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Nature and Scope of Business Economics – Business Economics

CA Foundation Notes Chapter 1
What is Economics about?
The word ‘Economics’ is derived from the Greek word ‘Oikonomia’ which means
household management. Till 19th century, economics was known as ‘Political
Economy’. In 1776, Adam Smith published his book entitled “An Inquiry into the
Nature and Causes of the Wealth of Nations” which is considered as the first
modern work of Economics.

Every individual, every society and every country in this world faces the problem
of making CHOICE. This is because of two facts –

Human wants are unlimited.

The means (resources) to satisfy unlimited wants are relatively scarce and
these scarce resources have alternative uses.

As a result we are confronted with the problem of making choice of wants to be

satisfied or the choice among the uses of resources. Thus, we are faced with the
problem of allocation of resources to various uses.

The definition of Economics is however is narrow because it concentrates only at

present i.e. how to use relative scarce resources to satisfy unlimited human wants.
So it gives the picture of a society with fixed resources, skills and productive
capacity, deciding what type of goods and services to be produced and how to
distribute among the members of society.

However, over a period of time growth takes place. With growth there is increase
in the resources and improvement in the quality of resources. But this growth in
production and income is not smooth. It is through ups and downs. Economics,
therefore, deals not only with how a country allocates its scarce productive
resources but also with increase in the productive capacity of resources and with
the reasons which led to sharp fluctuations in the use of resources.

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Economics gives us understanding on economic issues like changes in the price of

a commodity, changes in general price level of goods and services, poverty, level
of unemployment, etc. The understanding of such helps us to decide the models
and frameworks that can be applied in different situations. The tools of economics
helps us to choose the best course of action from various alternatives available.

However, economic problems are of complex nature and are affected by economic
forces, political setup, social norms, etc. Thus, economics does not guarantee that
all problems will be solved appropriately but it helps us to examine the problem in
right perspective and find suitable measures to deal with it.

Meaning of Business Economics:

→ Business Economics is also referred to as Managerial Economics. It is
application of economic theory and methodology.

→ Every business involves decision-making as survival and success depends on

sound decisions.
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→ Decision making means the process of –

evaluating various course of action,

making rational judgment on the basis of available
information, and selecting i.e. making choice of a suitable
alternative by decision maker.

→ Decision making is not simple and straight forward. It has become very
complex due to ever changing business environments, growing competition, large
scale production, big size of business houses, complex laws, cost awareness, etc. In
other words the economic environment in which the firm operates is very complex
and dynamic.

→ Business Economics provides a scientific base to the professional management

of a business activity. It provides tools like budgeting, market analysis, cost-benefit
analysis, etc. which can be scientifically applied to take sound business decisions.
Thus, Business Economics is a subbranch of Economics which aims at the
scientific application of economic knowledge, logic, theories and tools to take
rational business decisions. Thus, it is an APPLIED ECONOMICS.

→ Business Economics is closely connected with both viz., Micro-Economic

Theory as well as MacroEconomic Theory. It is also useful to the managers of
‘not-for-profit’ organisations.

Definitions of Business Economics:

1. “Business Economics in terms of the use of economic analysis in the formulation
of business policies.Business Economics is essentially a component of Applied
Economics as it includes application of selected quantitative techniques such as
linear programming, regression analysis, capital budgeting, break-even analysis
and cost’analysis.” (Joel Dean)

2. “Business Economics is concerned with the application of economic laws,

principles and
methodologies to the managerial decision making process within a business firm
under the H conditions of risks and uncertainties.” (Evans Douglas)
Nature of Business Economics:
→ The subject matter of Economics is broadly divided into two major parts
namely:
Micro-Economics, and Macro-Economics – Before dealing with nature of Business
Economics, it is necessary to understand the difference between the two.

→ Micro-Economics – Micro means a ‘small part’. Therefore, Micro-economics

study the be-haviour of small part or a small component or different individuals
and organisations of a national economy. It examines how the individual units take
decision about rational allocation of their scarce resources.

→ Micro-Economics covers the following :

Theory of Product Pricing;

Theory of Consumer Behaviour,
Theory of Factor Pricing;
The economic conditions of a section of people;
Behaviour of firms; and
Location of industry.

→ Macro-Economics – Macro means ‘large’. Therefore, macro-economics deals

with the large economic activity. It study the economic system of a country as a
whole ie. overall condition of an economy. It is a study of large aggregates like
total employment, the general price level. Total output, total consumption, total
saving and total investments. It also analyses how these aggregates change over
time.

→ Macro-Economics covers the following :

National Income and National Output;

The General Price Level and interest rates;
Balance of Trade and Balance of Payments;
External value of currency i.e. exchange rate;
Overall level of savings and investments i.e. capital
formation; and The level of employment and rate of
economic growth.
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→ Business Economics is primarily concerned with Micro-Economics. However,
knowledge and understanding of Macro-economic environment is also necessary.
This is because macro-economic environment influence individual firm’s
performance and decisions.

→ As already seen Business Economics enables application of economic

knowledge, logic, the-ories and analytical tools. It is Applied Economics that fills
the gap between economic theory and business practice. The following will
describe the nature of Business Economics:

(1) Business Economics is a Science: Science is a systematised body of

knowledge which trace the causeand effect relationships. Business Economics uses
the tools of Mathematics, Statistics and Econometrics with economic theory to take
decisions and frame strategies. Thus, it makes use of scientific methods.

(2) Based on Micro-Economics: As Business Economics is concerned more with

the decision makingproblems of a particular business establishment. Micro level
approach suits is more. Thus, Business Economics largely depends on the
techniques of Micro-Economics.

Show related topics

Efficient Output Choices

Ceteris Paribus in Economics

Eco415

Are Our Resources Scarce in Relation to Our Needs

How are the Central Problem Solved in Capitalist Economy

(3 Incorporates elements of Macro Analysis: A business unit is affected by external environment of

) the
economy in which it operates. A business units is affected by general price level, level of
employment,

govt, policies related to taxes, interest rates, industries, exchange rates, etc. A
business manager should consider such macro-economic variables which may
affect present or future business environment.
(4) Business Economics is an Art: It is related with practical application of laws
and principles to achievethe objectives.

(5) Use of Theory of Markets & Private Enterprise: It uses the theory of markets
and re-source allocationin a capitalist economy.

(6) Pragmatic Approach: Micro-Economics is purely theoretical while, Business

Economics is practical inits approach.

(7) Inter-disciplinary in nature: It incorporates tools from other disciplines like

Mathematics, Statistics,Econometrics, Management Theory, Accounting, etc.

(8) Normative in Nature: Economic theory has been developed along two lines –
POSITIVE andNORMATIVE.

A positive science or pure science deals with the things as they are and their
CAUSE and EFFECTS only. It states ‘what is’? It is DESCRIPTIVE in nature. It
does not pass any moral or value judgments.

A normative science deals with ‘what ought to be’ or ‘what should be’. It passes
value judgments and states what is right and what is wrong. It is PRESCRIPTIVE
in nature as it offers suggestions to solve problems. Normative science is more
practical, realistic and useful science.

Business Economics is normative in nature because it suggests application of

economic principles to solve problems of an enterprise, However, firms should
have clear understanding of their environment and therefore, it has to study
positive theory.

Scope of Business Economics:

→ The scope of Business Economics is wide. Economic theories can be directly
applied to two types of business issues namely –

Micro-economics is applied to operational or internal issues off a firm.

Macro-economics is applied to environment or external issues on which
the firm has no control.
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1. Micro-economics applied to operational or internal issues – Issues like choice of
business size ofbusiness, plant layout, technology, product decisions, pricing,
sales promotion, etc. are dealt by Microeconomic theories.
It covers –

Demand analysis and forecasting

Production and Cost Analysis
Inventory Management
 Market Structure and Pricing Analysis
Resource Allocation
Theory of Capital and Investment Decisions
Profitability Analysis
Risk and Uncertainty Analysis.

