Law of Demand

 

INTRODUCTION

For a long period of time economists are much interested to study the relationship of price and sales. An indepth knowledge of such relationship is necessary for the management

 

Demand Analysis

Demand analysis means an attempt to determine the factors affecting the demand of a commodity or service and to measure such factors and their influences. The demand analysis includes the study of law of demand, demand schedule, demand curve and demand forecasting. Main objectives of demand analysis are;

 

1) To determine the factors affecting the demand.

2) To measure the elasticity of demand.

3) To forecast the demand.

4) To increase the demand.

5) To allocate the recourses efficiently

 

Law of Demand

Among the many causal factors affecting demand, price is the most significant and the price- quantity relationship called as the Law of Demand is stated as follows:

“The greater the amount to be sold, the smaller must be the price at which it is offered in order that it may find purchasers, or in other words, the amount demanded increases with a fall in price and diminishes with a rise in price” (Alfred Marshall). In simple words other things being equal, quantity demanded will be more at a lower price than at higher price.

The law assumes that income, taste, fashion, prices of related goods, etc. remain the same in a given period. The law indicates the inverse relation between the price of a commodity and its quantity demanded in the market. However, it should be remembered that the law is only an indicative and not a quantitative statement. This means that it is not necessary that such variation in demand be proportionate to the change in price

 

Individual demand Schedule

An individual demand schedule is a list of quantities of a commodity purchased by an individual consumer at different prices. The following table shows the demand schedule of an individual consumer for apple.

 

 

Price of Apple (In Rs.) Quantity demanded
1086

4

2

123

4

5

 

When the price falls from Rs 10 to 8, the quantity demanded increases from one to two. In the same way as price falls, quantity demanded increases. On the basis of the above demand schedule we can draw the demand curve as follows;

demand curve

The demand curve DD shows the inverse relation between price and demand of apple. Due to this inverse relationship, demand curve is slopes downward from left to right. This kind of slope is also called “negative slope”

 

EXCEPTIONS TO THE LAW OF DEMAND

The Law of Demand will not hold good in certain peculiar cases in which more will be demanded at a higher price and less at a lower price. In these cases the demand curves will be exceptionally different, differing from the usual downward sloping shape of the demand curve. The exceptions are as follows:

(i) 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 utility. 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.

ii) Giffen goods:

Sir Robert Giffen, an economist, was surprised to find out that as the price of bread increased, the British workers purchased more bread and not less of it. This was something against the law of demand. Why did this happen? 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.

 

(iii) 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. But it is to be noted that here it is not the law of demand which is invalidated but there is a change in one of the factors which was held constant while deriving the law of demand, namely change in the price expectations of the people.

(iv) The law has been derived assuming consumers to be rational and knowledgeable about market-conditions. However, at times consumers tend to be irrational and make impulsive purchases without any cool calculations about price and usefulness of the product and in such contexts the law of demand fails.

(v) Similarly, 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. Under such circumstances, the law will not remain valid.

The law of demand will also fail if there is any significant change in other factors on which demand of a commodity depends. If there is a change in income of the household, or in prices of the related commodities or in tastes and fashion etc. the inverse demand and price relation may not hold good

 

Why does demand curve slopes downward?

 

Demand curve slopes downward from left to right (Negative Slope). There are many causes for downward sloping of demand curve:-

1) Law of Diminishing Marginal utility

As the consumer buys more and more of the commodity, the marginal utility of the additional units falls. Therefore the consumer is willing to pay only lower prices for additional units. If the price is higher, he will restrict its consumption

2) Principle of Equi- Marginal Utility

Consumer will arrange his purchases in such a way that the marginal utility is equal in all his purchases. If it is not equal, they will alter their purchases till the marginal utility is equal.

3) Income effect.

When the price of the commodity falls, the real income of the consumer will increase. He will spend this increased income either to buy additional quantity of the same commodity or other commodity.

4) Substitution effect.

When the price of tea falls, it becomes cheaper. Therefore the consumer will substitute this commodity for coffee. This leads to an increase in demand for tea.

5) Different uses of a commodity.

Some commodities have several uses. If the price of the commodity is high, its use will be restricted only for important purpose. For e.g. when the price of tomato is high, it will be used only for cooking purpose. When it is cheaper, it will be used for preparing jam, pickle etc…

6) Psychology of people.

Psychologically people buy more of a commodity when its price falls. In other word it can be termed as price effect.

7) Tendency of human beings to satisfy unsatisfied wants.

 

 

Comparison between extension/contraction and shift in demand SL. No Extension/Contraction of Demand Shift in Demand
1 Demand is varying due to changes in price Demand is varying due to changes in other factors
2 Other factors like taste, preferences, income etc… remaining the same. Price of commodity remain the same
3 Consumer moves along the same demand curve Consumer may moves to higher or lower demand curve

 

Different types of demand.

 

Joint demand:

When two or more commodities are jointly demanded at the same time to satisfy a particular want, it is called joint or complimentary demand.(demand for milk, sugar, tea for making tea).

Composite demand:

The demand for a commodity which can be put for several uses (demand for electricity)

Direct and Derived demand:

Demand for a commodity which is for a direct consumption is called direct demand.(food, cloth). When the commodity is demanded as s result of the demand of another commodity, it is called derived demand.(demand for types depends on demand of vehicles).

