UTILITY ANALYSIS AND DEMAND CURVE

MODULE 11

People demand goods and services because they satisfy the wants of the people. This want satisfying
power of a commodity or service is called utility. It is the want satisfying quality of a good. It in a sense, is a
measure of worthiness. The economic theory assumes that people do things if it provides them utility I.e., if they
find it worth doing. The consumer derives satisfaction of wants and needs from the use of goods. To that extent,
utility can also be viewed as the quality of being useful. The meaning of utility and usefulness or even pleasure
are so close that many a time these terms may used interchangeably in economics. They reflect the extent to which
the goods produced from limited resources can fulfill the unlimited wants. Utility is different from usefulness and
pleasure. A good may satisfy human want but it may not be useful or may not give any pleasure.

Utility of good changes with a change in conditions and circumstances. There are three forms of utility- form
utility, place utility, and time utility.

Consumers demand a commodity because they derive utility from the consumption of that commodity. Uitlity is
the want the satisfying quality of a good or service.It can be expressed in two ways(1) from the consumer angle
(2) from the product angle.

Product angle utility is the want satisfying property of a commodity.

Consumer angle it is the psychological feeling of satisfaction, pleasure, happiness or well being which a
consumer derives from the consumption, possession and use of commodity.

Utility in the sense of satisfaction is dependent on personnel taste and views subjective because

1. A commodity need not be useful for all.eg: drugs.

2. Utility of a commodity varies from person to person and from time to time.

3. A commodity need not have the same utility for the same consumer at different points of time.

Consumer’s Equilibrium

A situation where a consumer spends his given income purchasing one or more commodities so that he gets
maximum satisfaction and has no urge to change this level of consumption, given the prices of commodities, is
known as the consumer’s equilibrium.

A consumer is said to be in an equilibrium state when he feels that he cannot change his situation either by earning
more or by spending more or by changing the number of things he buys. A rational consumer will purchase a
commodity up to the point where the price of the commodity is equivalent to the marginal utility obtained from
the thing.

Importance of Consumer Equilibrium

It enables consumers to maximize his/her utility from the consumption of one or more commodities.

It helps the consumers to arrange the combination of two or more products based on consumer taste and preference
for maximum utility.

There are two main approaches to study consumer’s equilibrium. They are as follows:

1. Cardinal utility approach (or Marshall’s utility analysis)

2. Ordinal utility approach (or indifference curve analysis)

CARDINAL UTILITY APPROACH

The theory of consumers behaviour by using utility approach was first given by the noted economist Alfred
Marshall.Before discussing how a consumer attains equilibrium , we need to understand the concept of utility,
marginal utility and total utility.

UTILITY

Utility refers to want satisfying power of a commodity. It is the satisfaction, actual or expected, derived from the
consumption of a commodity. Utility differs from person- to-person, place-to- place and time-to-time. In the
words of Prof. Hobson, “Utility is the ability of a good to satisfy a want”.In short, when a commodity is capable
of satisfying human wants, we can conclude that the commodity has utility.

How to Measure Utility

After understanding the meaning of utility, the next big question is: How to measure utility?

1. Cardinal Utility

According to classical economists, utility can be measured, in the same way, as weight or height is measured. For
this, economists assumed that utility can be measured in cardinal (numerical) terms. By using cardinal measure
of utility, it is possible to numerically estimate utility, which a person derives from consumption of goods and
services. But, there was no standard unit for measuring utility. So, the economists derived an imaginary measure,
known as „Util‟.Utils are imaginary and psychological units which are used to measure satisfaction (utility)
obtained from consumption of a certain quantity of a commodity. One util is equal to one unit of money.
2. Ordinal Utility

Modern economist holds the view that utility is not quantitatively measurable. Utility can be expressed only
ordinally or in terms of less the or more than. It is therefore possible to list the goods and service in order of their
preferability or desirability.

For example, suppose a person prefers chocolate to icecream and ice cream to cold drinks.the consumer can
express the preference as chocolate>ice cream>cold drink. The preference cannot be expressed in quantitative
terms. This is known as the ordinal concepts of utility

Total Utility (TU):

Total utility refers to the total satisfaction obtained from the consumption of all possible units of a commodity. It
measures the total satisfaction obtained from consumption of all the units of that good. For example, if the 1st
ice-cream gives you a satisfaction of 20 utils and 2ndone gives 16 utils, then TU from 2 ice-creams is 20 + 16 =
36 utils. If the 3rd ice-cream generates satisfaction of 10 utils, then TU from 3 ice-creams will be 20+ 16 + 10 =
46 utils.

