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  1. Theory of Demand By:Asnakech .A Managerial Economics Chapter-Two
  2. Unit Objectives ⚫T o explainthe meaning of demand and types; ⚫T o identify the factorsthat affect demand; ⚫ T o explainthe concept of elasticity and its different types; ⚫T o explain the different waysof measuring elasticity; ⚫Toexplain the uses and applications of different elasticities; ⚫ T o understand different demand analysistechniques.
  3. Introduction ⚫ The growing competition teaches the lesson of knowing our customers in detail - in terms of their wants and needs which ultimately leads to their desires, rather than looking at them as sales prospective only. ⚫ Because; how good your product or service is, the simple truth is that no-one will buy it if they don't want it or believe they don't need it. ⚫ And you won't persuade anyone that they want or need to buy what you're offering unless you clearly understand what your customers really want.
  4. ⚫After all, knowing and understanding customer needs is at the centre of every successful business, whether it sells directly to individuals or other businesses. ⚫Once you have this knowledge, you can use it to persuade potential and existing customers that buying from you is in their best interests.
  5. Customer understanding….? “Customer understanding is the overall process of knowing your customers to build and maintain profitable customer relationships by delivering superior customer value and satisfaction.”
  6. Why Customer Understanding Matter?
  7. Introduction to Demand Theory ⚫ The success of any business largely depends on sales, and sales depend on market demand behaviour. ⚫ Consumer demand theory is aframework for thinking about whypeople make the choices they do. ⚫ The theory can potentially help business managers choose the types of products and services to offer and the pricesto set to maximize profit. ⚫ Demand relationships determine revenues and indirectly affect output and costs; they thus have a fundamental impact on profits. ⚫ Anunderstanding of demand is also relevant for planning purposes, involving production, transportation, inventory , sales, marketing and finance functions. ⚫ The identification of factors affecting demand and the precise effects that these have is therefore a core element in managerial economics.
  8. what is Demand??? ⚫ The word ‘demand’can be used in avariety of senses, which often causes misunderstanding and errors of analysis. i. Mystery behind/Reason for production economic activity. ii. Demand = Desire to acquire something + Willingness to pay for the desired thing + Ability to Paythe required scarification
  9. ⚫Tosum up, we can saythat the demand for aproduct is the desirefor that product backed bywillingnessaswell asability to pay for it. ⚫It is always defined with reference to a particular time, place, price and given values of other variables on which it depends.
  10. Basics of Consumer Demand: The Utility ⚫ The central theme of the traditional theory of consumer behaviour is a consumer’s utility maximizing behaviour. ⚫ The fundamental postulate of the consumption theory is that a consumer—an individual or a household—is a utility maximizing entity and all consumption decisions are directed towards maximization of total utility. ⚫ At the individual level, consumer demand theory states that consumers make choices based on utility: the value or benefit that is derived from an action.
  11. ⚫Consumers demand a commodity because they derive or expect to derive utility from the consumption of that commodity. ⚫The expected utility from a commodity is the basis of demand for it.
  12. The Meaning of Utility ⚫ The concept of utility can be looked upon two angles;-from the product angle and from the consumer’s angle. ⚫ From the product angle - utility is the want-satisfying property of a commodity. ⚫ From the consumer’s angle - utility is the psychological feeling of satisfaction, pleasure, happiness or well-being , which a consumer derives from the consumption, possession or the use of a commodity.
  13. ⚫ On the other hand, from a consumer’s point of view, utility is a post- consumption phenomenon as one derives satisfaction from a commodity only when one consumes or use it. ⚫ Thus, Utility in the sense of such satisfaction is a “subjective” or “relative” concept because: i. a commodity need not be useful for all- cigarettes do not have any utility for non-smokers, and meat has no utility for strict vegetarians; ii. Utility of a commodity varies from person to person and from time to time; and iii. a commodity need not have the same utility for the same consumer at different points of times, at different levels of consumption and for different moods of a consumer.
