2. Concept of utility
Utility is a property common to all commodities and services desired
by a person. It has no physical or material existence and so it is
inherent in a commodity.
Any commodity which has a capacity to satisfy consumer want, it has
utility.
Utility is subjective in nature. Utility has nothing to do with
usefulness. Hence in economics, the concept of utility is legally,
morally, socially and ethically neutral.
3. Approaches to utility
• It argues that a consumer
has the capacity to
measure the level of
satisfaction that she
derives from
consumption of a given
quantity of a commodity.
Cardinal
Utility
• It argues that a
consumer cannot
measure satisfaction
numerically or
subjectively instead
consumer can rank the
different baskets or
bundles so as to
choose the best basket.
Ordinal
4. Marginal Utility& Total Utility
Marginal utility is the utility of last unit or addition to total
utility by the consumption of one additional unit of commodity.
MU10 = TU10 – TU9
Total Utility- It is the sum of marginal utilities obtained from
consumption of each successive unit of a commodity or service.
If continuous units of a commodity 'X' are consumed, then
TUx = Σ MUx
5. Terms related to Utility
Initial Utility:
The amount of satisfaction to be obtained from the consumption of very first
unit of a commodity or service is called the initial utility e.g. the amount of
satisfaction to be obtained from consumption of the first apple is units. It is
called initial utility of the consumer.
Positive Utility:
When a consumer consumes successive units of a commodity or service, its
marginal utility decreases. The utility obtained from the consumption of all
the units of a commodity or service before reaching the marginal utility equal
to zero, is called positive utility.
Saturation Point:
By the consumption of that unit of a commodity where the marginal utility
drops down to zero, is called the saturation point.
6. Terms related to Utility
Negative Utility:
By using the next unit of a commodity after saturation point, that
unit gives negative satisfaction to the consumer and marginal utility
becomes negative, it is known as negative utility.
Util:
Although utility cannot be measured but in cardinal approach of
consumer behavior, the term which is used as a unit of utility is
known as Util and arithmetic numbers (1, 2, 3, .......) are used. For
example X ate an apple and got 10 Util of utility.
7. Law of diminishing marginal utility
The law of diminishing marginal utility describes a familiar and
fundamental tendency of human behavior. The law of diminishing
marginal utility states that:
“As a consumer consumes more and more units of a specific
commodity, the utility from the successive units goes on diminishing”.
Mr. H. Gossen, a German economist, was first to explain this law in
1854. Alfred Marshal later on restated this law in the following words:
“The additional benefit which a person derives from an increase of his
stock of a thing diminishes with every increase in the stock that
already has”.
8. Schedule to law
Unit Total Utility Marginal utility
1 glass of water 20 20
2 glass of water 32 12
3 glass of water 40 8
4 glass of water 42 2
5 glass of water 42 2
6 glass of water 39 -3
10. Assumption of law
The law of diminishing marginal utility is true under certain assumptions. These assumptions are
as under:
(i) Rationality: In the cardinal utility analysis, it is assumed that the consumer is rational. He aims
at maximization of utility subject to availability of his income.
(ii) Constant marginal utility of money: It is assumed in the theory that the marginal utility of
money based for purchasing goods remains constant. If the marginal utility of money changes
with the increase or decrease in income, it then cannot yield correct measurement of the marginal
utility of the good.
(iii) Diminishing marginal utility: Another important assumption of utility analysis is that the
utility gained from the successive units of a commodity diminishes in a given time period.
(iv) Utility is additive: In the early versions of the theory of consumer behavior, it was assumed that
the utilities of different commodities are independent. The total utility of each commodity is
additive.
U = U1 (X1) + U2 (X2) + U3 (X3)………. Un (Xn)
11. Assumption of law Conti…
v) Consumption to be continuous: It is assumed in this law that the consumption of
a commodity should be continuous. If there is interval between the consumption of
the same units of the commodity, the law may not hold good. For instance, if you
take one glass of water in the morning and the 2nd at noon, the marginal utility of
the 2nd glass of water may increase.
(vi) Suitable quantity: It is also assumed that the commodity consumed is taken in
suitable and reasonable units. If the units are too small, then the marginal utility
instead of falling may increase up to a few units.