2. Macro-economicsapplied to environmental or external issues.

The major economic factors relate to –

the type of economic system stage of business cycles the general trends in
national income, employment, prices, saving and investment.
government’s economic policies working of
financial sector and capital market socio-
economic organisations social and political
environment.

These external issues has to be considered by a firm in business decisions and frame its policies
accordingly to minimize their adverse effects.

Basic Problems of an Economy:

→ We know that human wants are unlimited and resources are scarce.
→ The problem of scarcity of resources is not only faced by individuals but also by the society
at large. → This gives rise to the problem of how to use scare resources so as to serve best the
needs of the society.
→ This economic problem is to be dealt with in all the economic systems whether capitalist or
socialist or mixed.
→ The central problems relating to allocation of resources are :

What to produce and how much to produce?

How to produce?
For whom to produce?
What provision should be made for economic growth?

What to produce and how much to produce?

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An economy has millions commodities to produce.
It has to decide what commodities are to be produced and how much.
Example – To produce luxury goods or consumer goods, etc.
Here, the guiding principle is to allocate the resources in the production of goods in such a
way that maximizes aggregate utility.
How to produce?

There are many alternative techniques to produce a commodity.

Choice has to be made between capital intensive technique or labour intensive
technique of production.
The choice of technique will depend upon
availability of various factors of production, &
the prices of factors of production.

Such techniques of production has to be adopted that makes best use of available resources.

For whom to produce?

Who will consume the goods and services that are produced in the economy?
Whether a few rich or many poor will consume?
Goods and services are produced for those people who can purchase them or pay for
them.
Paying capacity depends upon income or purchasing power.

What provisions should be made for economic growth?

A society cannot afford to use all its scarce resources for current consumption only.
It has to provide for the future as well so that high economic growth can be achieved.

Therefore, an economy has to take decisions about rate of savings, investment, capital
formation, etc.

Meaning of Economic System:

An economic system comprises the totality of forms through which the day to day economic
process is at work. It refers to the mode of production, exchange, distributions and the role
which government play in economic activity. There are three types of economic systems
Capitalism, Socialism and Mixed Economy.
Capitalist Economy:

Capitalistic economic systems is one in which all the means of production are
privately owned. The owners of property, wealth and capital are free to use them as
they like in order to earn profits.
The central problems about what, how and for whom to produce are solved by the free
play of market forces.

Characteristics of Capitalist Economy :

There is right to own and keep private property by individuals. People have a right to
acquire, use, control, enjoy or dispose off it as they like.
There is right of inheritance i.e. transfer of property of a person to his legal heirs after his
death.
There is freedom of enterprise i.e. everybody is free to engage in any type of economic
activity he likes.
There is freedom of choice by consumers i.e. consumer is free to spend his income on
what¬ever goods or services he wants to buy and consume.
Entrepreneurs or producers in their productive activity are guided by their profit motive.
Thus profit motive is the guiding force behind all the productive activity.
There is stiff competition among sellers or producers of similar goods. There is
competition among all the participants in the market.
Price mechanism is an important feature of capitalist economy were the price is
determined through the interaction of market forces of demand and supply.

Merits of Capitalist Economy:

Capitalism works through price mechanism and hence self regulating

In capitalism there is greater efficiency and incentive to work due to two motivating
force namely private property and profit motive.
Faster economic growth is possible.
There is optimum allocation of productive resources of the economy.
There is high degree of operative efficiency.
Cost effective methods are employed in order to maximise profits.
Consumers are benefited as large range of quality goods at reasonable prices are available
from which they makes the choice. This also results in higher standard of living.
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In capitalism there is more innovations and technological progress and country benefits
from research and development, growth of business talent, etc.
Fundamental rights like right to private property and right to freedom are preserved.
It leads to emergence of new entrepreneurial class who is willing to take risks.

Demerits of Capitalist Economy:

In capitalism there is vast economic inequality and social injustice which reduces the
welfare of the society.
There is precedence of property rights over human rights.
Cut-throat competition and profit motive work against consumer welfare leading to
exploitation of consumers.
There are wastage of resources due to duplication of work and cut-throat
competition. Income inequalities lead to differences in economic opportunities.
This lead to rich becoming richer and poor becoming poorer.
There is exploitation of labour.
More of luxury goods and less of wage goods are produced leading to misallocation of
resources. Unplanned production, economic instability in terms of over production,
depression, unemployment, etc. are common in a capitalist economy Leads to creation of
monopolies.
Ignores human welfare because main aim is profit.

Topic: Socialist Economy:

The concept of socialism was given by Karl Marx and Frederic Engels in their work ‘The
Communist
Manifesto’ published is 1848. A socialist economy is also called as “Command Economy” or a
“Centrally Planned Economy.”

In a socialist economy, all the property, wealth and capital is owned by State. There is no
private property.
 State organises all economic activities. It owns, controls and manages the production units;
it distributes the goods among the consumers; it decides the size and direction of
investment.
The state works for the welfare of the people and not for profit.

Characteristics of Socialist Economy:

1. There is collective ownership of means of production i.e all the important means of
production are state owned.

2. It is a centrally planned economy. All the basic decisions relating to the working and
the regulation ofthe economy are taken by central authority called planning commission.

3. Absence of Consumer Choice: Production and distribution of goods is ensured through

planning on preferences deter-mined by the state. So freedom from hunger is guaranteed but,
consumer’s sovereignty is restricted.
4. There is social welfare in place of profit motive. Those goods and services are given
top priority which is in the interest of largest number of people.
5. There is lack of competition because it avoid duplication of efforts and wastage of
resources. Hence, competition is done away.
6. Socialism tries to ensure equitable distribution of income through equality of
opportunities. Thus,right to work is guaranteed but choice of occupation is restricted.
7. Minimum role of Market Forces.

Merits of Socialist Economy:

 Social justice is maintained by equitable distribution of income and wealth and by

providing equal opportunities to all.
 Balanced economic development is possible. Central planning authority allocate
resources according to the plans and priorities.
 There are no class conflict and community develops a co-operative mentality.
 Unemployment is minimized, business fluctuations are eliminated resulting in
stability.
 Right to work is ensured and minimum standard of living is maintained.
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 There is no exploitation of consumers and workers.
 Wastage of resources are avoided due to planning resulting in better utilization of
resources and maximum production.
 Citizens feel secure as there is social security cover for them.

Demerits of Socialist Economy:

 There is predominance of bureaucracy resulting in inefficiency and delays.

 There is no freedom of individuals as it takes away basic rights also like right of
private property.
 Workers are not paid according to their personal efficiency and productivity. This acts
as disincentive to work hard.
 Prices are administered by the state.
 State monopolies may be created and may become uncontrollable. This will be more
dangerous than monopolies under capitalism.
 The consumers have no freedom of choice.

TOPIC: Mixed Economy:

Mixed economy combines the features of both capitalism and socialism. The concept is
designed to incorporate best of both. The main characteristics/features are:
 There is co-existence of both private and public sector i.e. economic resources are owned
by individuals and state.
 Private sector moves to those enterprises which produce higher profit.
There is co-existence of free price mechanism and economic planning.
 Public Sector: Industries under this sector are not primarily profit – oriented but
are set up by the state for welfare of community. Planning is done through
incentives like concessions, subsidies, etc. and disincentives like high rate of taxes,
strict licensing etc.
 Combined sector: This this sector both govt and prvt sector have equal access .

Merits of Mixed Economy:

Merits of capitalist economy and socialist economy are found in mixed economy.
There is right of private property and economic freedom. This results in incentive to work
hard and capital formation.
 Price mechanism and competition induces the private sector in efficient decision making
and better resource allocation.
There is freedom of occupation and consumption.
Encourages enterprise and risk taking.
Leads to development of technologies through research and development.
Economic and social equality is more.

