Managerial
Economics
Definition and Meaning of
Managerial Economics:
Managerial economics, used synonymously with
business economics. It is a branch of economics that deals with the application
of microeconomic analysis to decision-making techniques of businesses and
management units. It acts as the via media between economic theory and
pragmatic economics. Managerial economics bridges the gap between "theory
and practice". Managerial economics can be defines as:
According to Spencer
and Siegelman:
“The integration of economic
theory with business practice for the purpose of facilitating decision-making
and forward planning by management”.
According to McGutgan
and Moyer:
“Managerial economics is the
application of economic theory and methodology to decision-making problems
faced by both public and private institutions”.
Managerial economics studies
the application of the principles, techniques and concepts of economics to
managerial problems of business and industrial enterprises. The
term is used interchangeably
with micro economics, macro economics, monetary economics.
Characteristics of Managerial
Economics:
(i) It studies the problems and
principles of an individual business firm or an individual industry. It aids
the management in forecasting and evaluating the trends of the market.
(ii) It is concerned with
varied corrective measures that a management undertakes under various
circumstances. It deals with goal determination, goal development and
achievement of these goals. Future planning, policy making, decision making and
optimal utilization of available resources, come under the banner of managerial
economics.
(iii) Managerial
economics is pragmatic. In pure microeconomic theory, analysis is performed,
based on certain exceptions, which are far from reality. However, in managerial
economics, managerial issues are resolved daily and difficult issues of
economic theory are kept at bay.
(iv) Managerial economics
employs economic concepts and principles, which are known as the theory of Firm
or 'Economics of the Firm'. Thus, its scope is narrower than that of pure
economic theory.
(v) Managerial economics
incorporates certain aspects of macroeconomic theory. These are essential to
comprehending the circumstances and environments that envelop the working
conditions of an individual firm or an industry. Knowledge of macroeconomic
issues such as business cycles, taxation policies, industrial policy of the
government, price and distribution policies, wage policies and antimonopoly policies
and so on, is integral to the successful functioning of a business enterprise.
(vi) Managerial economics aims
at supporting the management in taking corrective decisions and charting plans
and policies for future.
(vii) Science is a system of rules
and principles engendered for attaining given ends. Scientific methods have
been credited as the optimal path to achieving one's goals. Managerial
economics has been is also called a scientific art because it helps the
management in the best and efficient utilization of scarce economic resources.
It considers production costs, demand, price, profit, risk etc. It assists the
management in singling out the most feasible alternative. Managerial economics
facilitates good and result oriented decisions under conditions of uncertainty.
(viii) Managerial economics is
a normative and applied discipline. It suggests the application of economic
principles with regard to policy formulation, decision-making and future
planning. It not only describes the goals of an organization but also
prescribes the means of achieving these goals.
Importance of Managerial
Economics:
Business and industrial
enterprises aim at earning maximum proceeds. In order to achieve this
objective, a managerial executive has to take recourse in decision making,
which is the process of selecting a specified course of action from a number of
alternatives. A sound decision requires fair knowledge of the aspects of
economic theory and the tools of economic analysis, which are directly involved
in the process of decision-making. Since managerial economics is concerned with
such aspects and tools of analysis, it is pertinent to the decision making
process.
(i) Accommodating traditional theoretical
concepts to the actual business behavior and conditions:Managerial economics
amalgamates tools, techniques, models and theories of traditional economics
with actual business practices and with the environment in which a firm has to
operate. According to Edwin Mansfield, “Managerial Economics attempts to bridge
the gap between purely analytical problems that intrigue many economic theories
and the problems of policies that management must face”.
(ii) Estimating economic
relationships: Managerial
economics estimates economic relationships between different business factors
such as income, elasticity of demand, cost volume, profit analysis etc.
(iii) Predicting relevant
economic quantities: Managerial
economics assists the management in predicting various economic quantities such
as cost, profit, demand,
capital, production, price etc.
As a business manager has to function in an environment of uncertainty, it is
imperative to anticipate the future working environment in terms of the said
quantities.
(iv) Understanding significant
external forces: The
management has to identify all the important factors that influence a firm.
These factors can broadly be divided into two categories. Managerial economics
plays an important role by assisting management in understanding these factors.
(a) External factors: A firm
cannot exercise any control over these factors. The plans, policies and
programs of the firm should be formulated in the light of these factors.
Significant external factors impinging on the decision making process of a firm
are economic system of the country, business cycles, fluctuations in national
income and national production, industrial policy of the government, trade and
fiscal policy of the government, taxation policy, licensing policy, trends in
foreign trade of the country, general industrial relation in the country and so
on.
(b) Internal factors: These
factors fall under the control of a firm. These factors are associated with
business operation. Knowledge of these factors aids the management in making
sound business decisions.
(v) Basis of business policies: Managerial economics is
the founding principle of business policies. Business policies are prepared
based on studies and findings of managerial economics, which cautions the
management against potential upheavals in national as well as international
economy. Thus, managerial economics is helpful to the management in its
decision-making process.
Nature
of Managerial Economics:
·
The primary function of
management executive in a business organisation is decision making and
forward planning.
·
Decision making and forward planning go
hand in hand with each other. Decision making means the process of selecting
one action from two or more alternative courses of action. Forward planning
means establishing plans for the future to carry out the decision so taken.
·
The problem of choice
arises because resources at the disposal of a business unit (land, labour,
capital, and managerial capacity) are limited and the firm has to make the most
profitable use of these resources.
·
The decision making function is that of
the business executive, he takes the decision which will ensure the most
efficient means of attaining a desired objective, say profit maximisation.
After taking the decision about the particular output, pricing, capital,
raw-materials and power etc., are prepared. Forward planning and
decision-making thus go on at the same time.
·
A business manager’s task is made
difficult by the uncertainty which surrounds business decision-making. Nobody
can predict the future course of business conditions. He prepares the best
possible plans for the future depending on past experience and future outlook
and yet he has to go on revising his plans in the light of new experience to
minimise the failure. Managers are thus engaged in a continuous process of
decision-making through an uncertain future and the overall problem confronting
them is one of adjusting to uncertainty.
·
In fulfilling the function of
decision-making in an uncertainty framework, economic theory can be, pressed
into service with considerable advantage as it deals with a number of concepts
and principles which can be used to solve or at least throw some light upon the
problems of business management. E.g are profit, demand, cost, pricing,
production, competition, business cycles, national income etc. The way economic
analysis can be used towards solving business problems, constitutes the
subject-matter of Managerial Economics.
·
Thus in brief we can say that Managerial
Economics is both a science and an art.
Scope
of Managerial Economics:
The
scope of managerial economics is not yet clearly laid out because it is a
developing science. Even then the following fields may be said to generally
fall under Managerial Economics:
1. Demand Analysis and Forecasting
2. Cost and Production Analysis
3. Pricing Decisions, Policies and Practices
4. Profit Management
5. Capital Management
These
divisions of business economics constitute its subject matter.
Recently,
managerial economists have started making increased use of Operation Research
methods like Linear programming, inventory models, Games theory, queuing up
theory etc., have also come to be regarded as part of Managerial Economics.
