Q.1 Mention the demand function. What is elasticity of demand?

Describe the determinants of

elasticity of demand. (3+2+5)

Demand function:

Demand function is a comprehensive formulation which specifies the factors that influence the demand
for a product. Mathematically, a demand function can be represented in the following manner.

A behavioral relationship between quantity consumed and a person's maximum willingness to pay for
incremental increases in quantity. It is usually an inverse relationship where at higher (lower) prices, less
(more) quantity is consumed. Other factors which influence willingness-to-pay are income, tastes and
preferences, and price of substitutes. Demand function specifies what the consumer would buy in each
price and wealth situation, assuming it perfectly solves the utility maximization problem. The quantity
demanded of a good usually is a storng function of its price. Suppose an experiment is run to determine
the quantity demanded of a particular product at different price levels, holding everything else constant.
Presenting the data in tabular form would result in a demand schedule.

Elasticity of Demand :

Elasticity of demand is generally defined as the responsiveness or sensitiveness of demand to a given

change in the price of a commodity. It refers to the capacity of demand either to stretch or shrink to a
given change in price. Elasticity of demand indicates a ratio of relative changes in two quantities.ie, price
and demand. According to prof. Boulding. “Elasticity of demand measures the responsiveness of demand
to changes in price” 1 In the words of Marshall, “The elasticity (or responsiveness) of demand in a market
is great or small according to the amount demanded much or little for a given fall in price, and diminishes
much or little for a given rise in price” 2.

Elasticity of demand is the economist’s way of talking about how responsive consumers are to price
changes. For some goods, like salt, even a big increase in price will not cause consumers to cut back
very much on consumption. For other goods, like vanilla ice cream cones, even a modest price increase
will cause consumers to cut back a lot on consumption. Elasticity of demand is an elasticity used to show
the responsiveness of the quantity demanded of a good or service to a change in its price. More
precisely, it gives the percentage change in demand one might expect after a one percent change in
price. Elasticity is almost always negative, although analysts tend to ignore the sign even though this can
lead to ambiguity. Only goods which do not conform to the law of demand, such as Veblen and Giffen
goods, have a positive elasticity demand. Goods with a small elasticity demand (less than one) are said
to be inelastic: changes in price do not significantly affect demand e.g. drinking water. Goods with large
elasticity demand’s (greater than one) are said to be elastic: even a slight change in price may cause a
dramatic change in demand. Revenue is maximised when price is set so as to create a ED of exactly
one; elasticity demand‘s can also be used to predict the incidence of tax. Various research methods are
used to calculate price elasticity, including test markets, analysis of historical sales data and conjoint
analysis. There is a neat way of classifying values of elasticity. When the numerical value of elasticity is
less than one, demand is said to be “inelastic”. When the numerical value of elasticity is greater than one,
demand is “elastic”. So “elastic” demand means that people are relatively responsive to price changes
(remember the vanilla ice cream cone). “Inelastic” demand means that people are relatively unresponsive
to price changes (remember salt). An important relationship exists between the elasticity of demand for a
good and the amount of money consumers want to spend on it at different prices. Spending is price times
quantity, p times Q. In general, a decrease in price leads to an increase in quantity, so if price falls
spending may either increase or decrease, depending on how much quantity increases. If demand is
elastic, then a drop in price will increase spending, because the percent increase in quantity is larger than
the percent decrease in price. On the other hand, if demand is inelastic a drop in price will decrease
spending because the percent increase in quantity is smaller than the percent decrease in price.

Determinants of Elasticity of Demand

The price elasticity of demand measures how responsive the quantity demanded of a good is to a change
in its price. The value illustrates if the good is relatively elastic (PED is greater than 1) or relatively
inelastic (PED is less than 1).
A good's PED is determined by numerous factors, these include :