Demerits:

However, mixed economy suffers from uncertainties, excess control by state, poor
implementation of plans, high taxes, corruption, wastage of resources, slow growth, lack of
efficiency, etc. There are possibilities of private sector growing, disproportionately if state does
not maintain a proper balance between public and private sectors.

Unit 2
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Topic: Conceptual Background of Demand:

In ordinary speech, the term demand is many times confused with ‘desire’ or ‘want’.Desire is
only a wish to have any thing. In economics demand means more than mere desire.

Demand in economics means an effective desire for a commodity i.e. desire backed by the
‘ability to pay’ and ‘willingness to pay’ for it.

Thus, demand refers to the quantity of a good or service that consumers are willing and
able to purchase at different prices during a period of time.

Thus, defined, the term demand shows the following features:

→ Demand is always with reference to a PRICE.

→ Demand is to be referred to IN A GIVEN PERIOD OF TIME.

→ Consumer must have the necessary purchasing power to back his desire for the
commodity.

→ Consumer must also be ready to exchange his money for the commodity he desires.

Topic 2: Determinants of Demand:

For estimating market demand for its products, a firm must have knowledge about –

the determinants of demand for its product, and the nature of relationship between demand and
is determinants.

The various factors on which the demand for a product/commodity depends are as follows:

1. Price of the commodity: Other things being equal, the demand for a commodity is
inversely related with its price. It means that a rise in price of a commodity brings about
fall in its demand and vice versa. This happens because of income and substitution effects.
2. Price of the related commodities: The demand for a commodity also depends on
the prices of related commodities.

Related commodities are of two types namely –

→ Substitutes or competitive goods, &

→ Complementary goods.

 Substitute goods are those goods which can be used with equal ease in place of one
another. Demand for a particular commodity is affected if the price of its substitute falls
or rises.

Example –Coke and Pepsi; ball pen and ink pen; tea and coffee; etc.

Thus, there is a POSITIVE RELATIONSHIP between price of a commodity and demand

for its substitutes.

 Complementary good are those goods whose utility depends upon the availability of
both the goods as both are to be used together.

Example – a ball pen and refill; car and petrol; a hand set and phone connection; a tonga and
horse, etc.

The demand for complementary goods have an INVERSE RELATIONSHIP with the price
of related goods.

Example – If the price of Scooters falls, its demand will increase leading to increase in
demand for petrol.

3. Income of the consumers:

 Other things being equal, generally the quantity demanded of a commodity bear a
DIRECT RELATIONSHIP to the income of the consumer i.e. with an increase in
income, the demand for a commodity rises.
 However, this may not always hold true. It depends upon the class to which commodity
belongs i.e. necessaries or comforts and luxuries or inferior goods:

→ Necessaries (E.g. Food, clothing and shelter). Initially, with an increase in the in-come,
the demand for necessaries also rises upto some limit. Beyond that limit, an increase in
income will leave the demand unaffected.

→ Comforts and Luxurious (Example Car; Air-Conditioners; etc.) Quantity demanded of

these group of commodities have a DIRECT RELATIONSHIP with the income of the
consumers. As the income increases, the demand for comforts and luxuries also increases.
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→ Inferior goods (E.g. Coarse grain; rough cloth; skimmed milk; etc.). Inferior goods are
those goods for which superior substitutes are available Quantity demanded of this group
of commodities Have an INVERSE RELATIONSHIP with the income of the consumer.

Exception: Giffin Goods: Giffen goods are low-priced products, the demand for which rises
along with the price. These products are necessary to fulfill the need for food, and they have
only a few substitutes. A Giffen good has an upward-sloping demand curve .

4. Tastes and Preferences of the consumers:

 Tastes and preferences of consumers generally change over time due to fashion,
advertisements, habits, age, family composition, etc. Demand for a commodity bears a
direct relationship to those determinants.
 The demand of certain goods is determined by ‘bandwagon effect’ or ‘demonstration
effect’. It means a buyer wants to have a good because others have it.
 Taste and preferences may also undergo a change when consumer discover that con-
sumption of a good increases his PRESTIGE. Example:Diamonds,
 Status seeking rich people buy highly priced goods only. This form of ‘conspicuous
consumption’ or ‘ostentatius consumption’ is called ‘VEBLEN EFFECT’ (named
after American economist THORSTEIN VEBLEN)
 Snob Effect: It arises when the preference for a good increases as the quantity in tha
market decreases.
 But in Bandwagon effect, the preference for a good increases as the number of
consumers buying a particular commodity increases.

5. Other Factors. Other things being equal demand for a commodity is also determined by the
following factors:

a. Size and composition of Population: Generally, larger the size of population of a country,
more will be the demand of the commodities. The composition of the population also
determines the demand for various commodities.

b. The level of National Income and its Distribution: National Income is an important
determinant of market demand. Higher the national income, higher will be the demand for
normal goods and services.

Note: If the income in a country is unevenly distributed, the demand for consumer goods will
be less. If the income is evenly distributed, there is higher demand for consumer goods.
c. Sociological factors:The household’s demand for goods also depends upon sociological
factors like class, family background, education, marital status, age, locality, etc.

d. Government Policy:The government’s taxation policy also affects the demand for
commodities. High tax on a commodity will lead to fall in the demand of the commodity.

e. Expectation about future prices: If consumers expect rise in the price of a commodity in
near future, the current demand for the commodity will increase and vice versa

Topic: Demand Function:

Mathematical/symbolic statement of functional relationship between the demand for a product
(the dependent variable) its determinants (the independent variables) is called demand
function

Dx = f (Px, Y, Ps ; Pc, T, A)

Where –
Dx = quantity demanded of product X
Px = the price of the product X
Y = income of the consumer
Ps = the price of its substitute
Pc = the price of its complementary goods
T = consumer’s tastes and preferences

Topic: The Law of Demand:

According to law of demand, “ other things being constant,if the price of the commodity
falls,the quantity demand of it will rise and if the price of commodity rises, its quantity
demand decline” i,e there is an inverse relationship between price and quantity demand
ceterus paribus.

Thus we can summarise the followings:

→ The Law of Demand expresses the nature of functional relationship between the price of a
commodity and its quantity demanded.

→ It simply states that demand varies inversely to the changes in price i.e. demand for a
commodity expands when price falls and contracts when price rises.
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→ “Law of Demand states that people will buy more at lower prices and buy less at higher
prices, other things remaining the same.” (Prof. Samuelson)

→ It is assumed that other determinants of demand are constant and ONLY PRICE IS THE
VARIABLE AND INFLUENCING FACTOR.

→ Thus, the law of demand is based on the following main assumptions:

 Consumers income remain unchanged.

 Tastes and preferences of consumers remain unchanged.
 Price of substitute goods and complement goods remain unchanged.
 There are no expectations of future changes in the price of the commodity.
 There is no change in the fashion of the commodity etc.
 No change in tax policy of the Government: The level of direct and indirect tax imposed by the
government on the income and goods should remain constant.

Topic: Demand schedule And Demand Curve:

The law of demand can be illustrated with the help of Demand Schedule and
Demand Curve:

 Individual Demand Schedule and Demand Curve : It is a table

which presents the different prices of a good and the corresponding Quantity Demamded
per unit of time.
 Individual Demand Schedule: Individual demand schedule is a tabular representation of the
quantities of goods that an individual demands at different prices and time, keeping all the other
factors constant.
 Individual Demand Curve: An individual demand curve is one that examines the price-
quantity relationship for an individual consumer, or how much of a product an individual will
buy given a particular price.
 Market Demand Schedule and Market Demand Curve:
 Market Demand Schedule Market consists of many individuals who are the
consumers of a particular commodity available in the market. Therefore, each of
these individuals will have a separate demand schedule.

