Demand forecasting is about making estimations of future customer demand using previous old data and other information. Proper demand forecasting gives managers of organisation information about their decisions for pricing, business growth and strategies for market growth. Without demand forecasting, Organisation may take poor decisions about their products and target markets.
Organization faces several internal and external risks, such as high competition, failure of technology, labour unrest, inflation, recession, and change in government laws.
Therefore, risk and uncertainty are the reason to make business decisions of an organization.
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.
Demand forecasting helps in taking 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.
Demand Forecasting helps in reducing risk and makes important decision.
The significance of demand forecasting is shown in the following points:
i. Fulfilling objectives:
With certain predicated objectives every business unit starts. Demand forecasting helps in fulfilling these objectives and setting up the goals.
ii. Preparing the budget:
By estimating cost and expected revenues, budgeting becomes more accurate and crucial.
iii. Stabilizing employment and production:
Helps an organization to control its production and recruitment activities. Also helps in avoiding the wastage of the resources of an organization.
iv. Expanding organizations:
Implies that demand forecasting helps in deciding about the expansion of the business of the organization. If the demand for products is more then the organization may expand further. But, if the demand for products is expected to fall or reduce, the organization may cut down the investment in the business.
v. Taking Management Decisions:
Helps in making critical decisions, like determining the requirement of raw material, plant capacity and availability of labour and capital.
vi. Evaluating Performance:
Helps in making corrections related to quality etc.If demand reduces of the product but by analysing and taking corrective action improves the level of demand by enhancing the quality of product.
vii. Helping Government:
Enables the government to coordinate import and export activities and plan international trade.
1) Methods which are dependent and follows surveys, interviews and opinions.
2) This method includes the consumer survey Delphi method market surveys etc. of demand forecasting.
3) This method follows the opinion of different groups of people who are linked with the product to predict the future demand.
4) For short term forecasting prediction qualitative methods are preferred.
Qualitative forecasting techniques include interpretation of data combined with the professional expertise during the job experience.
You might forecast demand by holding focus groups of customers to discuss and gauge their reactions to several new product features your company is considering.
Qualitative techniques uses information from sources like:
Market Research: Conducted through surveys.
Historical Analogy: The sale of new product or service is compared with the sales of a previous similar product or service.
Sales patterns It is assumed that the sales patterns associated with the previous product or service can be transferred to the new product or service
The opinions of experts in the particular area are sought. Experts give their views on current trends & likely future developments that may have an impact on the general economy or a specific industry or market.
Focus Groups: Consists of panels of customers who are asked to provide their opinions about a product or service.
Delphi Method: “A qualitative forecasting technique where the opinions of experts are combined in a series of iterations (repetitions). The results of each iteration are used to develop the next, so that convergence of the experts’ opinions is obtained”. This method is based on the knowledge & judgment of a small group of experts.
Panel Consensus: A group of people provides opinion about the future & a facilitator brings the group to a consensus.
1) Statistical tools are used to predict the future demand of the product
2) Time series analysis, barometric method and regression method fall under the quantitative methods of demand forecasting.
3) The quantitative methods emphasizes on the use of past sales data along with various factors influencing the demand to estimate the future demand of the product.
4) Long-term forecasts are usually undertaken through the quantitative methods of demand forecasting.
Quantitative forecasts often use historical data, such as previous sales and revenue figures, production and financial reports and website traffic statistics. Looking at seasonal sales data, for example, can help you plan next year’s production and labour needs based on last year’s monthly or quarterly figures.
Based on historical information that is usually available within the company. Various techniques are:
A method for forecasting sales data when a definite upward or downward pattern exists. Model includes double exponential smoothing, regression & triple smoothing.
Seasonal Adjustment :
Seasonal models take into account the variation of demand from season to season. Adjustments can be made to a baseline forecast to predict the impact of a seasonal demand.
“A method of forecasting where time series data are separated into up to three components: trend, seasonal, and cyclical; where trend includes the general horizontal upward or downward movement over time; seasonal includes a recurring demand pattern such as day of the week, weekly, monthly, or quarterly; and cyclical includes any repeating, non-seasonal pattern. A fourth component is random, that is, data with no pattern. The new forecast is made by projecting the patterns individually determined and then combining them”.