TU can be calculated as:

TUn = U1 + U2 + U3 + + Un

Where: TUn = Total utility from n units of a given commodity

U1, U2, U3,…Un = Utility from the 1st, 2nd, 3rd nth unit

n = Number of units consumed

Marginal Utility (MU):

Marginal utility is the additional utility derived from the consumption of one more unit of the given
commodity. It is the utility derived from the last unit of a commodity purchased. As per given
example, when 3rd ice-cream is consumed, TU increases from 36 utils to 46 utils. The additional
10 utils from the 3rd ice-cream is the MU.

In the words of Chapman, “Marginal utility is addition made to total utility by consuming one
more unit of a commodity”.

MU can be calculated as: MUn = TUn – TUn-1

Where: MUn = Marginal utility from nth unit; TUn = Total utility from n units;
TUn-1 = Total utility from n – 1 units; n = Number of units of consumption

MU of 3rd ice-cream will be: MU3 = TU3 – TU2 = 46 – 36 = 10 utils

One More way to Calculate MU

MU is the change in TU when one more unit is consumed. However, when change in units
consumed is more than one, then MU can also be calculated as

ATU

MU = Change in Total Utility/ Change in number of units = ∆TU/∆Q Total Utility is Summation
of Marginal Utilities:

Total utility can also be calculated as the sum of marginal utilities from all units, i.e.

TUn= MU1 + MU2 + MU3 + + MUn or simply,

TU = ∑MU

The concepts of TU and MU can be better understood from the following schedule and diagram:
TU and MU

Ice- Marginal Total

creams Utility Utility
Consumed(MU) (TU)

1 20 20

2 16 36

3 10 46

4 4 50

5 0 50

6 -6 44
Law of Diminishing Marginal Utility:

The law of dimininshing marginal utility is one of the fundamental laws of economics. This law
states that as the quantity consumed of a commodity goes on increasing, the utility derived from
each successive units goes on dimininshing, consumption of all the other commodities remaining
the same.

If a person consumes more units of the same commodity, he will get less and less satisfaction from
the additional units. That is the utility y form each additional unit goes on diminishing. The
consumer will be ready to buy the additional unit only if it is available at a lower price.

In law of diminishing marginal utility when a person consumes more and more units of the same
commodity the satisfaction derives from the each additional unit will be less and less/ When a
person enjoys the first unit of a commodity the satisfaction derived from that unit will be very high.
If he enjoys a second unit of the same commodity the satisfaction that he derives from the second
unit will be only less than the first unit. He will be ready to buy second unit only at lesser price. If
he goes on consuming more and more units of the same commodity he will come to appoint when
further units will not give him any satisfaction at all. The rate of decrease may vary in the case of
different commodities. This general tendency is known as law of diminishing marginal utility.

For eg: A thirsty man enjoys a glass of water. The first glass of water gives him greater satisfaction
than the 2nd glass. If he take the third glass the satisfaction will be less .With every additional
glass the satisfaction is goes on decreasing till it become zero.

Limitations:

It is assumed that a commodity is taken in standard units. If the units are too small or
insufficient , the utility will at first increase instead of decreasing

The commodity is consumed continuously. There should not be any gap between
consumption of various units.

The consumer taste and habits remain unchanged.

This law does not applicable for rare collection.

In Fig. 2.1, 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.
Disutility is the opposite of utility. It refers to loss of satisfaction due to consumption of too much
of a thing.

CONSUMER’S EQUILIBRIUM IN CASE OF A SINGLE COMMODITY

Consumer’s equilibrium in case of a single commodity can be explained on the basis of the law of
diminishing marginal utility. How does a consumer decide as to how much to buy of a good? It
will depend upon two factors.

(a) The price she pays for each unit which is given and

(b) The utility she gets

At the time of purchasing a unit of a commodity, a consumer compares the price of the given
commodity with its utility. The consumer will be at equilibrium when marginal utility (in terms of
money) equals the price paid for the commodity say ‘X’ i.e. MUx = PX. (Note that marginal utility
in terms of money is obtained by dividing marginal utility in utils by marginal utility of one rupee).

