Utility and Demand analysis 2021

Demand and Utility Analysis
• Law of Diminishing Marginal Utility
• Indifference curve, Budget line Consumer’s equilibrium
• Consumer surplus.
• Concept of Demand, Determinants of Demand, Law of
Demand, Exceptions to Law of Demand
• Elasticity of Demand:
• Price Elasticity – Definition, Types, Methods and Factors
determining
• Income Elasticity - Definition, Types and Methods
• Cross Elasticity- Definition, Types and Methods
• Uses of the concept of elasticity.
4/27/2021 Prepared by Dr. Samita Mahapatra

Theory of Consumer Choice and Demand
• Demand and Utility Analysis
Prepared by Dr. Samita Mahapatra
• Indifference Curve Analysis
• Revealed Preference Analysis
Alfred Marshal
J R Hicks
Paul
Samuelson
4/27/2021

Law of Diminishing Marginal Utility
According to Marshal, ‘The additional benefit which a person
derives from a given increase of his stock of a thing diminishes
with every increase in the stock that he already has.’
“The Law of diminishing marginal utility states that, as a
consumer consumes more and more units of a specific
commodity, utility from the successive units goes on
diminishing”
Assumptions:
a. Cardinal Approach – ‘utils’
b. MU of money is constant
c. Satiation
d. Equal measure
e. Continuous consumption

Calculation of Marginal Utility

Number of Chappatis Total Utility (utils) Marginal Utility (utils)
1 12 12
2 22 10
3 30 8
4 36 6
5 40 4
6 41 1
7 41 0
8 39 -2
9 34 -5

Total
&
Marginal
Utility
0
TU
MU
7 Number of Chappatis
Y
X
N

Limitations/Exceptions/Criticisms:
2. Hobbies/Rare collections
1. Habits/Addictions:
3. Money

4/27/2021
Marginal
Utility
0
MU
Units of commodity
Y
X
Price
F
MU = Price
Q
P
A
Consumer Surplus = Willingness to pay – Actually pays
Consumer Surplus
Price’
P1
Price’’
P2

Practice Multiple Choice Questions

1. Utility in economics means:
a. Want Satisfying Power
b. Pleasure
c. Happiness
d. None of the above
2. Marginal Utility is :
a. Difference in total and average utility
b. Addition to total utility
c. Total utility divided by the number of units

3. Law of diminishing marginal utility applies
to:
a. Drunkards
b. Misers
c. Stamp collectors
4. When the Total utility is maximum, marginal
utility is:
a. Zero
b. Highest
c. Negative
d. one

5. The marginal utility which a consumer derives from goods is:
a. The utility he derives from a particular good.
b. The change in his utility as a result of adding one unit to his
stock of commodity.
c. The change in total utility resulting from a change in the price
of the goods.
d. The change in the total utility with the change in cost.
6. When total utility falls, marginal utility is:
a. Zero
b. Positive
c. Negative
d. one

“Be Nice to the Ones who SMOKE…..
Every Cigarette might be their last…..”

Demand = Desire or Want
+ Willingness to Buy
+ Ability to Pay
At a specific price and
At a point of time
4/27/2021

Demand Functions:
Long Run function—
QDx = f{ Px, Y, Pr, A, T, N, Fe, Tx, O…..}
Independent Variable
Dependent Variable
Short – Run Function—
QDx = f (Px)
Dependent Variable Independent Variable
4/27/2021

Demand Determinants:
 Price of the product demanded
QDx = f (Px)
• Income of the consumer.
QDx = f (Y)
• Prices of related goods.
QDx = f (Py) (Substitutes goods)
QDx = f (Py) (Complementary goods)
4/27/2021

Demand Determinants
• Advertising expenditure.
• Future Expectations of the Consumer about the
Price of the product.
• Habits.
• Growth of Population, Age structure, Sex ratio etc
• Credit Facilities
• Brand Name
• Direct Taxes
• Fashion, Tastes, Trends etc
• Climatic Conditions
• Other factors…
4/27/2021