 Market Demand Curve: A market demand curve is the summation of the

individual demand curves in a given market. It shows the quantity of a good
demanded by all individuals at varying price points.

Note: Unlike individual demand curves, which are generally steeper, market
demand curves tend to be flatter.
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Topic: Rationale/ Reasons for Law of Demand

1. Law of Diminishing Marginal UtilityThe Law of Diminishing Marginal Utility states that
as more and more units of a commodity is consumed, the utility derived by the consumer
from each successive unit keeps decreasing. Hence, the consumer will buy more of the
commodity only when its price falls.
Note: According to Marshall Downward slopping of demand curve is due to Law of
Diminishing Marginal Utility

2. Substitution Effect: when the price of a commodity (let’s say coffee) falls, it becomes
relatively cheaper than its substitute (let’s say tea), assuming that the price of the substitute
(tea) does not change because of which the demand for the given commodity (coffee) increases.

3. Income Effect: When the real income of the consumer changes because of the change in the
price of the given commodity, there is an effect on its demand. This effect on demand is known
as Income Effect. In other words, when there is a fall in the price of the given commodity, it
increases the purchasing power of the consumer, resulting in an increase in the ability of the
consumer to buy more of it.

Note: Price Effect is the combined effect of Income Effect and Substitution Effect (Price
Effect = Substitution Effect + Income Effect).

Note: According to Hicks and Allen Downward slopping of demand curve is due to
Income and Substitution Effect:

4. Additional Customers: When the price of a commodity falls, various new customers who
could not purchase the commodity earlier due to its high price are now in a position to buy it
resulting in an increase in its total demand.

5: Different Uses: Some commodities have different uses. when the price of the commodity
reduces, consumers will use it for different purpose, whether it is important or not.

Topic: Exceptions to Law of Demand

1. Giffen Goods:
 The special kind of inferior goods on which the consumers spend a big part of their
income are known as Giffen Goods.
 The demand for these goods increases with an increase in price and falls with a
decrease in price.
 This phenomenon was initially observed by Sir Robert Giffen and is popularly known
as Giffen’s Paradox.

2. Fear of Shortage: If the consumers expect that a commodity will become scarce in the near
future, they will start buying more of it in the present, even if the price of the commodity
rises because of the fear of its shortage and rise in its price in the future.

3. Status Symbol or Goods of Ostentation: Another exception to the law of demand is the
goods that are used as status symbols by the people.

4. Ignorance: Sometimes consumers are unaware of the prevailing price of a good in the
market. In such cases, they buy more of a commodity, even at a higher price.

5. Necessities of Life:

 The commodities which are necessary for human life have more demand no matter
whether their price reduces or increases.
 For example, demand for necessity goods like medicines, pulses, wheat, etc., will
increase, even if their price increases.

6. Change in Weather: When there is a change in the weather, demand for some goods
changes, even if their price increases. For example, demand for raincoats in the rainy season
increases, even if their price increases.

7. Fashion-related goods: The goods related to fashion are demanded more, even when their
price is high. For example, if a specific model of Mobile Phone is in fashion, then consumers
will buy it, even if its price increases.
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Topic: Expansion and Contraction of Demand (changes in

quantity demanded. Or movement along a demand curve):
→ The law of demand, the demand schedule and the demand curve all show that:

 when the price of a commodity falls its quantity demanded rises or expansion takes place
and
 when the price of a commodity rises its quantity demanded fall or contraction takes
place.

→ Thus, expansion and contraction of demand means changes in quantity demanded due to
change in the price of the commodity other determinants like income, tastes, etc. remaining
constant or unchanged.

→ When price of a commodity falls, its quantity demanded rises. This is called expansion of
demand.

→ When price of a commodity rises, its quantity demanded falls. This is called contraction of
demand.

→ As other determinants of price like income, tastes, price of related goods etc. are constant,
the position of the demand curve remains the same. The consumer will move upwards or
downwards on the same demand curve.

→ At price OP quantity demanded is OQ.

  With a fall in price to OP1, the quantity demanded rises from OQ to OQ1. The
coordinate point moves down from E to E1. This is called ‘expansion of demand’ or ‘a
rise in quantity demanded’ or ‘downward movement on the same demand curve’.

→ At price OP quantity demanded is OQ.

 With a rise in price to P2, the quantity demanded falls from OQ to OQ2. The coordinate
point moves up from E to E2. This is called ‘contraction of demand’ or ‘a fall in quantity
demanded’ or ‘upward movement on the same demand curve’.

→ Thus, the downward movement on demand curve is known as expansion in demand and an
upward movement on demand curve is known as contraction of demand.

Topic: Increase and Decrease in demand (changes in

demand OR shift in demand curve):
 When there is change in demand due to change in factors other than price of the
commodity, it is called increase or decrease in demand.
 Thus, price remaining the same when demand rises due to change in factors other than
price, it is called increase in demand. Likewise price remaining the same when demand
falls due to change in factors other than price, it is called decrease in demand. Here, less
quantity is purchased at ame price or same quantity is purchased at lower price.

 In above cases demand curve shifts from its original position to rightward when demand
increases and to leftward when demand decreases. Thus, change in demand curve as a
result of increase or decrease in demand, is technically called shift in demand curve.

In the figure:
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1. Original demand curve is DD. At OP price OQ quantity is being demanded.

2. As the demand changes, the demand curve shifts either to the right (D1D1) or to the left
(D2D2)

3. At D1D1, OQ1 quantity is being demanded at the price OP. This shows increase in demand
(rightward shifts in demand curve) due to factor other than price.

4. At D2D2, QO2 quantity is being demanded at the price OP. This shows decrease in demand
(leftward shift in demand curve) due to a factor other than price.

5. When demand of a commodity INCREASES due to factors other than price, firms can sell a
larger quantity at the prevailing price and earn higher revenue.

6. The aim of a advertisement and sales promotion activities is to shift the demand curve to the
right and to reduce the elasticity of demand.
 Chapter 2 Elasticity of Demand

Topic : Elasticity of Demand:

Elasticity of demand is defined as the responsiveness or sensitiveness of the quantity demanded
of a commodity to the changes in any one of the variables on which demand depends.

These variables are price of the commodity, prices of the related commodities, income of the
consumers and many other factors on which demand depends.

Accordingly, we have price elasticity, cross elasticity, elasticity of substitution, income

elasticity and advertisement elasticity.

Unless mentioned otherwise, it is price elasticity of demand which is generally referred.

Topic: Price Elasticity of Demand:

→ Price elasticity measures the degree of responsiveness of quantity demanded of a commodity
to a change in its price, given the consumer’s income, his tastes and prices of all other goods.
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→ It reflects how sensitive buyers are to change in price.

→ Price elasticity of demand can be defined “as a ratio of the percentage change in the quantity
demanded of a commodity to the percentage change in its own price”.

→ It may be expressed as follows:

Where –

q = Original quantity demanded

p = Original price

∆ = indicates change

E = price elasticity

→ Since price and quantity demanded are inversely related, the value of price elasticity
coefficient will always be negative. But for the value of elasticity coefficients we ignore the
negative sign and consider the numerical value only.

→ The value of elasticity coefficients will vary from zero to infinity.

 When the coefficient is zero, demand is said to be perfectly inelastic.

 When the coefficient lies between zero and unity, demand is said to be inelastic.
 When coefficient is equal to unity, demand has unit elasticity.
 When coefficient is greater than one, demand is said to elastic.

In extreme cases co-efficient could be infinite.

The degrees (types) of price elasticity of demand.