1.Demand Analysis and Forecasting: A business firm is an
economic organisation which is engaged in transforming productive resources
into goods that are to be sold in the market. A major part of managerial
decision making depends on accurate estimates of demand. A forecast of future
sales serves as a guide to management for preparing production schedules and
employing resources. It will help management to maintain or strengthen its
market position and profit base. Demand analysis also identifies a number of
other factors influencing the demand for a product. Demand analysis and
forecasting occupies a strategic place in Managerial Economics.
2.Cost
and production analysis: A firm’s profitability depends much on its cost of
production. A wise manager would prepare cost estimates of a range of output,
identify the factors causing are cause variations in cost estimates and choose
the cost-minimising output level, taking also into consideration the degree
of uncertainty in production and cost calculations. Production processes
are under the charge of engineers but the business manager is supposed to carry
out the production function analysis in order to avoid wastages of materials
and time. Sound pricing practices depend much on cost control. The main topics
discussed under cost and production analysis are: Cost concepts, cost-output
relationships, Economics and Diseconomies of scale and cost control.
3.Pricing
decisions, policies and practices: Pricing is a very important area of
Managerial Economics. In fact, price is the genesis of the revenue of a firm ad
as such the success of a business firm largely depends on the correctness of
the price decisions taken by it. The important aspects dealt with this area
are: Price determination in various market forms, pricing methods, differential
pricing, product-line pricing and price forecasting.
4.Profit management: Business firms are generally
organized for earning profit and in the long period, it is profit which
provides the chief measure of success of a firm. Economics tells us that
profits are the reward for uncertainty bearing and risk taking. A successful
business manager is one who can form more or less correct estimates of costs
and revenues likely to accrue to the firm at different levels of output. The
more successful a manager is in reducing uncertainty, the higher are the
profits earned by him. In fact, profit-planning and profit measurement
constitute the most challenging area of Managerial Economics.
5.Capital
management: The problems relating to firm’s capital investments are
perhaps the most complex and troublesome. Capital management implies planning
and control of capital expenditure because it involves a large sum and moreover
the problems in disposing the capital assets off are so complex that they
require considerable time and labour. The main topics dealt with under capital
management are cost of capital, rate of return and selection of projects.
Economic objectives of
firms
The main
objectives of firms are:
1.
Profit maximisation
2.
Sales maximisation
3.
Increased market share/market dominance
4.
Social/environmental concerns
5.
Profit satisficing
6.
Co-operatives/
Sometimes there is an overlap of objectives. For example,
seeking to increase market share, may lead to lower profits in the short-term,
but enable profit maximisation in the long run.
Profit maximisation
Usually, in economics, we assume firms are concerned with
maximising profit. Higher profit means:
·
Higher dividends for shareholders.
·
More profit can be used to finance research and development.
·
Higher profit makes the firm less vulnerable to takeover.
·
Higher profit enables higher salaries for workers
1.
Profit Satisficing
·
In many firms, there is a separation of ownership and control.
Those who own the company (shareholders) often do not get involved in the day
to day running of the company.
·
This is a problem because although the owners may want to
maximise profits, the managers have much less incentive to maximise profits
because they do not get the same rewards, (share dividends)
·
Therefore managers may create a minimum level of profit to keep
the shareholders happy, but then maximise other objectives, such as enjoying
work, getting on with other workers. (e.g. not sacking them) This is the
problem of separation between owners and managers.
·
This ‘principal-agent‘
problem can be overcome, to some extent, by giving managers share options
and performance
related pay although in some industries it is difficult to measure
performance.
2.
Sales maximisation
Firms often seek to increase their market share – even if
it means less profit. This could occur for various reasons:
·
Increased market share increases monopoly power and may enable
the firm to put up prices and make more profit in the long run.
·
Managers prefer to work for bigger companies as it leads to greater
prestige and higher salaries.
·
Increasing market share may force rivals out of business. E.g.
the growth of supermarkets have lead to the demise of many local shops. Some
firms may actually engage in predatory pricing which involves making a loss to
force a rival out of business.
3.
Growth maximisation
This is similar to sales maximisation and may involve
mergers and takeovers. With this objective, the firm may be willing to make
lower levels of profit in order to increase in size and gain more market share.
More market share increases their monopoly power and ability to be a price
setter.
4.
Long run profit maximisation
In some cases, firms may sacrifice profits in the short
term to increase profits in the long run. For example, by investing heavily in new
capacity, firms may make a loss in the short run but enable higher profits in
the future.
5.
Social/environmental concerns
A firm may incur extra expense to choose products which
don’t harm the environment or products not tested on animals. Alternatively,
firms may be concerned about local community / charitable concerns.
·
Some firms may adopt social/environmental concerns as part of
its branding. This can ultimately help profitability as the brand becomes more
attractive to consumers.
·
Some firms may adopt social/environmental concerns on principal
alone – even if it does little to improve sales/brand image.
6.
Co-operatives
Co-operatives may have completely different objectives to
a typical PLC. A co-operative is run to maximise the welfare of all stakeholders
– especially workers. Any profit the co-operative makes will be shared amongst
all members.
Definition of Micro Economics
Microeconomics is the branch of economics that
concentrates on the behaviour and performance of the individual units, i.e.
consumers, family, industry, firms. Here, the demand plays a key role in
determining the quantity and the price of a product along with the price and
quantity of related goods (complementary goods) and substitute products, so as
to make a judicious decision regarding the allocation of scarce resources,
concerning their alternative uses.
Examples:
Individual Demand, Price of a product, etc.
Definition of Macro Economics
Macroeconomics is the branch of economics that
concentrates on the behaviour and performance of aggregate variables and those
issues which affect the whole economy. It includes regional, national and
international economies and covers the major areas of the economy like
unemployment, poverty, general price level, GDP (Gross Domestic Product),
imports and exports, economic growth, globalisation, monetary/ fiscal policy,
etc. It helps in resolving the various problems of the economy, thereby
enabling it to function efficiently.
Examples:
Aggregate Demand, National Income, etc.
Key Differences between Micro and Macro Economics
The points given below explains the difference between
micro and macro economics in detail:
- Microeconomics
studies the particular market segment of the economy, whereas Macroeconomics
studies the whole economy, that covers several market segments.
- Micro
economics stresses on individual economic units. As against this, the
focus of macro economics is on aggregate economic variables.
- While
microeconomics is applied to operational or internal
issues, environmental and external issues are the concern of macro
economics.
- Microeconomics
deals with an individual product, firm, household, industry, wages,
prices, etc., while Macroeconomics deals with aggregates like national
income, national output, price level, etc.
- Microeconomics
covers issues like how the price of a particular commodity will affect its
quantity demanded and quantity supplied and vice versa while
Macroeconomics covers major issues of an economy like unemployment,
monetary/ fiscal policies, poverty, international trade, etc.
- Microeconomics
determine the price of a particular commodity along with the prices of
complementary and the substitute goods, whereas the Macroeconomics is
helpful in maintaining the general price level.
- While
analysing any economy, micro economics takes a bottom-up approach, whereas
the macroeconomics takes a top-down approach into consideration.
