Utility Analysis and

Cardinal Utility of
Demand
 What is Utility?

 Product Angle: Want satisfying property of any Product

 Consumer Angle: The Psychological feeling of satisfaction or happiness derived by the

consumer by consumption of certain units of a good or a service at a certain point of

time.

Introduced by Jermy Bentham

Measurement ‘Utils‟

Subjective entity
 Measuring Utility

Utility Analysis

• Cardinal Utility analysis Ordinal Utility Analysis

• Alfred Marshal

• can be measured •J. R. Hicks &

R.G.D. Allen
• „Utils‟
•Cannot be
• Law of Diminishing Marginal Utility
measured but
• Quantitative compared as

• . Subjective entity or Personal rank

• Law of Equi-marginal Utility •Indifference

Curve analysis
 Assumptions of utility Analysis

The utility analysis is based on a set of following assumptions:

 The utility analysis is based on the cardinal concept which assumes that utility is measurable and
additive like weights and lengths of goods.
 Cardinal or Utility is measurable in terms of money.
 The marginal utility of money is assumed to be constant
 The consumer is rational who measures, calculates, chooses and compares the utilities of
different units of the various commodities and aims at the maximization of utility.
 He has full knowledge of the availability of commodities and their technical qualities.
 He possesses perfect knowledge of the choice of commodities open to him and his choices are
certain.
 They know the exact prices of various commodities and their utilities are not influencing by
variations in their prices.
There are no substitutes.
 Features of utility

The utility analysis has the following main features;

 Subjective.

 Relative.

 Usefulness, and.

 Morality.
 Types of utility

Utility is of two types:

 Total Utility

 Marginal Utility
 Total Utility

• Sum of utility derived by consumer from multiple units consumed

• at a point or over a period of time

• Example: A consumer consumes 3 units of X and derives utility u1, u2, u3 and
u4

• Total Utility Ux= u1 + u2 + u3

 Marginal Utility

 The change in total utility ( TU) derived from

• one additional unit of consumption ( X)

 MU = TU/ X
 Table : Total Utility (TU) and Marginal Utility (MU)

Icecreams Total Utility (TUx) Marginal Utility

consumed (MUx)
1 20 20

2 36 16

3 46 10

4 50 4

5 50 0

6 44 -6
Laws of Utility Part 1
 Law of Diminishing Marginal Utility

• “As the quantity consumed of a commodity goes on increasing, the utility

derived from each successive unit goes on diminishing, consumption of all

other commodities remaining the same” When the changes in

consumption are infinitely small, marginal utility is the derivative of total

utility.

• Initially formulated by a German economist H.H. Gossen and later

systematically formulated by Alfred Marshell

 Assumptions of the Law

The assumptions on which the law of diminishing marginal utility is formulated

are as follows:

 consumer acts rationally,

 there is cardinal measurement of utility,

 there is homogeneity of units,

 there is constancy of marginal utility of money,

 there is continuity in consumption,

 there is no change in fashion, habits and taste of consumer,

 there is no change in income and prices

Numerical example of the law

Icecreams Total Utility Marginal Utility (MUx)

consumed (TUx)
1 20 20

2 36 16

3 46 10

4 50 4

5 50 0

6 44 -6
Graphical Expa of the law
 Explanation of Example

• In Figure in the previous slide, units of ice-cream, are shown along the X-axis
and TU and MU are measured along the Y-axis. MU is positive and TU is
increasing till the 4th ice-cream. After consuming the 5th ice-cream, MU is zero
and TU is maximum.

• This point is known as the point of satiety or the stage of maximum

satisfaction. After consuming the 6th ice- cream, MU is negative (known as
disutility) and total utility starts diminishing.
 Explanation of Example

1st Icecream 2nd Icecream 3rd Icecream

4th Icecream 5th Icecream 6th Icecream

7th Icecream
Laws of Utility Part 2
 Law of Equimarginal Utility

 This law is based on the principle of obtaining maximum satisfaction

from a limited income.
 The law states that a consumer should spend his limited income on
different commodities in such a way that the last rupee spent on each
commodity yield him equal marginal utility in order to get maximum
satisfaction.
 Suppose there are different commodities like A, B, …, N. A consumer
will get the maximum satisfaction in the case of equilibrium i.e.,
MUA / PA = MUB / PB = … = MUN / PN
Where MU‟s are the marginal utilities for the commodities and P‟s are
the prices of the commodities.
 Assumptions of the Law

 There is no change in the price of the goods or services.

 The consumer has a fixed income.

 The marginal utility of money is constant.

 A consumer has perfect knowledge of utility.

 Consumer tries to have maximum satisfaction.

 The utility is measurable in cardinal terms.

 There are substitutes for goods.

