CONCEPT OF UTILITY & ELASTICITY OF DEMAND

UNIT- II
CONCEPT OF UTILITY
Dr.N.R.SARAVANAN
MBA, MBA, MA (Yoga), PGDHRM, M.Phil, Ph.D,
MANAGERIAL ECONOMICS

Definition:
In objective terms, utility may
be defined as the “amount of satisfaction
derived from a commodity or service at a
particular time”.
UTILITY
Utility may not be confused with usefulness as it
is purely subjective satisfaction derived from the
consumption of a commodity.
Example:
water has the ability to slake thirst, pen has
ability to write.

Two Types of Approach
Cardinal Approach
 The cardinal utility theory says that utility is
measurable and by placing a number of
alternatives so that the utility can be added.
 The index used to measure utility is called utils.
Ordinal Approach
 The ordinal utility theory says that utility is not
measurable but it can be compared.
 Ordinal approach uses the ranking of
alternatives as first, second, third and so on.
Utility Approach

Dependent upon human wants.
Immeasurable.
Utility depend upon use.
Utility is subjective.
Utility depends upon shape.
Utility depends upon on knowledge.
Utility depends upon ownership.
Classification of Utility

Initial Utility- Satisfaction Derived from very first
unit consumed of any object.
Total Utility – Total Satisfaction derived from
the Product.
Marginal Utility- The word Marginal means
“Border” or “Edge”.
It is the addition made to the total utility
by consuming one more unit of a commodity.
Concepts of Utility

UTILITY IS TWO TYPES
Total Utility
Marginal Utility
 The sum total of satisfaction which a consumer
receives by consuming the various unity of the
commodity.
 (The more unit of a commodity he consumes, the
greater will be his total utility)
 The total satisfaction of wants & needs obtained from the
consumption of goods & services
 Based on the presumption that the amount of utility generated
from the consumption of a good can be explicitly measures
 Hypothetical measure is util

Quantity Total Utility
1 10
2 18
3 24
4 28
5 30
CURE OF TOTAL UTILITY

The term marginal refers to the effects of a
small change in consumption.
'Marginal considerations are considerations
which concern a slight increase or reduction of
the stock of anything which we possess.’
MARGINAL
Marginal utility can be defined as a measure of
relative satisfaction gained or lost from an
increase or decrease in the consumption of
that good or service.
Examples:
A motor vehicle or A haircut

CONCEPT OF UTILITY & ELASTICITY OF DEMAND

Quantity
Marginal
Utility
1 10
2 8
3 6
4 4
5 2
6 0
7 -2
Curve of Marginal Utility

Quantity TU MU Description
0 0 --
1 8 8 Initial
2 14 6
3 18 4 Positive
4 20 2
5 20 0 Zero
6 18 -2 Negative
Relation Between TU & MU

LAW OF DIMINISHING MARGINAL
UTILITY
& INDIFFERENCE CURVE

This law states that as the quantity
consumed of a commodity goes on increasing , the
utility derived from each successive unit consumed
goes on decreasing, consumption of all other
commodities remaining constant.
LAW OF DIMINISHING MARGINAL
UTILITY

ASSUMPTIONS OF THE LAW
 All the units of the commodity must be same
in all respects.
 The unit of the good must be standard.
 Consumer’s taste or preference must remain
same during the period of consumption.
 There must be continuity in consumption.
 The mental condition of the consumer must
remain normal during the period of
consumption.

EXAMPLE ; Suppose a person eats Bread. 1st unit of
bread gives him maximum satisfaction. when he will eat
second bread his total satisfaction would increase. But
the utility added by the second bread (MU) is less than
the 1st bread. His total utility and marginal utility can be
put in the form of following schedule.
SLICES OF BREAD TOTAL UTILITY MARGINAL UTILITY
0 0 -
1 70 70
2 110 40
3 130 20
4 140 10
5 145 5
6 140 -5

• MONEY
• HOBIES AND RARE THINGS
• LIQUOR
• THINGS OF DISPLAY
EXCEPTIONS

INDIFFERENCE CURVE
An indifference curve may be defined as the
locus of points each representing a
different combination of two substitute
goods , which yield the same utility or level
of satisfaction to the consumer.