1. Nature of the Commodity : Commodities coming under the category of necessaries and
essentials tend to be inelastic because people buy them whatever may be the price. For
example, rice, wheat, sugar, milk, vegetables etc. on the other hand, for comforts and luxuries,
demand tends to be elastic e.g., TV sets, refrigerators etc.
2. Existence of Substitutes : Substitute goods are those that are considered to be economically
interchangeable by buyers. If a commodity has no substitutes in the market, demand tends to be
inelastic because people have to pay higher price for such articles. For example. Salt, onions,
garlic, ginger etc. In case of commodities having different substitutes, demand tends to be elastic.
For example, blades, tooth pastes, soaps etc.
3. Number of uses for the commodity : Single-use goods are those items which can be used for only
one purpose and multiple-use goods can be used for a variety of purposes. If a commodity has
only one use (singe use product) then demand tends to be inelastic because people have to pay
more prices if they have to use that product for only one use. For example, all kinds of. eatables,
seeds, fertilizers, pesticides etc. On the contrary, commodities having several uses, [multiple-use-
products] demand tends to be elastic. For example, coal, electricity, steel etc.
4. Durability and reparability of a commodity : Durable goods are those which can be used for a long
period of time. Demand tends to be elastic in case of durable and repairable goods because
people do not buy them frequently. For example, table, chair, vessels etc. On the other hand, for
perishable and non-repairable goods, demand tends to be inelastic e.g., milk, vegetables,
electronic watches etc.
5. Possibility of postponing the use of a commodity : In case there is no possibility to postpone the
use of a commodity to future, the demand tends to be inelastic because people have to buy them
irrespective of their prices. For example, medicines. If there is possibility to postpone the use of a
commodity, demand tends to be elastic e.g., buying a TV set, motor cycle, washing machine or a
car etc.
6. Level of Income of the people : Generally speaking, demand will be relatively inelastic in case of
rich people because any change in market price will not alter and affect their purchase plans. On
the contrary, demand tends to be elastic in case of poor.
7. Range of Prices : There are certain goods or products like imported cars, computers,
refrigerators, TV etc, which are costly in nature. Similarly, a few other goods like nails; needles
etc. are low priced goods. In all these cases, a small fall or rise in prices will have insignificant
effect on their demand. Hence, demand for them is inelastic in nature. However, commodities
having normal prices are elastic in nature.
8. Proportion of the expenditure on a commodity : hen the amount of money spent on buying a
product is either too small or too big, in that case demand tends to be inelastic. For example, salt,
newspaper or a site or house. On the other hand, the amount of money spent is moderate;
demand in that case tends to be elastic. For example, vegetables and fruits, cloths, provision
items etc.
9. Habits : When people are habituated for the use of a commodity, they do not care for price
changes over a certain range. For example, in case of smoking, drinking, use of tobacco etc. In
that case, demand tends to be inelastic. If people are not habituated for the use of any products,
then demand generally tends to be elastic.
10. Period of time : Price elasticity of demand varies with the length of the time period. Generally
speaking, in the short period, demand is inelastic because consumption habits of the people,
 customs and traditions etc. do not change. On the contrary, demand tends to be elastic in the
long period where there is possibility of all kinds of changes.
11. Level of Knowledge : emand in case of enlightened customer would be elastic and in case of
ignorant customers, it would be inelastic.
12. Existence of complementary goods : Goods or services whose demands are interrelated so that
an increase in the price of one of the products results in a fall in the demand for the other. Goods
which are jointly demanded are inelastic in nature. For example, pen and ink, vehicles and petrol,
shoes and socks etc have inelastic demand for this reason. If a product does not have
complements, in that case demand tends to be elastic. For example, biscuits, chocolates, ice
creams etc. In this case the use of a product is not linked to any other products.
13. Purchase frequency of a product : If the frequency of purchase is very high, the demand tends to
be inelastic. For e.g., coffee, tea, milk, match box etc. on the other hand, if people buy a product
occasionally, demand tends to be elastic. For example, durable goods like radio, tape recorders,
refrigerators etc.

The following example illustrates how to determine the price elasticity of demand for a good. The price
elasticity of demand for supermarket own produced strawberry jam is likely to be elastic. This is because
there are a very large number of close substitutes (both in jams and other preserves), and the good is not
a necessity item. Therefore, consumers can and will easily respond to a change in price.

Q.2 How is demand forecasting useful for managers ?

Demand forecasting is the activity of estimating the quantity of a product or service that consumers will
purchase. Demand forecasting involves techniques including both informal methods, such as educated
guesses, and quantitative methods, such as the use of historical sales data or current data from test
markets. Demand forecasting may be used in making pricing decisions, in assessing future capacity
requirements, or in making decisions on whether to enter a new market. Often forecasting demand is
confused with forecasting sales. But, failing to forecast demand ignores two important phenomena[1].
There is a lot of debate in demand-planning literature about how to measure and represent historical
demand, since the historical demand forms the basis of forecasting. The main question is whether we
should use the history of outbound shipments or customer orders or a combination of the two as proxy for
the demand.