Industry demand and company demand:

Demand for the product of particular company is company demand and total demand for the products of particular industry which includes number of companies is called industry demand

 

 

DEMAND ESTIMATION AND FORECASTING

 

Demand Estimation

Business enterprise needs to know the demand for its product. An existing unit must know current demand for its product in order to avoid underproduction or over production. The current demand should be known for determining pricing and promotion policies so that it is able to secure optimum sales or maximum profit. Such information about the current demand for the firm‟s product is known as demand estimation.

Demand Estimation is the process of finding current values of demand for various values of prices and other determining variables.

 

Steps in Demand Estimation

1. Identification of independent variables such as price, price of substitutes, population, percapita income, advertisement expenditure etc.,

2. collection of data on the variables from past records, publications of various agencies etc.,

3. Development a mathematical model or equation that indicates the relationship between independent and dependant variables.

4. Estimation of the parameters of the model. I.e., to estimate the unknown values of the parameters of the model.

5. Development of estimates based on the model.

 

Tools and techniques for demand estimation includes;

1. Consumer surveys.

2. Consumer clinics and focus groups

3. Market Experiment.

4. Statistical techniques.

 

Demand Forecasting.

Accurate demand forecasting is essential for a firm to enable it to produce the required quantities at the right time and to arrange well in advance for the various factors of production. Forecasting helps the firm to assess the probable demand for its products and plan its production accordingly.

Demand Forecasting refers to an estimate of future demand for the product. It is an “objective assessment of the future course of demand”. It is essential to distinguish between forecast of demand and forecast of sales. Sales forecast is important for estimating revenue, cash requirements and expenses. Demand forecast relate to production inventory control, timing, reliability of forecast etc…

 

Levels of Demand forecasting

Demand forecasting may be undertaken at three different levels;

1. Macro level – Micro level demand forecasting is related to the business conditions prevailing in the economy as a whole.

2. Industry Level – it is prepared by different trade association in order to estimate the demand for particular industries products. Industry includes number of firms. It is useful for inter- industry comparison.

3. Firm level – it is more important from managerial view point as it helps the management in decision making with regard to the firms demand and production.

 

Types of Demand Forecasting.

Based on the time span and planning requirements of business firms, demand forecasting can be classified into short term demand forecasting and long term demand forecasting.

Short term Demand forecasting: Short term Demand forecasting is limited to short periods, usually for one year. Important purposes of Short term Demand forecasting are given below;

1. Making a suitable production policy to avoid over production or underproduction.

2. Helping the firm to reduce the cost of purchasing raw materials and to control inventory.

3. Deciding suitable price policy so as to avoid an increase when the demand is low.

4. Setting correct sales target on the basis of future demand and establishment control. A high target may discourage salesmen.

5. Forecasting short term financial requirements for planned production.

6. Evolving a suitable advertising and promotion programme.

 

Long term Demand Forecasting: this forecasting is meant for long period. The important purpose of long term forecasting is given below;

1. Planning of a new unit or expansion of existing on them basis of analysis of long term potential of the product demand.

2. Planning long term financial requirements on the basis of long term sales forecasting.

3. Planning of manpower requirements can be made on the basis of long term sales forecast.

4. To forecast future problems of material supply and energy crisis.

 

Demand forecasting is a vital tool for marketing management. It is also helpful in decision making and forward planning. It enables the firm to produce right quantities at right time and arrange well in advance for the factors of production.

Methods of Demand Forecasting (Established Products)

Several methods are employed for forecasting demand. All these methods can be grouped into survey method and statistical method.

Survey Method.

Under this method, information about the desire of the consumers and opinions of experts are collected by interviewing them. This can be divided into four types;

1. Opinion Survey method: This method is also known as Sales- Force –Composite method or collective opinion method. Under this method, the company asks its salesmen to submit estimate for future sales in their respective territories. This method is more useful and appropriate because the salesmen are more knowledgeable about their territory.

 

2. Expert Opinion: Apart from salesmen and consumers, distributors or outside experts may also be used for forecast. Firms in advanced countries like USA, UK etc…make use of outside experts for estimating future demand. Various public and private agencies sell periodic forecast of short or long term business conditions.

 

3. Delphi Method: It is a sophisticated statistical method to arrive at a consensus. Under this method, a panel is selected to give suggestions to solve the problems in hand. Both internal and external experts can be the members of the panel. Panel members are kept apart from each other and express their views in an anonymous manner.

 

 

4. Consumer Interview method: Under this method a list of potential buyers would be drawn and each buyer will be approached and asked about their buying plans. This method is ideal and it gives firsthand information, but it is costly and difficult to conduct. This may be undertaken in three ways:

A) Complete Enumeration – In this method, all the consumers of the product are interviewed.

B) Sample survey – In this method, a sample of consumers is selected for interview. Sample may be random sampling or Stratified sampling.

C) End-use method – The demand for the product from different sectors such as industries, consumers, export and import are found out.

 

 

Factors Affecting Demand Forecasting.

The following are the important factors governing demand forecasting:

1. Prevailing Business conditions (price level change, percapita income, consumption pattern, saving, investments, employment etc..,

2. Condition within the Industry (Price –product-competition policy of firms within the industry).

3. Condition within the firm. (Plant capacity, quality, important policies of the firm).

4. Factors affecting Export trade (EXIM control, EXIM policy, terms of export, export finance etc..,)

5. Market behaviour

6. Sociological Conditions (Population details, age group, family lifecycle, education, family income, social awareness etc…)

7. Psychological Conditions (taste, habit, attitude, perception, culture, religion etc…)

8. Competitive Condition (competitive condition within the industry)

 

 

 

 

 

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