UNIT I INTRODUCTION TO ECONOMICS

Definitions of Economics
One of the earliest and most famous definitions of economics was that of Thomas Carlyle, who in the early 19th century termed it the "dismal science." According to a much-repeated story, what Carlyle had noticed was the anti-utopian implications of economics. Many utopians, people who believe that a society of abundance without conflict is possible, believe that good results come from good motives and good motives lead to good results. Economists have always disputed this, and it was to the forceful statement of this disagreement by early economists such as Thomas Malthus and David Ricardo that Carlyle supposedly reacted. Another early definition, one which is perhaps more useful, is that of English economist W. Stanley Jevons who, in the late 19th century, wrote that economics was "the mechanics of utility and self interest." One can think of economics as the social science that explores the results of people acting on the basis of self-interest. There is more to man than self-interest, and the other social sciences--such as psychology, sociology, anthropology, and political science-attempt to tell us about those other dimensions of man. As you read further into these pages, you will see that the assumption of self-interest, that a person tries to do the best for himself with what he has, underlies virtually all of economic theory. At the turn of the century, Alfred Marshall's Principles of Economics was the most influential textbook in economics. Marshall defined economics as "a study of mankind in the ordinary business of life; it examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requisites of wellbeing. Thus it is on one side a study of wealth; and on the other, and more important side, a part of the study of man." Many other books of the period included in their definitions something about the "study of exchange and production." Definitions of this sort emphasize that the topics with which economics is most closely identified concern those processes involved in meeting man's material needs. Economists today do not use these definitions because the boundaries of economics have expanded since Marshall. Economists do more than study exchange and production, though exchange remains at the heart of economics.

Most contemporary definitions of economics involve the notions of choice and scarcity. Perhaps the earliest of these is by Lionell Robbins in 1935: "Economics is a science which studies human behavior as a relationship between ends and scarce means which have alternative uses." Virtually all textbooks have definitions that are derived from this definition. Though the exact wording differs from author to author, the standard definition is something like this: "Economics is the social science that examines how people choose to use limited or scarce resources in attempting to satisfy their unlimited wants."

Adam Smith, father of modern Economics.

Economics is the study of how to achieve largest possible welfare or benefit

given limited amount of resources, examining and teaching people how to use scarce resources in an attempt to satisfy their wants. This can be further drilled at various different levels, incurring Microeconomics and Macroeconomics. Mostly looked at as the science of choice, Economics is also known as the "dismal science" in that it claims we can never get all that we want and that economic problem is a problem forever - we cannot even come close to solving it. On the contrary, science problems arise to be solved. The study of economics is classified as social science because it is associated with human problems and deals with human behavior, at least certain aspects of it. Consequently it is not an exact science that yields indisputable results, but easily finds differing and even conflicting views and conclusions along the way.

On definitions of Economics, economists usually find them each concerned with different approaches. However there are 3 distinct definitions that are particularly famous from very unique perspectives. By Alfred Marshall, a British economist whose ideas have helped shape modern economic analysis and governed for half a century, Economics is: ... the study of mankind in the ordinary business of life; it examines that part of individual and social action which is most closely concerned with the attainment and the use of the material requisites of well-being. Thus it is on the one side a study of wealth; and on the other, a more important side, a part of the study of man. Lionel Robbins, another famous British economist, proposed one of the earliest contemporary economics definitions that goes as following, Economics is a science which studies human behavior as a relationship between ends and scarce means which have alternative uses. From Frank H. Knight, an neoclassic economist of Chicago school in America, economics is the study of ... the social organization of economic activity. Yet as N.Gregory Mankiw, an inspiring economics professor at Harvard put it, Economics combines the virtues of politics and science. It is, truly, a social science. Its subject matter is society - how people choose to lead their lives and how they interact with one another. But it approaches the subject with the dispassion of a science. Economics is a lot more lively than many people have thought of. It's basically about decision making which we do everyday. And we live by participating in daily economic activities, influencing other people by making choices in our own interest and at the same time are subject to all other people's choices. On the grand scale, we each make decisions as either an individual or a group to form the big picture of an economy. As a happy person who neatly manages his or her life, you should know about Economics more than you think. This site and any other economics books do no more than sorting out and reinforcing your understanding of the governing ideas already in your head.

Man lives in a society and has to perform certain activities to fulfill his wants. Out of these activities, economics deals with the economic activities of a man in society. Economic activities are those activities, which concerned with the efficient use of scarce resources, which can satisfy human wants. Production, consumption, exchange, distribution, etc are the main economic activities. Thus, economics is concerned with mans wants and his efforts to satisfy his wants. The history of economics is as old as the history of mankind. The start of economics took place with Plato and Aristotle in 400 B.C. According to great Greek Philosopher Aristotle, economics is the science of household management and an art of wealth-getting and wealth-spending.

A definition gives the concise meaning and essence of a thing or subject. Economics is a dynamic subject. Therefore, it is not an easy task to provide a single and accurate definition of economics. In fact, economics is an unfinished science and is always in the socio-economic conditions. Here we can get several definitions by several economists. There is famous statements by Mrs. Barbara Wooten, Whenever six economists are gathered, her are seven opinions. For the sake of simplicity, several definitions of economics can be divided into four parts. 1. Wealth definitions or Classical definitions. 2. Welfare definitions or Neo-classical definitions. 3. Scarcity definitions or Modern definitions. 4. Growth definitions or recent definitions.