Individual Demand Schedule of Pizza
Price
(Rs)
Quantity Demanded by Gautam
(In units)
100 6
200 5
300 4
400 3
500 2
600 1
4/27/2021

Individual Demand Curve of Pizza
Quantity Demanded
X
Y
DD
P1
P2
P
Q1 Q Q2
O
PRICE
4/27/2021

Price
(Rs.)
QD by
Gautam
(Smokin
Joe’s)
QD by
Gayatri
(Pizza
Hut)
QD by
Jay
(Domino’s)
Market
demand
Or Total
Demand
400 1 3 3
300 2 4 5
200 3 5 7
100 5 9 10
Market /Industry Demand Schedule of Pizza
4/27/2021

Price
(Rs.)
QD by
Gautam
(Smokin
Joe’s)
QD by
Gayatri
(Pizza
Hut)
QD by
Jay
(Domino’s)
Market
demand
Or Total
Demand
400 1 3 3 7
300 2 4 5 11
200 3 5 7 15
100 5 9 10 24
Market /Industry Demand Schedule of Pizza
4/27/2021
….…is a horizontal summation of individual demand.
14.28 42.86 42.86 100
18.18 36.36 45.46 100
20 33.33 46.67 100
100
20.83 37.5 41.67

Law of Demand states that…
… “Other things remaining the same (Ceterius
Paribus) the higher the price the lower will be the
demand and vice versa.”
QDx = f {Px}
4/27/2021

“Other things remaining the same…” (Ceterius
Paribus)
• No change in consumers income
• No change in prices of related goods
• No change in advertising expenditure
• No change in fashion, tastes, preferences
• No expectations about future change in price
• No change in age-composition and sex ratio of the
population
• No change in government policy
• No change in climatic conditions
• No change in credit facilities, brand name, habits etc
4/27/2021

Exceptions to the Law of Demand
1. Giffen Paradox
2. Prestigious goods or
conspicuous
consumption or
status symbol goods
3. Speculation
4. Consumers
ignorance
5. Emergency
4/27/2021
0
DD
P
Q
P1
Q1
PRICE
QUANTITY DEMANDED
Y
X

Changes In Quantity Demanded
• Expansion in
quantity
demanded
• Contraction in
quantity
demanded.
4/27/2021
QUANTITY DEMANDED
X
Y
PRICE
o
DD
b
c
a
P’
P”
P
Q’ Q Q”

Changes in Demand
4/27/2021
Increase in demand Decrease in demand
QUANTITY DEMANDED
X
Y
PRICE
P
Q Q’
o
DD
DD’
X
Y
PRICE
P
Q Q’
o
DD’ DD
QUANTITY DEMANDED

Increase in Demand
• Increase in Income of
Consumer
• Product in fashion
• Festival Season
• Increase in Population
• Increase in employment
• Decrease in interest
rates on credit facilities
etc….
4/27/2021
Decrease in Demand
• Decrease in Income of
Consumer
• Product out of fashion
• Slack Season
• Increase in
unemployment
• Increase in interest
rates on credit facilities
etc…

“MISTAKES ARE NEW LESSONS FOR SUCCESS”
4/27/2021
Elasticity of Demand

Elasticity of Demand
“The degree of responsiveness of quantity
demanded due to change in any factor
affecting demand.”
Percentage change in quantity demanded
ed= ----------------------------------------------------------
Percentage change in any factor
affecting demand
4/27/2021

Law of Demand vs Elasticity of Demand
0
DD
P
Q
P1
Q1
PRICE
QUANTITY DEMANDED
Y
X
Q2
P2
How much?
How much?