(vii) Character of the consumer does not change: The law holds true if there is no
change in the character of the consumer. For example, if a consumer develops a
taste for wine, the additional units of wine may increase the marginal utility to a
drunkard.
(viii) No change to fashion: Customs and tastes: If there is a sudden change in fashion
or customs or taste of a consumer, it can than make the law inoperative.
(ix) No change in the price of the commodity: there should be any change in the
price of that commodity as more units are consumed.
12. Limitation to law
(i) Case of intoxicants: Consumption of liquor defies the low for a short
period. The more a person drinks, the more likes it. However, this is truer
only initially. A stage comes when a drunkard too starts taking less and
less liquor and eventually stops it.
(ii) Rare collection: If there are only two diamonds in the world, the
possession of 2nd diamond will push up the marginal utility.
(iii) Application to money: The law equally holds good for money. It is
true that more money the man has, the greedier he is to get additional units
of it. However, the truth is that the marginal utility of money declines with
richness but never falls to zero.
13. Law of equi-marginal utility
The law of equi marginal utility was presented in 19th century by
an Australian economists H. H. Gossen. It is also known as law of
maximum satisfaction or law of substitution or Gossen‘s second
law. A consumer has number of wants. He tries to spend limited
income on different things in such a way that marginal utility of all
things is equal. When he buys several things with given money
income he equalizes marginal utilities of all such things. The law
of equi marginal utility is an extension of the law of diminishing
marginal utility. The consumer can get maximum utility by
allocating income among commodities in such a way that last
dollar spent on each item provides the same marginal utility.
14. Statement of law
“A person can get maximum utility with his given income when it
is spent on different commodities in such a way that the marginal
utility of money spent on each item is equal".
It is clear that consumer can get maximum utility from the
expenditure of his limited income. He should purchase such
amount of each commodity that the last unit of money spend on
each item provides same marginal utility.
15. Assumption of law
There is no change in the prices of the goods.
The income of consumer is fixed.
The marginal utility of money is constant.
Consumer has perfect knowledge of utility obtained from goods.
Consumer is normal person so he tries to seek maximum
satisfaction.
The utility is measurable in cardinal terms.
Consumer has many wants.
The goods have substitutes.
16. Schedule and explanation
The law of substitution can be explained with the help of an
example. Suppose consumer has six dollars that he wants to spend
on apples and bananas in order to obtain maximum total utility.
The following table shows marginal utility (MU) of spending
additional dollars of income on apples and bananas:
Money ($) M.U. of apples M.U. of Bananas
1 10 8
2 9 7
3 8 6
4 7 5
5 6 4
6 5 3
17. The above schedule shows that consumer can spend six dollars in different ways:
$1 on apples and $5 on bananas. The total utility he can get is:
[(10) + (8+7+6+5+4)] = 40.
$2 on apples and $4 on bananas. The total utility he can get is:
[(10+9) + (8+7+6+5)] = 45.
$3 on apples and $3 on bananas. The total utility he can get is:
[(10+9+8) + (8+7+6)] = 48.
$4 on apples and $2 on bananas. This way the total utility is:
[(10+9+8+7) + (8+7)] = 49.
$5 on apples and $1 on bananas. The total utility he can get is:
[(10+9+8+7+6) + (8)] = 48.
Total utility for consumer is 49 utils that is the highest obtainable with expenditure of $4
on apples and $2 on bananas. Here the condition MU of apple = MU of banana i.e 7 = 7
is also satisfied. Any other allocation of the last dollar shall give less total utility to the
consumer.
18.
19. Limitations
The law is not applicable in case of indivisible goods. The consumer is
unable to divide the goods to adjust units of utility derived from
consumption of goods. The law is not applicable in case of indivisible
goods. The consumer is unable to divide the goods to adjust units of utility
derived from consumption of goods.
There is no measurement of utility. It is psychological concept. It is not
possible to express it into quantitative form.
The law does not hold well in case fashion and customs. The people like to
spend money on birthdays, marriages and deaths.
The does not hold well in case of very low income. The maximization of
utility is not possible due to low income.
20. Limitations continues…..
The law is not applicable in case of durable goods. The calculation of marginal utility of
durable goods is impossible.