If MUX > Px, the consumer goes on buying the commodity because she is paying less for each
additional amount of satisfaction. As she buys more, MU falls due to operation of law of
diminishing marginal utility. When MU becomes equal to price, consumer gets maximum
satisfaction and now she is at equilibrium. When MUX< Px, the consumer will have to reduce
consumption of the commodity to raise his total satisfaction till MU becomes equal to price. This
is because she is paying more than the additional amount of satisfaction that she is getting.

Consumer’s equilibrium (in case of single commodity) can be explained with the help of table
Suppose, the consumer wants to buy a good which is priced at.10 per unit. Further, suppose, MU
obtained from each successive unit is determined. Assumed that 1 util = Re. 1.

Consumer’s Equilibrium (in case of a single commodity)

It is clear from the table that the consumer will be at equilibrium when he buys 3 units of the
commodity X. He will increase consumption beyond 2 units as MUx> Px. He will not consume 4
units or more of the commodity X as MUx < Px.

CONSUMER’S EQUILIBRIUM IN CASE OF TWO OR MORE COMMODITIES

The law of diminishing marginal utility applies in case of one commodity only. But in real life a
consumer normally consumes more than one commodity. In such a situation, law of equi-marginal
utility helps in optimum allocation of his income. Law of equi-marginal utility is based on law of
diminishing marginal utility. According to the law of equi-marginal utility a consumer will be in
equilibrium when the ratio of marginal utility of a commodity to its price equals the ratio of
marginal utility of other commodity to its price.

Let a consumer buys two goods X and Y. Then at equilibrium

Similarly, if there are three goods X, Y, Z then the condition of equilibrium will besimply MU
Money.

Thus, to be in equilibrium

1.Marginal utility of the last rupee of expenditure on each good is the same.

2.Marginal utility of a good falls as more of it is consumed.

To explain the consumer’s equilibrium in thecase of two goods let us take an example. Suppose a
consumer has `24 with him to spend on two goods X and Y. Further, suppose the price of
each unit of X is `2 and that of Y is `3, and his marginal utilityschedule is given in table 14.3.

Units MU MUX/Px MU MUY/PY

X (A Rupee worth) Y (A Rupee worth)
of MU of MU

1 20 20/2 = 10 24 24/3 = 8

2 18 18/2=9 21 21/3=7
3 16 16/2 = 8 18 18/3=6

4 14 14/2 = 7 15 15/3 = 5
5 12 12/2 = 6 12 12/3 = 4

6 10 10/2=5 9 9/3=3
ORDINAL UTILITY APPROACH (INDIFFERENCE CURVE ANALYSIS)

An indifference curve may be defined as the locus of point each representing a different
ocombinations of two substitute goods, which yield the same utility or level of satisfaction to the
consumer. Therefore he is indifeernet between any two combinations of two goods when it comes
to making a choice between them. The graphical representation of such combinations is termed as
indifference curve

Combinations Good X Good Y Marginal Rate of Substitution

(Units) (Units) (Y/X)
A 1 8 –
B 2 4 4Y: 1X
C 3 2 2Y: 1X
D 4 1 1Y : 1X

Combinations A, B, C and D of good X and Y viz. (1X + 8Y), (2X + 4Y),(3X +2Y) and (4X +
1Y) give the consumer equal satisfaction. In other words, consumer is indifferent between these
combinations of good X and good Y. When these combinations are represented graphically,
we get an indifference curve as shownin Fig.

Good Y

8 A

7
6
5
B
4
3
C
2
D
1
IC
0 1 2 3 4 Good X
Indifference Map

An indifference map is a collection of indifference curves that represent different levels of

satisfaction. Higher indifference curves represent higher level of satisfaction because higher
indifference curves represent more quantities of both the goods or same quantity of one good and
more quantity of other good.

Good Y

IC3
IC2
IC1
0 Good X

An indifference map containing three indifference curves IC1, IC2 and IC3, is drawn in Fig. 14.3.
All the bundles on IC2 give more satisfaction to the consumer in comparison to IC1. Similarly, the
bundles on IC3 give more satisfaction to the consumer in comparison to IC1 and IC2. This is a
result of monotonic preferences.

Budget Line

A budget line graphically represents all possible combinations of two goods which a consumer can
buy with his entire income at the prevailing market prices. Anywhere on the budget line consumer
is spending his entire income either on single or both the goods.
 Y

Quantity of good Y
3

O X
1 2 3 B
Quantity of Good X

PROPERTIES OF INDIFFERENCE CURVES

(i) Indifference Curves are always convex to the origin

Indifference curves are always convex to the origin because of diminishing marginal rate of
substitution. As the consumer consumes more and more of one good, his marginal utility of this
good keeps on declining and he is willing to give up less of other good. Therefore, indifference
curves are convex to the origin.

(ii) Indifference Curves slope downwards

It implies that as a consumer consumes more of one good, he must consume less quantity of the
other good so that the total utility remains the same.

(iii) Higher Indifference Curves represent Higher level of satisfaction

(iv) Indifference Curves can never Intersect

Effect of income in Consumer equilibrium

An increase in money income shifts the budget line upward and to the right, and the movement is
a parallel shift because nominal prices are assumed to be constant. Changes in consumer’s income
lead to changes in his capacity to buy goods and services, other things remaining constant. These
changes are depicted by a parallel upward or downward shift in the consumer’s budget line.

The effect of changes in income on the consumption of different kinds of commodities is different.
It can be positive, negative or even neutral. Infect the nature of a commodity determines whether
the effect is positive or negative. The income-effect is positive in case of normal goods and
negative in case of inferior goods.

An inferior good is one for which the quantity demanded varies inversely with income- increases
in income reduce the quantity demanded and decreases in income increase the quantity demanded
of inferior goods

Effects of Changes in Prices:

When the price of a commodity changes the slope of the budget line of the consumer shifts. The
equilibrium of the consumer is also disturbed. A rational consumer, with a view to maximize his
satisfaction, tries to adjust his consumption basket. When, the price of a commodity changes, the
consumer alters his purchases. A change in the quantity demanded of a commodity due to a change
in its price is called the Price-effect.

The price- effect may be defined as the total change in the quantity consumed of a commodity due
to a change in its price.

Substitution Effect

A nominal price of a good causes a change in real income, or in the size of the bundle of goods
and services a consumer can buy. If the nominal price of one good falls, money income and other
nominal prices remaining constant, real income rises because the consumer can now buy more,
either of the good whose price declined or the other goods. This change in real income leads to an
income effect on quantity demanded.
DEMAND

“Demand implies a desire for a commodity backed up by the ability and willingness to pay for it”.
The desire without adequate purchasing power and willingness to pay do not affect the market, nor
do they generate production activity. a want with three attributes – desire to buy, willingness to
pay and ability to pay- become effective demand

A meaningful statement regarding the demand for a commodity should therefore contain the
following information:

A) The quantity demanded of a commodity

B) The price at which quantity is demanded
C) The time period over which a commodity is demanded
D) The market area in which a commodity is demanded

Types of Demand:

Individual Demand and Market Demand:

The quantity if commodity the an individual demand at particular price during a specific
period is individual demand.

Market demand is the total quantity that all the consumers buy at particular price during a
specific period. It is the sum total of individual demand.

Demand for consumer goods and producers goods:

Consumer goods are meant for final consumption. The demand for consumer goods is
known as direct demand; fro they are used directly for final consumption.

Producers goods are those used for production of other goods.The demand for producers
goods is a derived demand, as the demand of the same depend for consumer goods.

Demand for Perishable goods and Durable goods:

Durable goods are those that cn be used more than one. The utility is not destroyed by
single use. It can be used repeatedly for continuously over a period of time. Durable goods can be
classified into producer‟s durable goods and consumer durable goods.
 Perishable goods are meant to meet current demand its demand depends on current
conditions. Demand for perishable goods is subject to frequent change. Demand of durable
goods is influenced by expected price, income and change in technology. Demand for
durable goods change over a relatively longer period.

Derived Demand and Autonomous Demand:

The demand for a commodity that arises because of the demand for some of the commodity

called parent product is called derived demand.

Autonomous demand or direct demand for a commodity is one that arises on its won out
of a natural desire to consume or posses a commodity. It is independent of the demand for
any other commodity.

Industry demand and company demand:

Company demand denotes the demand for the product of a particular firm or company.

Industry demand means the demand for the product of a particular industry.

The Law of Demand:

The law of demand can be stated as all other things remaining constant, the quantity
demanded of a commodity increases when its price decreases and decreases when its price
increases. This law implies that demand and price are inversely related. This law holds under
‘ceteris paribus’ assumption that is all other things remaining unchanged

Demand has no meaning unless it is sated in terms of price. Demand always calculated at
a price. It always reveals how much of a commodity is purchased at a given price . Different
quantities are demanded at different prices. A person demand more at a lower price and less at a
higher price. The relation of price and demand in economics is Known as Law of Demand.

