Unit I – Industrial Economics

Economics is the social science that studies economic activity to gain an understanding of the processes
that govern the production, distribution and consumption of goods and services in an exchange
economy.

Economics focuses on the behavior and interactions of economic agents and how economies work.
Consistent with this focus, primary textbooks often distinguish between microeconomics and
macroeconomics. Microeconomics examines the behavior of basic elements in the economy, including
individual agents and markets, their interactions, and the outcomes of interactions. Individual agents
may include, for example, households, firms, buyers, and sellers. Macroeconomics analyzes the entire
economy (meaning aggregated production, consumption, savings, and investment) and issues affecting
it, including unemployment of resources (labor, capital, and land), inflation, economic growth, and the
public policies that address these issues (monetary, fiscal, and other policies).

Alfred Marshall provides a still widely cited definition in his textbook Principles of Economics (1890) that
extends analysis beyond wealth and from the societal to the micro-economic level:
Economics is a study of man in the ordinary business of life. It enquires how he gets his income and how
he uses it. Thus, it is on the one side, the study of wealth and on the other and more important side, a part
of the study of man.

Lionel Robbins (1932)- Economics is a science which studies human behaviour as a relationship between
ends and scarce means which have alternative uses.

MARKET –A market is one of the many varieties of systems, institutions, procedures, social
relations and infrastructures whereby parties engage in exchange. While parties may exchange goods and
services by barter, most markets rely on sellers offering their goods or services (including labor) in
exchange for money from buyers. It can be said that a market is the process by which the prices of goods
and services are established.
For a market to be competitive, there must be more than a single buyer or seller. It has been suggested
that two people may trade, but it takes at least three persons to have a market, so that there is competition
in at least one of its two sides. However,competitive markets, as understood in formal economic theory,
rely on much larger numbers of both buyers and sellers. A market with a single seller and multiple
buyers is a monopoly. A market with a single buyer and multiple sellers is a monopsony. These are the
extremes of imperfect competition.
In mainstream economics, the concept of a market is any structure that allows buyers and sellers to
exchange any type of goods, services and information. The exchange of goods or services for money is
a transaction. Market participants consist of all the buyers and sellers of a good who influence its price.
This influence is a major study of economics and has given rise to several theories and models concerning
the basic market forces of supply and demand. There are two roles in markets, buyers and sellers. The
market facilitates trade and enables the distribution and allocation of resources in a society. Markets
allow any tradable item to be evaluated and priced. A market emerges more or less spontaneously or
may be constructed deliberately by human interaction in order to enable the exchange of rights
(cf. ownership) of services and goods.

WANT – In economics, a want is something that is desired. It is said that every person has unlimited
wants, but limited resources (Economics is based on the assumption that only limited resources are
available to us from the infinite Universe). Thus, people cannot have everything they want and must look
for the most affordable alternatives.
Wants are often distinguished from needs. A need is something that is necessary for survival (such
as food and shelter), whereas a want is simply something that a person would like to have. Some
economists have rejected this distinction and maintain that all of these are simply wants, with varying
levels of importance. By this viewpoint, wants and needs can be understood as examples of the overall
concept of demand.

INCOME – Income is the consumption and savings opportunity gained by an entity within a specified
timeframe, which is generally expressed in monetary terms. However, for households and individuals,
"income is the sum of all the wages, salaries, profits, interests payments, rents and other forms of earnings
received... in a given period of time.
"income may be defined as the... sum of (1) the market value of rights exercised in consumption and (2)
the change in the value of the store of property rights..." Since the consumption potential of non-
monetary goods, such as leisure, cannot be measured, monetary income may be thought of as a proxy for
full income.

WEALTH – Wealth is the abundance of valuable resources or material possessions.