Price Elasticity
Percentage change in quantity
demanded
ep=---------------------------------------------------
Percentage change in price
Therefore; QDx = f (Px)
4/27/2021

Income Elasticity
ei=---------------------------------------------------------------------
Percentage change in the Income of consumer
QD = f (Y)
4/27/2021
Cross Elasticity
Percentage change in quantity demanded of
good X
Ec =-------------------------------------------------------------------
Percentage change in the price of good Y
QDY = f (PX) QDY = f (PX)

Price elasticity
“…The degree of responsiveness of quantity demanded
due to change in price.”
Ep= ------------------------------------------------------------------
Percentage change in price of the good
4/27/2021
Ratio or
Percentage
or Point
Method

Arc Method of Price Elasticity
ep =
Q2 – Q1
P
P2 + P1
Q2 + Q1
X
Q
Q2 + Q1
2
2
P2 – P1
P2 + P1
ep =
4/27/2021

Ratio/ Percentage/Point vs Arc Method
Where; P1 = Initial Price
P2 = New Price
Q1 = Initial Quantity
Q2 = New Quantity
4/27/2021
Arc
A
B C
D
E
A
B
Price
Quantity Demanded
Price
Quantity Demanded

Types of Price Elasticity
1. Perfectly elastic (ep = )
2. Perfectly inelastic (ep = 0 )
3. Relatively elastic demand (ep > 1)
or More elastic or elastic
4. Relatively inelastic demand (ep< 1)
or Less elastic or inelastic
5. Unitary elastic demand (ep = 1)
∞
4/27/2021

1. Perfectly elastic (ep=∞)
X
Y
Quantity demanded
Price
P DD
Q Q’ Q’’
0
4/27/2021

2. Perfectly inelastic (ep=0)
X
Y
Quantity demanded
Price
DD
Q
P
P’
P”
0
4/27/2021

3. Relatively elastic demand (ep > 1) Luxury goods
X
Y
Quantity demanded
Price
DD
Q
Q’
P
P’
Q
P
o
4/27/2021

4. Relatively inelastic demand (ep < 1) Necessary
Goods
X
Y
Quantity demanded
Price
DD
Q
Q’
P’
P
0
Q
P
4/27/2021

5. Unitary elastic demand (ep =1)
X
Price
DD
Q
Q’
P
P’
o
Quantity demanded

Total Revenue or Total Expenditure or Total
Outlay Method
Total Revenue = Price x Quantity
4/27/2021

Total Revenue/Total Expenditure/ Total Outlay
Method-More elastic (ep>1)
o
DD
2
4
4 10
a
b
Price
Quantity Demanded
24
c
4/27/2021
1
Y
X
Price Quantity TR
4 4 16
2 10 20
1 24 24

Method-less elastic (ep<1)
o
2
4
6 10
a
b
Price
Quantity Demanded
DD
1
16
c
4/27/2021
Y
X
Price Quantity TR
4 6 24
2 10 20
1 16 16

Method-Unitary elastic demand (ep =1)
X
Price
DD
10
5
2
o
Quantity demanded
4
1
20
a
b
c
Price Quantity TR
4 5 20
2 10 20
1 20 20
Y

Total Revenue Method and Price Elasticity of
Demand
4/27/2021
Price Quantity TR Price Elasticity (ep)
4 4 16
Ep >1
2 10 20
1 24 24
4 6 24
Ep <1
2 10 20
1 16 16
4 5 20
Ep =1
2 10 20
1 20 20

Y
X
A
B
Price
0
Quantity Demanded
ep=
ep>1
ep=1
ep<1
ep=0
8
Point Method or Geometric Method
C
F
G
4/27/2021
TR
M
P Q TR
0 10 0
1 9 9
2 8 16
3 7 21
4 6 24
5 5 25
6 4 24
7 3 21
8 2 16
9 1 9
10 0 0
5

Factors influencing price elasticity of demand:
1. Nature of the commodity :
 Necessaries – Inelastic
 Comforts and Luxuries – Elastic
2. Availability of substitutes :
 No substitutes – Inelastic
 Close substitutes – Elastic
3. Number of Uses :
 Single Use – Inelastic
 Multi Use – Elastic
4. Range of Price Change:
 Highly Priced – Elastic
 Low Priced – Inelastic
4/27/2021

