Utility, Demand,

and Elasticity of Demand

 Utility

Utility is the quality in goods to satisfy human wants. Thus, it is said that “Wants
satisfying capacity of goods or services is called Utility.

Utility is the basis of consumer demand. A consumer thinks about his demand for a
commodity on the basis of utility derived from the commodity.

Utility depends upon the intensity of want. When a want is unsatisfied or more
intense, there is a greater urge to demand of a particular commodity which satisfies a
given want.

In modern time utility has been called as ‘expected satisfaction.’ Expected

satisfaction may be less or equal to or more than the real satisfaction.
In economics, production refers to the creation of utilities in several ways. Thus,
there are different types of utility: Form Utility; Place Utility, Time Utility and
Service Utility.
 Utility
The utility is a psychological phenomenon; that implies the satisfying power of a good
or service.

Total Utility-It is defined as the total amount of satisfaction that a person can receive
from the consumption of all units of a specific product or service.
Marginal Utility-It is the utility derived from the last or marginal unit of consumption.
It refers to the additional utility derived from an extra unit of the given commodity
purchased, acquired or consumed by the consumer. Marginal utility is of three kinds-
Positive, Zero and Negative marginal utility.
 Law Of Diminishing Marginal Utility

The law of diminishing marginal utility is 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.
The law of diminishing marginal utility can also be represented by a diagram.
 Demand
Demand means the ability and willingness to buy a specific quantity of a
commodity at the prevailing price in a given period of time. Therefore, demand
for a commodity implies the desire to acquire it, willingness and the
ability to pay for it.

There are thus three main characteristic's of demand in economics.

 
(i) Willingness and ability to pay.
(ii) Demand is always at a price.
(iii) Demand is always per unit of time.
 Demand schedule

Demand schedule In economics, is a table of the quantity demanded of a good at

different price levels. Given the price level, it is easy to determine the expected
quantity demanded.

Price Quantity Demanded

1 50

2 40

3 30

4 20

5 10
 Demand Curve

A demand curve is a graphical representation of a demand schedule. The price is

quoted in the ‘Y’ axis and the quantity demanded over time at different price levels
is quoted in ‘X’ axis. Each point on the curve refers to a specific quantity that will
be demanded at a given price.
Movement along the Demand Curve
 Shift in Demand Curve

Demand Curve Shifting to the Left Demand Curve Shifting to the Right
 The law of demand
The law of demand states that other factors being constant (ceteris paribus),
price and quantity demand of any good and service are inversely related to
each other. When the price of a product increases, the demand for the same
product will fall.

The chart below depicts the law of demand using a demand curve, which is
always downward sloping. Each point on the curve (A, B, C) 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.
 Elasticity of Demand

 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.
 Types of Elasticity of Demand
The three main types of elasticity of demand are discussed in brief.

 Price Elasticity of Demand

 
Price elasticity of demand is the degree of responsiveness of quantity demanded of a good to a
change in its price. Precisely, it is defined as:
"The ratio of proportionate change in the quantity demanded of a good caused by a given
proportionate change in price".

Formula: 

•Price Elasticity of Demand = Percentage change in Quantity Demand

                                        Percentage Change in Price
Simplified formula:

                                                         Ed = ΔQ X P

                                                                ΔP   Q
 
 Price Elasticity of Demand: 
Example:
Let us suppose that price of a good falls from Tk.10 per unit to Tk.9 per unit in a day.
The decline in price causes the quantity of the good demanded to increase from 125
units to 150 units per day. The price elasticity using the simplified formula will be:
  
Ed = ΔQ X P
        ΔP    Q

 
ΔQ = 150 - 125 = 25
 ΔP = 10 - 9 = 1
 
Original Quantity = 125
 Original Price = 10

 Ed = 25 / 1 x 10 / 125 = 2
 Price Elasticity of Demand 
The concept of price elasticity of demand can be used to divide the
goods in to three groups.

(i) Elastic. When the percent change in quantity of a good is greater

than the percent change in its price, the demand is said to be elastic.
 