→ Price elasticity measures the degree of responsiveness of quantity demanded of a commodity

to a change in its price. Depending upon the degree of responsiveness of the quantity demanded
to the price changes, we can have the following kinds of price elasticity of demand.

1. Perfectly Inelastic Demand: (Ep = 0):

Theory of Demand and Supply – CA Foundation Economics Notes Chapter 2 5

When change in price has no effect on quantity demanded, then demand is perfectly inelastic.
Example – If price falls by 20% and the quantity demanded remains unchanged then, Ep = 020
= 0. In this case, the demand curve is a vertical straight line curve parallel to y-axis as shown in
the figure.

2. Perfectly Elastic Demand: (Ep = ∞):

Theory of Demand and Supply – CA Foundation Economics Notes Chapter 2 6

When with no change in price or with very little change in price, the demand for a commodity
expands or contracts to any extent, the demand is said to be perfectly elastic. In this case, the
demand curve is a horizontal and parallel to X-axis. The figure shows that demand curve DD is
parallel to X-axis which means that at given price, demand is ever increasing.

3. Unit Elastic Demand: (Ep = 1):

Theory of Demand and Supply – CA Foundation Economics Notes Chapter 2 7

When the percentage or proportionate change in price is equal to the percentage or

proportionate change in quantity demanded, then the demand is said to be unit elastic.

Example: If price falls by 10% and the demand rises by 10% then, Demand Curve DD is a
rectangular hyperbola curve suggesting unitary elastic demand.

4. Relatively Elastic Demand: ( Ep > 1):

When a small change in price leads to more than proportionate change in quantity demanded
then the demand is said to be relatively elastic

Example: If price falls by 10% and demand rises to by 30% then, Ep = 3010 = 3 > 1. The
coefficient of price elasticity would be somewhere between ONE and INFINITY. The elastic
demand curve is flatter as shown in figure.

Theory of Demand and Supply – CA Foundation Economics Notes Chapter 2 8

Demand curve DD is flat suggesting that the demand is relatively elastic or highly elastic.
Relatively elastic demand occurs in case of less urgent wants or if the expenditure on
commodity is large or if close substitutes are available.
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5. Relatively Inelastic Demand: (Ep < 1):

When a big change in price leads to less than proportionate change in quantity demanded, then
the demand is said to be relatively inelastic.

Theory of Demand and Supply – CA Foundation Economics Notes Chapter 2 9

Example: If price falls by 20% and demand rises by 5% then, Ep = 520 = 14 < 1 The coefficient
of price elasticity is somewhere between ZERO and ONE. The demand curve in this case has
steep slope.

Demand curve DD is steeper suggesting that demand is less elastic or relatively inelastic.
Relatively inelastic demand occurs in case compulsory goods i.e. necessities of life.

Measurement of price elasticity of demand:

The different methods of measuring price elasticity of demand are:

The Percentage or Ratio or Proportional Method,

The Total Outlay Method,

The Point or Geometrical Method, and

The Arc Method.

1. The Percentage Method:

This method is based on the definition of elasticity of demand. The coefficient of price
elasticity of demand is measured by taking ratio of percentage change in demand to the
percentage change in price. Thus, we measure the price elasticity by using the following
formula –

Ep = Δqq x pΔq = ΔqΔp x pq

Where –

∆ q = Change in quantity demanded

q = Original quantity demanded

∆ p = change in price
p = Original price

If the coefficient of above ratio is equal to ONE or UNITY, the demand will be unitary.

If the coefficient of above ratio is MORE THAN ONE, the demand is relatively elastic.

If the coefficient of above ratio is LESS THAN ONE, the demand is relatively inelastic.

2. The Total Outlay or Expenditure Method or Seller’s Total Revenue Method:

The total outlay refers to the total expenditure done by a consumer on the purchase of a
commodity. It is obtained by multiplying the price with the quantity demanded. Thus,

Total Outlay (TO) = Price (P) X Quantity (Q)

TO = P X Q

In this method, we measure price elasticity by examining the change in total outlay due to
change in price.

Dr. Alfred Marshall laid the following propositions:

When with the change in price, the TO remains unchanged, Ep = 1.

When with a rise in price, the TO falls or with a fall in price, the TO rises, Ep > 1.

When with a rise in price, the TO also rises and with a fall in price, the TO also falls, Ep < 1.

Price per Unit (₹) Quantity

Demanded

Total Outlay (P x Q) Elasticity of Demand

4 20 Units

25 Units 100

100 Ep = 1

Unitary

5
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4 20 Units

25 Units 100

120 Ep > 1

Elastic

4 20 Units

25 Units 100

88 Ep < 1

Inelastic

→ However, total outlay method of measuring price elasticity is less exact. This method only
classifies elasticity into elastic, inelastic and unit elastic.

→ The exact and precise coefficient of elasticity cannot be found out with this method.

3. The Point Method or Geometric Method:

→ The point elasticity method, we measure elasticity at a given point on a demand curve.

→ This method is useful when changes in price and quantity demanded are very small so that
they can be considered one and the* same point only.

→ Example: If price of X commodity was ₹ 5,000 per unit and now it changes to ₹ 5002 per
unit which is very small change. In such a situation we measure elasticity at a point on demand
curve by using formula ΔqΔp x pq

→ Diagrammatically also we can find elasticity at a point by using the formula –

Theory of Demand and Supply – CA Foundation Economics Notes Chapter 2 10

Figure:
The figure shows that even though the shape of the demand curve is constant, the elasticity is
different at different points on the curve.

If the demand curve is not a straight line curve, then in order to measure elasticity at a point on
demand curve we have to draw tangent at the given point and then measure elasticity using the
above formula.

We can also find out numerical elasticities on different points.

4. The Arc Elasticity Method:

→ When there is large change in the price or we have to measure elasticity over an arc of the
demand curve, we use the “arc method” to measure price elasticity of demand.

→ The arc elasticity is a measure of the “average elasticity” ie. elasticity at MID-POINT that
connects the two points on the demand curve.

→ Thus, an arc is a portion of a curved line, hence a portion of a demand curve. Here instead of
using original or new data as the basis of measurement, we use average of the two.

Theory of Demand and Supply – CA Foundation Economics Notes Chapter 2 11

→ The formula used is –

Ep = q1−q2q1+q2×p1+p2p1−p2

Where – P1 & q1 = Original price and quantity

p2 & q2 = new price and quantity

Ep = 5−125+12×10+510−5

Ep = −717×155 = Ep = 2117 = 1.23

Ep = 1.23

Theory of Demand and Supply – CA Foundation Economics Notes Chapter 2

Determinants of price elasticity of demand:

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Price elasticity of demand which measures the degree of responsiveness of quantity demand¬ed
of a commodity to a change in price (other things remaining unchanged) depends on the
following factors –

1. Nature of commodity:

The demand for necessities of life like food, clothing, housing etc. is less elastic or inelastic
because people have to buy them whatever be the price.

Whereas, demand for luxury goods like cars, air-conditioners, cellular phone, etc. is elastic.

2. Availability of Substitutes:

If for a commodity wide range of close substitutes are available i.e. if a commodity is easily
replaceable by others, its demand is relatively elastic. Example – Demand for cold drinks like
Thumbs-up, Coca-cola, Limca, etc.

Conversely, a commodity having no close substitute has inelastic demand. Example – Salt (but
demand for TATA BRAND SALT is elastic.)

3. Number of uses of a commodity:

A commodity which has many uses will have relatively elastic demand.

Example – Electricity can be put to many uses like lighting, cooking, motive-power, etc. If the
price of electricity falls, its consumption for various purposes will rise and vice versa.

On the other hand if a commodity has limited uses will have inelastic demand.

4. Price range:

If price of a commodity is either too high or too low, its demand is inelastic but those which are
in middle price range have elastic demand.