• Indifference curves slope downward to
right.
• Indifference curves are convex to origin .
• Indifference curves cannot intersect each
other .
• A higher indifference curve represents a
higher level of satisfaction than a lower
indifference curve .
Properties of indifference curve

CONSUMER SURPLUS
 Consumers buy goods because it makes them
better off (or provide utility).
 Consumer Surplus measures how much
better off they are.
 Consumer Surplus
from each unit: The amount a buyer is
willing to pay for a good minus the amount
the buyer actually pays for it.

CONSUMER SURPLUS
Price
D
Qx
0
P

CONSUMER SURPLUS AND DEMAND
Consumer surplus for a given quantity is
therefore the difference between your maximum
willingness to pay (reservation price) and what
you actually paid (actual price).
CS = the sum of the difference between Marginal
Benefit (MB) and Marginal Cost (MC) (price) for all
units consumed

What happens when you purchase
something for a price that is less than
your maximum willingness to pay?
E.g. you are willing to pay Rs.2000 for a
new Dress and you buy it for Rs.1200
You receive a “surplus” of benefit over
cost = Rs.800
CONSUMER SURPLUS EXAMPLE

CONSUMER SURPLUS - EXAMPLE
 Assume a student wants to buy concert tickets.
 Demand curve tells us the student’s willingness to pay for
each concert ticket
1st ticket worth Rs.20 but price is Rs.14 so
student generates Rs.6 worth of surplus.
We can measure this for each ticket.
Total surplus is sum of surplus from each ticket
purchased.

The consumer surplus
of purchasing 6 concert
tickets is the sum of the
surplus derived from
each one individually.
Consumer Surplus
6 + 5 + 4 + 3 + 2 + 1 = 21
CONSUMER SURPLUS - EXAMPLE
Price
($ per
ticket)
2 3 4 5 6 Rock Concert Tickets0 1
20
19
18
17
16
15
14
13
Market Price
Will not buy more than 7
because surplus from
additional ticket is negative

CONSUMER SURPLUS
 The stepladder demand curve can be converted into a
straight-line demand curve by making the units of the
good smaller.
 Consumer surplus measures the total net benefit
to consumers = total benefits from consumption
minus the total expenses.
 Thus, consumer surplus is area under the
demand curve and above the price.
 Note that the area under the demand curve up to the
level of consumption measures the total benefits.

CONSUMER SURPLUS AND DEMAND
Here, CS = $200
=½ (base)(height)
= ½ (20)(20)
S
D
 Graphically then, CS is the area above
the price line and below the demand
curve, up to Q*
 P
40
20
20 Q

CONSUMER SURPLUS: GRAPHICAL
SPmax
PE
D
QE
Consumer
Surplus

D
$10
$9
$8
$7
$6
1 2 3 4 5 6
Consumer’s
Expense
P
Q

D
$9
$8
$7
$6
1 2 3 4 5 6
Consumer Benefit
- Consumer Expense
CONSUMER SURPLUS!
$51 - $36 =
$15
P
$10
Q

CONSUMER SURPLUS AND MARKET PRICE
 A lower market price will usually increase
consumer surplus.
 A higher market price will usually reduce
consumer surplus.
 Consumer surplus will be smaller when the
demand curve is more elastic and larger
when the demand curve is inelastic.

HOW THE PRICE AFFECTS CONSUMER
SURPLUS?
Copyright©2003 Southwestern/Thomson Learning
Initial
consumer
surplus
Quantity
Consumer Surplus at Price P2
vs. at Price P1
Price
0
Demand
A
B
C
D E
F
P1
Q1
P2
Q2
Consumer surplus
to new consumers
Additional consumer
surplus to initial
consumers

Law of Demand
Law of Demand states that if price of
commodity increases quantity demanded will
falls and if price of commodity falls quantity will
increases.
Law of demand indicates only direction of
change in quantity demanded in response to
change in price but ELASTICITY OF DEMAND
states with how much or to what extent the
quantity demanded will change in response to
change in any determinants.