The United Nations definition of inclusive wealth is a monetary measure which includes the sum of
natural, human and physical assets.[5][6] Natural capital includes land, forests, fossil fuels, and minerals.
Human capital is the population's education and skills. Physical (or "manufactured") capital includes
such things as machinery, buildings, and infrastructure.
Adam Smith, inThe Wealth of Nations, described wealth as "the annual produce of the land and labour of
the society". This "produce" is, at its simplest, that which satisfies human needs and wants of utility. In
popular usage, wealth can be described as an abundance of items of economic value, or the state of
controlling or possessing such items, usually in the form of money, real estate and personal property. An
individual who is considered wealthy, affluent, or rich is someone who has accumulated substantial
wealth relative to others in their society or reference group. In economics, net wealth refers to the value
of assets owned minus the value of liabilities owed at a point in time. Wealth can be categorized into
three principal categories: personal property, including homes or automobiles; monetary savings, such as
the accumulation of past income; and the capital wealth of income producing assets, including real
estate, stocks, bonds, and businesses.All these delineations make wealth an especially important part
of social stratification. Wealth provides a type of social safety net of protection against an unforeseen
decline in one’s living standard in the event of job loss or other emergency and can be transformed into
home ownership, business ownership, or even a college education.
'Wealth' refers to some accumulation of resources (net asset value), whether abundant or not. 'Richness'
refers to an abundance of such resources (income or flow). A wealthy individual, community, or nation
thus has more accumulated resources (capital) than a poor one. The opposite of wealth is destitution. The
opposite of richness is poverty.

Cost, price and value are often used interchangeably but they have distinct meanings:

Cost: the cost of your product/service is the effort/amount you spent to produce it

Price: is the financial reward for providing the product/service

Value: is defined from the customers sight of view and represents their appraisal of the worth of the
product/service for him/her

These definitions get sharper by viewing on an example:

The cost for a plumber to fix a water-mains burst at a customer’s home may be 15€ for travel, materials
costing 5€ and an hour’s labour at 20€. But however, the value of the service to the customer – who may
has water leaking all over his/her house – is far greater than the 40€ cost, so the plumber may decide to
charge a total of 85€.
To increase the aggregated profit the selling person has to find a price which has a great enough Δ to the
cost but not a too big one, because then nobody will buy the product.
Utility is the economist's way of measuring pleasure or happiness and how it relates to the decisions that
people make. Utility measures the benefits (or drawbacks) from consuming a good or service or from
working. Although utility is not directly measurable, it can be inferred from the decisions that people
make.

Utility is an abstract concept rather than a concrete, observable quantity. The units to which we assign an
"amount" of utility, therefore, are arbitrary, representing a relative value. Total utility is the aggregate
sum of satisfaction or benefit that an individual gains from consuming a given amount of goods or
services in an economy. The amount of a person's total utility corresponds to the person's level of
consumption. Usually, the more the person consumes, the larger his or her total utility will be. Marginal
utility is the additional satisfaction, or amount of utility, gained from each extra unit of consumption.

Although total utility usually increases as more of a good is consumed, marginal utility usually decreases
with each additional increase in the consumption of a good. This decrease demonstrates the law of
diminishing marginal utility. Because there is a certain threshold of satisfaction, the consumer will no
longer receive the same pleasure from consumption once that threshold is crossed. In other words, total
utility will increase at a slower pace as an individual increases the quantity consumed.

Take, for example, a chocolate bar. Let's say that after eating one chocolate bar your sweet tooth has been
satisfied. Your marginal utility (and total utility) after eating one chocolate bar will be quite high. But if
you eat more chocolate bars, the pleasure of each additional chocolate bar will be less than the pleasure
you received from eating the one before - probably because you are starting to feel full or you have had
too manysweets for one day.

This table shows that total utility will increase at a much slower rate as marginal utility diminishes with
each additional bar. Notice how the first chocolate bar gives a total utility of 70 but the next
threechocolate bars together increase total utility by only 18 additional units.
The law of diminishing marginal utility helps economists understand the law of demand and the
negative sloping demand curve. The less of something you have, the more satisfaction you gain from
each additional unit you consume; the marginal utility you gain from that product is therefore higher,
giving you a higher willingness to pay more for it. Prices are lower at a higher quantity demanded
because your additional satisfaction diminishes as you demand more.

In order to determine what a consumer's utility and total utility are, economists turn to consumer
demand theory, which studies consumer behavior and satisfaction. Economists assume the consumer is
rational and will thus maximize his or her total utility by purchasing a combination of different products
rather than more of one particular product. Thus, instead of spending all of your money on three
chocolate bars, which has a total utility of 85, you should instead purchase the one chocolate bar, which
has a utility of 70, and perhaps a glass of milk, which has a utility of 50. This combination will give you a
maximized total utility of 120 but at the same cost as the three chocolate bars.
A law of economics stating that as a person increases consumption of a product - while keeping
consumption of other products constant - there is a decline in the marginal utility that person derives
from consuming each additional unit of that product.