5. Position of a commodity in the budget of consumer:

If a consumer spends a small proportion of his income to purchase a commodity, the demand is
inelastic.
Example – Newspaper, match box, salt, buttons, needles.

But if consumer spends a large proportion of his income to purchase a commodity, the demand
is elastic.

Example -Clothes, milk, etc.

6. Time period:

The longer any price change remains the greater is the price elasticity of demand.

On the other hand, shorter any price change remains, the lesser is the price elasticity of demand.

7. Habits:

Habits makes the demand for a commodity relatively inelastic.

Example – A smoker’s demand for cigarettes tend to be relatively inelastic even at higher price.

8. Tied Demand (Joint Demand):

Some goods are demanded because they are used jointly with other goods. Such goods
normally have inelastic demand as against goods having autonomous demand.

Example – Printers & Cartridges.

Knowledge of the concept of elasticity of demand and the factors that may change it is of great
IMPORTANCE in practical life. The concept of elasticity of demand is helpful to –

1. Business Managers as it helps then to recognise the effect of price change on their total sales
and revenues. The objective of a firm is profit maximization. If demand is ELASTIC for the
product, the managers can fix a lower price in order to expand the volume of sales and vice
versa.

2. Government for determining the prices of goods and services provided by them.

Example 1 : transport, electricity, water, cooking gas, etc. It also helps governments to
understand the nature of response of demand when taxes are raised and its effect on the tax
revenues.
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Example 2 : Higher taxes are imposed on the goods having INELASTIC DEMAND like
cigarettes, liquor, etc.

Income Elasticity of Demand:

→ The income elasticity of demand measures the degree of responsiveness of quantity

demanded to changes in income of the consumers.

→ The income elasticity is defined as a ratio of percentage change in the quantity demanded to
the percentage change in income.

Theory of Demand and Supply – CA Foundation Economics Notes Chapter 2 37

Symbolically – Ey = ΔQΔY x YQ

Where – AQ &AY denote new quantity & income.

Q & Y denote original quantity & income.

The income elasticity of demand is Positive for all normal or luxury goods and the income
elasticity of demand is Negative for inferior goods. Income elasticity can be classified under
five heads:

1. Zero Income Elasticity:

It means that a given increase in income does not at all lead to any increase in quantity
demanded of the commodity.

In other words, demand for the commodity is completely income inelastic or Ey < 0.

Commodities having zero income elasticity are called Neutral Goods.

Example – Demand in case of Salt, Match Box, Kerosene Oil, Post Cards, etc.

2. Negative Income Elasticity;

It means that an increase in income results in fall in the quantity demanded of the commodity or
Ey <0.

Commodities having negative income elasticity are called Inferior Goods. Example – Jawar,
Bajra, etc.
3. Unitary Income Elasticity:

It means that the proportion of consumer’s income spent on the commodity remains unchanged
before and after the increase in income or Ey = 1. This represents a useful dividing line.

4. Income Elasticity Greater Than Unity:

It refers to a situation where the consumers spends Greater proportion of his income on a
commodity when he becomes richer. Ey > 1,

Example – In the case of Luxuries like cars, T.V. sets, music system, etc.

5. Income Elasticity Less Than Unity:

It refers to a situation where the consumer spends a Smaller proportion of his income on a
commodity when he becomes richer. Ey < 1,

Theory of Demand and Supply – CA Foundation Economics Notes Chapter 2 12

Example – In the case of Necessities like rice, wheat, etc.

Cross elasticity of demand:

→ Many times demand for two goods are related to each other.

→ Therefore, when the price of a particular commodity changes, the demand for other
com¬modities changes, even though their own prices have not changed.

→ We measures this change under cross elasticity.

→ The cross elasticity of demand can be defined “as the degree of responsiveness of demand
for a commodity to a given change in the price of some RELATED commodity” OR “as the
ratio of percentage change in quantity demanded of commodity X to a given percentage change
in the price of the related commodity Y”. Symbolically:

Ec =
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Ec = ΔqxΔpy×pyqx

Where Ec = cross elasticity

qx = Original quantity of X which is demanded

py = Original price of Y

∆ = denotes change

Theory of Demand and Supply – CA Foundation Economics Notes Chapter 2 13

→ Cross elasticity of demand can be used to classify goods as follows:

1. Substitute Goods:

Example: Tea and Coffee. The cross elasticity between two substitutes is always Positive. If
cross elasticity is infinite, the two goods are perfect substitute and if it is greater than zero but
less than infinity, the goods are substitutes.

2. Independent Goods:

Example: Pastry and Scooter. The two commodities are not related. The cross elasticity in such
cases is Zero.

3. Complementary Goods:

Example: Petrol and Car. If the price of petrol rise, its demand falls and along with it demand
for cars also falls. The cross elasticity in such cases is Negative.

Advertisement or Promotional Elasticity of Demand:

→ Demand of many goods is also influenced by advertisement or promotional efforts.

→ It means that the demand for a good is responsive to the advertisement expenditure incurred
by a firm.

→ The measurement of the degree of responsiveness of demand of a good to a given change in

advertisement expenditure is called advertisement or promotional elasticity of demand.
→ It measures the percentage change in demand to a give ONE PERCENTAGE change in
advertising expenditure. It helps a firm to know the effectiveness of its advertisement
campaign.

→ Advertisement elasticity of demand is POSITIVE. Higher the value, higher is change in

demand to change in advertisement expenditure.

Ea =

Ea = ΔQΔA×AQ

Where –

A = advertisement expenditure

Q = quantity demanded

∆ = change

→ The value of advertisement elasticity varies between zero and infinity. If –

Ea = 0, no change in demand to increase in advertisement expenditure

Ea > 0 but < 1, less than proportionate change in demand to a change in advertisement
expenditure

Ea = 1, change in demand is equal to change in advertisement expenditure

Ea > 1, higher rate of change in demand than change in advertisement expenditure

Theory of Demand and Supply – CA Foundation Economics Notes Chapter 2

Demand Forecasting

Meaning:
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Demand forecasting is an estimate of the future market demand for a product. The process of
forecasting is based on reliable statistical data of past and present behaviour, trends, etc.

Demand forecasting cannot be hundred per cent correct. But, it gives a reliable estimates of the
possible outcome with a reasonable accuracy.

Demand forecasting may be at international level or local level depending upon area of
operation, cost, time, etc.

Usefulness:

Demand forecasting is an important function, of managers as it reduces uncertainty of

environment in which Decisions are made. Further, it helps in Planning for future level of
production. Its significance can be stated as follows:

1. Production Planning: Demand forecasting is a pre-requisite for planning of production in a

firm. Expansion of production capacity depends upon likely demand for its output. Otherwise,
there may be overproduction or underproduction leading to losses.

2. Sales Forecasting: Sales forecasting depends upon demand forecasting. Promotional efforts
of the firm like advertisements, suitable pricing etc. should be based on demand forecasting.

3. Control of Business: Demand forecast provide information for budgetary planning and cost
control in functional area of finance and accounting.

4. Inventory Control: Demand forecasting helps in exercising satisfactory control of business

inventories like raw-materials, intermediate goods, semi-finished goods, spare parts, etc.
Estimates of future requirement of inventories is to be done regularly and it can be known from
demand forecasts.

5. Capital Investments: Capital investments yield returns over many years in future. Decision
about investment is to be taken by comparing rate of return on capital investment and current
rate of interest. Demand forecasting helps in taking investment decisions.

Types of forecasts:
Macro-level forecasting deals with the general economic environment prevailing in the
economy as measured by the Index of Industrial Production (IIP), national income and general
level of employment, government expenditure, consumption level, consumers spending habits,
etc.

Industry-level forecasting refers to forecasting the demand of a good of a particular industry as

a whole. Example – Demand for two-wheelers in India.

Firm-level forecasting refers to forecasting the demand of a good of a particular firm. Example
– Bajaj motor cycle.