Graphical Methods :
Plotting information in a graphical form. It is relatively easy to convert a spreadsheet into a graph that conveys the information in a visual manner. Trends & patterns are easier to spot & extrapolation of previous demand can be used to predict future demands.
Econometric Modeling :
A set of equations intended to be used simultaneously to capture the way in which dependent and independent variables are interrelated.
Life Cycle Modeling :
“A quantitative forecasting technique based on applying past patterns of demand data covering introduction, growth, maturity, saturation, and decline of similar products to a new product family”.
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:
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:
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.
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.
Oligopoly Market is characterized by few sellers, selling the homogeneous or differentiated products. Or say, that Oligopoly market structure lies between the pure monopoly and monopolistic competition, in which limited sellers dominate the market and have control over the price of the product.
Oligopoly market products are of two types:
1) Homogeneous product : The firms producing the homogeneous products are called as Pure or Perfect Oligopoly. It is found in the producers of industrial products such as aluminium, copper, steel, zinc, iron, etc.
2) Heterogeneous Product: The firms producing the heterogeneous products are called as Imperfect or Differentiated Oligopoly. Such type of Oligopoly is found in the producers of consumer goods such as automobiles, soaps, detergents, television, refrigerators, etc.
There are five types of oligopoly market :
1. Few Seller: limited sellers and many customers . Few firms dominating the market enjoy a considerable control over the price of the product.
2. Interdependence: one of the most important features of an Oligopoly market, in which, the seller has to be cautious with respect to any action taken by the competing firms..
3. Advertising: It is the advertisement which makes the oligopoly. Under Oligopoly market, every firm advertises their products, with the aim to reach more customers and increase their customer base. So completion tough and in race with each other.
4. Competition: As few players are there in the market hence genuine players only have intense competition. Thus, every seller keeps an eye over its rival and be ready with the counter attack.
5. Entry and Exit Barriers: The firms can easily exit the industry whenever it wants, but has to face certain barriers to entering into it. These barriers could be Government license, Patent, large firm’s economies of scale, high capital requirement, complex technology, etc.
6. Lack of Uniformity: There is a lack of uniformity among the firms in terms of their size, some are big, and some are small. Since there are less number of firms, any action taken by one firm has a considerable effect on the other.
Monopolistic Competition, there are a large number of firms that produce differentiated products which are close substitutes for each other. In other words, large sellers selling the products that are similar, but not identical and compete with each other on other factors besides price.
Features of Monopolistic Competition
1.Product Differentiation: This is one of the major features of the firms operating under the monopolistic competition, that produces the product which is not identical but is slightly different from each other. The products being slightly different from each other remain close substitutes of each other and hence cannot be priced very differently from each other.
2. Large number of firms: A large number of firms operate under the monopolistic competition, and there is a stiff competition between the existing firms. Unlike the perfect competition, the firms produce the differentiated products which are substitutes for each other, thus make the competition among the firms a real and a tough one.
3. Free Entry and Exit: With an intense competition among the firms, the entity incurring the loss can move out of the industry at any time it wants. Similarly, the new firms can enter into the industry freely, provided it comes up with the unique feature and different variety of products to outstand in the market and meet with the competition already existing in the industry.
4. Some control over price: Since, the products are close substitutes for each other, if a firm lowers the price of its product, then the customers of other products will switch over to it. Conversely, with the increase in the price of the product, it will lose its customers to others. Thus, under the monopolistic competition, an individual firm is not a price taker but has some influence over the price of its product.
5. Heavy expenditure on Advertisement and other Selling Costs : Under the monopolistic competition, the firms incur a huge cost on advertisements and other selling costs to promote the sale of their products. Since the products are different and are close substitutes for each other; the firms need to undertake the promotional activities to capture a larger market share.
6. Product Variation: Under the monopolistic competition, there is a variation in the products offered by several firms. To meet the needs of the customers, each firm tries to adjust its product accordingly. The changes could be in the form of new design, better quality, new packages or container, better materials, etc. Thus, the amount of product a firm is selling in the market depends on the uniqueness of its product and the extent to which it differs from the other products.