1. Wealth definition Adam Smith was the first economist to present a systematic analysis of economics. Therefore, he is regarded as the father of Economics. In this famous book An Enquiry into the Nature and Causes of the Wealth of Nations published in 1776, 2. Smith defined economics as a science of wealth. From 1776 to 1850, several great economists such as J.B. Say, David Ricardo, T.R. Malthus, 3. J.S Mill, etc. had fully supported and followed the economic ideas of Adam Smith. So, they are called classical economists. They were of the view that

economics is concerned with production, consumption, exchange and distribution of wealth. Some important definitions are as follows: 4. According to Adam Smith, Economics is an enquiry into the nature and causes of the wealth of Nations. 5. In the words of J.S Mill, Economics is the practical science of production and distribution of wealth. 6. According to J.B. Say, Economics is the body of knowledge which relates to wealth. Characteristics of Wealth Definition 1. Study of wealth, 2. Secondary place to the study of man, 3. Meaning of wealth, 4. Study of economic man, 5. Investigation of the causes of wealth.

Welfare Definition

Alfred Marshall, an eminent English economist, recognized the incompleteness of the earlier definition of economi cs and brought about a fundamental change in it. According to him, economics is, on the one side, a study of man. Marshalls Principle of Economics Published in 1890 he defined economics as a subject concerned with those activities which promote the material welfare of mankind. Many economists such as A.C. Pigou, Cannon, Beveridge, etc supported this view. An opinion of different scholars is given below: According to A. Marshall, Economics is a study of mankind in the ordinary business of life; it examines that part of individual and social action which is most closely connected with the attainment and with the use of material

requisites

of

well-being.

According to Pigou, Economics deals with that part of social welfare that can be brought directly or indirectly into relation with the measuring rod of money. Scarcity Definition Professor Lionel Robbins of London School of Economics, in his book, An Essay on the Nature and Significance of Economic Science, published in 1932 gave a more exact and precise definition of economics. He defined economics entirely in terms of scarcity of means. Economists like Karl Manger, Peter, Stigler, etc. supported the view of Robbins. Opinions of different economists are as follows; According to Robbins, Economics is the science which studies human behavior as a relationship between ends and scarce means which have alternative uses. In the words of Stigler, Economics is the study of principles governing the allocation of scarce means among competing ends when the objective of allocation is to maximize the attainment of the ends.

Criticism of Wealth Definition This definition has been criticized by many writers such as Ruskin, Carlyle, Bailey, Morris, etc. They have characterized it as a 'Bastard Science' or 'Dismal Science' or 'Bread and Butter Science' or 'Gospel of Mammon. The main criticisms are as under: 1. Narrow meaning of wealth, 2. Undue importance to wealth, 3. Unrealistic concept of economic man, 4. Narrow subject matter of economics, 5. Neglect of economics welfare. However, the importance of this definition is that they have provided a unique place to economics. They could distinguish economics from other social sciences such as political science,ethics,etc. It was only with the publication of Adam Smiths book,'The Wealth of Nations that economics could develop as an

independent

and

important

economic

discipline.

Criticism of Welfare Definition This definition of economics has been strongly criticized by Robbins on the following grounds: 1. Difficulty to separate material and non-material things, 2. Connection between economics and welfare, 3. Welfare cannot be quantitatively measured, 4. A social science, 5. Confusion between ordinary and extra ordinary business of life

Criticism of Scarcity Definition Several economists like Boulding, Fraser, Durbin, Beveridge, Wootton, etc.have strongly criticized Robbins' definition of economics on the following grounds: 1. Hidden concepts of welfare, 2. Even abundance may create economic problems, 3. Self-contradictory, 4. Economics not only a positive science, 5. Incomplete definition. However, Robbins' definition is analytical, scientific and universally applicable. His definition, with minor changes here and there forms the basis of all other definitions of economics that has been given since Prof. Robbins gave his definition. MICRO ECONOMICS VS MACRO ECONOMICS Microeconomics. Micro economics is a study of individual units of economy. b. Micro economics studies individual economic units such as a consumer, a household, a firm, an industry, a commodity etc. c. Micro economics deals with determination of price of a commodity, a factor of production, satisfaction of a consumer, etc. d. Micro economics is based on a partial equilibrium analysis other things remaining the same. e. The subject- matter of micro economics is mortal. f. Micro economics is suitable to study the problem of individual economic units. g. Micro economic is also called Price Theory or Value Theory. Macroeconomics. Macro economics is a study of economy as a whole.b. Macro economics is a study of national aggregate such as national income, national

output, general price level, level of employment etc.c. Macro economics deals with the problems of unemployment, trade cycles, international trade, economic growth, etc.d. Macro economics is based on general equilibrium. The subject-matter of macro economics is immortal.f. Macro economics is suitable for the problem of economy as a whole. Macro economic is also called Theory of Income and Employment or Keynesian Theory.