Micro
Economics
Pros:
- It helps in the determination of
prices of a particular product and also the prices of various factors of
production, i.e. land, labour, capital, organisation and entrepreneur.
- It is based on a free enterprise
economy, which means the enterprise is independent to take decisions.
Cons:
- The assumption of full employment
is completely unrealistic.
- It only analyses a small part of an
economy while a bigger part is left untouched.
Macro Economics
Pros:
- It is helpful in determining the
balance of payments along with the causes of deficit and surplus of it.
- It makes the decision regarding economic
and fiscal policies and solves the issues of public finance.
Cons:
- Its analysis says that the
aggregates are homogeneous, but it is not so because sometimes they are
heterogeneous.
- It covers only the aggregate
variables which avoid the welfare of the individual.
Similarities
As microeconomics focuses on the allocation of limited
resources among the individuals, the macro economics examines that how the
distribution of limited resources is to be done among many people, so that it
will make the best possible use of the scarce resources. As micro economics
studies about the individual units, at the same time, macro economics studies
about the aggregate variables. In this way, we can say that they are
interdependent.
Conclusion
Micro and Macro Economics are not contradictory in
nature, in fact, they are complementary. As every coin has two aspects- micro
and macroeconomics are also the two aspects of the same coin, where one’s
demerit is others merit and in this way they cover the whole economy. The only
important thing which makes them different is the area of
application.
BASIC ECONOMIC
PROBLEM
The economic problem –
sometimes called the basic or central economic problem –
asserts that an economy's finite resources are
insufficient to satisfy all human wants and needs. It assumes that human wants are unlimited, but the means
to satisfy human wants are limited. Economy problem is the problem of rational
management of resources or the problem of optimum utilisation of resources.it
arises because 1 resources are scarce and 2
The economic problem – sometimes called
the basic or central economic problem –
asserts that an economy's finite resources are
insufficient to satisfy all human wants and needs. It assumes that human wants are unlimited, but the
means to satisfy human wants are limited. Economy problem is the problem of
rational management of resources or the problem of optimum utilisation of
resources.it arises because 1 resources are scarce and 2 resources have
alternative uses
Three questions arise from this:
• What to produce?
• How to produce? &
• For whom to produce?
·
What to produce?
'What and how much will you produce?' This question lies
with selecting the type of supply and the quantity of the supply, focusing
on efficiency.
e.g. "What should I produce more; laptops or
tablets?"
·
How to produce? Capital goods or consumer goods
'How do you produce this?' This question deals with the
assets and procedures used while making the product, also focusing on efficiency.
e.g. "Should I hire more workers, or do I invest in
more machinery?"
·
For whom to produce?
'To whom and how will you distribute the goods?' and 'For
whom will you produce this for?' arises from this question. This question deals
with distributing goods that have been produced, focusing on efficiency and equity.
e.g. "Do I give more dividends to
stock holders, or do I increase worker wages?"
Economics revolve
around these fundamental economic problems.
Overview
The economic problem is most simply explained by the
question: "How do we satisfy unlimited wants with limited resources?"
The premise of the economic problem model is that wants are constant and
infinite due to constantly changing demands (often closely related to
changing demographics of the population), but resources in the world to
satisfy human wants are always limited to the amount of natural or human resources available.
The economic problem and methods to curb it—revolve around the idea of choice
in prioritizing which wants can be fulfilled and what to produce for the
economy.
Opportunity cost is the loss in terms of potential
benefit had another action been taken. We make choices every day. We have to,
as we have limited resources but so many wants. We therefore must decide which
wants to satisfy and which not to. All choices involve giving something up.
This leads to opportunity cost. This issue of 'what to give up'
exists not only for consumers like us but for governments and businesses
too...........................
Needs and wants
Needs are things or material items of peoples need for
survival, such as food, clothing, housing, and water. Everyone has a different
needs and wants. Until the Industrial Revolution, the vast majority of the world's population struggled
for access to basic human needs.
Wants are effective desires for a
particular product, or for something that can only be obtained by working for
it. While the fundamental needs of survival are key in the function of the
economy, wants are the driving force that stimulates demand for goods and
services. To curb the economic problem, economists must classify the nature and
different wants of consumers, as well as prioritize wants and organize
production to satisfy as many wants as possible.
An assumption often made in mainstream neoclassical economics (and methods that try to solve the economic
problem) is that humans inherently pursue their self-interest, and that
the market mechanism best satisfies the various wants different individuals
might have. These wants are often divided into individual wants (which
depend on the individual's preferences and purchasing power parity) and collective wants (which are the
wants of entire groups of people). Things such as food and clothing can be
classified as either wants or needs, depending on what type and how often a
good is requested.
Four parts of the problem]
The economic problem can be divided into different parts,
which are given below.
Problem of
allocation of resources
The problem of allocation of resources arises due to the
scarcity of resources, and refers to the question of which wants should be
satisfied and which should be left unsatisfied. In other words, what to produce
and how much to produce. More production of a good implies more resources
required for the production of that good, and resources are scarce. These two
facts together mean that, if a society decides to increase production of some
good, it has to withdraw some resources from the production of other goods. In
other words, more production of a desired commodity can be made possible only
by reducing the quantity of resources used in the production of other goods.
The problem of allocation deals with the question of
whether to produce capital goods or consumer goods. If the community decides to
produce capital goods, resources must be withdrawn from the production of
consumer goods. In the long run, however, investment in
capital goods augments the production of consumer goods. Thus, both capital and
consumer goods are important. The problem is determining the optimal production
ratio between the two.
The problem
of all economic efficiency
Resources are scarce and it is important to use them as
efficiently as possible. Thus, it is essential to know if the production and
distribution of national product made by an economy is maximally efficient. The
production becomes efficient only if the productive resources are utilized in
such a way that any reallocation does not produce more of one good without
reducing the output of any other good. In other words, efficient
distribution means that redistributing goods cannot make anyone better
off without making someone else worse off. (See Pareto efficiency.)
The inefficiencies of production and distribution exist
in all types of economies. The welfare of the people can be increased if these
inefficiencies are ruled out. Some cost must be incurred to remove these
inefficiencies. If the cost of removing these inefficiencies of production and
distribution is more than the gain, then it is not worthwhile to remove them.
The problem
of full-employment of resources
In view of the scarce resources, the question of whether
all available resources are fully utilized is an important one. A community
should achieve maximum satisfaction by using the scarce resources in the best
possible manner—not wasting resources or using them inefficiently. There are
two types of employment of resources:
·
Labour-intensive
·
Capital-intensive
In capitalist economies, however, available resources are
not fully used. In times of depression, many people want to work but can't find
employment. It supposes that the scarce resources are not fully utilized in a
capitalistic economy.
The problem
of economic growth
If productive capacity grows, an economy can produce
progressively more goods, which raises the standard of living. The increase in productive capacity of an economy is
called economic growth. There are various factors affecting economic growth.
UNIT-II
Theory
of Consumer Behavior:
There are two main approaches to the of
consumer behavior of demand. The first approach is the Marginal Utility
or Cardinalist Approach. The second is the Ordinalist Approach.
We discuss these two approaches separately.
Human wants are unlimited and they are
of different intensity. The means at the disposal of a man are not only scarce
but they have alternative uses. As a result of scarcity of recourses, the
consumer cannot satisfy all his wants. Continue
reading.
People buy goods because they get
satisfaction from them. This satisfaction which the consumer experiences when
he consumes a good, when measured as number of utils is called utility. Continue
reading.
The law of diminishing
marginal utility describes a familiar and fundamental tendency of
human behavior. The law of diminishing marginal utility states that, “as a
consumer consumes more and more units of a specific commodity, the utility from
the successive units goes on diminishing”. Continue
reading.Law
of Equi Marginal Utility:
In the cardinal utility analysis, the
principle of equal marginal utility occupies an important place. We state the
assumptions of the law first and then proceed to explain it. Continue
reading.
Dr. Alfred
Marshal was of the view that the law
of demand and so the demand curve can be derived with the help of utility
analysis.
Comparison
Between Indifference Curve Analysis and Marginal Utility Analysis:
There is difference of opinion among
economists about the superiority of indifference analysis over cardinal utility
analysis.Professor Hicks is of the opinion that the indifference
analysis is more objective and scientific.Professor D.H. Rebertson is
of the view that the Hicksian indifference curve technique is simply “old wine
in new bottle”.
We give in brief the main points of
similarly between these two types of analysis and then discuss the superiority
of Hicksian indifference curve analysis over the Marshallian Utility Approach.
Similarities
Between the Two Approaches:
(i) Rationality assumption: In the two approaches, it is assumed that the consumer
behaves rationality for obtaining satisfaction from his expenditure on consumer
goods. Marshall uses the term utility, and Hicks satisfaction.
(ii) Proportionality rule: The equilibrium condition of the consumer in both the
analysis is the proportionality rule. In cardinal utility analysis , the
equilibrium condition of the consumer is:
MUa / Pa =
MUb / Pb = MUc / Pc ………….
= MUn / Pn
In the Hicksian analysis, this ratio of
marginal utility has been substituted by marginal rate of substitution is: MRSxy = Px /
Py
(iii) Diminishing MU and MRS: Another similarity between the two types of analysis is that
both assume that as the consumer gets more and more of a commodity, there is
diminishing satisfaction to the consumer.
(iv) Same conclusion: The cardinal utility analysis and the Hicksian indifference
curve analysis both reach at the same conclusion about the consumer behavior.
There is nothing new in the indifference approach.
Superiority of Hicksian Indifference
Curve Analysis:
The indifference curve analysis is
an improved form of utility analysis. It is consider more scientific and
particularly accepted able on the following grounds:
(i) It dispenses with cardinal
measurement of utility: Professor R.G.D. Allen and J.R Hicks claims
that the indifference curve technique is scientific and more realistic than the
Marshall’s utility analysis. The foundation of utility analysis is based, they
say, on the cardinal utility function which assumes that the utility is
measurable; whereas utility is purely subjective phenomena and cannot be
exactly measured. It varies from person to person and time to time. Any effort
to measure it precisely will be a futile one.
On the the other hand, the indifference
approach is based on ordinal utility function, i.e., it does not assign any
number to a commodity , representing the amount of the utility. It simply
assumes that the consumer weighs in his mind the relative desirability of the
different combinations of goods and services.
(ii) It explains the income effect and
price effect: Marshall assumes that
the marginal utility of money remains constant whereas the fact is that with a
rise or fall in income, the marginal utility of the money changes. The
indifference curve approach, however, takes into consideration the income
effect changes in price of the commodity.
(iii) It studies combination of two
goods: It assumed in the Marshallian
utility analysis that a consumer can measure the utility of a commodity in
isolation from other commodities, i.e., it confines itself to a single
commodity model. The indifference curve approach, on the other hand; studies
combinations of two goods commodity and analysis the relationship of substitutable
and complementarily.
(iv) Application of the principle of
MRS: The law of diminishing marginal utility has now been
replaced by the principle of diminishing marginal rate of substitution. This
law is more scientific and realistic and is well applicable in the field of
consumption, production and distribution.
(v) Popularity of indifference curve
technique for the analysis of welfare economies: The indifference curve technique is more popular among the
British economists and is mostly used for the analysis of welfare economies.
For instance,
the indifference curve approach helps us
to explain that the direct tax imposes a lesser burden than an indirect tax
upon the consumer.
(a) The indifference curve approach
helps us to explain that the direct tax imposes a lesser burden than an
indirect tax upon the consumer.
(b) The Hicksian indifference approach
is also used for constructing the supply curve of labor in the country. We can
explain with the help of indifference technique that when the wages of the
workers rise, they begin to prefer leisure. For example, if wife and husband
both work and the wages of the husband increases, wife often leaves the service
and begins to do the domestic work.
(c) The indifference curve technique is
also used for illustrating the concept of consumer's surplus.
(d) In case of rationing in the country,
the indifference approach tells us that as the income and preferences of
consumers differ, therefore, the goods should not be distributed equally. The
income and tastes of the consumers should always be kept in view.
Criticism of Indifference Curve
Approach:
The indifference curve approach has been
criticized on the following grounds:
(i) Old wine in new bottle: Professor D.H. Roberson is of the view that the difference
between Marshallian utility analysis and the indifference approach is that an
old wine has been put in a new bottle. The only change which Hicks and Allen
has made is that they have used the words marginal rate of substitution
instead, of marginal utility.
(ii) Away from reality: The indifference curve technique is away from reality as the
indifference hypothesis are more complicated.
(iii) Midway house: Schumpeter describes indifference analysis as a midway house as it
particularly no better than the utility analysis.
(iii) The consumer is not rational: The consumer is not rational as he acts under various
social, economic and legal disabilities.
(iv) Two goods model unrealistic: Two goods model unrealistic because a consumer buys large
number of commodities to satisfy his unlimited wants.
(v) All commodities are not
divisible: There is no doubt that
indifference curve technique is not without defects, but when we take into
consideration the position as a whole, we find that the indifference approach
is superior to that of utility approach because it is more realistic and less
restrictive.
What is the 'Law of Demand'
The law of demand states that quantity purchased
varies inversely with price. In other words, the higher the price, the
lower the quantity demanded. The reason for this phenomenon is that
consumers' opportunity cost increases, so they must give something else up
or switch to a substitute product.
Meaning
of Demand:
The demand for a
commodity is its quantity which consumers are able and willing to buy at
various prices during a given period of time.
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So, for a commodity to have demand the consumer must possess
willingness to buy it, the ability or means to buy it, and it must
be related to per unit of time i.e. per day, per week, per month or per year.
Demand is a function of price (p), income (y), prices of related goods (pr) and
tastes (f) and is expressed as D=f (p, y, pr, t). When income, prices of
related goods and tastes are given, the demand function is D=f(p). It shows the
“quantities of a commodity purchased at given prices. In the Marshallian
analysis, the other determinants of demand are taken as given and constant.
Factors Influencing Demand:
The
factors which determine the level of demand for any commodity are the
following:
1. Price:
The
higher the price of a commodity, the lower the quantity demanded. The lower the
price, the higher the quantity demanded.
2. Prices of other Commodities:
There
are three types of commodities in this context.
Substitutes:
If
a rise (or fall) in the price of one commodity leads to an increase (or
decline) in the demand for another commodity, the two commodities are said to
be substitutes. In other words, substitutes are those commodities which satisfy
similar wants, such as tea and coffee.
If
the price of coffee falls, the demand for coffee rises which brings a fall in
the demand for tea because the consumers of tea shift their demand to coffee
which has become cheaper. On the other hand, if the price of coffee rises, its
demand will fall. But the demand for tea will rise because the consumers of
coffee will shift their demand to tea.
Complementary Commodities:
Where
the demand for two commodities is linked to each other, such as cars and
petrol, bread and butter, tea and sugar, etc., they are said to be
complementary goods. Complementary goods are those which cannot be used without
each other. If, say, the price of cars rises and they become expensive, the
demand for them will fall and so will the demand for petrol. On the contrary,
if the price of cars falls and they become cheaper, the demand for them will
increase and so will the demand for petrol.
Unrelated Goods:
If
the two commodities are unrelated, say refrigerator and bicycle, a change in
the price of one will have no effect on the quantity demanded of the other.
3. Income:
A
rise in the consumer’s income raises the demand for a commodity, and a fall in
his income reduces the demand for it.
4. Tastes:
When
there is a change in the tastes of consumers in favour of a commodity, say due
to fashion, its demand will rise, with no change in its price, in the prices of
other commodities, and in the income of the consumer. On the other hand, a
change in tastes against a commodity leads to a fall in its demand, other
factors affecting demand remaining unchanged.
An Individuals Demand Schedule and Curve:
An
individual consumer’s demand refers to the quantities of a commodity demanded
by him at various prices, other things remaining equal (y, pr and t). An
individual’s demand for commodity “is shown on the demand schedule and on the
demand curve. A demand schedule is a list of prices and quantities and its
graphic representation is a demand curve.
Table 10.1: Demand Schedule:
|
Price (Rs.)
|
Quantity (units)
|
|
6
|
10
|
|
5
|
20
|
|
4
|
30
|
|
3
|
40
|
|
2
|
60
|
|
1
|
80
|
The demand schedule reveals that
when the price is Rs. 6, the quantity demanded is 10 units. If the price
happens to be Rs 5, the quantity demanded is 20 units, and so on. In Figure
10.1, DD1 is the demand curve drawn on the basis of the
above demand schedule. The dotted points D, P, Q, R, S, T and U show the
various price-quantity combinations.
Marshall calls them “demand
points”. The first combination is represented by the first dot and the
remaining price- quantity combinations move to the right toward D1.
The Market Demand Schedule and Curve:
In
a market, there is not one consumer but many consumers of a commodity. The
market demand of a commodity is depicted on a demand schedule and a demand
curve. They show the sum total of various quantities demanded by all the
individuals at various prices.
Suppose
there are three individuals A, В and С in a market who purchase the commodity.
The demand schedule for the commodity is depicted in Table 10.2.
The
last column (5) of the Table represents the market demand of the commodity at
various prices. It is arrived at by adding columns (2), (3) and (4)
representing the demand of consumers A, В and С respectively. The relation
between columns (1) and (5) shows the market demand schedule. When the price is
very high Rs. 6 per kg. the market demand for the commodity is 70 kgs. As the
price falls, the demand increases. When the price is the lowest Re. 1 per kg.,
the market demand per week is 360 kgs.
Definition: The Demand for a product
refers to the quantity of goods and services that the consumers are willing to
buy at a particular price for a given point of time.
Types of Demand
The
demand can be classified on the following basis:
1.
Individual Demand and Market Demand: The individual demand
refers to the demand for goods and services by the single consumer, whereas the
market demand is the demand for a product by all the consumers who buy that
product. Thus, the market demand is the aggregate of the individual demand.
2.
Total Market Demand and Market Segment Demand: The total market demand
refers to the aggregate demand for a product by all the consumers in the market
who purchase a specific kind of a product. Further, this aggregate demand can
be sub-divided into the segments on the basis of geographical areas, price
sensitivity, customer size, age, sex, etc. are called as the market segment
demand.
3.
Derived Demand and Direct Demand: When the demand
for a product/outcome is associated with the demand for another product/outcome
is called as the derived demand or induced demand. Such as the demand for
cotton yarn is derived from the demand for cotton cloth. Whereas, when the
demand for the products/outcomes is independent of the demand for another
product/outcome is called as the direct demand or autonomous demand. Such as,
in the above example the demand for a cotton cloth is autonomous.
4.
Industry Demand and Company Demand: The industry
demand refers to the total aggregate demand for the products of a particular
industry, such as demand for cement in the construction industry. While the
company demand is a demand for the product which is particular to the company
and is a part of that industry. Such as demand for tyres manufactured by the Goodyear.
Thus, the company demand can be expressed as the percentage of the industry
demand.
5.
Short-Run Demand and Long-Run Demand: The short term
demand is more elastic which means that the changes in price or income are
reflected immediately on the quantity demanded. Whereas, the long run demand is
inelastic, which shows that demand for commodity exists as a result of
adjustments following changes in pricing, promotional strategies, consumption
patterns, etc.
6.
Price Demand: The demand is often
studied in parlance to price, and is therefore called as a price demand. The
price demand means the amount of commodity a person is willing to purchase at a
given price. While studying the demand, we often assume that the other factors
such as income of the consumer, their tastes, and preferences, the prices of
other related goods remain unchanged. There is a negative relationship between
the price and demand Viz. As the price increases the demand decreases and as
the price decreases the demand increases.
7.
Income Demand: The income demand refers to the
willingness of an individual to buy a certain quantity at a given income level.
Here the price of the product, customer’s tastes and preferences and the price
of the related goods are expected to remain unchanged. There is a positive
relationship between the income and demand. As the income increases the demand
for the commodity also increases and vice-versa.
8.
Cross Demand: It is one of the important types of
demand wherein the demand for a commodity depends not on its own price, but on
the price of other related products is called as the cross demand. Such as with
the increase in the price of coffee the consumption of tea increases, since tea
and coffee are substitutes to each other. Also, when the price
of cars increases the demand for petrol decreases, as the car and petrol
are complimentary to each other.
These
are some of the important types of demand that the firms must cater to before
deciding on the price and other factors related to their products.
10 Determinants of
Demand for a Product
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The demand of a
product is influenced by a number of factors.
An organization should
properly understand the relationship between the demand and its each
determinant to analyze and estimate the individual and market demand of a
product.
The demand for a
product is influenced by various factors, such as price, consumer’s income, and
growth of population.
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For example, the
demand for apparel changes with change in fashion and tastes and preferences of
consumers. The extent to which these factors influence demand depends on the
nature of a product.
An organization, while
analyzing the effect of one particular determinant on demand, needs to assume
other determinants to be constant. This is due to the fact that if all the
determinants are allowed to differ simultaneously, then it would be difficult
to estimate the extent of change in demand.
Following are the
determinants of demand for a product:
i. Price of a Product
or Service:
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Affects the demand of
a product to a large extent. There is an inverse relationship between the price
of a product and quantity demanded. The demand for a product decreases with
increase in its price, while other factors are constant, and vice versa.
For example, consumers
prefer to purchase a product in a large quantity when the price of the product
is less. The price-demand relationship marks a significant contribution in
oligopolistic market where the success of an organization depends on the result
of price war between the organization and its competitors.
ii. Income:
Constitutes one of the
important determinants of demand. The income of a consumer affects his/her
purchasing power, which, in turn, influences the demand for a product. Increase
in the income of a consumer would automatically increase the demand for
products by him/her, while other factors are at constant, and vice versa.
For example, if the
salary of Mr. X increases, then he may increase the pocket money of his
children and buy luxury items for his family. This would increase the demand of
different products from a single family. The income-demand relationship can be
analyzed by grouping goods into four categories, namely, essential consumer
goods, inferior goods, normal goods, and luxury goods.
The relationship
between the income of a consumer and each of these goods is explained as
follows:
a. Essential or Basic
Consumer Goods:
Refer to goods that
are consumed by all the people in the society. For example, food grains, soaps,
oil, cooking fuel, and clothes. The quantity demanded for basic consumer goods
increases with increase in the income of a consumer, but up to a fixed limit,
while other factors are constant.
b. Normal Goods:
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Refer to goods whose
demand increases with increase in the consumer’s income. For example, goods,
such as clothing, vehicles, and food items, are demanded in relatively
increasing quantity with increase in consumer’s income. The demand for normal
goods varies due to .different rate of increase in consumers’ income.
c. Inferior Goods:
Refer to goods whose
demand decreases with increase in the income of consumers. For example, a
consumer would prefer to purchase wheat and rice instead of millet and cooking
gas instead of kerosene, with increase in his/her income. In such a case,
millet and kerosene are inferior goods for the consumer.
However, these two
goods can be normal goods for people having lower level of income. Therefore,
we can say that goods are not always inferior or normal; it is the level of
income of consumers and their perception about the need of goods.
d. Luxury Goods:
Refer to goods whose
demand increases with increase in consumer’s income. Luxury goods are used for
the pleasure and esteem of consumers. For example, expensive jewellery items,
luxury cars, antique paintings and wines, and air travelling.
iii. Tastes and
Preferences of Consumers:
Play a major role in
influencing the individual and market demand of a product. The tastes and
preferences of consumers are affected due to various factors, such as life
styles, customs, common habits, and change in fashion, standard of living,
religious values, age, and sex.
A change in any of
these factors leads to change in the tastes and preferences of consumers.
Consequently, consumers reduce the consumption of old products and add new
products for their consumption. For example, if there is change in fashion,
consumers would prefer new and advanced products over old- fashioned products,
provided differences in prices are proportionate to their income.
Apart from this,
demand is also influenced by the habits of consumers. For instance, most of the
South Indians are non-vegetarian; therefore, the demand for non- vegetarian
products is higher in Southern India. In addition, sex ratio has a relative
impact on the demand for many products.
For instance, if
females are large in number as compared to males in a particular area, then the
demand for feminine products, such as make-up kits and cosmetics, would be high
in that area.
iv. Price of Related
Goods:
Refer to the fact that
the demand for a specific product is influenced by the price of related goods
to a greater extent.
Related goods can be
of two types, namely, substitutes and complementary goods, which are explained
as follows:
a. Substitutes:
Refer to goods that
satisfy the same need of consumers but at a different price. For example, tea
and coffee, jowar and bajra, and groundnut oil and sunflower oil are substitute
to each other. The increase in the price of a good results in increase in the
demand of its substitute with low price. Therefore, consumers usually prefer to
purchase a substitute, if the price of a particular good gets increased.
b. Complementary
Goods:
Refer to goods that
are consumed simultaneously or in combination. In other words, complementary
goods are consumed together. For example, pen and ink, car and petrol, and tea
and sugar are used together. Therefore, the demand for complementary goods
changes simultaneously. The complementary goods are inversely related to each
other. For example, increase in the prices of petrol would decrease the demand
of cars.
v. Expectations of
Consumers:
Imply that
expectations of consumers about future changes in the price of a product affect
the demand for that product in the short run. For example, if consumers expect
that the prices of petrol would rise in the next week, then the demand of
petrol would increase in the present.
On the other hand,
consumers would delay the purchase of products whose prices are expected to be
decreased in future, especially in case of non-essential products. Apart from
this, if consumers anticipate an increase in their income, this would result in
increase in demand for certain products. Moreover, the scarcity of specific
products in future would also lead to increase in their demand in present.
vi. Effect of
Advertisements:
Refers to one of the
important factors of determining the demand for a product. Effective
advertisements are helpful in many ways, such as catching the attention of
consumers, informing them about the availability of a product, demonstrating
the features of the product to potential consumers, and persuading them to
purchase the product. Consumers are highly sensitive about advertisements as
sometimes they get attached to advertisements endorsed by their favorite
celebrities. This results in the increase demand for a product.
vii. Distribution of
Income in the Society:
Influences the demand
for a product in the market to a large extent. If income is equally distributed
among people in the society, the demand for products would be higher than in
case of unequal distribution of income. However, the distribution of income in
the society varies widely.
This leads to the high
or low consumption of a product by different segments of the society. For
example, the high income segment of the society would prefer luxury goods,
while the low income segment would prefer necessary goods. In such a scenario,
demand for luxury goods would increase in the high income segment, whereas
demand for necessity goods would increase in the low income segment.
viii. Growth of
Population:
Acts as a crucial
factor that affect the market demand of a product. If the number of consumers
increases in the market, the consumption capacity of consumers would also
increase. Therefore, high growth of population would result in the increase in
the demand for different products.
ix. Government Policy:
Refers to one of the
major factors that affect the demand for a product. For example, if a product
has high tax rate, this would increase the price of the product. This would
result in the decrease in demand for a product. Similarly, the credit policies
of a country also induce the demand for a product. For example, if sufficient
amount of credit is available to consumers, this would increase the demand for
products.
x. Climatic
Conditions:
Affect the demand of a
product to a greater extent. For example, the demand of ice-creams and cold
drinks increases in summer, while tea and coffee are preferred in winter. Some
products have a stronger demand in hilly areas than in plains. Therefore,
individuals demand different products in different climatic conditions.
Elasticity
of Demand: Meaning and Types of Elasticity (explained with diagram)
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Meaning
of Elasticity of Demand:
Demand extends or
contracts respectively with a fall or rise in price. This quality of demand by
virtue of which it changes (increases or decreases) when price changes
(decreases or increases) is called Elasticity of Demand.
“The elasticity (or responsiveness) of
demand in a market is great or small according as the amount demanded increases
much or little for a given fall in price, and diminishes much or little for a
given rise in price”. – Dr. Marshall.
Elasticity means
sensitiveness or responsiveness of demand to the change in price.
This change,
sensitiveness or responsiveness, may be small or great. Take the case of salt.