Law of Diminishing Marginal Utility - Utility refers to the amount of satisfaction a person gets from
consumption of a certain item and marginal utility refers to the addition made to total utility, we get after
consuming one more unit.

An individual's wants are unlimited in number yet each individual's want is satiable. Because of this, the
more we have a commodity, the less we want to have more of it.
This law state that as the amount consumed of a commodity increases, the utility derived by the
consumer from the additional units, i.e marginal utility goes on decreasing.

Definition
According to Marshall, “The additional benefit a person derives from a given increase of his stock of a
thing diminishes with every increase in the stock that he already has”

Assumptions:
All the units of a commodity must be same in all respects
The unit of the good must be standard
There should be no change in taste during the process of consumption
There must be continuity in consumption
There should be no change in the price of the substitute goods

Explanation:
As more and more quantity of a commodity is consumed, the intensity if desire decreases and also the
utility derived from the additional unit.

Suppose a person eats Bread. and 1st unit of bread gives him maximum satisfaction. When he will ead
2nd bread his total satisfaction would increase. But the utility added by 2nd bread(MU) is less then the
1st bread. His Total utility and marginal utility can be put in the form of a following schedule.
Plotting the above data on a graph gives

Here, from the MU curve we can see that MU is declinig as consumer consumes more of the commodity.
When TU is maximum, MU is Zero.
After that, TU starts declining and MU becomes negative.

Exceptions:
Money
Hobbies and Rare Things
Liquor and Music
Things of Display

Importance:
Basis of Law of Demand
Basis of Consumption Expenditure
The basis of Progressive Taxation
Supply and demand is perhaps one of the most fundamental concepts of economics and it is the
backbone of a market economy. Demand refers to how much (quantity) of a product or service is desired
by buyers. The quantity demanded is the amount of a product people are willing to buy at a certain price;
the relationship between price and quantity demanded is known as the demand
relationship. Supply represents how much the market can offer. The quantity supplied refers to the
amount of a certain good producers are willing to supply when receiving a certain price. The correlation
between price and how much of a good or service is supplied to the market is known as the supply
relationship. Price, therefore, is a reflection of supply and demand.

The relationship between demand and supply underlie the forces behind the allocation of resources.
In market economy theories, demand and supply theory will allocate resources in the most efficient way
possible. How? Let us take a closer look at the law of demand and the law of supply.

A. The Law of Demand

The law of demand states that, if all other factors remain equal, the higher the price of a good, the less
people will demand that good. In other words, the higher the price, the lower the quantity demanded.
The amount of a good that buyers purchase at a higher price is less because as the price of a good goes
up, so does the opportunity cost of buying that good. As a result, people will naturally avoid buying a
product that will force them to forgo the consumption of something else they value more. The chart
below shows that the curve is a downward slope.

A, B and C are points on the demand curve. Each point on the curve reflects a direct correlation between
quantity demanded (Q) and price (P). So, at point A, the quantity demanded will be Q1 and the price will
be P1, and so on. The demand relationship curve illustrates the negative relationship between price and
quantity demanded. The higher the price of a good the lower the quantity demanded (A), and the lower
the price, the more the good will be in demand (C).

B. The Law of Supply

Like the law of demand, the law of supply demonstrates the quantities that will be sold at a certain price.
But unlike the law of demand, the supply relationship shows an upward slope. This means that the
higher the price, the higher the quantity supplied. Producers supply more at a higher price because
selling a higher quantity at a higher price increases revenue.

A, B and C are points on the supply curve. Each point on the curve reflects a direct correlation between
quantity supplied (Q) and price (P). At point B, the quantity supplied will be Q2 and the price will be P2,
and so on. (To learn how economic factors are used in currency trading, read Forex Walkthrough:
Economics.)

Time and Supply

Unlike the demand relationship, however, the supply relationship is a factor of time. Time is important to
supply because suppliers must, but cannot always, react quickly to a change in demand or price. So it is
important to try and determine whether a price change that is caused by demand will be temporary or
permanent.

Let's say there's a sudden increase in the demand and price for umbrellas in an unexpected rainy season;
suppliers may simply accommodate demand by using their production equipment more intensively. If,
however, there is a climate change, and the population will need umbrellas year-round, the change in
demand and price will be expected to be long term; suppliers will have to change their equipment and
production facilities in order to meet the long-term levels of demand.

C. Supply and Demand Relationship

Now that we know the laws of supply and demand, let's turn to an example to show how supply and
demand affect price.