Nature and Scope of Managerial Economics

Well scope is something which tells us how far a particular subject will go. As far as Managerial Economic is concerned it is very wide in scope. It takes into account almost all the problems and areas of manager and the firm. ME deals with Demand analysis, Forecasting, Production function, Cost analysis, Inventory Management, Advertising, Pricing System, Resource allocation etc. Following aspects are to be taken into account while knowing the scope of ME: 1. Demand analysis and forecasting: Unless and until knowing the demand for a product how can we think of producing that product. Therefore demand analysis is something which is necessary for the production function to happen. Demand analysis helps in analyzing the various types of demand which enables the manager to arrive at reasonable estimates of demand for product of his company. Managers not only assess the current demand but he has to take into account the future demand also. 2. Production function: Conversion of inputs into outputs is known as production function. With limited resources we have to make the alternative uses of this limited resource. Factor of production called as inputs is combined in a particular way to get the maximum output. When the price of input rises the firm is forced to work out a combination of inputs to ensure the least cost combination. 3. Cost analysis: Cost analysis is helpful in understanding the cost of a particular product. It takes into account all the costs incurred while producing a particular product. Under cost analysis we will take into account determinants of costs, method of estimating costs, the relationship between cost and output, the forecast of the cost, profit, these terms are very vital to any firm or business. 4. Inventory Management: What do you mean by the term inventory? Well

the actual meaning of the term inventory is stock. It refers to stock of raw materials which a firm keeps. Now here the question arises how much of the inventory is ideal stock. Both the high inventory and low inventory is not good for the firm. Managerial economics will use such methods as ABC Analysis, simple simulation exercises, and some mathematical models, to minimize inventory cost. It also helps in inventory controlling. 5. Advertising: Advertising is a promotional activity. In advertising while the copy, illustrations, etc., are the responsibility of those who get it ready for the press, the problem of cost, the methods of determining the total advertisement costs and budget, the measuring of the economic effects of advertising- -- - are the problems of the manager. Theres a vast difference between producing a product and marketing it. It is through advertising only that the message about the product should reach the consumer before he thinks to buy it. Advertising forms the integral part of decision making and forward planning. 6. Pricing system: Here pricing refers to the pricing of a product. As you all know that pricing system as a concept was developed by economics and it is widely used in managerial economics. Pricing is also one of the central functions of an enterprise. While pricing commodity the cost of production has to be taken into account, but a complete knowledge of the price system is quite essential to determine the price. It is also important to understand how product has to be priced under different kinds of competition, for different markets. Pricing = cost plus pricing and the policies of the enterprise Now it is clear that the price system touches the several aspects of managerial economics and helps managers to take valid and profitable decisions. 7. Resource allocation: Resources are allocated according to the needs only to achieve the level of optimization. As we all know that we have scarce resources, and unlimited needs. We have to make the alternate use of the available resources. For the allocation of the resources various advanced tools such as linear programming are used to arrive at the best course of action.

Demand Analysis

In general, the term demand refers to the desire or will of any person or community for any commodity. But in economics, only a desire or will is not the demand. In economics, demand refers to an effective desire of a consumer in a fixed period of time in which he/s is able and willing to pay for that. Therefore, a desire should include following factors to be termed itself into demand.

a. Effective desire b. Willingness or ready to pay c. Ability to pay and d. A fixed period of time.

There is a great difference between a desire and a demand. A poor person may desire to buy a car but that desire may not be termed into demand because he is not able to pay the price in a fixed period of time. In the same way, a rich but miser merchant may have a desire to buy a car but he is not willing to pay for. Then his desire also is not a demand DEMAND FUNCTION Demand is influenced by different factors, such as, the price of the commodities tastes preferences weather etc. The functional relationship between the demand determining factors is known as the demand function. In short, it can be expressed as D = f (px, Y, Pxy, W, F,Pf .etc) Here, D =Demand f =functional relationship Px =price of the commodity Y=Consumers income Pxy =Price of the related commodities W = weather F =fashion Pf = preferences

For simplicity, demand function is expressed only as a function of price of a commodity, i.e. D =f (P) P= price of a commodity FEATURES OF DEMAND a. Effective Desire: - Demand in economics means demand is backed up money to pay for the goods demanded. b. Price:-We cannot speak of demand without specifying some price. Thus, demand is always. c. Time:-Demand has to be stated with reference to a period of time. d. Market:-Demand is always held in the market. Market is a set of points of contact between buyers and sellers .It need not be in a definite geographical area. e. Amount:-Demand is always a specific amount in which a person is willing to purchase. It is not an approximation, but is to be expressed in numbers. In economics, therefore, demand is defined as a schedule of quantities of a given commodity or services which consumers are willing to buy at various prices in one market at a given period of time or over a given period of time IMPORTANCE OF LAW OF DEMAND

1. Determination of price The study of law of demand is helpful for a trader to fix the price of a commodity. He knows how much demand will fall by increase in price to a particular level and how much it will rise by decrease in price of the commodity. The schedule of market demand can provide the information about total market demand at different prices. It helps the management in deciding whether how much increase or decrease in the price of commodity is desirable. 2. Importance to Finance Minister

The study of this law is of great advantage to the finance minister. If by raising the tax the price increases to such an extend than the demand is reduced considerably. And then it is of no use to raise the tax, because revenue will almost remain the same. The tax will be levied at a higher rate only on those goods whose demand is not likely to fall substantially with the increase in price.