  14. The Law of Diminishing Marginal Utility(LDMU) ⚫ The LDMU is one of the fundamental laws of economics to the analysis of consumer behavior. ⚫ This law states that as the quantity consumed of a commodity goes on increasing, the utility derived from each successive unit consumed goes decreasing, consumption of all other commodities remain constant. ⚫ This law stems from the facts that: (i) the utility derived from a commodity depends on the intensity or urgency of the need for that commodity, and (ii) that as more and more quantity of a commodity is consumed, the intensity of desire decreases and therefore the utility derived from the marginal unit decreases.
  15. Determinants (Influencing factors of Demand) ⚫ Demand for a commodity depends upon number of factors called determinants. ⚫ The demand function can be symbolically expressed as: QdN=f(PN,PR,I,T,E,,A, O) ⚫ Where:  QdN = Quantity demanded for the commodity  PN = Price of the commodity itself  PR = Price of related commodity  I = Income of consumers  T = Taste & preferences of the consumers  E = Expectations about the future prices  A=Advertisement  O = Other factors
  16. ⚫ It is useful from a managerial decision-making viewpoint to distinguish between controllable and uncontrollable factors/determinants of demand. ⚫ Controllable in this context means controllable by the firm; the distinction in practice between what can be controlled and what cannot is somewhat blurred, aswill be seen.
  17. ⚫ The law of demand states that, "conditional on all else being equal, as the price of a good increases (↑), quantity demanded decreases (↓); conversely, as the price of a good decreases (↓), quantity demanded increases (↑)". ⚫ In other words, the law of demand describes an inverse relationship between price and quantity demanded of agood. ⚫ The factors held constant refer to other determinants of demand, such as the prices of other goods and the consumer's income. ⚫ There are, however, some possible exceptions to the law of demand, such as Giffen goods andV eblen goods.
  18. ⚫ There are at least three accepted explanationsof why demand curves slope downwards: 1. The law of diminishing marginal utility  This law suggests that asmore of aproduct is consumed the marginal (additional) benefit to the consumer falls;hence consumers are prepared to payless. 2.The income effect  Theincome effect suggeststhat, asthe price ofagoodfalls,real income- that is, what consumers canbuywith their moneyincome- rises and consumersincrease their demand. 3. The substitution effect  Asthe price of one good falls,it becomes relativelylessexpensive.  Therefore,assuming other alternative products stay at the same price, at lower prices the good appears cheaper,and consumers will switch from the expensive alternative to the relatively cheaper one.
  19. The Concept of Demand Elasticity ⚫ The 'Law of Demand' states that, all other factors being equal, as the price of a good or service increases, consumer demand for the good or service will decrease, and vice versa. ⚫ Demand elasticity is a measure of how much the quantity demanded will change if another factor changes.
  20. Changes in Demand ⚫Change in demand is a term used in economics to describe that there hasbeen achange,or shift in, amarket's total demand. ⚫This is represented graphically in a price vs. quantity plane, and is a result of more/less entrants into the market, and the changing of consumer preferences. ⚫The shift can either be parallel or nonparallel.
  21. Demand Elasticity ⚫Law of demand explains the inverse relationship between price and demand of a commodity but it does not explain to the extent to which demand of a commodity changes due to change in price. ⚫A measure of a variable's sensitivity to a change in another variable is elasticity. ⚫In economics, elasticity refers the degree to which individuals change their demand in response to its determinant.
  22. Definition… ⚫ The demand elasticity (elasticity of demand) refers to how sensitive the demand for a good is to changes in other economic variables, such as prices and consumer income. ⚫ Elasticity of demand is the degree of responsiveness of change in demand of a commodity due to a change in its determinants. ⚫ Demand elasticity is calculated as the percent change in the quantity demanded divided by a percent change in another economic variable. Demand Elasticity = %change in quantity demanded/ % change in demand determinants ⚫ A higher demand elasticity for an economic variable means that consumers are more responsive to changes in this variable.
  23. ⚫ Importance of Elasticity of Demand ⚫ Importance to producer −A producer has to consider elasticity of demand before fixing the price of a commodity. ⚫ Importance to government −If elasticity of demand of a product is low then government will impose heavy taxes on the production of that commodity and vice – versa. ⚫ Importance in foreign market −If elasticity of demand of a produce is low in the international market then exporter can charge higher price and earn more profit.