The monopolistic competition is also called as imperfect competition because this market structure lies between the pure monopoly and the pure competition.
Restaurants are a monopolistically competitive sector; in most areas there are many firms, each is different, and entry and exit are very easy. Each restaurant has many close substitutes—these may include other restaurants, fast-food outlets, and the deli and frozen-food sections at local supermarkets. Other industries that engage in monopolistic competition include retail stores, barber and beauty shops, auto-repair shops, service stations, banks, and law and accounting firms.
A cartel is defined as a group of firms that gets together to make output and price decisions. The conditions that give rise to an oligopolistic market are also conducive to the formation of a cartel; in particular, cartels tend to arise in markets where there are few firms and each firm has a significant share of the market. In the U.S., cartels are illegal; however, internationally, there are no restrictions on cartel formation. The organization of petroleum?exporting countries (OPEC) is perhaps the best?known example of an international cartel; OPEC members meet regularly to decide how much oil each member of the cartel will be allowed to produce.
Oligopolistic firms join a cartel to increase and improve their market power, and members work together to determine jointly the level of output that each member will produce and/or the price that each member will fix. By working together, the cartel members are able to behave like a monopolist. For example, if each firm in an oligopoly sells an undifferentiated product like oil, the demand curve that each firm faces will be horizontal at the market price. If, however, the oil?producing firms form a cartel like OPEC to determine their output and price, they will jointly face a downward?sloping market demand curve, just like a monopolist. In fact, the cartel’s profit?maximizing decision is the same as that of a monopolist, as Figure reveals. The cartel members choose their combined output at the level where their combined marginal revenue equals their combined marginal cost. The cartel price is determined by market demand curve at the level of output chosen by the cartel. The cartel’s profits are equal to the area of the rectangular box labeled abcd in Figure . Note that a cartel, like a monopolist, will choose to produce less output and charge a higher price than would be found in a perfectly competitive market.
Once established, cartels are difficult to maintain. The problem is that cartel members will be tempted to cheat on their agreement to limit production. By producing more output than it has agreed to produce, a cartel member can increase its share of the cartel’s profits. Hence, there is a built?in incentive for each cartel member to cheat. Of course, if all members cheated, the cartel would cease to earn monopoly profits, and there would no longer be any incentive for firms to remain in the cartel. The cheating problem has plagued the OPEC cartel as well as other cartels and perhaps explains why so few cartels exist
According to the indifference curve approach, it is not possible for the consumer to say how much utility he derives from the consumption of a commodity, because utility is not a measureable magnitude.
But a consumer can compare two or more combi¬nations of goods and say which of them he likes best or whether he likes them all equally well. The Laws of Consumer Demand can be deduced from these preferences.
Suppose a consumer is asked to choose between the following two combinations:
a. 4 apples and 2 oranges
b. 2 apples and 3 oranges
He may prefer a to b or b to a or he may like both combinations equally well. In the last case we say that he is indifferent between them. It is not necessary at this stage to know how much utility is obtained from an apple or an orange. The consumer can compare the relative desirability of, or indifference between, two combinations of goods without knowing the exact amount of “utility” and “satis¬faction” obtained from each combination.
To show how Indifference Curves are constructed let us take the example of a consumer purchasing two goods only, apple and orange. He may prefer apple to orange but if orange becomes relatively cheap he may be induced to eat a few more units of it. If the price of apple becomes much cheaper he may give up orange altogether.
On the other hand, if the price of apple becomes very high he may be forced by lack of means to give up apple. Between these two extremes he will purchase both apple and orange, but will vary the proportions according to relative prices so that he obtains the advantages of small price changes of either commodity. It follows, therefore, that there are more than one combinations of apple and orange which are equally satisfactory to him.