Factors influencing price elasticity of demand:
5. Proportion of Expenditure :
 Less expenditure – Inelastic
 More expenditure – Elastic
6. Time Period :
 Short Period – Inelastic
 Long Period – Elastic
7. Possibility of Postponement :
 Can be postpone – Elastic
 Cannot postpone – Inelastic
8. Influence by Habits, Customs, Traditions etc:
Inelastic demand
4/27/2021

Uses or Applications of Price elasticity
• For a Businessman
• Price discrimination by a monopolist.
• For Finance Minister
• For International Trade
• For the Trade Unions
4/27/2021

4/27/2021
1. An university decides to raise tuition fees to increase the total
revenue it receives from students. This strategy will work if the
demand for education at that university is:
a. Elastic
b. Inelastic
c. Unitary Elastic
d. Perfectly elastic
2. The bus fare charged by the local bus company is £2.00 during
the morning rush hour, but only £1.50 during the early afternoon.
This can be explained by the fact that the demand for bus rides
during the morning rush hour is _____; but during the early
afternoon the demand for bus rides is _____:
a. Perfectly elastic, perfectly inelastic
b. Unitary elastic, more elastic
c. More elastic, less elastic
d. Less elastic, more elastic

3. The government wants to reduce the consumption of
electricity by 5%. The price elasticity of demand for electricity is
00.4. The government should:
a. raise the price of electricity by 12.5%.
b. raise the price of electricity by 0.8%
c. raise the price of electricity by 0.2%
d. Raise the price of electricity by 0.4%
4. If the government is seeking to raise revenue by increasing
the rate of indirect tax on a product, it will be most successful
where price elasticity of demand is:
a. Perfectly inelastic.
b. Relatively elastic
c. More elastic
d. Perfectly elastic

5. We might expect a __________ in price for a product with a
relatively price elastic demand to raise total revenue.
a. Fall
b. Raise
c. Same
d. static
6. A government seeking to raise revenue should _____________
taxes on products with relatively elastic demands.
a. Decrease
b. Increase
c. No change
d. Impose

4/27/2021
7. Match the A and B:
A
1. Perfectly Elastic demand
curve
2. Elastic demand curve
3. Inelastic demand curve
4. Perfectly Inelastic
demand curve
B
a. Steeper demand curve
b. Vertical straight line
demand curve
c. Flatter demand curve
d. Horizontal straight line
demand curve
8. Which of the following best describes the concept of price elasticity of
demand?
a. The amount by which quantity changes for a given change in price.
b. The proportion of change in sales for a given proportional change in
price.
c. The proportion of change in price for a given proportional change in
sales.
d. The proportion of change in sales for a given proportional change in the
Consumer Price Level.

9. If price falls by 1 percent and quantity demanded
rises by 2 percent, then the price elasticity of demand:
a. is inelastic over that range.
b. is 0.5.
c. is elastic over that range.
d. cannot be calculated from this information.
10. If price rises and total revenue rises, then the price
elasticity of demand over that range is:
a. elastic.
b. inelastic.
c. unit elastic.
d. equal to 1.

Income Elasticity
“…the degree of responsiveness of the quantity
demanded due to the change in income of the
consumer.”
4/27/2021
ei=--------------------------------------------------------------------
Percentage change in the Income of consumer
Ratio or
Percentage
or Point
Method

Arc Method
4/27/2021
Y
X
Quantity Demanded
Income
0
DD
I
Q Q1
I1
Q2
I2
DD
Y
X
Quantity Demanded
ARC A
B
0

Ratio/Percentage/Point/Arc Method of Income Elasticity
Where, I1 = Initial Income
I2 = New Income
Q1 = Initial Quantity
Q2 = New Quantity
4/27/2021
Types of Income elasticity:
1. Positive Income Elasticity
2. Negative Income Elasticity
3. Zero Income Elasticity

Positive Income elasticity
4/27/2021
X
Quantity Demanded
Income
ei < 1 (necessary goods)
0
I
Q
DD
Y
I
Q Q1
I1
X
Y
0
DD
ei > 1 (Luxury goods)
I
Q Q1
I1
I
Q