Based on time period, demand forecasting may be –

Short-term demand forecasting normally relates to a period not exceeding a year. It is also
called as ‘operating forecast’. It is useful for estimating stock requirement, providing working
capital, etc.

Long-term demand forecasting may cover one to five years, depending on the nature of the
firm. It provides information for taking decisions like expansion of plant capacity, man-power
planning, long-term financial planning, etc.

Demand Distinctions:

Producer’s goods and Consumer’s Goods –

The goods which are used for the production of other goods are called producer’s goods.
Example – Machines

The goods which are used for final consumption are called consumer’s goods. Example –
readymade clothes, toothpaste, soap, house etc.

Durable goods and Non-durable goods:

1. Goods can be further divided into durable and non-durable goods.

2. Durable goods are those which can be consumed more than once and yield utility over a
period of time.
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Producer’s Durable Goods – Example – Building, Plant, Machinery etc.

Consumer’s Durable Goods – Example – Cars, TV, Refrigerators, etc.

3. Non-durable goods are those which cannot be consumed more than once. These will meet
only the current demand.

Producer’s Non-durable Goods – Example – raw material, fuel, power, etc.

Consumer’s Non-durable Goods – Example – milk, bread, etc.

Derived demand and Autonomous demand:

1. The demand for a commodity is said to be derived when its demand depends on the demand
for some other commodity. In other words, it is the demand which has been derived from the
demand for some other commodity called “parent product”.

Example – The demand for bricks, cement, steel, sand, etc. is derived demand because their
demand depends on the demand for houses. Producer goods and complementary goods have
derived demand.

2. When the demand of a commodity is independent of the demand for other commodity, then it
is called autonomous demand.

Industry demand and Company demand:

1. The total demand of a commodity of a particular industry is called industry demand.

Example – the total demand for shoes in the country.

2. The demand for the commodity of a particular company is called company demand.

Example – shoes produced by BATA.

Short-run demand and long-run demand:

1. When the demand respond immediately to price changes, income changes etc. is re-ferred as
short-run demand.

2. When the demand still exist as a result of changes in pricing, sales promotion, quality
improvement etc. after enough time is allowed to let the market adjust to the new situation is
called long-run demand.

Factors affecting demands for non-durable goods:

The factors which affects the demand of Non-durable consumer goods are as follows:

→ Disposable Income: The income left with a person after paying direct taxes and other deduc-
tions is called as disposable income. Other things being equal, more the disposable income of
the household, more is its demand for goods and vice versa.

→ Price: The demand for a commodity depends upon its price and the prices of its substitutes y
and complements. The demand for a commodity is inversely related to its own price and the
price of its complements. The demand for a commodity is positively related to its substitutes.

→ Demography: This involves the characteristics of the populations, human as well as non
human which use the given product. E.g. – If forecast about the demand for toys is to be made,
we will have to estimate the number and characteristics of children whose parents can afford
toys.

Factors affecting the demand for consumer durable goods:

→ Long time use or replacement: For how long a consumer can use a good depends on the
factors like his status, prestige attached to good, his level of money income, etc. Replacement
of a good depends upon the factors like the wear and tear rate, the rate of obsolescence, etc.

→ Special Facilities: Some goods need special facilities for their use. Example – Roads for
cars, elec-tricity for T.V., refrigerators etc. The expansion of such facilities expands the demand
for such goods.
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→ Joint use of a good by household: As consumer durables are used by more than one person,
the decision to purchase may be influenced by family characteristics like size of family, age and
sex consumption.

→ Price and Credit facilities: Demand for consumer durables is very much influenced by their
prices and credit facilities like hire purchase, low interest rates, etc. available to buy them. More
the easy credit facilities higher is the demand for goods like two wheelers, cars TVs. etc.

Factors affecting the demand for producer goods:

→ The demand for producer or capital goods is a derived demand. It is derived from the
demand of consumer goods they produce.

→ The forecasting of a capital good depends upon the following factors:

Increase in the price of substitutable factor increases the demand for capital goods.

The existing stock of the capital goods.

Technology advancement leading to reduced cost of production.

Prevailing rates of interest etc.

Theory of Demand and Supply – CA Foundation Economics Notes Chapter 2

Methods of Demand Forecasting:

There is no easy method to predict the future with certainty. The firm has to apply a proper mix
of methods of forecasting to predict the future demand for a product. The various methods of
demand forecasting are as follows:

→ Survey of Buyer’s intentions: In this method, customers are asked what they are planning to
buy for the forthcoming time period usually a year.

1. This method involve use of conducting direct interviews or mailing questionnaire asking
customers about their intentions or plans to buy the product.
2. The survey may be conducted by any of the following methods:

Complete Enumeration where all potential customers of a product are interviewed about what
they are planning or intending to buy in future. It is cumbersome, costly and time consuming
method.

Sample Survey where only a few customers are selected and interviewed about their future
plans. It is less cumbersome and less costly method.

End-use method or Input-output method where the bulk of good is made for industrial
manufactures who usually have definite future plans.

3. This method is useful for short-term forecasts.

4. In this method burden of forecasting is put on the customers.

Collective opinion Method: The method is also known as sales force opinion method or grass
roots approach.

1. Under this method, salesmen are asked to estimate expectations of sales in their territories.
Salesmen are considered to be the nearest persons to the customers retailers and wholesalers
and have good knowledge and information about the future demand trend.

2. The estimates of all the sales-force is collected are examined in the light of proposed changes
in selling price, product design, expected competition, etc. and also factors like purchasing
power, employment, population, etc.

3. This method is based on first hand knowledge of the salesmen. However, its main drawback
is that it is subjective. Its accuracy depends on the intelligence, vision and his ability to foresee
the influence of many unknown factors.

Expert Opinion Method (Delphi Method): Under this method of demand forecasting views of
specialists/experts and consultants are sought to estimate the demand in future. These experts
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may be of the firm itself like the executives and sales managers or consultant firms who are
professionally trained for forecasting demand.

1. The Delphi technique, developed by OLAF HEMLER at the Rand Corporation of the U.S.A.
is used to get the opinion of a number of experts about future demand.

2. Experts are provided with information and opinion feedbacks of other experts at different
rounds and are repeatedly questioned for their opinion and comments till consensus emerges.

3. It is a time saving method.

Statistical Method:

Statistical method have proved to be very useful in demand forecasting. Statistical methods are
superior, more scientific, reliable and free from subjectively. The important statistical methods
of demand forecasting are –

1. Trend Projection Method: The method is also known as Classical Method. It is considered as
a ‘naive’ approach to demand forecasting.

Under this, data on sales over a period of time is chronologically arranged to get a ‘time series’.
The time series shows the past sales pattern. It is assumed that the past sales pattern will
continue in the future also. The techniques of trend projection based on, time series data are
Graphical Method and Fitting trend equation or Least Square Method.

2. Graphical Method: This is the simplest technique to determine the trend.

Under this method, all values of sales for different years are plotted and free hand curve is
drawn passing through as many points as possible. The direction of the free hand curve shows
the trend.

The main drawback of this method is that it may show trend but not measure it.

3. Fitting Trend Equation/Least Square Method: This method is based on the assumption that
the past rate of change will continue in the future. ‘ .
It is a mathematical procedure for fitting a time to a set of observed data points in such a way
that the sum of the squared deviation between the calculated and observed values is minimized.

This method is popular because it is simple and inexpensive.

4. Regression Analysis: This is a very common method of forecasting demand.

Under this method, a quantitative relationship is established between quantity demanded

(dependent variable) and the independent variables like income, price of good, price of related
goods, etc. Based on this relationship, an estimate is made for future demand.