Imagine that a special edition CD of your favorite band is released for $20. Because the record company's
previous analysis showed that consumers will not demand CDs at a price higher than $20, only ten CDs
were released because the opportunity cost is too high for suppliers to produce more. If, however, the ten
CDs are demanded by 20 people, the price will subsequently rise because, according to the demand
relationship, as demand increases, so does the price. Consequently, the rise in price should prompt more
CDs to be supplied as the supply relationship shows that the higher the price, the higher the quantity
supplied.
If, however, there are 30 CDs produced and demand is still at 20, the price will not be pushed up because
the supply more than accommodates demand. In fact after the 20 consumers have been satisfied with
their CD purchases, the price of the leftover CDs may drop as CD producers attempt to sell the remaining
ten CDs. The lower price will then make the CD more available to people who had previously decided
that the opportunity cost of buying the CD at $20 was too high.

D. Equilibrium

When supply and demand are equal (i.e. when the supply function and demand function intersect) the
economy is said to be at equilibrium. At this point, the allocation of goods is at its most efficient because
the amount of goods being supplied is exactly the same as the amount of goods being demanded. Thus,
everyone (individuals, firms, or countries) is satisfied with the current economic condition. At the given
price, suppliers are selling all the goods that they have produced and consumers are getting all the goods
that they are demanding.

As you can see on the chart, equilibrium occurs at the intersection of the demand and supply curve,
which indicates no allocative inefficiency. At this point, the price of the goods will be P* and the quantity
will be Q*. These figures are referred to as equilibrium price and quantity.

In the real market place equilibrium can only ever be reached in theory, so the prices of goods and
services are constantly changing in relation to fluctuations in demand and supply.

E. Disequilibrium

Disequilibrium occurs whenever the price or quantity is not equal to P* or Q*.

1. Excess Supply
If the price is set too high, excess supply will be created within the economy and there will be allocative
inefficiency.
At price P1 the quantity of goods that the producers wish to supply is indicated by Q2. At P1, however,
the quantity that the consumers want to consume is at Q1, a quantity much less than Q2. Because Q2 is
greater than Q1, too much is being produced and too little is being consumed. The suppliers are trying to
produce more goods, which they hope to sell to increase profits, but those consuming the goods will find
the product less attractive and purchase less because the price is too high.

2. Excess Demand
Excess demand is created when price is set below the equilibrium price. Because the price is so low, too
many consumers want the good while producers are not making enough of it.

In this situation, at price P1, the quantity of goods demanded by consumers at this price is Q2.
Conversely, the quantity of goods that producers are willing to produce at this price is Q1. Thus, there are
too few goods being produced to satisfy the wants (demand) of the consumers. However, as consumers
have to compete with one other to buy the good at this price, the demand will push the price up, making
suppliers want to supply more and bringing the price closer to its equilibrium.

F. Shifts vs. Movement

For economics, the "movements" and "shifts" in relation to the supply and demand curves represent very
different market phenomena:
1. Movements
A movement refers to a change along a curve. On the demand curve, a movement denotes a change in
both price and quantity demanded from one point to another on the curve. The movement implies that
the demand relationship remains consistent. Therefore, a movement along the demand curve will occur
when the price of the good changes and the quantity demanded changes in accordance to the original
demand relationship. In other words, a movement occurs when a change in the quantity demanded is
caused only by a change in price, and vice versa.

Like a movement along the demand curve, a movement along the supply curve means that the supply
relationship remains consistent. Therefore, a movement along the supply curve will occur when the price
of the good changes and the quantity supplied changes in accordance to the original supply relationship.
In other words, a movement occurs when a change in quantity supplied is caused only by a change in
price, and vice versa.

2. Shifts
A shift in a demand or supply curve occurs when a good's quantity demanded or supplied changes even
though price remains the same. For instance, if the price for a bottle of beer was $2 and the quantity of
beer demanded increased from Q1 to Q2, then there would be a shift in the demand for beer. Shifts in the
demand curve imply that the original demand relationship has changed, meaning that quantity demand
is affected by a factor other than price. A shift in the demand relationship would occur if, for instance,
beer suddenly became the only type of alcohol available for consumption.