3. Importance to the Farmers Goods or bad crop affects the economic condition of the farmers. If a goods crop fails to increase the demand, the price of the crop will fall heavily. The farmer will have no advantage of the good crop and vice-versa.

LAW OF DEMAND Other things remaining the same, when price falls demand rises and when price rises demand falls. There is a close but inverse relation between price and demand. This relationship is known as the law of demand. Consumers are rational. It means that the consumers change their demand on the basis of a change in price. Therefore, they purchase more units at a low price and fewer units at a high price. According to Prof. Samuelson, Law of demand states that the people will buy more at the lower price and buy fewer at the higher price, other things remaining the same.

Exceptions to the Law of Demand

The law of demand does not apply in every case and situation. The circumstances when the law of demand becomes ineffective are known as exceptions of the law. Some of these important exceptions are as under. 1. Giffen goods: Some special varieties of inferior goods are termed as Giffen goods. Cheaper varieties of this category like bajra, cheaper vegetable like potato come under this category. Sir Robert Giffen or Ireland first observed that people used to spend more their income on inferior goods like potato and less of their income on meat. But potatoes constitute their staple food. When the price of potato increased, after purchasing potato they did not have so many surpluses to buy meat. So the rise in price of potato compelled people to buy more potato and thus raised the demand for potato. This is against the law of demand. This is also known as Giffen paradox. 2. Conspicuous Consumption: This exception to the law of demand is associated with the doctrine propounded by Thorsten Veblen. A few goods like diamonds etc are purchased by the rich and wealthy sections of the society. The prices of these goods are so high that they are beyond the reach of the common man. The higher the price of the diamond the higher the prestige value of it. So when price of these goods falls, the consumers think that the prestige value of these goods comes down. So quantity demanded of these goods falls with fall in their price. So the law of demand does not hold good here. 3. Conspicuous necessities: Certain things become the necessities of modern life. So we have to purchase them despite their high price. The demand for T.V. sets, automobiles and refrigerators etc. has not gone down in spite of the increase in their price. These things have become the symbol of status. So they are purchased despite their rising price. These can be termed as U sector goods. 4. Ignorance:

A consumers ignorance is another factor that at times induces him to purchase more of the commodity at a higher price. This is especially so when the consumer is haunted by the phobia that a high-priced commodity is better in quality than a low-priced one. 5. Emergencies: Emergencies like war, famine etc. negate the operation of the law of demand. At such times, households behave in an abnormal way. Households accentuate scarcities and induce further price rises by making increased purchases even at higher prices during such periods. During depression, on the other hand, no fall in price is a sufficient inducement for consumers to demand more. 6. Future changes in prices: Households also act speculators. When the prices are rising households tend to purchase large quantities of the commodity out of the apprehension that prices may still go up. When prices are expected to fall further, they wait to buy goods in future at still lower prices. So quantity demanded falls when prices are falling.

7. Change in fashion: A change in fashion and tastes affects the market for a commodity. When a broad toe shoe replaces a narrow toe, no amount of reduction in the price of the latter is sufficient to clear the stocks. Broad toe on the other hand, will have more customers even though its price may be going up. The law of demand becomes ineffective.

Determinants of Demand The determinants of demand have been explained in brief as follows:

 Price:

The price of a commodity is an important determinant of demand. price and demand are inversely related. Higher the price less is the demand and vice versa.
Price

of related goods:

The price of related goods like substitutes and complementary goods also affect the demand. In the case of substitutes, rise in price of one commodity lead to increase in demand for its substitute. In the case of complementary goods, fall in the price of one commodity lead to rise in demand for both the goods.
Income:

This is directly related to demand. If the disposable income increases, demand will be more.
Taste,

preference, fashions and habits:

These are very effective factors affecting demand for a commodity.

Population:

If the size of the population is more, demand will be more for goods.
Money

Circulation:

More money in circulation, more will be the demand and vice versa.

 Weather

Condition:

It is also an important factor to determine the demand for certain goods.

Advertisement

and Salesmanship:

If the advertisement is very attractive for a commodity, demand will be more and if the salesmanship and publicity is effective then the demand for the commodity will be more.
Speculation:

If the consumers expect a change in price in near future then

their present demand will not vary inversely with the present change in price.
Government

policy:

High taxes will increase the price and reduce demand, while low tax will reduce the price and extend the demand.

UNIT II ELASTICITY OF DEMAND

TYPES OF ELASTICITY OF DEMAND We may distinguish between the three types of elasticitys, viz., Price Elasticity, Income Elasticity And Cross Elasticity. PRICE ELASTICITY Price elasticity measures responsiveness of potential buyers to changes in price. It is the ratio of percentage change in quantity demanded in response to a percentage change in price.