(ii) Unitary Elasticity. When the percentage change in the quantity
of a good demanded equals percentage in its price, the price
elasticity of demand is said to have unitary elasticity
 
(iii) Inelastic. When the percent change in quantity of a good
demanded is less than the percentage change in its price, the demand
is called inelastic.
 Measurement of Price Elasticity of Demand

There are three methods of measuring price elasticity of demand:

 
(1) Total Expenditure/Revenue Method.
(2) Geometrical Method or Point Elasticity Method.
(3) Arc Method.
 
Total Expenditure/Revenue Method
 Total Expenditure /Revenue Method
The figure shows that at price of Tk. 20 per pen, the quantity demanded is 10 pens,
the total expenditure OABC (Tk.200). When the price falls down to Tk.10, the
quantity demanded of pens is 30. The total expenditure is OEFG (Tk. 300).
 
Since OEFG is greater than OABC, it implies that change in quantity demanded is
proportionately more than the change in price. Hence the demand is elastic (more
than one) Ed > 1.
 
 Geometric Method/Point Elasticity Method

The measurement of elasticity at a point of the demand curve is called

point elasticity".
 
The point elasticity of demand method is used as a measure of the change
in the quantity demanded in response to a very small changes in price. The
point elasticity of demand is defined as:
 
"The proportionate change in the quantity demanded resulting from a very
small proportionate change in price".
 
Geometric/Point Elasticity Method
 Geometric/Point Elasticity Method

• The formula applied for measuring the elasticity at any point on the straight
line demand curve is:
  
• The elasticity at each point on the demand curve can be traced with the help
of point method as:
 
• Ed = Lower Segment
      Upper Segment
 
• In the figure AG is the linear demand curve (1). Elasticity of demand at its
mid point D is equal to unity. At any point to the right of D, the elasticity is
less than unity (Ed < 1) and to the left of D, the elasticity is greater than unity
(Ed > 1).
 Geometric/Point Elasticity Method

(1) Elasticity of demand at point D = DG = 400 = 1 (Unity).

                                                   DA    400
 (2) Elasticity of demand at point E = GE = 200 = 0.33 (<1).
                                                     EA    600
 (3) Elasticity of Demand at point C = GC = 600 = 3 (>1).
                                                       CA    200
 

Summing up, the elasticity of demand is different at each point

along a linear demand curve. At high prices, demand is elastic.
At low prices, it is inelastic. At the midpoint, it is unit elastic.
 Arc Method
Normally the elasticity varies along the length of the demand curve. If we are to measure
elasticity between any two points on the demand curve, then the Arc Elasticity Method, is
used. Arc elasticity is a measure of average elasticity between any two points on the demand
curve. It is defined as-"The average elasticity of a range of points on a demand curve".
Formula:
Arc elasticity is calculated by using the following formula:

∆Q P1 P2
Ed X +
= ∆P    Q 1
Q2
Here:
∆Q denotes change in quantity.
∆P denotes change in price.
Q1 signifies initial quantity.
Q2 denotes new quantity.
P1 stands for initial price.
P2 denotes new price.
 Income Elasticity of Demand

The degree of change or responsiveness of quantity demanded of a good to a

change in the income of a consumer is called income elasticity of demand.
 
Formula:
The formula for measuring the income elasticity of demand is the percentage
change in demand for a good divided by the percentage change in income.
Putting this in symbol gives.    
              
Ey = Percentage Change in Demand
Percentage Change in Income
 Simplified formula:
 Ey = ΔQ X I
        ΔI    Q
 GOODS
• Normal goods have a positive income elasticity of demand so as consumers' income rises more is
demanded at each price i.e. there is an outward shift of the demand curve
• Normal necessities have an income elasticity of demand of between 0 and +1 for example, if income
increases by 10% and the demand for fresh fruit increases by 4% then the income elasticity is +0.4.
Demand is rising less than proportionately to income.
• Luxury goods and services have an income elasticity of demand > +1 i.e. demand rises more than
proportionate to a change in income – for example a 8% increase in income might lead to a 10% rise in
the demand for new kitchens. The income elasticity of demand in this example is +1.25.
• Inferior goods have a negative income elasticity of demand meaning that demand falls as income rises.
Typically inferior goods or services exist where superior goods are available if the consumer has the
money to be able to buy it.
• substitute goods or substitutes are products that a consumer perceives as similar or comparable, so that
having more of one product makes them desire less of the other product. Formally, X and Y are
substitutes if, when the price of X rises, the demand for Y rises.
• Complementary goods are goods that are usually consumed together or that have the ability to provide a
higher utility when consumed together.
 Cross Elasticity of Demand
The concept of cross elasticity of demand is used for measuring the
responsiveness of quantity demanded of a good to changes in the price of related
goods. Cross elasticity of demand is defined as: "The percentage change in the
demand of one good as a result of the percentage change in the price of another
good".
 
