following applications:

1. Determination of Price Policy: While fixing the price of this product. A businessman has to
consider the elasticity of demand for the product He should consider whether lowering of price will
stimulate demand for his product, and if so to what extent and whether his profits will also
increase a result thereof. If the increase in his sales is more than 'proportionate to the reduction in
price, his total revenue will increase and his profits might be larger. In general, for items having
inelastic demand, the producer will fix a higher price and items whose demand is elastic the
businessman will fix a lower price.

2. Price Discrimination: Price discrimination refers to the act of selling the technically same products at
different prices to different section of consumers or different in different sub-markets. The policy of
price-discrimination is profitable to the monopolist when elasticity of demand for his product is different
in different sub-markets. Those consumers whose demand is inelastic can be charged a higher price than
those with more elastic demand.

3. Shifting of Tax Burden: To what extent a producer can shift the burden of indirect tax to the
buyers by increasing price of his product depends upon the degree of elasticity of demand.

4. Taxation and Subsidy Policy: The government can impose higher taxes and collect more revenue if
the demand for the commodity on which a tax is levied is inelastic. On the other hand, in case of a
commodity with elastic demand high tax rates may fail to bring in the required revenue for the
government. Government should provide subsidy on those goods whose demand is elastic and in the
production of the commodity the law of increasing returns operates.

5. Importance in International Trade: The concept of elasticity of demand is of crucial

importance in many aspects of international trade. The success of the policy of devaluation to
correct the adverse balance of payment depends upon the elasticity of demand for exports aid
imports of the country.

6. Importance in the Determination of Factors Prices: A factor with an elastic demand

can always command a higher price as compared to a factor with relatively elastic demand. This
helps the trade unions in knowing that where they can easily get the wage rate increased.
Bargaining capacity of trade unions depend upon elasticity of demand for workers services.

7. Pricing of Joint Supply Products: The goods that are produced by a single production
process are joint supply products. The cost of production of these goods is also joint. Therefore,
while determining the prices of these products their elasticity of demand is considered. The price
of a joint supply product is fixed high if its demand is inelastic and low price is fixed for that
joint supply whose demand is elastic.

8. Effect on Use of Machines on Employment: Ordinarily it is thought that use of machines

reduced the demand for labor. Therefore, trade unions often oppose the use of machines
fearing unemployment. But this fear is not always true because use of machines may not reduce
demand for labor. It depends on the price elasticity of demand for the products.

9. Public Utilities: The nationalization of public utility services can also be justified with the
help of elasticity of demand. Demand for public utilities such as electricity, water supply,
post and telegraph, public transportation etc. is generally inelastic in nature. The public utility
enterprises decide their price policy on the basis of elasticity of demand. A suitable price policy
for public utility enterprises is to charge from consumers according to their elasticity of demand
for public utility.

10. Output Decisions: The elasticity of demand helps the businessman to decide
about production. A businessman chooses the optimum product-mix on the basis of elasticity
of demand for various products.

SIGNIFICANCE OF DEMAND FORECASTING

Demand forecasting is very essential in the course of business decision making. Its significance
may be traced as under:

1. Production Planning: Demand forecasting is prerequisite for the production planning of a

business firm. Expansion of output of the firm should be based on the estimates of likely
demand, otherwise there may be overproduction and consequent losses may have to be
faced.

2. Sales Forecasting: Sales forecasting is based on the demand forecasting. Promotional

efforts of the firm should be based on sales forecasting.
 3. Control. of Business: For controlling the business on a sound footing, it is essential
to have a well conceived budgeting of costs and profits that is based on the forecast of
annual demand/sales and prices.

4. Inventory Control: A satisfactory control of business inventories, raw materials,

intermediate goods, semi finished product, finished product, spare parts, etc., requires
satisfactory estimates of the future requirements which can be traced through demand
forecasting.

5. Growth and Long Term Investment Programmes: Demand forecasting is necessary for
determining the growth rate of the firm and its long-term investment programmes and
planning.

6. Stability: Stability in production and employment over a period of time can be made
effective by the management in the light of the suitable forecasting about market demand and
other business variables and smoothening of the business operations through counter-cyclical and
seasonally adjusted business programme.

7. Economic Planning and Policy Making: Demand forecasting at macro level for the nation
as a whole is of a great help to the planners and policy makers for a better planning and
rational allocation of the country's productional resources. The Government can determine
its import and export policies in view of the long term demand forecasting for various goods
in the country its import and export policies in view of the long term demand forecasting for
various goods in the country.