Price Elasticity = Proportionate change in amount demanded -----------------------------------------------------Proportionate change in price = Change in demand change in price -----------------------+ ------------------------Amount demanded price Suppose the price of a particular brand of a radio set falls from Rs. 500 to Rs. 400 each, i.e., 20 per cent fall. As a result of this fall in price, suppose further that the demand for the radio sets has gone up from Rs. 400 to 600, i.e., 50 per cent. Elasticity of demand will be 50/20 or 2.5 percent. The concept of price elasticity can be used in comparing the sensitivity of the different types of goods (e.g., luxuries and necessaries) to change in their prices. For example, by this means we may find that the price elasticity for food grains, in general, is 0.5, whereas for fruit it may be1.5. This means that the demand for food grains is less sensitive to price changes than demand for fruit. Food is a necessary of life and people must buy almost the same quantity, even if its price has risen. The consumer can, however, economize in fruit or any other commodity included in the family budget The elasticity of demand is always negative, although by convention it is taken to be positive. Its negative because change in quantity demanded is in opposite direction to the change in price. That is a fall in price is followed by rise in demand, and vice versa. Hence, elasticity is always less than zero, unless of course the demand curve is abnormal, i.e., sloping upward from right to left. Strictly speaking, in mathematical terms, there should be minus sign (-) beforefigureindicating price elasticity. But by convention, for the sake of simplicity, theminussignisdropped in economics. INCOME ELASTICITY Income Elasticity is a measure of responsiveness of potential buyers to change in income. It shows how the quantity demanded will change when the income of the purchaser changes, the price of the commodity remaining the same. It may be defined thus: The Income Elasticity of demand for a good is the ratio of the percentage change in the amount spent on the commodity to a percentage change in the consumers income, price of commodity remaining constant. Thus,

Income Elasticity = Proportionate change in the quantity purchased _______________________________________ Proportionate change in Income While prices remain constant. It is equal to unity or one when the proportion of income spent on good remains the same even though income has increased. It is said to be greater than unity when the proportion of income spent on a good increases as income increases. It is said to be less than unity when the proportion of income spent on a good decreases as income increases. Generally speaking, when our income increases, we desire to purchase more of the things than we were previously purchasing unless the commodity happens to be an inferior good. Normally, then, since the income effect is positive, income elasticity of demand is also positive. It is zero income elasticity of demand when change in income makes no change in our purchases, and it is negative when with an increase in income, the consumer purchases less, e.g., in the case of inferior goods. It may be carefully noted that for any individual seller or firm, the demand for the product as a whole may be inelastic. By lowering the price, as compared with his rivals, the seller can infinitely increase the demand for his product. The demand curve will thus be a horizontal line. Elasticity, viz., price elasticity and income elasticity, are valuable aids in the measurement of demand for different commodities. As such they are also helpful in measuring the incidence of taxation. CROSS ELASTICITY Here, a change in the price of one good causes a change in the demand for another. Cross Elasticity of Demand for X and Y

= Proportionate change in purchases of commodity X -----------------------------------------------------------------Proportionate change in the price of commodity Y This type of elasticity arises in the case of inter-related goods such as substitutes and Complementary goods. The two commodities will be complementary, if a fall in the price of Y increases the demand for X and conversely, if a rise in the price of one commodity decreases the demand for the other. They will be substitute or rival goods if a reduction in the price of Y decreases the demand for X, and also if a rise in price of one commodity (say tea) increases the demand for the other commodity (say coffee). The cross elasticity of complementary goods is positive and that between substitutes, it is negative. It should, however, be remembered that cross elasticity will indicate complementarities or rivalry only if the commodities in question figure in the family budget in small proportions.

Types of Price Elasticity of Demand Price Elasticity of demand can be defined as a measure of change in quantity demanded to the corresponding change in price. Below are the various types of elasticity of demand 1. Elastic Demand If the change in price leads to greater change than proportional change in demand then the demand for that good is price elastic. For example a 20% fall in price leads to a 30% increase in quantity demanded. 2. Inelastic Demand If the change in price leads to less than proportional change in demand then the demand for that good is price inelastic. For example a 30% increase in price leads to a 15% fall in quantity demanded. 3. Unitary Demand - If the change in price leads to equal change in demand then the demand for that good is unitary. For example a 10% increase in price leads to 10% decrease in demand.

4. Perfectly Elastic Demand It refers to a situation when any change in price will see quantity demanded fall to zero. 5. Perfectly Inelastic Demand It refers to a situation when any change in price will not affect the demand for a good that is quantity demanded will remain unchanged irrespective of change in the price of that good.

Price Elasticity of Demand

An important aspect of a product's demand curve is how much the quantity demanded changes when the price changes. The economic measure of this response is the price elasticity of demand. Price elasticity of demand is calculated by dividing the proportionate change in quantity demanded by the proportionate change in price. Proportionate (or percentage) changes are used so that the elasticity is a unit-less value and does not depend on the types of measures used (e.g. kilograms, pounds, etc). As an example, if a 2% increase in price resulted in a 1% decrease in quantity demanded, the price elasticity of demand would be equal to approximately 0.5. It is not exactly 0.5 because of the specific definition for elasticity uses the average of the initial and final values when calculating percentage change. When the elasticity is calculated over a certain arc or section of the demand curve, it is referred to as the arc elasticity and is defined as the magnitude (absolute value) of the following: Q2 - Q1 ( Q1 + Q2 ) / 2 P2 - P1 ( P1 + P2 ) / 2 Where Q1 = Initialquantity Q2 = Finalquantity