Stock effects
The effects that inventory levels have on sales. In the extreme case of stock-outs, demand coming into
your store is not converted to sales due to a lack of availability. Demand is also untapped when sales for
an item are decreased due to a poor display location, or because the desired sizes are no longer
available. For example, when a consumer electronics retailer does not display a particular flat-screen TV,
sales for that model are typically lower than the sales for models on display. And in fashion retailing, once
the stock level of a particular sweater falls to the point where standard sizes are no longer available,
sales of that item are diminished.

Market response effect

The effect of market events that are within and beyond a retailer’s control. Demand for an item will likely
rise if a competitor increases the price or if you promote the item in your weekly circular. The resulting
sales increase reflects a change in demand as a result of consumers responding to stimuli that potentially
drive additional sales. Regardless of the stimuli, these forces need to be factored into planning and
managed within the demand forecast.

In this case demand forecasting uses techniques in causal modeling. Demand forecast modeling
considers the size of the market and the dynamics of market share versus competitors and its effect on
firm demand over a period of time. In the manufacturer to retailer model, promotional events are an
important causal factor in influencing demand. These promotions can be modeled with intervention
models or use a consensus to aggregate intelligence using internal collaboration with the Sales and
Marketing functions.
Q.3 Explain production function. How is it useful for business ? (5+5)

A production function is a function that specifies the output of a firm, an industry, or an entire economy for
all combinations of inputs. Almost of all macroeconomic theories, like macroeconomic theory, real
business cycle theory, neoclassical growth theory (classical and new) presuppose (aggregate) production
function. Heckscher-Ohlin-Samuelson theory in international trade theory also presupposes production
function. In this sense, production function is one of the key concepts of necoclassical macroeconomic
theories. It is also important to know that there is a subversive criticism on the very concept of production
function.

A production function is a function that specifies the output of a firm, an industry, or an entire economy for
all combinations of inputs. A meta-production function (sometimes metaproduction function) compares
the practice of the existing entities converting inputs X into output y to determine the most efficient
practice production function of the existing entities, whether the most efficient feasible practice production
or the most efficient actual practice production.[1] In either case, the maximum output of a
technologically-determined production process is a mathematical function of input factors of production.
Put another way, given the set of all technically feasible combinations of output and inputs, only the
combinations encompassing a maximum output for a specified set of inputs would constitute the
production function. Alternatively, a production function can be defined as the specification of the
minimum input requirements needed to produce designated quantities of output, given available
technology. It is usually presumed that unique production functions can be constructed for every
production technology.

By assuming that the maximum output technologically possible from a given set of inputs is achieved,
economists using a production function in analysis are abstracting away from the engineering and
managerial problems inherently associated with a particular production process. The engineering and
managerial problems of technical efficiency are assumed to be solved, so that analysis can focus on the
problems of allocative efficiency. The firm is assumed to be making allocative choices concerning how
much of each input factor to use, given the price of the factor and the technological determinants
represented by the production function. A decision frame, in which one or more inputs are held constant,
may be used; for example, capital may be assumed to be fixed or constant in the short run, and only
labour variable, while in the long run, both capital and labour factors are variable, but the production
function itself remains fixed, while in the very long run, the firm may face even a choice of technologies,
represented by various, possible production functions.

The relationship of output to inputs is non-monetary, that is, a production function relates physical inputs
to physical outputs, and prices and costs are not considered. But, the production function is not a full
model of the production process: it deliberately abstracts away from essential and inherent aspects of
physical production processes, including error, entropy or waste. Moreover, production functions do not
ordinarily model the business processes, either, ignoring the role of management, of sunk cost
investments and the relation of fixed overhead to variable costs. (For a primer on the fundamental
elements of microeconomic production theory, see production theory basics).
The primary purpose of the production function is to address allocative efficiency in the use of factor
inputs in production and the resulting distribution of income to those factors. Under certain assumptions,
the production function can be used to derive a marginal product for each factor, which implies an ideal
division of the income generated from output into an income due to each input factor of production.