The law fails when goods of choice are not available. The consumer is bound to use
commodity, which provides low utility due to non availability of goods having high utility.
There are certain lazy consumers. They do not care for maximum utility. The law fails to
operate in case of laziness of consumers. They go on consuming goods with comparing
utility. There is no measurement of utility. It is psychological concept. It is not possible to
express it into quantitative form. The law does not hold well in case fashion and customs.
The people like to spend money on birthdays, marriages and deaths.
It does not work when there are frequent prices changes. The consumer is unable to
calculate utility of different commodities. Changing price levels create confusion in the
minds of consumers.
21. Practical implications-
The law of equi marginal utility is helpful in the field of production. The
producer has limited resources. He uses limited resources to purchase
production factors. He tries to equalize marginal utility of all factors. He
wishes to get maximum output and profit.
National income is distributed among factors of production according to this
law. An entrepreneur can pay factors of production equal to marginal
product measured in money terms. He will substitute one factor for another
until marginal productivity of all factors is equal to prices of their services.
The law is used in the field of exchange. The people like to exchange a
commodity having low utility with a commodity having high utility. There
is maximum benefit from exchange of commodities. The law is helpful in
exchange of wealth, trade, import and export
22. Practical implication continues….
The law is applicable in consumption. A rational consumer tries to
get maximum satisfaction when he spends his limited resources on
various things. He tries to equalize weighted marginal utility of all
the things.
The law is applicable in public finance. The government can spend
its revenue to get maximum social advantage. The marginal utility
of each dollar spent in one sector must be equal to marginal utility
derived from all other sectors.
The law is helpful in prices. Due to scarcity of commodity its prices
go up. The law tells us to use substitute commodity, which is less
scarce. The result is that the price of commodity comes down.
23. Law of demand
In economic terminology the term demand conveys a wider and
definite meaning than in the ordinary usage. Ordinarily demand
means a desire, whereas in economic sense it is something more
than a mere desire.
It is interpreted as a want backed up by the - purchasing power.
Further demand is per unit of time such as per day, per week etc.
moreover it is meaningless to mention demand without reference
to price.
“Demand for anything means the quantity of that commodity,
which is bought, at a given price, per unit of time”.
24. Demand price relationship
This law explains the functional relationship between price of a
commodity and the quantity demanded of the same.
It is observed that the price and the demand are inversely related
which means that the two move in the opposite direction.
An increase in the price leads to a fall in the demand and vice
versa.
“Other things being equal, the demand for a commodity varies
inversely as the price”
27. Assumptions of law
The law of demand in order to establish the price-demand
relationship makes a number of assumptions as follows:
Income of the consumer is given and constant.
No change in tastes, preference, habits etc.
Constancy of the price of other goods.
No change in the size and composition of population.
These Assumptions are expressed in the phrase “other things
remaining equal”.
28. Exceptions to law
Continuous changes in the price lead to the exceptional behavior. If the price
shows a rising trend a buyer is likely to buy more at a high price for
protecting himself against a further rise. As against it when the price starts
falling continuously, a consumer buys less at a low price and awaits a further
in price.
Giffen's Paradox describes a peculiar experience in case of inferior goods.
When the price of an inferior commodity declines, the consumer, instead of
purchasing more, buys less of that commodity and switches on to a superior
commodity. Hence the exception.
Conspicuous Consumption refers to the consumption of those commodities
which are bought as a matter of prestige. Naturally with a fall in the price of
such goods, there is no distinction in buying the same. As a result the demand
declines with a fall in the price of such prestige goods.
Ignorance Effect implies a situation in which a consumer buys more of a
commodity at a higher price only due to ignorance.
29. Factors affecting demand
The law of demand, while explaining the price-demand relationship assumes other
factors to be constant. In reality however, these factors such as income, population,
tastes, habits, preferences etc., do not remain constant and keep on affecting the
demand. As a result the demand changes i.e. rises or falls, without any change in
price.
Income: The relationship between income and the demand is a direct one. It means
the demand changes in the same direction as the income. An increase in income leads
to rise in demand and vice versa.
Population: The size of population also affects the demand. The relationship is a
direct one. The higher the size of population, the higher is the demand and vice versa.