It can be expressed as follows –

Y=a+bX

Where

X, Y are variables

a, b are constants

Controlled Experiments: Under this method, an effort is made to vary certain determinants of
demand like price, advertising, etc. and conduct the experiments assuming that the other factors
remain constant.

The effect of demand determinants on sales can be assessed either by varying then in different
markets or by varying over a period of time in the same market.

The responses of demand to such changes over a period of time are recorded and are used for
estimating the future demand for the product.

This method is used less as it is expensive and time consuming.

This method is also called as market experiment method.

Barometric Method of forecasting: This method is based on the assumption that future can be
predicted from certain events occurring in the present. We need not depend upon the past
observations for demand forecasting.

1. There are economic ups and downs in an economy which indicate the turning points. There
are many economic indicators like income, population, expenditure, investment, etc. which can
be used to forecast demand. There are three types of economic indicators, viz.
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Coincidental Indicators are those which move up and down simultaneously with aggregate
economy. It measures the current economic activity. Example – rate of employment.

Leading Indicators reflect future change in the trend of aggregate economy.

Lagging Indicators reflect future changes in the trend of aggregate economic activities.

Theory of Demand and Supply – CA Foundation Economics Notes Chapter 2

Nature of Human Wants:

All wish, desires, tastes and motives of human beings are called wants in Economics. Human
wants show some well marked characteristics as follows:

Wants are unlimited

Particular want is satiable

Wants are complementary

Wants are competitive

Some wants are both complementary and competitive

Wants are alternative

Wants vary with time, place, and person

Wants vary in urgency and intensity

Wants recur

Wants are influenced by advertisement

Wants become habits and customs

Present wants appear to be more important than future wants

Classification of wants:

1. Necessaries:
Necessaries of existence – These are the things without which we cannot exist. Example –
minimum of food, clothing and shelter.

Necessaries of Efficiency – These are the things which are not necessary to enable us to live,
but are necessary to make us efficient workers and to take up any productive activities.

Conventional Necessaries – These are the things which are needed either because of social
custom or traditions and because the people around us expect us to so.

2. Comforts:

Those goods and services which make for a fuller life and happy life are called comforts.
Example – for a student book is a necessity, a table and a chair are necessaries of efficiency, but
cushioned chair is comfort.

3. Luxuries:

Luxuries are those wants which are superfluous and expensive. They are something we could
easily do without. Example – jewellery, big house, luxurious car, dining in a five star hotel etc.

What is Utility?

The demand of a commodity depends on the utility of that commodity to a consumer.

The want satisfying capacity or power of a commodity is called utility. It is anticipated

satisfaction by a consumer.

It is a subjective and relative term and varies from person to person, place to place and time to
time.

Utility does not mean the same things as usefulness.

Example – Liquor, Cigarettes, etc. have utility as people are ready to buy them but they are
harmful for the health.

Therefore, utility has no moral or ethical significance.

To study the consumer behaviour, the two important theories are –

→ Marginal utility analysis, given by Dr. Alfred Marshall.

→ Indifference curve analysis given by Hicks and Allen.

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Marginal Utility Analysis:

The theory of Marginal utility Analysis of demand was given by Alfred Marshall, a British
economist.

He explained how a consumer spends his money income on different goods and services in
order to get maximum satisfaction i.e. how a consumer reaches equilibrium.

Dr. Alfred Marshall assumes that the utility derived from the consumption of a commodity is
measurable. Hence, this approach is called Cardinal Approach.

Marginal utility Analysis is based on the following assumptions:

1. The Cardinal Measurability of utility: According to this theory, utility is a cardinal concept,
ie. it is possible to measure and quantify satisfaction derived from the consumption of various
commodities. According to Marshall, money is the measuring rod of marginal utility.

Example – If a person is ready to pay ₹ 10 for pastry and ₹ 6 for burger, we can say that price
represents the utility which he is expecting from these commodities.

2. Constancy of the Marginal Utility of Money: The marginal utility of money remain constant
during the time when the consumer is spending money on a good and as a result of which the
amount of money is reducing. This is so because money is used as a measuring rod of utility. If
the money which is a unit of measurement itself varies, it cannot give correct measurement of
the marginal utility of a good.

3. Independent Utilities: According to this assumption, the amount of utility which a consumer
gets from one commodity, does not depend upon the quantity of other commodities consumed.

Example – If a person is consuming Rooh Hafza Sharbat, its utility is not affected by the
availability of sugar or Rose Sharbat. It just depends upon the availability of Rooh Hafza
Sharbat only. This assumption, in other words, totally ignores the presence of complementary
and substitute goods.
4. Rationality: The consumer is assumed to be rational whose aim is to maximise his utility
subject to the constraint imposed by his given income. He makes all calculations carefully and
then purchases the commodities.

The Law of Diminishing Marginal Utility – The Law of Diminishing Marginal Utility is based
on two important facts, namely:

Human wants are unlimited

Each separate human want is limited. The amount of any commodity which a man can
consume, in a given period of time is limited and hence each single want is satiable.

The law describes that, as the consumer has more and more of a commodity, the additional
utility which he derives from an additional unit of commodity goes on falling. Marshall stated
the law as follows –

“The additional benefit which a person derives from a given increase in stock of a thing
diminishes with every increase in the stock that he already has.” The law can be explained with
the help of following table:

Table : Utility Schedule

Units of Rossgulla’s Consumed Total Utility Marginal Utility

1 TU = U1 + U2 + ….. Un MU = TUn – TUn-1

2 10 10

3 15 5

4 15 0

The above table shows that as the consumer goes on consuming rossgullas, the additional or
marginal utility goes on diminishing.

The consumption of 3rd unit of rossgulla gives no additional utility and the 4th unit is giving
negative utility.

The 4th unit instead of giving satisfaction causes dissatisfaction.

Total utility goes on increasing as long as MU is positive, but at diminishing rate.

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When total utility is highest, marginal utility is zero. This is the point of full satisfaction.

When marginal utility becomes negative, total utility starts falling.

MU is the rate of change in TU or slope of TU curve.

MU can be positive, zero or negative.

We can show the information given in the table on a graph as follows:

The figure shows that marginal utility curve goes on declining as the consumption increases. It
even crosses the X-axis and suggest negative marginal utility. Total utility curve rises upto a
point and then starts falling.

Theory of Demand and Supply – CA Foundation Economics Notes Chapter 2 14

The Law of Diminishing Marginal Utility helps us to understand how a consumer reaches
equilibrium in One Commodity Case:

→ A consumer tries to equalize marginal utility of a commodity with its price in order to
maximize the satisfaction. A consumer thus compares the price with the marginal utility of a
commodity.

→ He keep on purchasing a commodity till MU > P. In other words, so long as price is less, he
buys more which is also the basis of the law of demand.

→ The consumer is at equilibrium where:

Marginal Utility of the commodity = Price of the commodity

MUx = Px. MU money

MUxPx = MU money

In reality, a consumer spends his money income to buy different commodities. In case of many
commodities, consumer equilibrium is explained with the Law of Equi-Marginal Utility:

1. The law states that a consumer will allocate his expenditure in a way that the utility gained
from the last rupee spent on each commodity is equal or the marginal utility each commodity is
proportional to its price.
2. The consumer is said to be equilibrium when the following condition is met –

MUxPx=MUyPyMUmoney

OR

MUxMUy=PxPy

The Law of Diminishing Marginal Utility is based on the following assumptions:

1. Homogeneous Units:

It is assumed that all the units of the commodity are homogeneous ie. identical in every respect
like size, taste, colour, quality, blend, etc.

Example – If a consumer is consuming Cadbury Dairy Milk Chocolate (40 gms.), then all bars
of chocolate must be of Dairy Milk Chocolates and not of any other type.

2. Continuous Consumption:

There should not be any time gap or interval between the consumption of one unit and another
unit.

3. Rationality: