Elasticity & forecasting

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Elasticity and Its Application

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Elasticity – The concept

The responsiveness of one variable to changes in another

When price rises what happens to demand?

Demand falls BUT! How much does demand fall?

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Elasticity – The concept

If price rises by 10% - what happens to demand?

We know demand will fall By more than 10%? By less than 10%? Elasticity measures the extent to which

demand will change

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Elasticity . . .

… is a measure of how much buyers and sellers respond to changes in market conditions

… allows us to analyze supply and demand with greater precision.

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Price Elasticity of Demand

Price elasticity of demand is the percentage change in quantity demanded given a percent change in the price.

It is a measure of how much the quantity demanded of a good responds to a change in the price of that good.

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Determinants of Price Elasticity of Demand

Necessities versus Luxuries

Availability of Close Substitutes

Definition of the Market

Time Horizon

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Determinants of Price Elasticity of Demand

Demand tends to be more elastic :

if the good is a luxury. the longer the time period. the larger the number of close

substitutes. the more narrowly defined the market.

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Computing the Price Elasticity of Demand

The price elasticity of demand is computed as the percentage change in the quantity demanded divided by the percentage change in price.

Price Elasticity of Demand=

Percentage Changein Quantity Demanded

Percentage Changein Price

Price Elasticity of Demand=

Percentage Changein Quantity Demanded

Percentage Changein Price

The Percentage Method

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price inchange Percentage

demandedquatity inchange Percentagedemand of elasticityPrice

Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones then your elasticity of demand would be calculated as:

2percent10

percent20

100002

002202

10010

810

.)..(

)(

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Ranges of Elasticity

Inelastic Demand Quantity demanded does not respond strongly to

price changes. Price elasticity of demand is less than one.

Elastic Demand Quantity demanded responds strongly to changes

in price. Price elasticity of demand is greater than one.

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Ranges of Elasticity

Perfectly InelasticQuantity demanded does not respond to price

changes. Perfectly ElasticQuantity demanded changes infinitely with any

change in price. Unit ElasticQuantity demanded changes by the same

percentage as the price.

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A Variety of Demand Curves

Because the price elasticity of demand measures how much quantity demanded responds to the price, it is

closely related to the slope of the demand curve.

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Perfectly Inelastic Demand- Elasticity equals 0

Quantity

Price

4

5

Demand

1002. ...leaves the quantity demanded unchanged.

1. Anincreasein price...

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Inelastic Demand- Elasticity is less than 1

Quantity

Price

4

51. A 25%increasein price...

100902. ...leads to a 10% decrease in quantity.

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Unit Elastic Demand- Elasticity equals 1

Quantity

Price

4



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Elastic Demand- Elasticity is greater than 1

Quantity

Price

4



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Perfectly Elastic Demand- Elasticity equals infinity

Quantity

Price

Demand4

1. At any priceabove 4, quantitydemanded is zero.

2. At exactly 4,consumers willbuy any quantity.

3. At a price below 4,quantity demanded is infinite.

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Computing the Price Elasticity of Demand ( Other methods)

Price elasticity of demand can also be calculated by a few other methods. These methods are :

Total Outlay Method Midpoint Formula Geometric Method

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Total Outlay Method

This method, measures the change on expenditure on commodities due to a change in price.

If a given change does not cause any change in the total amount spent on the commodity, the demand is said to be unitary elastic.

If the total expenditure increases due to fall in price, the demand is said to be elastic and vice versa.

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Demand is Unitary elastic

Price ( in Rs.) Quantity demanded Total expenditure

4.50 4 18

4.00 4.5 18

3.00 6 18

As price falls, the quantity demanded increases, But the total outlay remains constant. Hence, elasticity of demand is equal to unity.

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Demand is Elastic


4.50 6 27

4 7 28

3 10 30

As price falls, the quantity demanded increases, And the total outlay also increases. Hence, demand is elastic. ( Greater than unity)

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Demand is inelastic


4.50 4 18

4 4.25 17

3 5 15

As price falls, the quantity demanded increases, but the total outlay decreases. Hence, demand is inelastic. ( Lesser than unity)

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Midpoint Formula

The midpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the change.

)/2]P)/[(PP(P)/2]Q)/[(QQ(Q

=Demand of Elasticity Price1212

1212

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Example: If the price of an ice cream cone increases from 2.00 to 2.20 and the amount you buy falls from 10 to 8 cones the your elasticity of demand, using the midpoint formula, would be calculated as:

32.25.9

22

2/)00.220.2()00.220.2(

2/)810()810(

percent

percent

)/2]P)/[(PP(P)/2]Q)/[(QQ(Q

=Demand of Elasticity Price1212

1212

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Geometric method Elasticity at a point on a straight line demand curve

can be calculated as follows :

e = Length of the lower segment--------------------------------------------------

Length of the upper segment

At the midpoint of the demand curve e = 1 At all points above the midpoint e >1 At all points below the midpoint e < 1

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Geometric Method At the point M,

the demand curve is unit elastic. M is the midpoint of this linear demand curve

Above M, demand is elastic,

Below M, demand is inelastic

Price

Quantity

M

Elasticity = 1

Elasticity > 1

Elasticity < 1

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Perfectly Inelastic Supply- Elasticity equals 0

Quantity

Price

4

5

Supply

1002. ...leaves the quantity supplied unchanged.

1. Anincreasein price...

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Inelastic Supply - Elasticity is less than 1

Quantity

Price

4


90 100leads to a 10% increase in Supply

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Unit Elastic Supply - Elasticity equals 1

Quantity

Price

4


75 100leads to a 25% increase in Supply

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Elastic Demand- Elasticity is greater than 1

Quantity

Price


50 75

4

5

Leads to a 50% increase in quantity supplied

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Perfectly Elastic Supply Elasticity equals infinity

Quantity

Price

Supply4

1. At any priceabove 4, quantitysupplied is infinite.

2. At exactly 4,Producers will sell any quantity.

3. At a price below 4,quantity supplied is zero.

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ElasticityPrice

Quantity Demanded

D

The importance of elasticity is the information it provides on the effect on total revenue of changes in price.

5

100

Total revenue is price x quantity sold. In this example, TR = 5 x 100 = 500.

This value is represented by the shaded rectangle.

Total Revenue

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ElasticityPrice

Quantity Demanded

D

If the firm decides to decrease price to (say) 3, the degree of price elasticity of the demand curve would determine the extent of the increase in demand and the change therefore in total revenue.

5

100

3

140

Total Revenue

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Elasticity Price

Quantity Demanded

10

D

5

5

6

% Δ Price = -50%

% Δ Quantity Demanded = +20%

Ped = -0.4 (Inelastic)

Total Revenue would fall

Producer decides to lower price to attract sales

Not a good move!

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ElasticityPrice (£)

Quantity Demanded

D

10

5 20

Producer decides to reduce price to increase sales

7

% Δ in Price = - 30%

% Δ in Demand = + 300%

Ped = - 10 (Elastic)Total Revenue rises

Good Move!

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Elasticity

If demand is price elastic:

Increasing price would reduce TR (%Δ Qd > % Δ P)

Reducing price would increase TR (%Δ Qd > % Δ P)

If demand is price inelastic:

Increasing price would increase TR (%Δ Qd < % Δ P)

Reducing price would reduce TR (%Δ Qd < % Δ P)

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Importance of Elasticity

Relationship between changes in price and total revenue

Importance in determining what goods to tax (tax revenue)

Importance in analysing time lags in production

Influences the behaviour of a firm

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Importance of Elasticity Concepts

For a Businessman : If a businessman finds that the demand is inelastic, he is free to increase prices. In case if the demand is elastic, by slightly reducing the price, the demand will increase sharply and hence the total revenue will also increase.

The better a company can assess future demand, the better it can plan its resources. Each company is exposed to three types of factors influencing demand: company, competitive and macroeconomic factors.

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Demand Forecasting

A forecast is a prediction or anticipation of any event which is likely to happen in future.

Demand forecast is the prediction of the future demand for a firm’s product.

It can either be made through experience or by statistical methods.

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Forecasts are necessary for :

Fulfillment of the objectives. Preparations of budgets. Stabilization of employment and

production. Decisions about expansion of a firm. Other decisions like long term investment

plans, warehousing and inventory decisions.

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1. A forecast becomes a basis for setting and maintaining a production schedule – manufacturing.

2. It determines the quantity and timing of needs for labor, equipment, tools, parts, and raw materials – purchasing, personnel.

3. It influences the amount of borrowed capital needed to finance the production and the necessary cash flow to operate the business – controller.

4. It provides a basis for sales quota assignments to various segments of the sales force – sales management.

5. It is the overall base that determines the company’s business and marketing plans, which are further broken down into specific goals – marketing offer.

A forecast is important for at least five reasons:

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Methods of Demand forecasting

There are two different sets of methods for demand forecasting :

Interview & survey methods ( for short term forecasts )

Projection Approach ( for long term forecasts )

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Interview and Survey approach

To anticipate the demand for a product, information needs to be collected about the expected expenditure patterns of consumers. Depending on the various approaches to collect this information, different sub – methods are formulated.

We will study them one by one.

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Executive Opinion : In small companies, usually the owner

takes the responsibility of forecasting. As a result of the experience and

knowledge he is expected to have, he can predict what would be the course of activities in future and plan his own activities accordingly.

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Opinion polling method : Information about the consumer’s expenditure can be collected either by the market research department or through the wholesalers and retailers.

As a result of technological advancements, it is now possible to collect this information by the means of internet.

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Collective opinion method : Jury is a group of individuals, usually the top

bosses or sales, production, marketing managers having experience in different fields.

The advantage of this method is that instead of basing the forecast on the opinion of one single individual, a more accurate forecast can be drawn.

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Sample survey method : The total number of customers of a

company is called as its population. When this number is more, it is not possible to collect information for all the customers. When only a few customers are contacted, it is called as a Sample Survey.

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User’s Expectations

Consumer and industrial companies often poll their actual or potential customers.Some Industrial manufacturers ask about the quantities of products their customers may purchase in future and take this as their forecast.

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Delphi Method

Administering a series of questionnaires to panels of experts. This method gathers information from all experts and the opinion of all the experts is shared by all other experts.In case if an expert finds that his own forecast is unrealistic, after going through the opinion of other experts, there is a chance for corrections.

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Projection Approach

In this method, the past experience is projected for the future. This can be done by tow methods :

Correlation or regression analysis. Time series analysis.

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Past sales can be used to forecast future demand. Past sales are viewed from the angles of trends, various cycles of business, seasonality and then a forecast is drawn after checking the possibility of the same treads, cycles and seasonality factors.

This method is easy to use, it is based on past behavior and does not include new company, competitor or macroeconomic developments.

Classical approach to time series analysis:

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Naïve Method

Next Year’s Sales = This Year’s Sales X This Year’s SalesLast Year’s Sales

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Moving Average

Moving averages are used to allow for marketplace factors changing at different rates and at different times.

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PERIOD

SALES

VOLUME

SALES FOR

THREE-YEAR PERIOD

THREE-YEAR MOVING

AVERAGE

1 200

2 250

3 300 750

4 350 900 300

5 450 1100 ( 3) = 366.6

6 ?

Period 6 Forecast = 366.6

EXAMPLE OF MOVING-AVERAGE FORECAST

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Trend Projections – Least Squares

Eyeball fitting is simply a plot of the data with a line drawn through them that the forecaster feels most accurately fits the linear trend of the data.

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600

500

400

300

200

100

01984

T im e1985 1986 1987 1988 1989 1990

O bserved Sales F orecast Sales

Sale

s

T rend L ine

A TREND FORECAST OF SALES

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Categories of New ProductsNew-To-The-WorldNew-To-The-World

New Product LinesNew Product Lines

Product Line AdditionsProduct Line Additions

Improvements/RevisionsImprovements/Revisions

Repositioned ProductsRepositioned Products

Lower-Priced ProductsLower-Priced Products

SixCategories

ofNew

Products

SixCategories

ofNew

Products

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Forecasting of New Products

Evolutionary method : Whenever a new product has been evolved from an existing product ( eg. Colour TV from Black & White TV ), the information of the existing product may be used for prediction of future for the new product.

Substitution method : Many new goods are purchased by customers for replacing the old ones. ( Eg. LCD TV’s in place of Colour TV’s).

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Growth pattern methods : To predict the demand for a new product, the growth pattern of an established related goods can be understood.

Opinion polling method : This method advocates the direct questioning to the probable buyers or the influencers of sales of such products. (Eg. demand for drugs can be ascertained by asking the doctors )

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Sample survey method : A product is first introduced in a test market ( small city having profiles of customers of metros ). Responses from these markets are taken as a base for forecasts.

Indirect opinion polling : Instead of asking the probable buyers, here, the resellers are consulted.

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Elasticity & forecasting