Suppose the following combinations are equivalent:
(a) 1 unit of apple and 4 units of orange
(b) 2 units of apple and 3 units of orange
(c) 3 units of apple and 2 units of orange
(d) 4 units of apple and 1 unit of orange
An Indifference Curve:
These combinations are represented by small circles in Fig. 4.7 where apple is measured on the horizontal axis and orange on the vertical axis. There may be many other such combinations. Let I be a continuous line joining the small circles and other similar points. The curve I1 is called an indifference curve.
Thus an indifference curve may be defined as a curve which shows combinations of goods which are equivalent to one another. It is a locus of points sharing alternative combinations of apple and orange which give the same satisfaction to the consumer. The consumer has no reason to prefer any of the combinations on the curve to any other on the same curve. He is indifferent as to which of these combinations he uses. Each indifference curve is an equal-utility curve.
The indifference curve approach is based upon the following assumptions:
A rational person will prefer a larger quantity of a good than a smaller amount of it.
The consumer is supposed to be consistent about his tastes and pre¬ference.
3. Diminishing Marginal Substitutability:
Suppose a consumer buys orange and apple. It can be assumed that as more and more of units of apple are substituted for orange, the consumer will be willing to give up fewer and fewer units of orange for additional units of apple. As the quantity of orange consumed increases, more of it will be required to compensate for loss of apple. This follows from the principle that as the consumption of orange increases the desire for it will fall and as the consumption of apple decreases the desire for it will increase.
Therefore, the marginal rate of substitution of orange for apple increases as the quantity of orange increases relatively to apple. Alternatively we can say that the marginal rate of substitution of orange for apple diminishes as the supply of apple diminishes. This is called the Principle of Diminishing Marginal Substitutability. It is assumed that the two goods are not perfect substitutes for one another and that want for the goods are not satiable.
Properties (Characteristics) of Indiffe¬rence Curves:
Indifference curves have the following four properties:
1. An indifference curve which lies above and to the right of another shows preferred combinations of the two commodities.
2. Indifference Curves Have a Negative Slope:
when the quantity of one commodity (A) in a combination of two goods increase, the quantity of the other commodity (O) must decline. Therefore, an indifference curve must slope downwards from left to right.
The Marginal Rate of Substitution:
The slope of the indifference curve is called the MRS which is the ratio of the marginal utilities of the two commodities. This is expressed as
MRS x,y = – ?Y /?X = MUx/MUy
3. An Indifference Curve cannot Intersect or Touch Another Indifference Curve:
This can be proved by showing that if two indifference curves on the same indifference map intersect, there is logical contradiction (or inconsis¬tency). Suppose I1, and I2 intersect as in Fig 4.8, then from I1.
This explains why indifference curves cannot intersect.
… Transitivity implies that if A is preferred to B and B is preferred to C then A is preferred to C.
4. Indifference Curves are Convex to the Origin:
Thus it is concluded that
(i) each indifference curve is a distinct line;
(ii) it slopes downwards from left to right and
(iii) it is convex to the origin.
There are, however, certain exceptions to rule 3. Under certain special circumstances an indifference curve may be a straight line or even concave to the origin.
The term Iso-quant or Iso-product is composed of two words, Iso = equal, quant = quantity or product = output.
Thus it means equal quantity or equal product. Different factors are needed to produce a good. These factors may be substituted for one another.
A given quantity of output may be produced with different combinations of factors. Iso-quant curves are also known as Equal-product or Iso-product or Production Indifference curves. Since it is an extension of Indifference curve analysis from the theory of consumption to the theory of production.
Thus, an Iso-product or Iso-quant curve is that curve which shows the different combinations of two factors yielding the same total product. Like, indifference curves, Iso- quant curves also slope downward from left to right. The slope of an Iso-quant curve expresses the marginal rate of technical substitution (MRTS).
“The Iso-product curves show the different combinations of two resources with which a firm can produce equal amount of product.” Bilas
“Iso-product curve shows the different input combinations that will produce a given output.” Samuelson
“An Iso-quant curve may be defined as a curve showing the possible combinations of two variable factors that can be used to produce the same total product.” Peterson
“An Iso-quant is a curve showing all possible combinations of inputs physically capable of producing a given level of output.” Ferguson
The main assumptions of Iso-quant curves are as follows:
1. Two Factors of Production:
Only two factors are used to produce a commodity.