Conversely, if the price for a bottle of beer was $2 and the quantity supplied decreased from Q1 to Q2,
then there would be a shift in the supply of beer. Like a shift in the demand curve, a shift in the supply
curve implies that the original supply curve has changed, meaning that the quantity supplied is effected
by a factor other than price. A shift in the supply curve would occur if, for instance, a natural disaster
caused a mass shortage of hops; beer manufacturers would be forced to supply less beer for the same
price.

There are mainly 8 types of demands in Marketing which have to be taken into consideration by the
marketing manager during demand forecasting. The various types of demands, and how to tackle the
challenges for marketers in these various demands, is discussed below.
Negative Demand – Negative demand is a type of demand which is created if the product is disliked in
general. The product might be beneficial but the customer does not want it. For example – Dental work
where people don’t want problems with their teeth and use preventive measures to avoid the same.
Insurance, which people should have but they delay buying an insurance policy. Similarly, people would
like to avoid heart attacks and hence may pay for a full body check up where the results might be
negative, but still the customer has to pay. The marketer has to solve the issue of no demand by analyzing
why the market dislikes the product and then counter acting with the right marketing tactics.
Unwholesome demand – Unwholesome demand is the other side of Negative demand. In negative type
of demands, customer does not want the product even though product might be necessary for the
customer. But in unwholesome demand, the customer should not desire the product, yet the customer
wants the product badly. Best example of unwholesome demand are cigarettes, alcohol, pirated movies,
guns etc.
No demands – Certain products face the challenge of no demand. The best example for the same can be
education courses where there is very low demand or no demand at all. Such cases are very hard to
counter.
Latent Demand – Latent demand is, as the name suggests, a demand which the customer realizes later.
Thus, while buying the product, he might not desire some features. But later on, he might think about
those features and buy the product. The best example of latent demand are normal phones vs smart
phones. People nowadays want more and more features in the smartphone. They might settle for a
normal phone, but then later on they get the itch to buy a smart phone. Similarly, people might buy a
petrol car. But most likely their second car will be a diesel car. A marketing managers job is to find out
the features which people might be looking for later and market them to the customer in such a manner
that he immediately wants them.
Declining demand – Declining demand is when demand for a product is declining. For example, when
CD players were introduced and IPOD came in the market, the demand for walkman went down.
Although there was still a demand for the product, the demand was a declining demand. A marketers job
in such a case to think ways to revive the product so that the demand is not declining.
Irregular demand – Irregular demand can be demand which is not consistent. The best example of
irregular demand is seasonal products like umbrellas, air conditioners or resorts. These products sell
irregularly and sell more during peak season whereas their demand is very low during non seasons. The
best way to counter irregular demand is to introduce incentives for the customer to buy the product.
Full demand – In an ideal environment, a company should always have full demand. Full demand means
that the demand is meeting the supply potential of the company. It also means that the markets are
happy with the products of the company and that people want to buy from the same company. The
marketing challenge in this type of demand is to maintain the same level of interest in the product and
the company.
Overfull demands – Overfull demands happen when the companies manufacturing capacity is limited
but the demand is more than the supply. This can be observed in the cement industry occasionally.
Generally, most cement industries have limited manufacturing capacity. And hence, brand switching in
cement industry is high. Many companies use de marketing techniques to counter act overfull demands.
This is because if the company keeps marketing, but it is not able to supply the material, then the
company might suffer badly in brand equity.

The five determinants of demand are:

Price of the good or service.
Prices of related goods or services. These are either complementary, which are things that are usually
bought along with the product in demand. They could also be substitutes for the product in demand.
Income of those with the demand.
Tastes or preferences of those with the demand.
Expectations. These are usually about whether the price will go up.