Even a big fall in its price may not induce an appreciable ex appreciable
extension in its demand. On the other hand, a slight fall in the price of
oranges may cause a considerable extension in their demand. That is why we say
that the demand in the former case is ‘inelastic’ and in the latter case it is
‘elastic’.
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The demand is
elastic when with a small change in price there is a great change in demand; it
is inelastic or less elastic when even a big change in price induces only a
slight change in demand. In the words of Dr. Marshall, “The elasticity (or
responsiveness) of demand in a market is great or small according as the amount
demanded increases much or little for a given fall in price, and diminishes
much or little for a given rise in price.”But the demand cannot be perfectly
‘elastic’ or ‘inelastic’.
Completely
elastic demand will mean that a slight fall (or rise) in the price of the
commodity concerned induces an infinite extension (or contraction) in its
demand. Completely inelastic demand will mean that any amount of fall (or rise)
in the price of the commodity would not induce any extension (or contraction)
in its demand. Both these conditions are unrealistic. That is why we say that
elasticity of demand may be ‘more or less’, but it is seldom perfectly elastic
or absolutely inelastic.
Types
of Elasticity:
Distinction may
be made between Price Elasticity, Income Elasticity and Cross Elasticity. Price
Elasticity is the responsiveness of demand to change in price; income
elasticity means a change in demand in response to a change in the consumer’s
income; and cross elasticity means a change in the demand for a commodity owing
to change in the price of another commodity.
Degrees
of Elasticity of Demand:
We have seen
above that some commodities have very elastic demand, while others have less
elastic demand. Let us now try to understand the different degrees of
elasticity of demand with the help of curves.
(a)
Infinite or Perfect Elasticity of Demand:
Let as first take
one extreme case of elasticity of demand, viz., when it is infinite or perfect.
Elasticity of demand is infinity when even a negligible fall in the price of
the commodity leads to an infinite extension in the demand for it. In Fig. 10.1
the horizontal straight line DD’ shows infinite elasticity of demand. Even when
the price remains the same, the demand goes on changing.
(b) Perfectly Inelastic Demand:
The other extreme
limit is when demand is perfectly inelastic. It means that howsoever great the
rise or fall in the price of the commodity in question, its demand remains
absolutely unchanged. In Fig. 10.2, the vertical line DD’ shows a perfectly
inelastic demand. In other words, in this case elasticity of demand is zero. No
amount of change in price induces a change in demand.
In the real
world, there is no commodity the demand for which may be absolutely inelastic,
i.e., changes in its price will fail to bring about any change at all in the
demand for it. Some extension/contraction is bound to occur that is why
economists say that elasticity of demand is a matter of degree only. In the
same manner, there are few commodities in whose case the demand is perfectly
elastic. Thus, in real life, the elasticity of demand of most goods and services
lies between the two limits given above, viz., infinity and zero. Some have
highly elastic demand while others have less elastic demand.
(c) Very Elastic Demand:
Demand is said to
be very elastic when even a small change in the price of a commodity leads to a
considerable extension/contraction of the amount demanded of it. In Fig. 10.3,
DD’ curve illustrates such a demand. As a result of change of T in the price,
the quantity demanded extends/contracts by MM’, which clearly is comparatively
a large change in demand.
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(d) Less Elastic Demand:
When even a substantial change in
price brings only a small extension/contraction in demand, it is said to be
less elastic. In Fig. 10.4, DD’ shows less elastic demand. A fall of NN’ in
price extends demand by MM’ only, which is very small.
emand
Forecasting: Concept, Significance, Objectives and Factors
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An organization
faces several internal and external risks, such as high competition, failure of
technology, labor unrest, inflation, recession, and change in government laws.
Therefore, most
of the business decisions of an organization are made under the conditions of
risk and uncertainty.
An organization
can lessen the adverse effects of risks by determining the demand or sales
prospects for its products and services in future. Demand forecasting is a systematic
process that involves anticipating the demand for the product and services of
an organization in future under a set of uncontrollable and competitive forces.
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Some of the popular definitions of demand
forecasting are as follows:
According to Evan
J. Douglas, “Demand estimation (forecasting) may be defined as a process of
finding values for demand in future time periods.”
In the words of
Cundiff and Still, “Demand forecasting is an estimate of sales during a
specified future period based on proposed marketing plan and a set of
particular uncontrollable and competitive forces.”
Demand
forecasting enables an organization to take various business decisions, such as
planning the production process, purchasing raw materials, managing funds, and
deciding the price of the product. An organization can forecast demand by
making own estimates called guess estimate or taking the help of specialized
consultants or market research agencies. Let us discuss the significance of
demand forecasting in the next section.
Significance
of Demand Forecasting:
Demand plays a
crucial role in the management of every business. It helps an organization to
reduce risks involved in business activities and make important business
decisions. Apart from this, demand forecasting provides an insight into the
organization’s capital investment and expansion decisions.
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The significance of demand forecasting is
shown in the following points:
i. Fulfilling objectives:
Implies that
every business unit starts with certain pre-decided objectives. Demand
forecasting helps in fulfilling these objectives. An organization estimates the
current demand for its products and services in the market and move forward to
achieve the set goals.
For example, an
organization has set a target of selling 50, 000 units of its products. In such
a case, the organization would perform demand forecasting for its products. If
the demand for the organization’s products is low, the organization would take
corrective actions, so that the set objective can be achieved.
ii. Preparing the budget:
Plays a crucial
role in making budget by estimating costs and expected revenues. For instance,
an organization has forecasted that the demand for its product, which is priced
at Rs. 10, would be 10, 00, 00 units. In such a case, the total expected
revenue would be 10* 100000 = Rs. 10, 00, 000. In this way, demand forecasting
enables organizations to prepare their budget.
iii. Stabilizing employment and
production:
Helps an
organization to control its production and recruitment activities. Producing
according to the forecasted demand of products helps in avoiding the wastage of
the resources of an organization. This further helps an organization to hire
human resource according to requirement. For example, if an organization
expects a rise in the demand for its products, it may opt for extra labor to
fulfill the increased demand.
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iv. Expanding organizations:
Implies that
demand forecasting helps in deciding about the expansion of the business of the
organization. If the expected demand for products is higher, then the
organization may plan to expand further. On the other hand, if the demand for
products is expected to fall, the organization may cut down the investment in
the business.
v. Taking Management Decisions:
Helps in making
critical decisions, such as deciding the plant capacity, determining the
requirement of raw material, and ensuring the availability of labor and
capital.
vi. Evaluating Performance:
Helps in making
corrections. For example, if the demand for an organization’s products is less,
it may take corrective actions and improve the level of demand by enhancing the
quality of its products or spending more on advertisements.
vii. Helping Government:
Enables the
government to coordinate import and export activities and plan international
trade.
Objectives
of Demand Forecasting:
Demand
forecasting constitutes an important part in making crucial business decisions.
The objectives of demand forecasting are
divided into short and long-term objectives, which are shown in Figure-1:
The objectives of demand forecasting (as
shown in Figure-1) are discussed as follows:
i. Short-term Objectives:
Include the following:
a. Formulating production policy:
Helps in covering
the gap between the demand and supply of the product. The demand forecasting
helps in estimating the requirement of raw material in future, so that the
regular supply of raw material can be maintained. It further helps in maximum
utilization of resources as operations are planned according to forecasts.