Scope of Forecasting

Forecasting can be at the international level depending upon the area of operation of given economic
institution. It can also be confined to a given product or service supplied by a small firm in local
area. The scope of work will depend upon the area of operation in the present and proposed in future.
Much would depend upon the cost and time involved in relation to the benefit of the information
acquired through the study of demand. The necessary trade-off has to be struck between the cost of
forecasting and the benefits flowing from such forecasting.

Criteria of a Good Forecasting Method

1. Simplicity and Ease of Comprehension: Management must be able to understand and have
 confidence in the techniques used. Complicated mathematical and statistical techniques may be
avoided.

2. Economy: Cost must be weighed against the importance of the forecast to the operations of the
business. The criticism should be the economic consideration of balancing the benefits from
increased accuracy against the extra cost of providing the improved forecasting.

3. Availability: Techniques should give quick results and useful information.

4. Durability: Durability of the forecasting power of a demand and functions depends on

reasonableness and simplicity of functions fitted.

5. Accuracy: Sales forecasting is the basis of marketing planning and, therefore, sales forecasts
should be as much accurate as possible.

6. Flexibility: Another attribute of a good forecasting method is its flexibility. It means we should
be able to accommodate some changes in the variables which determine the demand. If the
model for demand forecasting is very rigid, then its predictive power is considerably reduced.

7. Availability of Data: Any forecasting is based on the availability of data, which is fitted in
a model to estimate future demand. If the data, whether primary or secondary, is easily
available, then only it can be used. If the data requirement is clumsy or unavailable, then
obviously the forecasting method is of little use.
1. Statistical or Analytical Methods /Quantitative Techniques: Statistical methods are
considered to be superior techniques of demand estimation because:
 The element of subjectivity in this method is minimum,
 Method of estimation is scientific,
 Estimation is based on the theoretical relationship between the dependents
and independents variables,
 Estimates are relatively more reliable; and
 Estimation involves smaller cost.
The statistical methods, which are frequently used, for making demand projections are:
I. Trend Projection Method: An old firm can use its own data of past years regarding its
sales in past years. These data are known as time series of sales. A firm can predict sales of
 its product by fitting trend to the time series of sales. A trend line can be fitted by graphic
method or by algebraic equations. Equations method is more appropriate. The trend can
be estimated by using any one of the following methods:
a. Graphical Method: A trend line can be fitted through a series graphically. Old
values of sales for different areas are plotted on a graph and a free hand curve is
drawn passing through as many points as possible. The direction of this free hand
curve shows the trend. The main draw back of this method is that it may show the
trend but not measure it.
b. Least Square metnoa: I ne least square method is based on the assumption that
the past rattof change of the variable under study will continue in the future. It is a
mathematical procedure for fitting a line to a set of observed data points in such a
manner that the sum of the squared differences between the calculated and observed
value is minimized. This technique is used to find a trend line which best fit'the
available data. This trend is then used to project dependant variable in the future. This
method is very popular because it is simple and in expensive.
c. Time Series Data: Time series data refer to data collected over a period of time
recording historical changes in price, income, and other relevant variables influencing
demand for a commodity. Time cries analysis relate to the determination of change in
a variable in relation to time. Usually, trend prJjections are important in this regard.
d. Moving Average Method: Under this method, the moving average of the sales of the
past years is computed. The• computed moving average is taken as forecast for the
next year or period. This is based on the assumption that future sales are the average
of the past sales. The moving average is the process of computing average of leaving
the oldest observation and including the next one.
e. Exponential Smoothing: Exponential smoothing is a popular technique for short-run
forecasting. It uses a weighted average of past data as the basis for a forecast. The
procedure gives heaviest weight to more recent information and smaller weights to
observations in the more distant past. The reason for this is that the future is more
dependent on the recent past than on the distant past. The method is known to be
effective when there is randomness and no seasonal fluctuations in the data.
Advantages of Trend Projection Method
a) It is a very simple method.
b) The method provides reasonably accurate forecasts.
c) It is quick and inexpensive.
Disadvantages of Trend Projection Method
a) Can be used only if past data is available.
b) It is not necessary that past trends may continue to hold good in the futureas well.
c) There is no analysis of causal relations between the demand and time series explaining
the whys of it.

ii) Barometric Method: It is also known as leading indicators forecasting.

National Bureau of Economic Research of U.S.A. has identified three types of
indicators - Leading indicators, Coincidental Indicators and Lagging indicators.

The analyst should establish relationship between the sales of the product and the
economic indicators to project the correct sales and to measure to what extent these
indicators affect the sales. To establish relationship is not easy task especially in case of
new product where there is no past record.