ELASTICITY - The Concept
• If price rises by 10% - what happens to demand?
• We know demand will fall.
• By more than 10% ?
• By less than 10% ?
• Elasticity measures the extent to which demand
will change.

Meaning & Definition of Elasticity of
Demand
Elasticity of Demand measures the extent to which
quantity demanded of a commodity increases or
decreases in response to increase or decrease in any of
its quantitative determinants.
So, we have several types of elasticity of demand
according to the source of the change in the demand.
For example, if the price is the source of the change, we
have the “price elasticity of demand”.
“The elasticity (or responsiveness) of demand in a market
is great or small according as the amount demanded
increases much or little for a given fall in price, and
diminishes much or little for a given rise in price”.
– Dr. Marshall.

Elasticity of Demand
According to the source of the change, the following types of elasticity of
demand can be mentioned:
 Price Elasticity of Demand
 Cross Elasticity of Demand
(the elasticity in relation to the change of the price of other good and services)
 Income Elasticity of Demand

 According to the degree of the change in the
demand, the elasticity can be classified in:
• Perfectly Elastic
• Relatively Elastic
• Unitary Elasticity
• Relatively Inelastic
• Perfect Inelastic

Price Elasticity of Demand
Price Elasticity of demand is a measurement of
percentage change in demand due to
percentage change in own price of the
commodity.
The price elasticity of Demand may be defined as
the ratio of the relative change in demand and
price variables.
e= Percentage/Proportional Change in Quantity Demanded
Percentage/Proportional Change in Price

Degree of Price Elasticity of Demand
Five cases of elasticity of demand are studied
depending upon their degree:
 Perfectly Elastic
 Perfectly Inelastic
 Unitary Elastic
 Relatively Elastic
 Relatively Inelastic

Perfectly Elastic Demand
When a small change in price of a product causes a major change in its
demand, it is said to be perfectly elastic demand. In perfectly elastic
demand, a small rise in price results in fall in demand to zero, while a
small fall in price causes increase in demand to infinity.
A perfectly elastic demand refers to the situation when demand is
infinite at the prevailing price.
In perfectly elastic demand, a small rise in price results in fall in
demand to zero, while a small fall in price causes increase in demand to
infinity.
The degree of elasticity of demand helps in
defining the shape and slope of a demand
curve. Therefore, the elasticity of demand can
be determined by the slope of the demand
curve. Flatter the slope of the demand
curve, higher the elasticity of demand.

Perfectly Inelastic Demand
A Perfectly inelastic demand is one in which a change in price causes
no change in quantity demanded.
It is a situation where even substantial changes
in price leave the demand unaffected.
It can be interpreted from Figure that the
movement in price from OP1 to OP2 and
OP2 to OP3 does not show any change in
the demand of a product (OQ).
The demand remains constant for any
value of price.
Perfectly inelastic demand is a theoretical
concept and cannot be applied in a
practical situation. However, in case of
essential goods, such as salt, the
demand does not change with change in
price. Therefore, the demand for essential
goods is perfectly inelastic.

Unitary Elastic Demand
• When the proportionate change in demand produces the same
change in the price of the product, the demand is referred as unitary
elastic demand. The numerical value for unitary elastic demand is
equal to one (ep=1).
• The demand curve for unitary elastic
demand is represented as a rectangular
hyperbola.

Relatively Elastic Demand
Relatively elastic demand refers to the demand when the
proportionate change produced in demand is greater than the
proportionate change in price of a product.
Mathematically, relatively elastic demand
is known as more than unit elastic
demand (ep>1). For example, if the price
of a product increases by 20% and the
demand of the product decreases by
25%, then the demand would be
relatively elastic.
In this the demand is more responsive to the
change in price

Relatively Inelastic Demand
Relatively inelastic demand is one when the
percentage change produced in demand is
less than the percentage change in the
price of a product.
For example, if the price of a product
increases by 30% and the demand for the
product decreases only by 10%, then the
demand would be called relatively
inelastic.
The numerical value of relatively elastic
demand ranges between zero to one (ep<1).
Marshall has termed relatively inelastic
demand as elasticity being less than unity.