Negative Income Elasticity
X
Y
Quantity demanded
Income
DD
0
ei < 0 (Inferior goods)
Y
Q
I
I1
Q
Q1
4/27/2021
Zero Income Elasticity
0
Y
X
DD
I
Q
I1
I2
Quantity demanded
Salt, Gas Cylinder, Electricity etc
ei = 0
Income

Cross Elasticity
It is the degree of responsiveness of quantity
demanded of good X due to the change in Price of good
Y (where good X and Y are either substitutes or
complementary)
Percentage change in Quantity demanded
of good X
Percentage change in price of good Y
Ec =
4/27/2021
QDY = f (PX) QDY = f (PX)
Substitute Commodities Complimentary Commodities

Ratio or Point or Percentage Method:
4/27/2021
Arc Method:

Types of Cross Elasticity
Y
X
0
DDTea
P
Q
Quantity demanded of Tea
Price
of
coffee
P1
Q1
Ec > 0 Y
X
0
Quantity demanded of Vehicles
Price
of
Petrol
DDVehicles
Ec < 0
P
Q
P1
Q1

Unrelated goods or Independent goods:
Price
of
Ice
cream
Demand for Cloths
DDCloths
P
P1
Q
Exy = 0
0
X
Y
P2
4/27/2021

1. If the cross elasticity of demand between two
goods is negative, then the two goods are:
a. Substitutes
b. Complementary
c. Inferior goods
d. Giffen goods
2. Tennis racquets and tennis balls are likely to have a
_________ cross-elasticity of demand.
a. Negative
b. Zero
c. Positive
d. One

3. If the income elasticity of a demand for a good is
negative, then the good is:
a. Normal goods
b. Luxury goods
c. Necessary goods
d. Inferior goods
4. Siri considers tofu a normal good and peanut butter an
inferior good. We can predict that with an increase in her
income she will consume:
a. More of both goods
b. More tofu and less peanut butter
c. More peanut butter less tofu
d. Less of both

5. If college enrollments drop by 10% when textbook
prices double; textbooks and enrollments are
__________ goods and the cross price elasticity is
__________.
a. Complementary, positive
b. Substitutes, positive
c. Substitutes, negative
d. Complementary, negative
6. What is a possible example of a good with negative income
elasticity?
a. High quality of rice
b. Cars
c. Hotels
d. Poorer quality of rice

71
Indifference Curves
John Richard Hicks

72
Assumptions of Indifference Approach
1. Ordinal Approach.
2. There are only two Goods (Good X and Good Y).
3. Inconsistency.
4. Weak ordering.
5. Transitivity.
6. Rationality.
7. Non-satiation.
Indifference Curve
……is a locus a points which showing different
combinations which gives equal level of satisfaction.

73
Indifference Schedule-1
Combinat
ions
Good
X
Good
Y
A 1 15 --
B 2 10 -5
C 3 6 -4
D 4 3 -3
E 5 1 -2
Combin
ations
Good X Good
Y
F 2 20 --
G 3 15 -5
H 4 11 -4
J 5 8 -3
K 6 6 -2
Indifference Schedule-2
Combinations Good X Good Y
L 3 25 --
M 4 20 -5
N 5 16 -4
R 6 13 -3
S 7 11 -2
Indifference Schedule -3

74
Indifference Curve
IC
Good X
X
o
Good
Y
Y
A
B
C
D
E
Y
X
The amount of Good Y the consumer
is willing to give up to maintain the
same level of satisfaction level as
more of Good X is acquired

75
Indifference Map
Good
Y
o
Good X
IC1
IC2
IC3
X
Y
A
B
C
D
F
G
H
J
K
L
M
N
R
It is a set of Indifference
curves. Higher the
Indifference curve, higher is
the level of satisfaction.