 A consumer has many wants

 Limitations of the Law

There are some limitations to this law. They are

•The law is not applicable in case of knowledge. Reading books provides more knowledge

and has more utility.

•This law is not applicable in case of fashion and customs.

•This law is not applicable for very low income.

•There is no measurement of utility.

•Not all consumer care for variety.

•The law fails when there are no choices available for the good.

•The law fails in case of frequent price change.

 Importance of the Law

This law is helpful in the field of production. A producer has limited resources and tries to get

maximum profit.

This law is helpful in the field of exchange. The exchange is of anything like some goods,

wealth, trade, import, and export.

It is applicable to public finance.

The law is useful for workers in allocating the time between the work and rest.

It is useful in case of saving and spending.

It is useful to look for substitution in case of price rise.

Indifference Curve
Analysis
 Indifference Curve

 The concept of indifference curve was first developed by British economist Francis Ysidro
Edgeworth and was put into use by Italian economist Vilfredo Pareto during the early 20th
century.
 An indifference curve is a graph showing combination of two goods that give the consumer
equal satisfaction and utility.
 Each point on an indifference curve
 Indifference Curve

 The concept of indifference curve was first

Combination Good A Good B
developed by British economist Francis Ysidro
A 10 10
Edgeworth and was put into use by Italian
B 20 5
economist Vilfredo Pareto during the early 20th
century.
 An indifference curve is a graph showing
combination of two goods that give the
consumer equal satisfaction and utility.
 Each point on an indifference curve indicates
that an consumer is indifferent about the choces
he makes between two commodities as he
derives same utility from choices
 Assumptions of Indifference Curve

The indifference curve theory is based on some assumptions. These assumptions are –

 Two Commodities: It is assumed that the consumer has fixed amount of money, all of which is
to be spent only on two goods while prices of both goods are constant.

 Non Satiety: Satiety means full satisfaction. Indifference curve theory assume that the
consumer has hot yet reached the point of satiety. It implies that the consumer still has the will to
consume more of both the goods.

 Ordinal Utility: According to this theory, utility is a psychological phenomenon and thus it is
unquantifiable. However, the theory assumes that a consumer can express utility in terms of
rank. The consumer can do it by the basis of satisfaction yielded from each combination of
goods.
 Assumptions of Indifference Curve

 Diminishing Marginal Rate of Substitution: Marginal rate of substitution may be defined as the

amount of a commodity that a consumer is willing to trade off for another commodity, as long

as the second commodity provides the same level of utility as the first one.

 Rational Consumer: A consumer always behaves in a rational manner, i.e. a consumer always

aims to maximize his total satisfaction.

 Indifference Curve Schedule

It refers to a schedule that indicates different combinations of two commodities

which yield equal satisfaction.

Combination of Apples Oranges Utility derived

Apples and
Oranges
A 10 5 U
B 8 9 U
C 6 8 U
D 9 7 U
 Indifference Map

It refers to a set of indifference curve.

 Properties of
Indifference Curve
 Properties of Indifference curve

Indifference Curve is a locus of all such points which shows

different combination of two commodities which yield
equal satisfaction to the consumer, so that he is indifferent
to the particular combination he consumes. It has following
properties:
1.Indifference Curve Slope Downwards to Right: When a
consumer wants to have more of a commodity, he/she will
have to give up some of the other commodity, given that
the consumer remains on the same level of utility at
constant income. As a result, the indifference curve slopes
downward form left to right.
 Properties of Indifference curve

2. Indifference Curve is Convex to the Origin: They are

convex to the origin (bowed inward). This is equivalent
to saying that as the consumer substitutes commodity X
for commodity Y, the marginal rate of substitution
diminishes of X for Y along an indifference curve.

3. Indifference Curve Cannot Intersect Each Other: The

level of satisfaction of the consumer for any given
combination of two goods is same throughout the
curve, that‟s why indifference curve cannot intersect
each other.
 Properties of Indifference curve

4. Higher indifference curve represents higher

satisfaction: This means any combination of two goods
on the higher curve give higher level of satisfaction to
the consumer then the lower one.
Marginal rate of
substitution
 Marginal rate of Substitution (MRS)

 In economics, the marginal rate of substitution (MRS) is the amount of a good that a

consumer is willing to consume in relation to another good, as long as the new good is equally

satisfying.

 Marginal rates of substitution are graphed along an indifference curve which is usually

downward sloping and convex.