The different types of price elasticity of
demand are summarized in Table

FORMULA
Ep = Percentage Change in Quantity Demanded
Percentage Change in the Price of the good

Income Elasticity of Demand
Income elasticity of demand is the degree of
responsiveness of quantity demanded of a commodity
due to change in consumer’s income, other things
remaining constant.
In other words, it measures by how much the quantity
demanded changes
with respect to the change in income.
The income elasticity of demand is defined as the
percentage change in quantity demanded due to certain
percent change in consumer’s income.

Expression of Income Elasticity of
Demand
Where,
•EY = Elasticity of demand
•q = Original quantity demanded
•∆q = Change in quantity demanded
y = Original consumer’s income
•∆y= Change in consumer’s income

Example to Explain Income Elasticity
of Demand
Suppose that the initial income of a person is Rs.2000 and
quantity demanded for the commodity by him is 20 units. When
his income increases to Rs.3000, quantity demanded by him also
increases to 40 units. Find out the income elasticity of demand.
Solution:
Here, q = 100 units
∆q = (40-20) units = 20 units
y = Rs.2000
∆y =Rs. (3000-2000) =Rs.1000
Hence, an increase of Rs.1000 in income i.e. 1% in income leads to a
rise of 2% in quantity demanded.

Types of Income Elasticity of demand
Types of Income
Elasticity of
Demand
PositiveIncome
Elasticity Of
DemandE>0
IncomeElasticity
Greater than
Unity E>1
IncomeElasticity
Equal to Unity
E=1
IncomeElasticity
Less than Unity
E<1
NegativeIncome
Elasticity Of
DemandE<0
Zero Income
Elasticity E=0

1. Positive income elasticity of demand (EY>0)
If there is direct relationship between income of the consumer and
demand
for the commodity, then income elasticity will be positive.
That is, if the quantity demanded for a commodity increases with
the rise in income of the consumer and vice versa, it is said to be
positive income elasticity of demand.
For example: as the income of consumer increases, they consume more
of superior (luxurious) goods. On the contrary, as the income of
consumer decreases, they consume less of luxurious goods.
Positive income elasticity can be further classified into three
types:
•Income Elasticity Greater than Unity E>1
•Income Elasticity Equal to Unity E=1
•Income Elasticity Less than Unity E<1

(A) Income elasticity greater than unity (EY > 1)
 demanded for a commodity is greater than
percentage change in income of the consumer, it
is said to be income greater than unity.
 For example: When the consumer’s income rises
by 3% and the demand rises by 7%, it is the case of
income elasticity greater than unity.
 In the given figure, quantity demanded and consumer’s income is
measured along X-axis and Y-axis respectively. The small rise in income
from OY to OY1has caused greater rise in the quantity demanded from OQ
to OQ1 and vice versa. Thus, the demand curve DD shows income elasticity
greater than unity.
If the percentage change in quantity

(B) Income elasticity equal to unity (EY = 1)
If the percentage change in quantity demanded for a
commodity is equal to percentage change in income
of the consumer, it is said to be income elasticity
equal to unity.
For example: When the consumer’s income rises by
5% and the demand rises by 5%, it is the case of
income elasticity equal to unity.
In the given figure, quantity demanded and
consumer’s income is measured along X-axis and Y-
axis respectively. The small rise in income from OY
to OY1 has caused equal rise in the quantity
demanded from OQ to OQ1 and vice versa. Thus,
the demand curve DD shows income elasticity equal
to unity.

(C) Income elasticity less than unity (EY < 1)
If the percentage change in quantity demanded for
a commodity is less than percentage change in
income of the consumer, it is said to be income
greater than unity.
For example: When the consumer’s income rises
by 5% and the demand rises by 3%, it is the case
of income elasticity less than unity.
consumer’s income is measured along X-axis and
Y-axis respectively. The greater rise in income
from OY to OY1has caused small rise in the
quantity demanded from OQ to OQ1 and vice
versa. Thus, the demand curve DD shows income
elasticity less than unity.