Tastes and Habits: The tastes, habits, likes, dislikes, prejudices and preference etc.
of the consumer have a profound effect on the demand for a commodity. If a
consumers dislikes a commodity, he will not buy it despite a fall in price. On the
other hand a very high price also may not stop him from buying a good if he likes it
very much.
30. Other Prices: This is another important determinant of demand for a
commodity. The effects depends upon the relationship between the
commodities in question. If the price of a complimentary commodity rises,
the demand for the commodity in reference falls.
Advertisement: This factor has gained tremendous importance in the
modern days. When a product is aggressively advertised through all the
possible media, the consumers buy the advertised commodity even at a
high price and many times even if they don’t need it.
Fashions: Hardly anyone has the courage and the desire to go against the
prevailing fashions as well as social customs and the traditions. This factor
has a great impact on the demand.
Imitation: This tendency is commonly experienced everywhere. This is
known as the demonstration effects, due to which the low income groups
imitate the consumption patterns of the rich ones. This operates even at
international levels when the poor countries try to copy the consumption
patterns of rich countries.
31. Variation and changes in demand
The law of demand explains the effect of only-one factor viz., price, on the
demand for a commodity, under the assumption of constancy of other
determinants.
In practice, other factors such as, income, population etc. cause the rise or
fall in demand without any change in the price. These effects are different
from the law of demand.
They are termed as changes in demand in contrast to variations in demand
which occur due to changes in the price of a commodity.
In economic theory a distinction is made between
(a) Variations i.e. extension and contraction in demand due to price and
(b) Changes i.e. increase and decrease in demand due to other factors.
32. Variations in demand refer to those which occur due to
changes in the price of a commodity.
These are two types.
Extension of Demand: This refers to rise in demand due to
a fall in price of the commodity. It is shown by a
downwards movement on a given demand curve.
Contraction of Demand: This means fall in demand due to
increase in price and can be shown by an upwards
movement on a given demand curve.
33.
34. Changes in demand imply the rise and fall due to factors
other than price.
It means they occur without any change in price. They are of
two types.
Increase in Demand: This refers to higher demand at the
same price and results from rise in income, population etc.,
this is shown on a new demand curve lying above the
original one.
Decrease in demand: It means less quantity demanded at
the same price. This is the result of factors like fall in
income, population etc. this is shown on a new demand lying
below the original one.
35.
36. Concluding Remarks
The law of demand explains the functional relationship between
price and demand.
In fact, the demand for a commodity depends not only on the price
of a commodity but also on other factors such as income,
population, tastes and preferences of the consumer.
The law of demand assumes these factors to be constant and states
the inverse price-demand relationship. Barring certain exceptions,
the inverse price- demand relationship holds good in case of the
goods that are bought and sold in the market.
37. Concluding Remarks…..
The law of demand explains the direction of a change as it states
that with a rise in price the demand contracts and with a fall in
price it expands. However, it fails to explain the extent or
magnitude of a change in demand with a given change in price.
In other words, the law of demand merely shows the direction in
which the demand changes as a result of a change in price, but
does not throw any light on the amount by which the demand
will change in response to a given change in price.
Thus, the law of demand explains the qualitative but not the
quantitative aspect of price- demand relationship.
38. Base for elasticity of demand
Although it is true that demand responds to change in price of a
commodity, such response varies from commodity to commodity.
Some commodities are more responsive or sensitive to change in
price while some others are less. The concept of the elasticity of
demand has great significance as it explains the degree of
responsiveness of demand to a change in price.
It thus elaborates the price-demand relationship. The elasticity of
demand thus means the sensitiveness or responsiveness of demand
to a change in price.
39. Elasticity of demand-
According to Marshall, “the elasticity (or responsiveness) of demand in
a market is great or small accordingly as the demand changes (rises or
falls) much or little for a given change (rise or fall) in price.”
Elasticity of demand is a measure of relative changes in the amount
demanded in response to a small change in price.
The demand is said to be elastic when a small change in price brings
about considerable change in demand.
On the other hand, the demand for a good is said to be inelastic when a
change in price fails to bring about significant change in demand.