How Each Determinant Affects Demand

How do these factors affect demand? We'll examine each in detail, one at a time. That means that you can
understand how a particular determinant affects demand, but you've got to first assume that all of the
other determinants don't change. That's the principle known as ceteris paribus -- all other things being
equal.
So, ceteris paribus, here's how each element affects demand.
Price - The law of demand states that when prices rise, the quantity demanded falls. This also means that,
when prices drop, demand will rise. People base their purchasing decisions on price, if all other things
are equal. The reverse, of course, is also true. When demand rises, businesses will usually raise the price
to avoid being out of stock and disappointing customers. Conversely, when demand falls, businesses will
usually drop the price, even if only temporarily for a sale, to sell more of the good or service.
Income - When income rises, so will the quantity demanded. When income falls, so will demand.
However, even if your income doubles, you will buy twice as much of a particular good or service.
There's only so many pints of ice cream you'd want to eat, no matter how rich you are. That's where the
concept of marginal utility comes into the picture. The first pint of ice cream tastes delicious. You might
have another. But after that the marginal utility starts to decrease to the point where you don't want any
more. (At least until tomorrow.)
Prices of related goods or services - The price of complementary goods or services raises the overall cost
of using the good you demand, so you'll want less. For example, when gas prices rose to $4 a gallon in
2008, the demand for Hummervees fell. Gas is a complementary good to Hummers. The overall cost of
driving a Hummer rose along with gas prices.
The opposite reaction occurs when the price of a substitute rises. When that happens, people will want
less of the good or service. That's why Apple constantly innovates with its iPhones and iPods. As soon as
a substitute, such as the Droid, appears at a lower price, Apple comes out with a better product, so now
the Droid isn't really a substitute.
Tastes - This is the desire, emotion, or preference for a good or service. When tastes rise, so does the
quantity demanded. Likewise, when tastes fall, it will depress the quantity demanded. This is what brand
advertising is all about. Companies spend millions to make you feel strongly that you want a product.
Expectations - When people expect that the value of something will rise, then they demand more of it.
This explains the housing bubble of 2005. Housing prices rose, but people bought more because they
expected the price to continue to go up. This drove prices even further, until the bubble burst in 2006.
Between 2007 and 2011, housing prices fell 30%. However, the quantity demanded didn't rise because
people expected prices to continue to fall thanks to record levels of foreclosures entering the market.
When people expect prices to rise again, so will demand for housing.
Number of buyers in the market -When the number of buyers in the market rises, so will the quantity
demanded. This is another reason for the housing bubble. Low-cost mortgages increased the number of
people who were told they could afford a house. The number of buyers actually increased, driving up the
demand for housing. When they found they really couldn't afford the mortgage, especially when housing
prices started to fall, they foreclosed. This reduced the number of buyers, and demand also fell.

DEMAND FORECASTING
Forecasting product demand is crucial to any supplier, manufacturer, or retailer. Forecasts of future
demand will determine the quantities that should be purchased, produced, and shipped. Demand
forecasts are necessary since the basic operations process, moving from the suppliers' raw materials to
finished goods in the customers' hands, takes time. Most firms cannot simply wait for demand to emerge
and then react to it. Instead, they must anticipate and plan for future demand so that they can react
immediately to customer orders as they occur. In other words, most manufacturers "make to stock" rather
than "make to order" – they plan ahead and then deploy inventories of finished goods into field locations.
Thus, once a customer order materializes, it can be fulfilled immediately – since most customers are not
willing to wait the time it would take to actually process their order throughout the supply chain and
make the product based on their order. An order cycle could take weeks or months to go back through
part suppliers and sub-assemblers, through manufacture of the product, and through to the eventual
shipment of the order to the customer.
Firms that offer rapid delivery to their customers will tend to force all competitors in the market to keep
finished good inventories in order to provide fast order cycle times. As a result, virtually every
organization involved needs to manufacture or at least order parts based on a forecast of future demand.
The ability to accurately forecast demand also affords the firm opportunities to control costs through
leveling its production quantities, rationalizing its transportation, and generally planning for efficient
logistics operations.
In general practice, accurate demand forecasts lead to efficient operations and high levels of customer
service, while inaccurate forecasts will inevitably lead to inefficient, high cost operations and/or poor
levels of customer service. In many supply chains, the most important action we can take to improve the
efficiency and effectiveness of the logistics process is to improve the quality of the demand forecasts.
General Approaches to Forecasting
All firms forecast demand, but it would be difficult to find any two firms that forecast demand in exactly
the same way. Over the last few decades, many different forecasting techniques have been developed in a
number of different application areas, including engineering and economics. Many such procedures have
been applied to the practical problem of forecasting demand in a logistics system, with varying degrees of
success. Most commercial software packages that support demand forecasting in a logistics system
include dozens of different forecasting algorithms that the analyst can use to generate alternative demand
forecasts. While scores of different forecasting techniques exist, almost any forecasting procedure can be
broadly classified into one of the following four basic categories based on the fundamental approach
towards the forecasting problem that is employed by the technique.

1. Judgmental Approaches. The essence of the judgmental approach is to address the forecasting issue by
assuming that someone else knows and can tell you the right answer. That is, in a judgment-based
technique we gather the knowledge and opinions of people who are in a position to know what demand
will be. For example, we might conduct a survey of the customer base to estimate what our sales will be
next month.