P1 = Initialprice P2 = Final price The average values for quantity and price are used so that the elasticity will be the same whether calculated going from lower price to higher price or from higher price to lower price. For example, going from $8 to $10 is a 25% increase in price, but going from $10 to $8 is only a 20% decrease in price. This asymmetry is eliminated by using the average price as the basis for the percentage change in both cases. For slightly easier calculations, the formula for arc elasticity can be rewritten as: ( Q2 - Q1 ) ( P2 + P1 ) ( Q2 + Q1 ) ( P2 - P1 ) To better understand the price elasticity of demand, it is worthwhile to consider different ranges of values. Elasticity > 1 In this case, the change in quantity demanded is proportionately larger than the change in price. This means that an increase in price would result in a decrease in revenue, and a decrease in price would result in an increase in revenue. In the extreme case of near infinite elasticity, the demand curve would be nearly horizontal, meaning than the quantity demanded is extremely sensitive to changes in price. The case of infinite elasticity is described as being perfectly elastic and is illustrated below: Perfectly Elastic Demand Curve

From this demand curve it is easy to visualize how an extremely small change in price would result in an infinitely large shift in quantity demanded.

Elasticity < In this case, the change in quantity demanded is proportionately smaller than the change in price. An increase in price would result in an increase in revenue, and a decrease in price would result in a decrease in revenue. In the extreme case of elasticity near 0, the demand curve would be nearly vertical, and the quantity demanded would be almost independent of price. The case of zero elasticity is described as being perfectly inelastic. Perfectly Inelastic Demand Curve

From this demand curve, it is easy to visualize how even a very large change in price would have no impact on quantity demanded.

Elasticity = 1 This case is referred to as unitary elasticity. The change in quantity demanded is in the same proportion as the change in price. A change in price in either direction therefore would result in no change in revenue.

Applications of Price Elasticity of Demand The price elasticity of demand can be applied to a variety of problems in which one wants to know the expected change in quantity demanded or revenue given a contemplated change in price. For example, a state automobile registration authority considers a price hike in personalized "vanity" license plates. The current annual price is $35 per year, and the registration office is considering increasing the price to $40 per year in an effort to increase revenue. Suppose that the registration office knows that the price elasticity of demand from $35 to $40 is 1.3. Because the elasticity is greater than one over the price range of interest, we know that an increase in price actually would decrease the revenue collected by the automobile registration authority, so the price hike would be unwise.

Factors Influencing the Price Elasticity of Demand The price elasticity of demand for a particular demand curve is influenced by the following factors: 1. Availability of substitutes: the greater the number of substitute products, the greater the elasticity. 2. Degree of necessity or luxury: luxury products tend to have greater elasticity than necessities. Some products that initially have a low degree of necessity are habit forming and can become "necessities" to some consumers. 3. Proportion of income required by the item: products requiring a larger portion of the consumer's income tend to have greater elasticity. 4. Time period considered: elasticity tends to be greater over the long run because consumers have more time to adjust their behavoir to price changes. 5. Permanent or temporary price change: a one-day sale will result in a different response than a permanent price decrease of the same magnitude. 6. Price points: decreasing the price from $2.00 to $1.99 may result in greater increase in quantity demanded than decreasing it from $1.99 to $1.98.

METHODS OF DEMAND FORECASTING Broadly speaking, there are two approaches to demand forecasting- one is to obtain information about the likely purchase behavior of the buyer through collecting experts opinion or by conducting interviews with consumers, the other is to use past experience as a guide through a set of statistical techniques. Both these methods rely on varying degrees of judgment. The first method is usually found suitable for short-term forecasting, the latter for long-term forecasting. There are specific techniques which fall under each of these broad methods. Simple Survey Method: For forecasting the demand for existing product, such survey methods are often employed. In this set of methods, we may undertake the following exercise. 1) Experts Opinion Poll: In this method, the experts on the particular product whose demand is under study are requested to give their opinion or feel about the product. These experts, dealing in the same or similar product, are able to predict the likely sales of a given product in future periods under different conditions based on their experience. If the number of such experts is large and their experience-based reactions are different, then an average-simple or weighted is found to lead to unique forecasts. Sometimes this method is also called the hunch method but it replaces analysis by opinions and it can thus turn out to be highly subjective in nature. 2) Reasoned Opinion-Delphi Technique: This is a variant of the opinion poll method. Here is an attempt to arrive at a consensus in an uncertain area by questioning a group of experts repeatedly until the responses appear to converge along a single line. The participants are supplied with responses to previous questions (including seasonings from others in the group by a coordinator or a leader or operator of some sort). Such feedback may result in an expert revising his earlier opinion. This may lead to a narrowing down of the divergent views (of the experts) expressed earlier. The Delphi Techniques, followed by the Greeks earlier, thus generates reasoned opinion in place of unstructured opinion; but this is still a poor proxy for market behavior of economic variables. 3) Consumers Survey- Complete Enumeration Method: Under this, the forecaster undertakes a complete survey of all consumers whose demand he intends to forecast, Once this information is collected, the sales forecasts are