Similarly, human resource requirements are easily met with the help of demand
forecasting.
b. Formulating price policy:
Refers to one of
the most important objectives of demand forecasting. An organization sets
prices of its products according to their demand. For example, if an economy
enters into depression or recession phase, the demand for products falls. In
such a case, the organization sets low prices of its products.
c. Controlling sales:
Helps in setting
sales targets, which act as a basis for evaluating sales performance. An
organization make demand forecasts for different regions and fix sales targets
for each region accordingly.
d. Arranging finance:
Implies that the
financial requirements of the enterprise are estimated with the help of demand
forecasting. This helps in ensuring proper liquidity within the organization.
ii. Long-term Objectives:
Include the following:
a. Deciding the production capacity:
Implies that with
the help of demand forecasting, an organization can determine the size of the
plant required for production. The size of the plant should conform to the
sales requirement of the organization.
b. Planning long-term activities:
Implies that
demand forecasting helps in planning for long term. For example, if the
forecasted demand for the organization’s products is high, then it may plan to
invest in various expansion and development projects in the long term.
Factors Influencing
Demand Forecasting:
Demand
forecasting is a proactive process that helps in determining what products are
needed where, when, and in what quantities. There are a number of factors that
affect demand forecasting.
Some of the factors that influence demand
forecasting are shown in Figure-2:
The various factors that influence demand
forecasting (“as shown in Figure-2) are explained as follows:
i. Types of Goods:
Affect the demand
forecasting process to a larger extent. Goods can be producer’s goods, consumer
goods, or services. Apart from this, goods can be established and new goods.
Established goods are those goods which already exist in the market, whereas
new goods are those which are yet to be introduced in the market.
Information
regarding the demand, substitutes and level of competition of goods is known
only in case of established goods. On the other hand, it is difficult to
forecast demand for the new goods. Therefore, forecasting is different for
different types of goods.
ii. Competition Level:
Influence the
process of demand forecasting. In a highly competitive market, demand for
products also depend on the number of competitors existing in the market.
Moreover, in a highly competitive market, there is always a risk of new
entrants. In such a case, demand forecasting becomes difficult and challenging.
iii. Price of Goods:
Acts as a major
factor that influences the demand forecasting process. The demand forecasts of
organizations are highly affected by change in their pricing policies. In such
a scenario, it is difficult to estimate the exact demand of products.
iv. Level of Technology:
Constitutes an
important factor in obtaining reliable demand forecasts. If there is a rapid
change in technology, the existing technology or products may become obsolete.
For example, there is a high decline in the demand of floppy disks with the
introduction of compact disks (CDs) and pen drives for saving data in computer.
In such a case, it is difficult to forecast demand for existing products in
future.
v. Economic Viewpoint:
Play a crucial
role in obtaining demand forecasts. For example, if there is a positive
development in an economy, such as globalization and high level of investment,
the demand forecasts of organizations would also be positive.
Apart from aforementioned factors,
following are some of the other important factors that influence demand
forecasting:
a. Time Period of Forecasts:
Act as a crucial
factor that affect demand forecasting. The accuracy of demand forecasting
depends on its time period.
Forecasts can be of three types, which are
explained as follows:
1. Short Period Forecasts:
Refer to the
forecasts that are generally for one year and based upon the judgment of the
experienced staff. Short period forecasts are important for deciding the
production policy, price policy, credit policy, and distribution policy of the
organization.
2. Long Period Forecasts:
Refer to the
forecasts that are for a period of 5-10 years and based on scientific analysis
and statistical methods. The forecasts help in deciding about the introduction
of a new product, expansion of the business, or requirement of extra funds.
3. Very Long Period Forecasts:
Refer to the
forecasts that are for a period of more than 10 years. These forecasts are
carried to determine the growth of population, development of the economy,
political situation in a country, and changes in international trade in future.
Among the
aforementioned forecasts, short period forecast deals with deviation in long
period forecast. Therefore, short period forecasts are more accurate than long
period forecasts.
4. Level of Forecasts:
Influences demand
forecasting to a larger extent. A demand forecast can be carried at three
levels, namely, macro level, industry level, and firm level. At macro level,
forecasts are undertaken for general economic conditions, such as industrial production
and allocation of national income. At the industry level, forecasts are
prepared by trade associations and based on the statistical data.
Moreover, at the
industry level, forecasts deal with products whose sales are dependent on the
specific policy of a particular industry. On the other hand, at the firm level,
forecasts are done to estimate the demand of those products whose sales depends
on the specific policy of a particular firm. A firm considers various factors,
such as changes in income, consumer’s tastes and preferences, technology, and
competitive strategies, while forecasting demand for its products.
5. Nature of Forecasts:
Constitutes an
important factor that affects demand forecasting. A forecast can be specific or
general. A general forecast provides a global picture of business environment,
while a specific forecast provides an insight into the business environment in
which an organization operates. Generally, organizations opt for both the
forecasts together because over-generalization restricts accurate estimation of
demand and too specific information provides an inadequate basis for planning
and execution.
Steps of Demand Forecasting:
The Demand
forecasting process of an organization can be effective only when it is
conducted systematically and scientifically.
It involves a number of steps, which are
shown in Figure-3:
The steps involved in demand forecasting
(as shown in Figure-3) are explained as follows:
1. Setting the Objective:
Refers to first
and foremost step of the demand forecasting process. An organization needs to
clearly state the purpose of demand forecasting before initiating it.
Setting objective of demand forecasting
involves the following:
a. Deciding the
time period of forecasting whether an organization should opt for short-term
forecasting or long-term forecasting
b. Deciding
whether to forecast the overall demand for a product in the market or only- for
the organizations own products
c. Deciding
whether to forecast the demand for the whole market or for the segment of the
market
d. Deciding
whether to forecast the market share of the organization
2. Determining Time Period:
Involves deciding
the time perspective for demand forecasting. Demand can be forecasted for a
long period or short period. In the short run, determinants of demand may not
change significantly or may remain constant, whereas in the long run, there is
a significant change in the determinants of demand. Therefore, an organization
determines the time period on the basis of its set objectives.
3. Selecting a Method for Demand
Forecasting:
Constitutes one
of the most important steps of the demand forecasting process Demand can be
forecasted by using various methods. The method of demand forecasting differs
from organization to organization depending on the purpose of forecasting, time
frame, and data requirement and its availability. Selecting the suitable method
is necessary for saving time and cost and ensuring the reliability of the data.
4. Collecting Data:
Requires
gathering primary or secondary data. Primary’ data refers to the data that is
collected by researchers through observation, interviews, and questionnaires
for a particular research. On the other hand, secondary data refers to the data
that is collected in the past; but can be utilized in the present
scenario/research work.
5. Estimating Results:
Involves making
an estimate of the forecasted demand for predetermined years. The results
should be easily interpreted and presented in a usable form. The results should
be easy to understand by the readers or management of the organization.