2. Experimental Approaches. Another approach to demand forecasting, which is appealing when an item is
"new" and when there is no other information upon which to base a forecast, is to conduct a demand
experiment on a small group of customers and to extrapolate the results to a larger population. For
example, firms will often test a new consumer product in a geographically isolated "test market" to
establish its probable market share. This experience is then extrapolated to the national market to plan the
new product launch. Experimental approaches are very useful and necessary for new products, but for
existing products that have an accumulated historical demand record it seems intuitive that demand
forecasts should somehow be based on this demand experience. For most firms (with some very notable
exceptions) the large majority of SKUs in the product line have long demand histories.

3. Relational/Causal Approaches. The assumption behind a causal or relational forecast is that, simply put,
there is a reason why people buy our product. If we can understand what that reason (or set of reasons)
is, we can use that understanding to develop a demand forecast. For example, if we sell umbrellas at a
sidewalk stand, we would probably notice that daily demand is strongly correlated to the weather – we
sell more umbrellas when it rains. Once we have established this relationship, a good weather forecast
will help us order enough umbrellas to meet the expected demand.

4. "Time Series" Approaches. A time series procedure is fundamentally different than the first three
approaches we have discussed. In a pure time series technique, no judgment or expertise or opinion is
sought. We do not look for "causes" or relationships or factors which somehow "drive" demand. We do
not test items or experiment with customers. By their nature, time series procedures are applied to
demand data that are longitudinal rather than cross-sectional. That is, the demand data represent
experience that is repeated over time rather than across items or locations. The essence of the approach is
to recognize (or assume) that demand occurs over time in patterns that repeat themselves, at least
approximately. If we can describe these general patterns or tendencies, without regard to their "causes",
we can use this description to form the basis of a forecast.
In one sense, all forecasting procedures involve the analysis of historical experience into patterns and the
projection of those patterns into the future in the belief that the future will somehow resemble the past.
The differences in the four approaches are in the way this "search for pattern" is conducted. Judgmental
approaches rely on the subjective, ad-hoc analyses of external individuals. Experimental tools extrapolate
results from small numbers of customers to large populations. Causal methods search for reasons for
demand. Time series techniques simply analyze the demand data themselves to identify temporal
patterns that emerge and persist.

Demand Elasticity - Demand elasticity refers to how sensitive the demand for a good is to changes in
other economic variables, such as the prices and consumer income. Demand elasticity is calculated by
taking the percent change in quantity of a good demanded and dividing it by a percent change in another
economic variable. A higher demand elasticity for a particular economic variable means that consumers
are more responsive to changes in this variable, such as price or income.

Demand elasticity measures a change in demand for a good when another economic factor changes.
Demand elasticity helps firms model the potential change in demand due to changes in price of the good,
the effect of changes in prices of other goods and many other important market factors. A grasp of
demand elasticity guides firms toward more optimal competitive behavior and allows them to make
more precise forecasts of their production needs. If the demand for a particular good is more elastic in
response to changes in other factors, companies must be more cautions with raising prices for their
goods.

Types of Demand Elasticity

One common type of demand elasticity is the price elasticity of demand, which is calculated by dividing
the percent change in quantity demanded of a good by the percent change in its price. Firms collect data
on price changes and how consumers respond to such changes and later calibrate their prices accordingly
to maximize their profits. Another type of demand elasticity is cross-elasticity of demand, which is
calculated by taking the percent change in quantity demanded for a good and dividing it by percent
change of the price for another good. This type of elasticity indicates how demand for a good reacts to
price changes of other goods.

Price Elasticity of Demand

Price elasticity of demand is a measure of the relationship between a change in the quantity demanded of
a particular good and a change in its price. Price elasticity of demand is a term in economics often used
when discussing price sensitivity. The formula for calculating price elasticity of demand is:

Price Elasticity of Demand = % Change in Quantity Demanded / % Change in Price

If a small change in price is accompanied by a large change in quantity demanded, the product is said to
be elastic (or responsive to price changes). Conversely, a product is inelastic if a large change in price is
accompanied by a small amount of change in quantity demanded.
Price elasticity of demand measures the responsiveness of demand to changes in price for a particular
good. If the price elasticity of demand is equal to 0, demand is perfectly inelastic (i.e., demand does not
change when price changes). Values between zero and one indicate that demand is inelastic (this occurs
when the percent change in demand is less than the percent change in price). When price elasticity of
demand equals one, demand is unit elastic (the percent change in demand is equal to the percent change
in price). Finally, if the value is greater than one, demand is perfectly elastic (demand is affected to a
greater degree by changes in price).