Advantages of Barometric Method

a) It is a simple method.
b) It predicts directional changes quite accurately.
Disadvantages of Barometric Method
a) It does not predict the magnitude of changes very well.
b) Finding out a leading indicator for any series is nOt always feasible.
c) The lead time is maintained consistently by a very few time series.
d) The method can be used for short-term forecastd only.

iii) Regression Method: This is a very common method of, forecasting demand. Under
this method a relationship is established between quantity demanded (dependent
variable) and independent variables such as income, price of the good, prices ofthe
related goods etc. once the relationship is established, we derive regression equation
assuming relationship to be linear. The equation will 'be of the form Y =-A + BX. There
 could also be a curvy linear relationship between dependent and independent variables.
Once the regression equation is derived the value of Y i.e. quantity demand can be
estimated for any given value of X.

Advantages of Regression Method

 As the method is based on causal relationships, it produces reliable and accurate results.

 Besides generating the forecast, it also explains the economic phenomenon.

 It is neither as subjective as the qualitative techniques nor as mechanistic as the

quantitative ones.

 This method not only forecasts the direction but also the magnitude of the change.

 The method is quite consistent

Disadvantages of Regression Method
 The method uses complex calculations.
 It is costly and time consuming,
 It requires the use of some other forecasting technique for estimating the value of the causal
variables.
iv) Econometric Method: The econometric model forecasting involves estimating several
simultaneous equations, which are, generally, behavioral equations, mathematical identities and
market-clearing equations. The econometric model technique is known also as simultaneous
equations method and complete system approach to forecasting. This technique uses
sophisticated mathematical and statistical tools.

Advantages of Econometric Method

 This method possesses all the advantages of the regression method.

 Furthermore„ if one is not worried about the size of the model, it can almost eliminate
the regression method's major problem of forecasting the values of the independent variables
in the prediction period.

 Provided the data are available, one should not really be concerned with the model's size, for
the computer is there to help the forecasters to estimate and solve the model.
Limitations of Econometric Method

 To the extent the structural changes have taken place, the past relationship between
independent and dependent variables will not continue in the future.

 The forecasts under this method assume that the forecast equation holds exactly in the
prediction period. To the extent it is stochastic, i.e., the disturbance term is non-zero, the
forecasts will be wrong.

Opportunities and Challenges in Demand Forecasting

a. Information on Demand Throughput: The most well-established forecasting techniques are

based on historical demand. In today's business environment, changes in the marketplace are swift
and sudden, and milty not follow the historical pattern; hence future demand may not be
predicted accurately by relying on past demand alone.

b. Information on Selling Price and Product Promotion: Changes in the selling price and the
presence of product promotions are known to have a significant effect on demand in many
industries. Today, in large part, due to the proliferation of information and other technologies,
price changes are less costly. Price changes in electronic business-to-business product catalogs
or Web-based retail businesses incur little incremental cost. Even in traditional retail stores, the
day will soon come when a button on a computer is pressed to issue a price change, and new
prices will be reflected on a liquid crystal shelf label in a physical store a few seconds later. Such
opportunities imply that price changes and promotion actions may be used very frequently, and so
they can no longer be analyzed separately from "normal" demand

c. Information on Product Life Cycle: One of the serious challenges facing a demand
forecaster in the business environment is ever shortening product life cycles. In many industries, a
product can be expected to have a life of at the most one year. As is customary, it can inherit
older history from its predecessor product, which can in turn inherit history from its own
predecessor and so on. This means that in order to get, say, two to-three years history, we need a
well-organized product map over time. At this point in time, we have found; .that many
organizations do not have such product map data stored in a usable manner.

d. Information on the Marketplace: As econometrics have long known, demand history is only one
 of many streams of information from which .a forecast can be made. The e-business environment
presents at least two key opportunities. on forecast information. First, high level indicators 'of
economic activities such as total production output of an industry are more up-to-date the
previously possible. Data are collected continuously and automatically, in transactions, and should
also be less error prone. This will be increasingly so as more and more business to-business as
well as business-to-consumer transactions are performed electronically. Second, more detailed
economic date is available, such as those by product types within industry.

e. Information on Consumers . History consisting of the quantity sold, and ;

selling price is no longer the only pieces of information coming directly from past
consumers. Customer database collected by an organization, over time, previously limited only
to expensive products such as mainframe computers or automobiles, is now likely to cover
regular products such as end-user software packages or even children's products: Thus, the
existing customer base is no longer characterized only by a total sales number, but rather a
database of information at the manufacturer's own request.