2. Divisible Factor:
Factors of production can be divided into small parts.
3. Constant Technique:
Technique of production is constant or is known beforehand.
4. Possibility of Technical Substitution:
The substitution between the two factors is technically possible. That is, production function is of ‘variable proportion’ type rather than fixed proportion.
5. Efficient Combinations:
Under the given technique, factors of production can be used with maximum efficiency.
Properties of Iso-Product Curves:
The properties of Iso-product curves are summarized below:
1. Iso-Product Curves Slope Downward from Left to Right:
They slope downward because MTRS of labour for capital diminishes. When we increase labour, we have to decrease capital to produce a given level of output.
2. Isoquants are Convex to the Origin:
Like indifference curves, isoquants are convex to the origin. In order to understand this fact, we have to understand the concept of diminishing marginal rate of technical substitution (MRTS), because convexity of an isoquant implies that the MRTS diminishes along the isoquant. The marginal rate of technical substitution between L and K is defined as the quantity of K which can be given up in exchange for an additional unit of L. It can also be defined as the slope of an isoquant.
It can be expressed as:
MRTSLK = – ?K/?L = dK/ dL
Where ?K is the change in capital and AL is the change in labour.
Equation (1) states that for an increase in the use of labour, fewer units of capital will be used. In other words, a declining MRTS refers to the falling marginal product of labour in relation to capital. To put it differently, as more units of labour are used, and as certain units of capital are given up, the marginal productivity of labour in relation to capital will decline.
Thus it may be observed that due to falling MRTS, the isoquant is always convex to the origin.
3. Two Iso-Product Curves Never Cut Each Other:
As two indifference curves cannot cut each other, two iso-product curves cannot cut each other.. Therefore two curves which represent two levels of output cannot intersect each other.
4. Higher Iso-Product Curves Represent Higher Level of Output:
A higher iso-product curve represents a higher level of output
5. Isoquants Need Not be Parallel to Each Other:
It so happens because the rate of substitution in different isoquant schedules need not be necessarily equal. Usually they are found different and, therefore, isoquants may not be parallel
6. No Isoquant can Touch Either Axis:
If an isoquant touches X-axis, it would mean that the product is being produced with the help of labour alone without using capital at all.
7. Each Isoquant is Oval-Shaped.
It means that at some point it begins to recede from each axis. This shape is a consequence of the fact that if a producer uses more of capital or more of labour or more of both than is necessary, the total product will eventually decline. The firm will produce only in those segments of the isoquants which are convex to the origin and lie between the ridge lines. This is the economic region of production.
Difference between Indifference Curve and Iso-Quant Curve:
The main points of difference between indifference curve and Iso-quant curve are explained below:
1. Iso-quant curve expresses the quantity of output. Each curve refers to given quantity of output while an indifference curve to the quantity of satisfaction. It simply tells that the combinations on a given indifference curve yield more satisfaction than the combination on a lower indifference curve of production.
2. Iso-quant curve represents the combinations of the factors whereas indifference curve represents the combinations of the goods.
3. Iso-quant curve gives information regarding the economic and uneconomic region of production. Indifference curve provides no information regarding the economic and uneconomic region of consumption.
4. Slope of an iso-quant curve is influenced by the technical possibility of substitution between factors of production. It depends on marginal rate of technical substitution (MRTS) whereas slope of an indifference curve depends on marginal rate of substitution (MRS) between two commodities consumed by the consumer.
The study of the concept cross elasticity of demand plays a major role in forecasting the effect of change in the price of a good on the demand of its substitutes and complementary goods.
Therefore, it helps in deciding the price of a good by determining the change in the demand of its substitutes and complementary goods.
The demand for a good is generally associated with the demand for another good. Therefore, change in the price of one good produces change in the price of another good. The extent of relationship between two related goods can be measured by cross- elasticity of demand. In other words, cross-elasticity of demand measures the receptiveness of quantity demanded of a good with respect to change in the price of its substitute or complementary good.
Some of the definitions of cross-elasticity of demand are as follows:
In the words of Leibhafsky, “the cross elasticity of demand is a measure of the responsiveness of T to change in the price of X.”