2. Negative Income Elasticity of Demand ( EY<0)
If there is inverse relationship between income of the consumer and
demand for the commodity, then income elasticity will be negative.
That is, if the quantity demanded for a commodity decreases with the
rise in income of the consumer and vice versa, it is said to be
negative income elasticity of demand.
For example: As the income of consumer increases,
they either stop or consume less of inferior goods.
consumer’s income is measured along X-axis and
Y-axis respectively. When the consumer’s income
rises from OY to OY1 the quantity demanded of
inferior goods falls from OQ to OQ1 and vice versa.
Thus, the demand curve DD shows negative income
elasticity of demand.

3. Zero income elasticity of demand ( EY=0)
If the quantity demanded for a
commodity remains constant with
any rise or fall in income of the
consumer and, it is said to be zero
income elasticity of demand.
For example: In case of basic necessary
goods such as salt, kerosene, electricity,
etc. there is zero income elasticity of
demand.
In the given figure, quantity demanded and consumer’s income is
measured along X-axis and Y-axis respectively. The consumer’s
income may fall to OY1 or rise to OY2 from OY, the quantity demanded
remains the same at OQ. Thus, the demand curve DD, which is
vertical straight line parallel to Y-axis shows zero income elasticity of
demand.

Cross Elasticity of Demand
The measure of responsiveness of the demand for a good
towards the change in the price of a related good is called cross
price elasticity of demand. It is always measured in percentage
terms.
With the consumption behavior being related, the change in
the price of a related good leads to a change in the demand of
another good. Related goods are of two kinds, i.e. substitutes and
complementary goods.
In case the two goods are substitutes for each other like tea
and coffee, the cross price elasticity will be positive, i.e. if the price
of coffee increases, the demand for tea increases.
On the other hand, in case the goods are complementary in nature
like pen and ink, then the cross elasticity will be negative, i.e.
demand for ink will decrease if prices of pen increase or vice-versa.
It can be expressed as:

Definition:
“The cross elasticity of demand is the proportional change in
the quantity of X good demanded resulting from a given
relative change in the price of a related good Y” Ferguson
“The cross elasticity of demand is a measure of the
responsiveness of purchases of Y to change in the price of X”
Leibafsky
In case the two goods are substitutes for each other like tea
and coffee, the cross price elasticity will be positive, i.e. if the
price of coffee increases, the demand for tea increases.
On the other hand, in case the goods are complementary in
nature like pen and ink, then the cross elasticity will be
negative, i.e. demand for ink will decrease if prices of pen
increase or vice-versa.

Substitute Goods:
In case the two goods are substitutes for each other like tea and
coffee, the cross price elasticity will be positive, i.e. if the
price of coffee increases, the demand for tea increases.
Complementary Goods:
On the other hand, in case the goods are complementary in
nature like pen and ink, then the cross elasticity will be
negative, i.e. demand for ink will decrease if prices of pen
increase or vice-versa.

Types of Cross Elasticity of Demand
Types of Cross
Elasticity of
Demand
Positive Negative Zero

Positive Cross Elasticity of Demand
When goods are substitute of each other
then
cross elasticity of demand is positive.
In other words, when an increase in the
price of Y leads to an increase in the
demand of X.
For instance, with the increase in price
of tea, demand of coffee will increase.
In figure quantity has been measured on OX-axis and price on OY-
axis. At price OP of Y-commodity, demand of X-commodity is OM.
Now as price of Y commodity increases to OP1 demand of X-
commodity increases to OM1 Thus, cross elasticity of demand is
positive.

Negative Cross Elasticity of Demand
In case of complementary goods,
cross
elasticity of demand is negative.
A proportionate increase in price of
one commodity leads to a
proportionate fall in the demand of
another commodity because both
are demanded jointly.
In figure quantity has been measured on OX-axis while price has
been measured on OY-axis. When the price of commodity increases
from OP to OP1 quantity demanded falls from OM to OM1. Thus,
cross elasticity of demand is negative.