Q.4 How do external and internal economies affect returns to scale ? (5+5)

Economies of scale external to the firm (or industry wide scale economies) are only considered examples
of network externalities if they are driven by demand side economies. In many industries, the production
of goods and services and the development of new products requires the use of specialized equipment or
support services. An individual company does not provide a large enough market for these services to
keep the suppliers in business. A localized industrial cluster can solve this problem by bringing together
many firms that provide a large enough market to support specialized suppliers. This phenomenon has
been extensively documented in the semiconductor industry located in Silicon Valley.

Labor Market Pooling

A cluster of firms can create a pooled market for workers with highly specialized skills.
It is an advantage for:

Producers
They are less likely to suffer from labor shortages.

Workers
They are less likely to become unemployed.

Knowledge Spillovers
Knowledge is one of the important input factors in highly innovative industries.
The specialized knowledge that is crucial to success in innovative industries comes from:
Research and development efforts

Reverse engineering
Informal exchange of information and ideas
As firms become larger and their scale of operations increase they are able to experience reductions in
their average costs of production. The firm is said to be experiencing increasing returns to scale.
Increasing returns to scale results in the firm's output increasing at a greater proportion than its inputs
and hence its total costs. As a consequence its average costs fall.

Thus initially the firm's long run average cost curve slopes downward as the scale of the enterprise
expands. The firm enjoys benefits called internal economies of scale. These are cost reductions accruing
to the firm as a result of the growth of the firm itself. (An external economy of scale is a benefit that the
firms experience as a result of the growth of the industry.)

After the firm has reached its optimum scale of output, where the long run average cost curves are at
their lowest point, continued expansion means that its average costs may start to rise as the firm now
experiences decreasing returns to scale. The long run average cost curve therefore starts to curve
upwards. This occurs because the firm is now experiencing internal diseconomies of scale.

Types of internal economies of scale

Types of internal economies of scale

Financial The farm has been able to gain loans and assistance at preferential interest rates from the
 EIB, World Bank and the EU
Marketing It has managed to dedicate resources to its strategy of niche marketing
Technical The access to finance has allowed it to invest in sophisticated Israeli irrigation technology
Managerial It large size enables it to employ specialised personnel such as estate managers
Risk The farm has used some of its land to diversify into producing fresh vegetables for export as
bearing well as continue producing maize.

These large scale farms are attracting a considerable amount of overseas development aid funding from
organisations such as the World Bank and the European Union as they are seen as being an integral part
of the export earning capacity of the country.

Q.5 Discuss the profit maximization model.

The profit maximization principle stresses on the fact that the motive of business firms to maximize profit
is solely justified as being a method of maximizing the income of their shareholders.

Firms may maximize profit by maximizing sales, stock price, market share or cash flow. In order to
achieve maximum profit the firm needs to find out the point where the difference between total revenue
and total cost is the highest.

The rules that apply for profit maximization are:

i. increase output as long as marginal profit increases
ii. profit will increase as long as marginal revenue (MR) > marginal cost (MC)
iii. profit will decline if MR < MC
iv. summing up (ii) and (iii), profit is maximized when MR = MC

Profit Maximization model means a scenario where the busniess is runned by the motive of profit making
and keep the cost low.
The business firm is the productive unit in an exchange economy. In order to survive, a firm must deal
with three constraints: the demand for its product, the production function, and the supply of its inputs.
When the firm successfully deals with these constraints, it makes a profit.

These readings explore the assumption that firms maximize profits, pointing out some of the ambiguities
of this assumption. It then explores how the rules of maximization apply to the firm. It considers two ways
in which the maximization principle can be used: to determine the proper levels of inputs or to determine
the proper level of output. The first leads to the rule that marginal resource cost should equal marginal
revenue product, and the second to the rule that marginal cost should equal marginal revenue. The
readings show that these two rules are equivalent and simply represented different ways of using the
information from the three constraints that a firm faces. Much of this material is quite technical, but it is at
the core of microeconomics.

Profit is maximized where MR = MC.

Profit maximization rule: Produce until the point where the change in revenue from producing 1 more unit
equals the change in cost from producing 1 more unit.