According to Ferugson, “the cross-elasticity of demand is the proportional change in the quantity of good-X demanded resulting from a given relative change in the price of the related good-Y.”
It should be noted that the cross-elasticity of demand would be positive, when two goods are substitute of each other. This is because the increase in the price of one good increases the demand for the other. On the other hand, in case of complementary goods, the cross-elasticity of demand would be negative as increase in the price of one good decreases the demand for the other. For example, increase in the price of tea would result in the increase in the demand for coffee, whereas increase in the price of petrol would cause decrease in the demand for cars.
Measurement of Cross Elasticity of Demand:
Cross-elasticity of demand expresses the ratio of percentage change in demand of good X produced due to the percentage change in price of related good Y.
Therefore, the formula for cross-elasticity (ec) of demand is as follows:
ec = Percentage change in quantity demanded of X/Percentage change in price of Y
Percentage change in quantity demanded of X= New demand for X (?QX)/Original demand for X (QX)
Percentage change in price of Y= New price for Y (?PY/Original price for Y (PY)
The symbolic representation of the formula for cross elasticity of demand is as follows:
ec = ?QX/QX: ?PY/PY
ec = ?QX/QX */PY/?PY
ec = ?QX/?PY */PY/QX
?QX can be calculated by subtracting original demand for X (QX) from increase in demand (QX1), which is as follows:
?QX = QX1 – QX
Similarly, PY is the difference between the new price of Y (PY1) and original price for Y (PY).
It can be calculated by the following formula:
?PY = PY1 -PY
Types of Cross Elasticity of Demand:
The numerical value of cross-elasticity of demand is not same for every related goods. It differs for different types of goods.
The various types of cross-elasticity of demand are as follows:
i. Positive Cross Elasticity of Demand:
Implies that the cross elasticity of demand would be positive when increase in the price of one good (X) causes increase in the demand for the other good (Y). In simple terms, cross elasticity would be positive for substitutes. For example, the quantity demanded for coffee has increased from 500 units to 550 units with increase in the price of tea from Rs. 8 to Rs. 10. Calculate the cross elasticity of demand and state the type of relationship between coffee (X) and tea(Y).
QX1 =550 units
QX =500 units
PY1 = Rs. 10
PY = Rs. 8
Therefore, ?QX = QX1 – QX = 550 – 500 = 50 units
Similarly, ?PY = PY1 – PY = Rs. 2
Now ec = 50/2*8/500= 0.4
The cross elasticity of “demand is positive; therefore, X and Y are substitutes.
ii. Negative Cross Elasticity of Demand:
Refers to a situation when the rise in the price of one good (X) reduces the demand for the other good (Y). The cross elasticity of demand would be negative for complementary goods. For example, the quantity demanded for X decreases from 220 to 200 units with the rise in prices of Y from Rs. 10 to 12.
Now, the cross elasticity of demand would be as follows:
QX1 =200 units
QX =220 units
PY1 = Rs. 12
PY = Rs. 10
Therefore, ?QX = QX1 – QX = 200 – 220= – 20 units
Similarly, ?PY = PY1 – PY = Rs. 12 – Rs. 10 = Rs. 2
Now ec = – 20/2* 12/200= -0.6
The cross elasticity of demand is negative; therefore, X and Y are complementary to each other.
iii. Zero Cross Elasticity of Demand:
Implies that the cross elasticity of demand would be zero when two goods X and Y are not related to each other. In other words, the increase or decrease in the price of one good (X) would not affect the demand of other good (Y).
Significance of Cross Elasticity of Demand:
The study of the concept cross elasticity of demand plays a major role in forecasting the effect of change in the price of a good on the demand of its substitutes and complementary goods. Therefore, it helps in deciding the price of a good by determining the change in the demand of its substitutes and complementary goods.
Apart from this, cross elasticity of demand helps in determining the nature of relationship between two goods whether they are substitutes, complementary to each other or totally different from each other. In addition, it also enables an organization to anticipate the intensity of monopoly and extent and type of competition in the market.