Ep = [Percentage change in quantity demanded / Percentage change
in the price]
40. Price elasticity
The concept of price elasticity reveals that the degree of
responsiveness of demand to the change in price differs from
commodity to commodity.
Demand for some commodities is more elastic while that for certain
others is less elastic.
Perfectly inelastic demand (ep = 0)
Relatively less elastic demand (e < 1)
Unitary elasticity (e = 1)
Relatively more elastic demand (e > 1)
Perfectly elastic demand (e = ∞)
41. Perfectly inelastic demand (ep = 0)
This describes a situation in which demand shows no response to a change in price. In
other words, whatever be the price the quantity demanded remains the same.
Relatively less elastic demand (e < 1)
In this case the proportionate change in demand is smaller than in price
Unitary elasticity demand (e = 1)
When the percentage change in price produces equivalent percentage change in
demand.
Relatively more elastic demand (e > 1)
In case of certain commodities the demand is relatively more responsive to the change
in price. It means a small change in price induces a significant change in, demand.
Perfectly elastic demand (e = ∞)
This is experienced when the demand is extremely sensitive to the changes in price. In
this case an insignificant change in price produces tremendous change in demand.
42. Determinants of elasticity
Nature of the Commodity
Number of Substitutes Available
Number Of Uses
Possibility of Postponement of Consumption
Range of prices
Proportion of Income Spent
43. Quiz
Identify the elasticity of demand-
Food grains
Salt
Luxuries or comforts
Tea/coffee
Electricity
Milk
Coal in railways
Coal in household
Umbrella
Woolen clothes in rainy season
Consumer durables
Clothes for occassions
44. Income elasticity of demand
Demand for a commodity changes in response to a change in
income of the consumer.
The income effect suggests the effect of change in income on
demand. The income elasticity of demand explains the extent of
change in demand as a result of change in income.
In other words, income elasticity of demand means the
responsiveness of demand to changes in income. Thus, income
elasticity of demand can be expressed as-
EY = [Percentage change in demand / Percentage change in
income]
45. Income Elasticity of Demand Greater than One: When the percentage change
in demand is greater than the percentage change in income, a greater portion of
income is being spent on a commodity with an increase in income- income
elasticity is said to be greater than one.
Income Elasticity is unitary: When the proportion of income spent on a
commodity remains the same or when the percentage change in income is equal
to the percentage change in demand, EY = 1 or the income elasticity is unitary.
Income Elasticity Less Than One (EY< 1): This occurs when the percentage
change in demand is less than the percentage change in income.
Zero Income Elasticity of Demand (EY=o): This is the case when change in
income of the consumer does not bring about any change in the demand for a
commodity.
Negative Income Elasticity of Demand (EY< o): It is well known that income
effect for most of the commodities is positive. But in case of inferior goods, the
income effect beyond a certain level of income becomes negative. This implies
that as the income increases the consumer, instead of buying more of a
commodity, buys less and switches on to a superior commodity. The income
elasticity of demand in such cases will be negative.
46. Cross Elasticity of Demand
The concept of cross elasticity explains the degree of change in demand for X as, a
result of change in price of Y. This can be expressed as:
EC = [Percentage Change in demand for X / Percentage change in price of Y]
The relationship between any two goods is of two types. –
The goods X and Y can be complementary goods (such as pen and ink) or
substitutes (such as pen and ball pen). In case of complementary commodities, the
cross elasticity will be negative. This means that fall in price of X (pen) leads to
rise in its demand so also rise in t) demand for Y (ink).
On the other hand, the cross elasticity for substitutes is positive which means a fall
in price of X (pen) results in rise in demand for X and fall in demand for Y (ball
pen)
If two commodities, say X and Y, are unrelated there will be no change i. Demand
for X as a result of change in price of Y. Cross elasticity in cad of such unrelated
goods will then be zero.
47. Importance of Elasticity
The law of demand merely explains the qualitative relationship while the
concept of elasticity of demand analyses the quantitative price-demand
relationship.
The Pricing policy of the producer is greatly influenced by the nature of
demand for his product. If the demand is inelastic, he will be benefited
by charging a high price. If on the other hand, the demand is elastic, low
price will be advantageous to the producer. The concept of elasticity
helps the monopolist while practicing the price discrimination.