Zero Cross Elasticity of Demand
Cross elasticity of demand is
zero when two goods are not
related to each other.
For instance, increase in price
of car does not effect the
demand of cloth. Thus, cross
elasticity of demand is zero.

Definition Of Price Elasticity Of supply
• The change in the quantity
supplied of a product due to
a change in its price is
known as Price elasticity of
supply.

1) Perfectly elastic supply
2) Relatively elastic supply
3) Elasticity of supply equal to utility
4) Relatively inelastic supply
5) Perfectly inelastic supply
Let Us See Some Views On Them
Kinds Of Price Elasticity Of supply

Perfectly elastic supply
P
R
I
C
E
y
0
Perfectly elastic
supply curve
S S
When the supply
for a product
changes –
increases or
decreases even
when there is no
change in price, it
is known as
Perfect elastic
supply

Relatively elastic supply
Relatively elastic supply
curve
P
R
I
C
E
supply0 x
y
When the
proportionat
e change in
supply is
more than
the
proportionat
e changes in
price, it is
known as
relatively
elastic
supply.
S
S

Elasticity of supply equal to utility
Elasticity of
supply equal
to utility curve
y
x0 supply
P
R
I
C
E
When the
proportionate
change in
supply is
equal to
proportionate
changes in
price, it is
known as
unitary
elastic
supply
S

Relatively inelastic supply
Relatively inelastic
supply curve
XO
Y
supply
P
R
I
C
E
When the
proportionate
change in
supply is less
than the
proportionate
changes in
price, it is
known as
relatively
inelastic
supply
S
S

Perfectly inelastic supply
supply
S
Perfectly inelastic
supply curve
0
Y
X
P
R
I
C
E
When there is
no change in
the quantity
supplied with
the change in
its price, it is
perfectly
inelastic
supply
S

ALL KINDS OF supply CAN BE SHOWN
IN ONE DIAGRAM AS FOLLOW
S
S1
Y
X0 S5
supply
P
R
I
C
E
WHERE
S1) Perfectly elastic
supply
S2) Relatively elastic
supply
S3) Elasticity of
supply equal to
utility
S4) Relatively
inelastic supply
S5) Perfectly inelastic
supply
S5
S2
S3
S4

Measurement Of Price Elasticity
Of supply
There are two methods like
1. Percentage method or proportionate
method
2. Geometric method or point method

• (Es) =% Change in Quantity Supplied
% Change in Price
• ES = ∆Q/ ∆P*P/Q
• ∆Q= change in quantity supplied.
• ∆P= change in price
• Q= initial quantity supplied.
• P= initial price of the good
1. Percentage method or proportionate
method

Geometric method or point
method
Es= Difference b/w Qty and intersect on X axis
Difference between Qty and origin

EXAMPLE
• Price of a good falls from Rs.15 to Rs.10
and the supply decreases from 100 units
to 50 units. Calculate Es.
• Q=100
• Q1=50
P= 15
P1=10
• Es= P/Q*∆Q/∆P = 15/100*50/5 = 1.5
• Es> 1, it is a case of elastic supply

(5) Factors Affecting Price Elasticity Of supply
• Time Factor
1.Short period - relatively less elastic
2.Long period – more elastic
. Nature of the commodity
1. Perishable goods – relatively less
elastic
2. Durable goods – elastic supply
. Technique of production
1.Complex technique - inelastic
2.Simple technique – elastic

.NATURE OF INPUTS USED
1.Commonly used factors – elastic
2.Specialised factors –inelastic
. Future price expectation
1.price increase- inelastic
2.price decrease – elastic
. Natural constraint
less elastic
. Risk Taking
1.Willing to take risk- more elastic
2.Unwilling to take risk- less elastic

(6) Practical Importance of the Concept of
Price Elasticity Of supply
• The concept is helpful in taking Business
Decisions
• Importance of the concept in formatting Tax
Policy of the government
• For determining the rewards of the Factors of
Production
• To determine the Terms of Trades Between
the Two Countries

CONCEPT OF UTILITY & ELASTICITY OF DEMAND

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CONCEPT OF UTILITY & ELASTICITY OF DEMAND