• Formula:
• Exy = % Change in Quantity Demanded of Good X
          % Change in Price of Good Y

Simplified formula:
Exy = %ΔQx / %ΔPy
 Importance of Elasticity of Demand
(i) Importance in taxation policy : If the demand is inelastic, government can
increase the tax and thus can collect larger revenue. But if the demand of a commodity
is elastic, it is not in a position to increase the rate of a tax.

(ii) Price discrimination by monopolist. If the monopolist finds that the demand for
his commodities is inelastic, he will at once fix the price at a higher level in order to
maximize his net profit. In case of elastic demand, he will lower the price in order to
increase, his sale and derive the maximum net profit. Thus we find that the monopolists
also get practical advantages from the concept of elasticity.
    
(iii) Importance to businessmen. The concept of elasticity is of great importance to
businessmen. When the demand of a good is elastic, they increases sale by towering its
price. In case the demand' is inelastic, they are then in a position to charge higher price
for a commodity.
 Importance of Elasticity of Demand
(iv) Help to trade unions. The trade unions can raise the wages of the labor in an
industry where the demand of the product is relatively inelastic. On the other hand, if the
demand, for product is relatively elastic, the trade unions cannot press for higher wages.

(v) Use in international trade. The term of trade between two countries are based on the
elasticity of demand of the traded goods.
 
(vi) Determination of rate of foreign exchange. The rate of foreign exchange is also
considered on the elasticity of imports and exports of a country. 
                                               .
(vii) Guideline to the producers. The concept of elasticity provides a guideline to the
producers for the amount to be spent on advertisement. If the demand for a commodity is
elastic, the producers shall have to spend large sums of money on advertisements for
increasing the sales.

(viii) Use in factor pricing. The factors of production which have inelastic demand can
obtain a higher price in the market then those which have elastic demand. This concept
explains the reason of variation in factor pricing.
 Demand Forecasting
 

All organizations operate in an atmosphere of uncertainty but decisions must be

made today that affect the future of the organization. A forecast is a prediction or
estimation of a future situation, under given conditions.
There are various ways of making forecasts that rely on logical methods of
manipulating the data that have been generated by historical events. Demand
forecast will help the manager to take the following decisions effectively.

The steps to be followed:

 Ֆ Identification of objectives
Ֆ Nature of product and market
Ֆ Determinants of demand
Ֆ Analysis of factors
Ֆ Choice of technology
Ֆ Testing the accuracy
 Demand Forecasting Methods
 

1. Survey of buyers’ intension

2. Delphi method
3. Expert opinion
4. Collective opinion
5. Naïve model
6. Smoothing techniques
7. Time series / trend projection
8. Controlled experiments
9. Judgmental approach
 Demand Forecasting Methods

Time Series / Trend Projection

The linear trend is the most commonly used method of time series analysis.

Linear Trend Equation:

Y = a + b X Y = demand
X = time period

a, b constant values representing intercept and slope of the line. To calculate Y for any
value of X we have to solve the following equations, (i) and (ii). We can derive the
values of ‘a’ and ‘b’ through solving these equations and by substituting the same in
the above given linear trend equation we can forecast demand for ‘X’ time period.
 
 Demand Forecasting Methods
Apart from the above mentioned statistical methods the survey methods are also
commonly used. They are:
 1. Complete Enumeration Method: the survey covers all the potential consumers
in the market and an interview is conducted to find out the probable demand. The
sum of all gives the total demand for the industry. If the number of customers is too
many this method cannot be used.
2. Sample Survey Method: the complete enumeration is not possible always. The
forecaster can go in for sample survey method. In this method, only few (a sample)
customers are selected from the total and interviewed and then the average demand is
estimated.
3. Expert’s Opinion: the experienced people from the same field or from marketing
agents can also be taken into consideration for collecting information about the
future demand.
The above discussed qualitative and quantitative methods are commonly used to
forecast the future demand and based on this information firms will take production
decision.