obtained by simply adding the probable demands of all consumers. The principle merit of this method is that the forecaster does not introduce any bias or value judgment of his own. He simply records the data and aggregates. But it is a very tedious and cumbersome process; it is not feasible where a large number of consumers are involved. Moreover if the data are wrongly recorded, this method will be totally useless. 4) Consumer Survey-Sample Survey Method: Under this method, the forecaster selects a few consuming units out of the relevant population and then collects data on their probable demands for the product during the forecast period. The total demand of sample units is finally blown up to generate the total demand forecast. Compared to the former survey, this method is less tedious and less costly, and subject to less data error; but the choice of sample is very critical. If the sample is properly chosen, then it will yield dependable results; otherwise there may be sampling error. The sampling error can decrease with every increase in sample size 5) End-user Method of Consumers Survey: Under this method, the sales of a product are projected through a survey of its end-users. A product is used for final consumption or as an intermediate product in the production of other goods in the domestic market, or it may be exported as well as imported. The demands for final consumption and exports net of imports are estimated through some other forecasting method, and its demand for intermediate use is estimated through a survey of its user industries.

Complex Statistical Methods: We shall now move from simple to complex set of methods of demand forecasting. Such methods are taken usually from statistics. As such, you may be quite familiar with some the statistical tools and techniques, as a part of quantitative methods for business decisions. (1) Time series analysis or trend method: Under this method, the time series data on the under forecast are used to fit a trend line or curve either graphically or through statistical method of Least Squares. The trend line is worked out by fitting a trend equation to time series data with the aid of an estimation method. The trend equation could take either a linear or any kind of non-linear form. The trend method outlined above often yields a dependable forecast. The advantage in this method is that it does not require the formal knowledge of economic theory and the market, it only needs the time series data. The only limitation in this method is that

it assumes that the past is repeated in future. Also, it is an appropriate method for long-run forecasts, but inappropriate for short-run forecasts. Sometimes the time series analysis may not reveal a significant trend of any kind. In that case, the moving average method or exponentially weighted moving average method is used to smoothen the series. (2) Barometric Techniques or Lead-Lag indicators method: This consists in discovering a set of series of some variables which exhibit a close association in their movement over a period or time. For example, it shows the movement of agricultural income (AY series) and the sale of tractors (ST series). The movement of AY is similar to that of ST, but the movement in ST takes place after a years time lag compared to the movement in AY. Thus if one knows the direction of the movement in agriculture income (AY), one can predict the direction of movement of tractors sale (ST) for the next year. Thus agricultural income (AY) may be used as a barometer (a leading indicator) to help the short-term forecast for the sale of tractors. Generally, this barometric method has been used in some of the developed countries for predicting business cycles situation. For this purpose, some countries construct what are known as diffusion indices by combining the movement of a number of leading series in the economy so that turning points in business activity could be discovered well in advance. Some of the limitations of this method may be noted however. The leading indicator method does not tell you anything about the magnitude of the change that can be expected in the lagging series, but only the direction of change. Also, the lead period itself may change overtime. Through our estimation we may find out the best-fitted lag period on the past data, but the same may not be true for the future. Finally, it may not be always possible to find out the leading, lagging or coincident indicators of the variable for which a demand forecast is being attempted. 3) Correlation and Regression: These involve the use of econometric methods to determine the nature and degree of association between/among a set of variables. Econometrics, you may recall, is the use of economic theory, statistical analysis and mathematical functions to determine the relationship between a dependent variable (say, sales) and one or more independent variables (like price, income, advertisement etc.). The relationship may be expressed in the form of a demand function, as we have seen earlier. Such relationships, based on past data can be used for forecasting. The analysis can be carried with varying degrees of complexity. Here we shall not get into the methods of finding out correlation

coefficient or regression equation; you must have covered those statistical techniques as a part of quantitative methods. Similarly, we shall not go into the question of economic theory. We shall concentrate simply on the use of these econometric techniques in forecasting. We are on the realm of multiple regression and multiple correlation. The form of the equation may be: DX = a + b1 A + b2PX + b3Py You know that the regression coefficients b1, b2, b3 and b4 are the components of relevant elasticity of demand. For example, b1 is a component of price elasticity of demand. The reflect the direction as well as proportion of change in demand for x as a result of a change in any of its explanatory variables. For example, b 2< 0 suggest that DX and PX are inversely related; b4 > 0 suggest that x and y are substitutes; b3 > 0 suggest that x is a normal commodity with commodity with positive income-effect. Given the estimated value of and bi, you may forecast the expected sales (DX), if you know the future values of explanatory variables like own price (P X), related price (Py), income (B) and advertisement (A). Lastly, you may also recall that the statistics R2 (Co-efficient of determination) gives the measure of goodness of fit. The closer it is to unity, the better is the fit, and that way you get a more reliable forecast. The principle advantage of this method is that it is prescriptive as well descriptive. That is, besides generating demand forecast, it explains why the demand is what it is. In other words, this technique has got both explanatory and predictive value. The regression method is neither mechanistic like the trend method nor subjective like the opinion poll method. In this method of forecasting, you may use not only time-series data but also cross section data. The only precaution you need to take is that data analysis should be based on the logic of economic theory. (4) Simultaneous Equations Method: Here is a very sophisticated method of forecasting. It is also known as the complete system approach or econometric model building. In your earlier units, we have made reference to such econometric models. Presently we do not intend to get into the details of this method because it is a subject by itself. Moreover, this method is normally used in macro-level forecasting for the economy as a whole; in this course, our focus is limited to micro elements only. Of course, you, as corporate managers, should know the basic elements in such an approach.