  24. Types of Elasticity of Demand 1. Price Elasticity of demand  The price elasticity of demand is the percentage change in the quantity demanded of a good or a service, given a percentage change in its price.
  25. 2. Income Elasticity of Demand ⚫ Income elasticity is a measure of the relationship between a change in the quantity demanded for a commodity and a change in real income. ⚫ Formula for calculating income elasticity is as follows − Ei = %Change in quantity demanded/%Change in income ⚫ Followingare the Features of Income Elasticity−  If the proportion of income spent on goods remains the same as income increases, then income elasticity for the goods is equal to one.  If the proportion of income spent on goods increases as income increases, then income elasticity for the goods is greater than one.  If the proportion of income spent on goods decreases as income increases, then income elasticity for the goods is less than one.
  26. 3.Cross Elasticity of Demand ⚫ An economic concept that measures the responsiveness in the quantity demanded of one commodity when a change in price takes place in another good. ⚫ The measure is calculated by taking the percentage change in the quantity demanded of one good, divided by the percentage change in price of the substitute good − Ec = [Δqx/Δpy] × [py/qx]
  27. Implication…. I. If two goods are perfect substitutes for each other, cross elasticity is infinite. II. If two goods are totally unrelated, cross elasticity between them is zero. III.If two goods are substitutes like tea and coffee, the cross elasticity is positive. IV.When two goods are complementary like tea and sugar to each other, the cross elasticity between them is negative.
  28. Total Revenue (TR) and Marginal Revenue ⚫ Total revenue is the total amount of money that a firm receives from the sale of its goods. ⚫ If the firm practices single pricing rather than price discrimination, thenTR is the total expenditure of the consumer TR= P× Q ⚫ The total revenue test is a means for determining whether demand is elastic or inelastic. ⚫ If an increase in price causes an increase in total revenue, then demand can be said to be inelastic, since the increase in price does not have a large impact on quantity demanded.
  29. ⚫ If an increase in price causes a decrease in total revenue, then demand can be said to be elastic, since the increase in price has a large impact on quantity demanded. ⚫ The relationship between elasticity of demand and a firm's total revenue is an important one. 1. When demand is inelastic – a rise in price leads to a rise in total revenue – a 20% rise in price might cause demand to contract by only 5% (Ped = -0.25) 1. When demand is elastic – a fall in price leads to a rise in total revenue - for example a 10% fall in price might cause demand to expand by only 25% (Ped = +2.5).
  30. Demand Analysis: Estimation and Forecasting ⚫ In the preceding sections, we have dealt with consumer’s decision- making behavior — how consumers decide what quantity of a commodity to consume; how they allocate the total consumption expenditure on various goods and services; how collective decisions of consumers reflect in market demand; and how total demand responds to change in its determinants. ⚫ The theory of demand discussed so far deals with current demand whereas a major concern of businessmen, especially the big one, is ‘what would be the future demand for their product?
  31. ⚫ Demand analysiswas introduced asatool for managerial decision-making. ⚫ Demand forecasting and estimation gives businesses valuable information about the markets in which they operate and the markets theyplanto pursue. ⚫ The purpose of demand forecasting and estimation is to find a business's potential demand so managers can make accurate decisions about pricing,business growth and market potential. ⚫ Managers base pricing on demand trends in the market. ⚫ The first question which arises is,what is the difference between demand estimation anddemand forecasting?
  32. ⚫ The answer is that demand estimation attempts to quantify the links between the level of demand and the variableswhich determine it. ⚫ Demand forecasting, on the other hand, attempts to predict the overall level of future demand rather than looking at specific linkages. ⚫ For this reason, the set of techniques used may differ, although there will be some overlap between the two. ⚫ In general, an estimation technique can be used to forecast demand but aforecasting technique cannot be used to estimate demand.
  33. Methods of demand forecasting ⚫ The following points highlight the top seven methods of demand forecasting: 1. Survey of Buyer’s Intentions 2. Collective Opinion or Sales Force Composite Method 3. Trend Projection 4. Executive Judgment Method 5. Economic Indicators 6. Controlled Experiments 7. Expert’s Opinions.
  34. End of ChapterTwo