 The MRS is the slope of the indifference curve at any given point along the curve.
 Example of MRS

For example, a consumer must choose between Coke and hot dogs. In order to determine the
marginal rate of substitution, the consumer is asked what combinations of Coke and hot dogs
provide the same level of satisfaction.
When these combinations are graphed, the slope of the resulting line is negative. This means that
the consumer faces a diminishing marginal rate of substitution: the more Cokes they have
relative to hot dogs, the fewer hot dogs they are willing to consume.
 Limitations of Marginal Rate of Substitution

 The marginal rate of substitution limits only to two variables

 MRS does not necessarily examine marginal utility since it treats the utility of both

comparable goods equally though in actuality they may have varying utility.
Relationship Between MRS and Marginal Utility
Revealed Preference
Theory
 Revealed Preference theory of demand

• The revealed preference approach has been propounded by the American

Economists, Prof. Paul A. Samuelson in his article “Consumption Theory In Terms Of

Revealed Preference” in 1938.

• This theory relies on the market behaviour of the consumer to know about his

preferences with regard to the various combinations for the two reactions and

responses of the consumer.

 Assumptions of Revealed Preference theory of demand

 The consumer has only two combinations of commodities

 The income of the consumer, prices of the two commodities are constant during
the period of analysis

 The tastes of the consumer are given and remain unchanged during the period of

analysis

 The consumer should choose only one combination of the commodities in a given

price-income situation .

 Based on observed facts and ordinal utility analysis

 Assumptions of Revealed Preference theory of demand

 A consumer can be persuaded to buy more of a commodity if its price is subjected to

substantial cut

 The choice of the consumer reveals his preference and market behaviour of the consumer

 Consistency states strong ordering preference hypothesis of Samuelson

 Transitivity states that no two observations of choice behaviour can conflict with regard to an

individual consumer‟s preferences.

 Explanation of the theory

 When a consumer purchases some commodities either because, he likes them more than other

cheaper than other commodities

 There are two combinations of commodities; X and Y

 Consumer buys combination of X and not combination of Y

 Assuming that both the commodities are equally same cost and are equally good

 If the consumer buys X combination rather than Y commodity, because he like X combination

better and revealed preference took place

Explanation of the theory
 Merits of the theory

 More realistic

 More scientific

 More consistent

 Based on fewer assumptions

 Demand
Forecasting
and its need
 Demand Forecasting
Meaning of Demand Forecasting:
•Demand forecasting is the activity of estimating the quantity of a product or
service that consumers will purchase. Demand forecasting involves
techniques including both informal methods, such as educated guesses, and
quantitative methods, such as the use of historical sales data or current data
from test markets.

•Demand forecasting may be used in making pricing decisions, in assessing

future capacity requirements, or in making decisions on whether to enter a
new market.

•Demand forecasting is the process of making estimations about future

customer demand over a defined period, using historical data and other
information.
 Need of Demand Forecasting
•Sales forecasting helps with business planning, budgeting, and goal
setting. Once you have a good understanding of what your future sales
could look like, you can begin to develop an informed procurement
strategy to make sure your supply matches customer demand.

•It allows businesses to more effectively optimize inventory,

increase inventory turnover rates and reduce holding costs.

•It provides an insight into upcoming cash flow, meaning businesses can
more accurately budget to pay suppliers and other operational costs, and
invest in the growth of the business.
 Need of Demand Forecasting
•Through sales forecasting, you can also identify and rectify any kinks in
the sales pipeline ahead of time to ensure your business performance
remains robust throughout the entire period.

•When it comes to inventory management, most E-Commerce business

owners know all too well that too little or too much inventory can be
detrimental to operations.

•Anticipating demand means knowing when to increase staff and other

resources to keep operations running smoothly during peak periods.
Techniques of
Demand
Forecasting-
Qualitative
Techniques
 Techniques of Demand Forecasting
Qualitative Method

Quantitative Method

The qualitative method is when you forecast demand when there is no

prior data or sales numbers to work with by using the opinions of a group of
experts. This can be either via a focus group or the strategic use of surveys.
The data that you collect from your group of experts is then used to predict a
possible quantity of future demand.
 Qualitative methods of Demand Forecasting
Survey Methods: Survey methods help us in obtaining information about the future
purchase plans of potential buyers through collecting the opinions of experts or by
interviewing the consumers. These methods are extensively used in short run and
estimating the demand for new products. There are different approaches under
survey methods. They are:

1. Consumers interview method: Under this method, efforts are made to collect
the relevant information directly from the consumers with regard to their future
purchase plans.

a) Survey of buyer’s intentions or preferences: Under this method, consumer-

buyers are requested to indicate their preferences and willingness about particular
products. They are asked to reveal their ‘future purchase plans with respect to
specific items.
 Qualitative methods of Demand Forecasting

b) Direct Interview Method: Under this method, customers are directly

contacted and interviewed. Direct and simple questions are asked to them.

i. Complete enumeration method: Under this method, all potential

customers are interviewed in a particular city or a region.

ii. Sample survey method or the consumer panel method: Under this
method, different cross sections of customers that make up the bulk of the
market are carefully chosen. Only such consumers selected from the relevant
market through some sampling method are interviewed or surveyed.
 Qualitative methods of Demand Forecasting
Focus Groups: To use a focus group, you need to find a representative
group of your potential customers. You then sit them all down in a
comfortable group setting and talk with them. You find out what products they
currently use for cookie cutters, how satisfied they are with them, what
improvements they would like to see, how likely they are to purchase a new
product, and how much they would be willing to pay.
 Qualitative methods of Demand Forecasting
Collective opinion method or opinion survey method: Under this
method, sales representatives, professional experts and the market
consultants and others are asked to express their considered opinions
about the volume of sales expected in the future.