Income Elasticity Of Demand

Income elasticity of demand refers to the sensitivity of the quantity demanded for a certain good to a
change in real income of consumers who buy this good, keeping all other things constant. The formula
for calculating income elasticity of demand is the percent change in quantity demanded divided by the
percent change in income. With income elasticity of demand, you can tell if a particular good represents a
necessity or a luxury.

Income elasticity of demand measures the responsiveness of demand for a particular good to changes in
consumer income. The higher the income elasticity of demand in absolute terms for a particular good, the
bigger consumers' response in their purchasing habits, if their real income changes. Businesses typically
evaluate income elasticity of demand for their products to help predict the impact of a business cycle on
product sales.

Consider a local car dealership that gathers data on changes in demand and consumer income for its cars
for a particular year. When the average real income of its customers fell from $50,000 to $40,000, the
demand for its cars plummeted from 10,000 to 5,000 units sold, all other things unchanged. The income
elasticity of demand is calculated by taking a negative 50% change in demand, a drop of 5,000 divided by
the initial demand of 10,000 cars, and dividing it by a 20% change in real income, the $10,000 change in
income divided by the initial value of $50,000. This produces an elasticity of 2.5, which indicates local
customers are particularly sensitive to changes in their income when it comes to buying cars.

The Significance of Elasticity

Elasticity is an important economic trend to study, particularly for sellers of goods or services because it
gives them an idea of how much of a good or service buyers consume when the price changes. When a
good is elastic, a change in price quickly results in a change in the quantity demanded. When a good is
inelastic, there is little change to the quantity demanded if the price of the good changes. The change that
is observed for an elastic good is an increase in demand when the price decreases and a decrease in
demand when the price increases.
For consumers, elasticity also communicates important information. If the market price of a good goes
down for an elastic good, firms likely reduce the amount of good or service they are willing to supply. If
the market price goes up, firms likely increase the amount of good they are willing to sell. This is
important for consumers who need a good and are concerned with potential scarcity.
Cross Elasticity Of Demand
Cross elasticity of demand is an economic concept that measures the responsiveness in the quantity
demand of one good when a change in price takes place in another good. Also called cross price elasticity
of demand, this measurement is calculated by taking the percentage change in the quantity demanded of
one good and dividing it by the percentage change in price of the other good.

Items with a coefficient of 0 are unrelated items and are goods independent of each other. Items may be
weak substitutes, in which the two products have a positive but low cross elasticity of demand. This is
often the case for different product substitutes, such as tea versus coffee. Items that are strong substitutes
have a higher cross elasticity of demand. Consider different brands of tea; a price increase in one
company’s green tea has a higher impact on another company’s green tea demand.
Substitute Goods
The cross elasticity of demand for substitute goods is always positive because the demand for one good
increases if the price for the other good increases. For example, if the price of coffee increases, the
quantity demanded for tea (a substitute beverage) increases as consumers switch to a less expensive yet
substitutable alternative. This is reflected in the cross elasticity of demand formula, as both the numerator
(percentage change in the demand of tea) and denominator (the price of coffee) show positive increases.

Complimentary Goods
Alternatively, the cross elasticity of demand for complimentary goods is negative. As the price for one
goods increases, an item closely associated with that item and necessary for its consumption decreases
because the demand for the main good has also dropped. For example, if the price of coffee increases, the
quantity demanded for coffee stir sticks drops as consumers are drinking less coffee and need to purchase
fewer sticks. In the formula, the numerator (quantity demanded of stir sticks) is a negative figure and the
denominator (the price of coffee) is positive. This results in a negative cross elasticity.
Usefulness of Cross Elasticity of Demand
Companies utilize cross elasticity of demand to establish prices to sell their goods. Products with no
substitutes have the ability to be sold at higher prices, because there is no cross elasticity of demand to
consider. However, incremental price changes to goods with substitutes are analyzed to determine the
appropriate level of demand desired and the associated price of the good. Additionally, complimentary
goods are strategically priced based on cross elasticity of demand. For example, printers may be sold at a
loss with the understanding that the demand for future complementary goods, such as printer ink,
should increase.