The method is indeed very complicated. However, in the days of computer, when package programmes are available, this method can be used easily to derive meaningful forecasts. The principle advantage in this method is that the forecaster needs to estimate the future values of only the exogenous variables unlike the regression method where he has to predict the future values of all, endogenous and exogenous variables affecting the variable under forecast. The values of exogenous variables are easier to predict than those of the endogenous variables. However, such econometric models have limitations, similar to that of regression method. STEPS IN DEMAND FORECASTING Demand or sales forecasting is a scientific exercise. It has to go through a number of steps. At each step, you have to make critical considerations. Such considerations are categorically listed below: 1) Nature of forecast: To begin with, you should be clear about the uses of forecast data- how it is related to forward planning and corporate planning by the firm. Depending upon its use, you have to choose the type of forecasts: short-run or long-run, active or passive, conditional or non-conditional etc. 2) Nature of product: The next important consideration is the nature of product for which you are attempting a demand forecast. You have to examine carefully whether the product is consumer goods or producer goods, perishable or durable, final or intermediate demand, new demand or replacement demand type etc. A couple of examples may illustrate the importance of this factor. The demand for intermediate goods like basic chemicals is derived from the final demand for finished goods like detergents. While forecasting the demand for basic chemicals, it becomes essential to analyze the nature of demand for detergents. Promoting sales through advertising or price competition is much less important in the case of intermediate goods compared to final goods. The elasticity of demand for intermediate goods depends on their relative importance in the price of the final product. Time factor is a crucial determinant in demand forecasting. Perishable commodities such as fresh vegetables and fruits can be sold over a limited period of time. Here skilful demand forecasting is needed to avoid waste. If there are storage facilities, then buyers can adjust their demand according to availability, price and income. The time taken for such adjustment varies from product to product. Goods of daily necessities that are bought more frequently will lead to quicker adjustments. Whereas in case of expensive equipment which is worn out

and replaced after a long period of time, adaptation of demand will be spread over a longer duration of time. 3) Determinants of demand: Once you have identified the nature of product for which you are to build a forecast, your next task is to locate clearly the determinants of demand for the product. Depending on the nature of product and nature of forecasts, different determinants will assume different degree of importance in different demand functions. In the preceding unit, you have been exposed to a number of price-income factors or determinants-own price, related price, own income-disposable and discretionary, related income, advertisement, price expectation etc. In addition, it is important to consider socio-psychological determinants, specially demographic, sociological and psychological factors affecting demand. Without considering these factors, long-run demand forecasting is not possible. Such factors are particularly important for long-run active forecasts. The size of population, the age-composition, the location of household unit, the sexcomposition-all these exercise influence on demand in. varying degrees. If more babies are born, more will be the demand for toys; if more youngsters marry, more will be the demand for furniture; if more old people survive, more will be the demand for sticks. In the same way buyers psychology-his need, social status, ego, demonstration effect etc. also effect demand. While forecasting you cannot neglect these factors. 4) Analysis of factors &determinants: Identifying the determinants alone would not do, their analysis is also important for demand forecasting. In an analysis of statistical demand function, it is customary to classify the explanatory factors into (a) trend factors, which affect demand over long-run, (b) cyclical factors whose effects on demand are periodic in nature, (c) seasonal factors, which are a little more certain compared to cyclical factors, because there is some regularly with regard to their occurrence, and (d) random factors which create disturbance because they are erratic in nature; their operation and effects are not very orderly. An analysis of factors is specially important depending upon whether it is the aggregate demand in the economy or the industrys demand or the companys demand or the consumers; demand which is being predicted. Also, for a long-run demand forecast, trend factors are important; but for a short-run demand forecast, cyclical and seasonal factors are important.

5) Choice of techniques: This is a very important step. You have to choose a particular technique from among various techniques of demand forecasting. Subsequently, you will be exposed to all such techniques, statistical or otherwise. You will find that different techniques may be appropriate for forecasting demand for different products depending upon their nature. In some cases, it may be possible to use more than one technique. However, the choice of technique has to be logical and appropriate; for it is a very critical choice. Much of the accuracy and relevance of the forecast data depends accuracy required, reference period of the forecast, complexity of the relationship postulated in the demand function, available time for forecasting exercise, size of cost budget for the forecast etc. 6) Testing accuracy: This is the final step in demand forecasting. There are various methods for testing statistical accuracy in a given forecast. Some of them are simple and inexpensive, others quite complex and difficult. This stating is needed to avoid/reduce the margin of error and thereby improve its validity for practical decision-making purpose. Subsequently you will be exposed briefly to some of these methods and their uses.