End Use or Input – Output Method: Under this method, the sale of the
product under consideration is projected on the basis of demand surveys of
the industries using the given product as an intermediate product.
 Qualitative methods of Demand Forecasting

Delphi Method or Experts Opinion Method: Under this method, outside experts
are appointed. They are supplied with all kinds of information and statistical data.
The management requests the experts to express their considered opinions and
views about the expected future sales of the company.
 Techniques of
Demand
Forecasting-
Quantitative
Techniques-Part 1
 Quantitative methods of Demand Forecasting
Quantitative Method: It is the second most popular method of demand
forecasting. It is the best available technique and most commonly used
method in recent years. Under this method, statistical, mathematical models,
equations etc are extensively used in order to estimate future demand of a
particular product. They are used for estimating long term demand. They are
highly complex and complicated in nature.
 Qualitative methods of Demand Forecasting
Trend Projection Method: An old firm operating in the market for a long
period will have the accumulated previous data on either production or
sales pertaining to different years. If we arrange them in chronological
order, we get what is called „time series This method is not based on any
particular theory as to what causes the variables to change but merely
assumes that whatever forces contributed to change in the recent past will
continue to have the same effect. On the basis of time series, it is possible
to project the future sales of a company.
 Qualitative methods of Demand Forecasting
Economic Indicators: Under this method, a few economic indicators
become the basis for forecasting the sales of a company. An economic
indicator indicates change in the magnitude of an economic variable. It
gives the signal about the direction of change in an economic variable. This
helps in decision making process of a company
 Qualitative methods of Demand Forecasting
Causal Demand Forecasting Method: This method is used to produce a
demand forecasting models based on the existence of a substantial cause
and effect relationship between explanatory variables (i.e., independent
variables) and the demand variable itself (i.e., dependent variable)
(Armstrong and Green 2012). Depending on the depth of knowledge of the
variables affecting the situation of interest (i.e., demand) and availability of
data, causal methods may have the following branches: regression
analysis, the index method, and segmentation (Armstrong and Green
2012).
 Qualitative methods of Demand Forecasting
Advantages of Causal Forecasting
Possess explanatory powers.
Allows for the execution of if forecasting by exploring the interaction
among demand variables.
Acts as a valuable tool for planners, marketers, and strategists.
Allows the forecasting of the effect of policy changes such as price
changes and promotions.
 Quantitative methods of Demand Forecasting
Time Series Demand Forecasting Method:
For this method to work, the variable to undergo forecast must have
consistently shown specific unique patterns in a past time horizon and that this
identified pattern will be sustained into the future (Anonymous 2011; Brockwell &
Davis 1986). These patterns can either be cyclical, seasonal or periodic (Taylor
2008).

Time series collected at regular intervals are then used to produce models. The
time series method is most applicable when there is a lack of a distinct upward or
downward pattern in the historical data being explored, showing an absence of a
linear relationship between demand and time (Armstrong and Green 2012).

Moving Average, Exponential smoothing, and Trend projections are all offshoots
of the Time Series method of demand forecasting.
 Qualitative methods of Demand Forecasting
Time series models: The model assumes that the information needed to
generate a forecast is included in time series of data. A time series here, is
a set of observations taken at regular intervals over a specified period of
time. Different techniques which are based on this model are:

•Naive Forecast: Uses last period's actual demand value as the forecast
for current period.

•Simple Mean Forecast: Simply sums up the demand values and finds the
mean. The mean value is taken as the forecast for the next period.
 Qualitative methods of Demand Forecasting
•Simple Moving Average Forecast: Finds the mean but, considers only
specified time period. For ex: 3 months moving average will find the mean
of the recent 3 months data for the forecast.

•Weighted Moving Average: Assigns weightage to the recent data to

ensure accuracy. Calculates mean as usual.

•Exponential Smoothing: It provides an excellent forecast result for short

term. It is a weighted average procedure with weights declining
exponentially as the data gets older.
 Qualitative methods of Demand Forecasting
•Trend adjusted Exponential Smoothing: It uses the exponential
smoothing model but, there are 2 seperate equations to generate the
forecast. One is for Trend correction and other, the usual smoothing
equation.
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