76
Properties of Indifference Curve
I. Indifference curves slope downwards or negatively.
II. Indifference curve is convex to the origin.
III. Two Indifference curve do not intersect each other.
IV. Higher the Indifference curve higher is the level of
satisfaction.

77
I. Indifference curves slope downwards or negatively
IC
Good X
X
Y
Y
0
a b c
X1 X2 X3
Good
Y
a > b > c
X
Y
Good X
Good
Y
IC
X1
Y2
Y1
Y3
a
b
c
a > b > c
0

78
IC
c
b
X1
a
X2 X3
0
Y1
Y2
Y3
Good X
Good
Y
X
Y
a > b > c
I. Indifference curves slope downwards or negatively
IC
Good X
X
o
Good
Y
Y
A
B
C
D
E
A = B = C= D = E

79
II. Indifference curve is convex to the origin
IC
Good X
X
o
Good
Y
Y
A
B
C
D
E
Y
X

80
Y
X
Y
X
IC
Good X
Good
Y
0
A
B
C
X
Y
D

81
Good X
Good
Y
0
I
C
B
A
C
Y
Y
X
X
Perfect Substitutes
Y
X

82
IC
X1
Y1
Good X
Good
Y
0
X
Y
Perfect Complementary

83
III. Two Indifference curve do not intersect each other.
IC2
IC1
C
B
A
Good X
Good
Y
0
Y
X
Satisfaction at A = B; A=C but C > B
Violates the Transitivity condition i.e
A=B, B=C, Therefore, A= C

84
IV. Higher the Indifference curve higher is the level
of satisfaction.
Good
Y
o Good X
IC1
IC2
IC3
X
Y
A
B
C
D
F
G
H
J
K
L
M
N
R

85
Derivation of Price Line
Example:
• If a consumer has Rs.
100 in his pocket to
spend on two goods
(Good X and Good Y)
• The Price of Good X is
Rs. 10
• The Price of Good Y is
Rs. 5
X
Y
Good X
Good
Y
o
L
F
D
20
10
P
C

86
Consumer Equilibrium in Indifference Curve
Conditions of consumer equilibrium:

87
Consumer’s Equilibrium
Good X
X
Good
Y
Y
P
L
IC1
IC2
IC3
2
X1
Y1
o
1
3
6
4
F
E1
E
E2
5
G
H

1. An indifference curve shows combinations of two goods that:
a. would provide the consumer with the same level of
satisfaction
b. could provide the consumer with similar levels of
satisfaction.
c. could be available to the consumer in a given time period.
d. a consumer could buy with their given income.
2. Which of the following statements is NOT TRUE of
indifference curves?
a. They could intersect.
b. They exhibit higher levels of utility as you move from the
origin
c. They are downward sloping
d. They are convex to the origin.

3. “Utility or satisfaction is a subjective concept; therefore it
could only be ranked”. The statement supports:
a. Cardinal utility theorist
b. Ordinal utility theorist
c. Behavioral theorist of the firm
d. Monetary theorist
4. The basic doctrine of consumers surplus is based on:
a. Indifference curve analysis
b. Revealed preference theory
c. Law of substitution
d. Law of diminishing marginal utility

5. As per indifference curve analysis consumer equilibrium
is attained when:
a. Slope of indifference curve is constant
b. Slopes of both indifference curve and income price line
are equal
c. Slopes of both indifference curve and income price line
are opposite
d. Both income price line and indifference curve are
parallel.
6. In case of a convex indifference curve:
a. MRSxy is constant
b. MRSxy is increasing
c. MRSxy is negligible
d. MRSxy is diminishing

Reference Books
• ‘Managerial Economics: Theory & Applications’- by
D. M. Mithani
• ‘Managerial Economics: Analysis, Problems &
Cases’- by P. L. Mehta
• ‘Managerial Economics’- by H. L. Ahuja
• ‘Managerial Economics in the Global Economy’ – by
Dominick Salvatore
• ‘Principles of Economics’ – by Prem J. Bhutani
4/27/2021

4/27/2021

Utility and Demand analysis 2021

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