The price of joint products can be fixed on the basis of elasticity of
demand. In case of such joint products, such as wool and mutton, cotton
and cotton seeds, separate costs of production are not known. High price
is charged for a product having inelastic demand (say cotton) and low
price for its joint product having elastic demand (say cotton seeds).
48. Importance of Elasticity
The concept of elasticity of demand is helpful to the Government in fixing the prices of
public utilities.
The Elasticity of demand is important not only in pricing the commodities but also in fixing
the price of labour viz., wages.
The concept of elasticity of demand is very important in the field international trade. It
helps in solving some of the problems of international trade such as gains from trade,
balance of payments etc. policy of tariff also depends upon the nature of demand for a
commodity.
The concept of elasticity of demand is useful to Government in formulation of economic
policy in various fields such as taxation, international trade etc.
(a) The concept of elasticity of demand guides the finance minister in imposing the
commodity taxes. He should tax such commodities which have inelastic demand so that the
Government can raise handsome revenue.
(b) The concept of elasticity of demand helps the Government in formulating commercial
policy. Protection and subsidy is granted to the industries which face an elastic demand.
49. Supply- Conceptual framework
Supply during a given period of time means the quantities of goods
which are offered for sale at particular price.
Supply is a relative term. It is always referred to in relation to price
and time.
Supply is what the seller is able and willing to offer for sale.
The law, reflects the general tendency of the sellers in offering their
stock of a commodity for sale in relation to the varying price.
It is noted that usually sellers are willing to supply more as the price
increases.
50. Statement of law-
Ceteris Paribus, the supply of a commodity expands(I.e. rises)
with a rise in its price, and contracts (I.e. falls) with a fall in its
price.
The law, thus, suggests that the supply varies directly with the
changes in price. So, a larger amount is supplied at a higher price
than at lower price in the market.
52. Assumptions underlying the law
Cost of production in unchanged
No change in technique of production
Fixed scale of production
Government policies are unchanged
No change in transport costs
No speculation
The prices of other goods are held constant.
56. RESOURCE COST :
RESOURCE COST If resource cost decreases supply Increases [making
more $] If resource cost increases supply Decreases [making less $]
ALTERNATIVE OUTPUT PRICE CHANGE :
ALTERNATIVE OUTPUT PRICE CHANGE One opportunity cost of
producing eggs is not selling chickens. An increase in the price people are
willing to pay for fresh chicken would make it more profitable to sell
chickens and would thus increase the opportunity cost of producing eggs. It
would shift the supply curve for eggs to the left, reflecting a decrease in
supply.
TECHNOLOGICAL IMPROVEMENT :
TECHNOLOGICAL IMPROVEMENT An improvement in technology
usually means that fewer and/or less costly inputs are needed. If the cost of
production is lower, the profits available at a given price will increase, and
producers will produce more. With more produced at every price, the supply
curve will shift to the right, meaning an increase in supply
57. NUMBER OF SUPPLIERS :
NUMBER OF SUPPLIERS A change in the number of sellers in an industry changes
the quantity available at each price and thus changes supply. An increase in the
number of sellers supplying a good or service shifts the supply curve to the right; a
reduction in the number of sellers shifts the supply curve to the left
EXPECTATIONS :
EXPECTATIONS . If a change in the international political climate leads many
owners to expect that oil prices will rise in the future, they may decide to leave their
oil in the ground, planning to sell it later when the price is higher. Thus, there will be a
decrease in supply; the supply curve for oil will shift to the left.
SUBSIDIES :
SUBSIDIES Free money from the government (subsidies) induces suppliers to supply
more.
TAXES :
TAXES If business have their taxes decreased, it moves the supply curve to the right.
If business have their taxes increased, it moves the supply curve to the left.
58. Demand forecasting
Demand forecasting is predicting the future demand for the firm’s
product.
The knowledge about the future demand for the product helps a great
deal in the following areas of business decision making.
Planning and scheduling production
Acquiring inputs
Making provisions for finances
Formulation of pricing strategy
Planning advertisement.
59. Steps involved-
Specifying the objective
Determining time perspective
Making choice of method for demand forecasting
Collection of data and data adjustment
Estimation and interpretation of result