Why?
Suppose MR > MC. If I produce 1 more unit, my revenues increase by more than my costs. Therefore, if
MR > MC, producing more will increase my profit. If I can increase my profit by changing how much I
produce, then when producing where MR > MC can't be profit-maximizing.
Suppose MR < MC. If I produce 1 less unit, my revenues decrease by less than my costs decrease.
Therefor, if MR < MC, I can increase profit by decreasing output. If I can increase profit when MR < MC,
then choosing q such that MR < MC can not be profit-maximizing.
So, in order to maximize profit, I must choose a quantity q such that MR = MC.
MR = MC is an equilibrium in the sense that it is the only place where there is no incentive to change the
production level.

This rule, the profit maximization rule, is just an application of the marginal principle (MB = MC).
Why? This MB of producing an extra unit is the extra revenue you get. MR is the MB. So the 2
statements are equivalent. The marginal principle is more general, and the profit maximization rule is
specific to the firm production decision.

Q.6 Examine the relationship between revenue concepts and price elasticity of demand.

There is a predictable relationship between revenue and elasticity. Depending on PED, one may raise
revenue either by increasing prices and sacrificing quantity or by reducing them and outputting more.
revenues or revenue is income that a company receives from its normal business activities, usually from
the sale of goods and services to customers. In many countries, such as the United Kingdom, revenue is
referred to as turnover. Some companies receive revenue from interest, dividends or royalties paid to
them by other companies. In general usage, revenue is income received by an organization in the form of
cash or cash equivalents. Sales revenue or revenues is income received from selling goods or services
over a period of time. Tax revenue is income that a government receives from taxpayers. In more formal
usage, revenue is a calculation or estimation of periodic income based on a particular standard
accounting practice or the rules established by a government or government agency. Two common
accounting methods, cash basis accounting and accrual basis accounting, do not use the same process
for measuring revenue. Corporations that offer shares for sale to the public are usually required by law to
report revenue based on generally accepted accounting principles or International Financial Reporting
Standards. Revenues from a business's primary activities are reported as sales, sales revenue or net
sales. This excludes product returns and discounts for early payment of invoices. Most businesses also
have revenue that is incidental to the business's primary activities, such as interest earned on deposits in
a demand account. This is included in revenue but not included in net sales. Sales revenue does not
include sales tax collected by the business. Other revenue (a.k.a. non-operating revenue) is revenue
from peripheral (non-core) operations. For example, a company that manufactures and sells automobiles
would record the revenue from the sale of an automobile as "regular" revenue. If that same company also
rented a portion of one of its buildings, it would record that revenue as “other revenue” and disclose it
separately on its income statement to show that it is from something other than its core operations. A firm
considering a price change must know what effect the change in price will have on total revenue.
Generally any change in price will have two effects: the price effect: an increase in unit price will tend to
increase revenue, while a decrease in price will tend to decrease revenue. The quantity effect: an
increase in unit price will tend to lead to fewer units sold, while a decrease in unit price will tend to lead to
more units sold. Because of the inverse nature of the price-demand relationship the two effects offset
each other; in determining whether to increase or decrease prices a firm needs to know what the net
effect will be. Elasticity provides the answer. In short, the percentage change in revenue is equal to the
change in quantity demanded plus the percentage change in price. In this way, the relationship between
PED and revenue can be described for any particular good:

When the price elasticity of demand for a good is perfectly inelastic (Ed = 0), changes in the price do not
affect the quantity demanded for the good; raising prices will cause revenue to increase.
When the price elasticity of demand for a good is inelastic (|Ed| < 1), the percentage change in quantity
demanded is smaller than that in price. Hence, when the price is raised, the total revenue of producers
rises, and vice versa.

When the price elasticity of demand for a good is unit elastic (or unitary elastic) (|Ed| = 1), the percentage
change in quantity is equal to that in price and a change in price will not affect revenue.
When the price elasticity of demand for a good is elastic (|Ed| > 1), the percentage change in quantity
demanded is greater than that in price. Hence, when the price is raised, the total revenue of producers
falls, and vice versa.
When the price elasticity of demand for a good is perfectly elastic (Ed is infinite i.e. undefined), any
increase in the price, no matter how small, will cause demand for the good to drop to zero. Hence, when
the price is raised, the total revenue of producers falls to zero.
Hence, to maximise revenue, a firm ought to operate close to its unit-elasticity price.