The law of demand states that higher the price lowers the demand and lower the price
higher the demand and other things remains the same. Even when the price remains unchanged a
change in other things like fashion, season, custom,population customer taste and income ect may
result in change in demand.
Demand Schedule:

A demand schedule is a tabular representation of different prices of a commodity and its

corresponding commodities demanded per unit of time

The law of demand establishes a relation between the price and quantity demanded. The price and
quantity relation can be arithmetically represented in a form of table showing different prices and
corresponding quantities demanded. This table is known as demand schedule.

Price of Oranges per Kg(in Rs) Kg of Oranges Demanded

80 2
60 3
50 4
30 5
20 8

Demand Curve

The law of demand or the price –quantity relation can also be shown by means of a chart known
as „Demand curve‟.Demnad curve is a graphical presentation of demand schedule. The demand
curve “DD‟” slopes downward from left to right. The downward slope of the demand curve shows
that more is demanded at lower prices. The curve shows that if the price is reduced from Rs.80 to
Rs 60 the quantity of oranges demanded from 2 to 3.If the price is reduced from Rs.50 to 30 the
quantity of oranges demanded will increase from 3 to 5.
Why the demands Curve slope downwards?

Income effect: A fall in price result in an increase in income of the consumer. As price
falls he can buy the same quantity as before with less amount of money. Thus he gains some money,
apart of which can be used for purchasing some more units of the same commodity. This result in
an increase in demand for that commodity. When the price rises the consumers disposable income
is reduced . This cause a fall in the purchasing power of the consumer. Now he can buy only lesser
quantity with the same amount. Hence a decrease in demand of that commodity.

Substitution Effect: When the price of a commodity raises the consumer may substitute
that relatively costly commodity with less costly one.

Diminishing Marginal Utility: If a person consumes more and more units of the same
commodity, he will get less satisfaction from the additional units the utility from each additional
unit goes on diminishing.

Consumers Expectations: If consumers expect changes in supply conditions or in prices,

the demand for the commodity will also change. If consumers anticipate a rise in price of a
commodity at the current price so that they can avoid an increase in price future.

Population of the country: The demand for a product depends on the number of
consumers .A change in the size of population affects demand. An increase in population increases
the demand of certain goods.

Consumers taste and preferences: Consumers taste and preferences are important factors
determining the demand for a product. The demand a commodity changes with the taste and
preferences of consumer change.

Assumptions:

There is no change in the income of the consumers.

There are no changes in the tastes, habits and preferences of consumers.

There is no change in fashion.

The prices of related goods like substitutes and complementary goods remain unchanged.

There is no expectation of a future change in price.

 A future shortage in supply is not expected

No innovations or no new, better substitute products in the market.

The number of consumers remains the same.

Exceptions to the Law of Demand

The demand curve slope downwards to the left. But sometimes the demand curve, instead of
sloping downward, will rise upwards. Sometimes people will buy more when the price rises. This
can be represented only by a rising demand curve. Such cases are very rare, but we can imagine
some.These were first investigated by Sir Robert Giffen .The Giffen Paradox holds that the
demand is strengthened with a rise or weakened with a fall in price .The reason for this is as follows

1. Expectations of further price rise in future: When consumers expect a continuous increase
in the price of durable commodity, they buy more of it despite the increase in its price with a view
to avoiding the pinch of a much higher price in future and vice versa.

2. Status goods: The law of demand does not apply to the commodities which are used as
status symbol or for enhancing social prestige or for displaying wealth and riches eg gold,precious
stones etc.

3. Giffen goods: A giffen good is defined as an inferior good whose demand increases when
its price increases. There are several inferior commodities consumed by the poor households as an
essential commodity. If the price of such goods increases, its demand increases instead of
decreasing because, in case of a Giffen good, income effect of a price rise is greater than its
substitution effect. The reason is when price of an inferior goods increases, income remaining the
same, people cut the consumption of the superior substitutes so that they are able to buy sufficient
quantity of the inferior good to meet their basic need.

Determinants of Demand.

The various factors that determine the demand for a commodity are as follows.

1. Price of the product

2. Consumers Income

3. Price of related goods

4. Consumers tastes and preferences

5. Consumers expectations

6. Population of the country

7. Consumer credit facility

8. Distribution of National Income

9. Demonstration effect

10. Advertisement Expenditure

Shift in Demand:

Increase or decrease in demand:

The demand of a product depends not only on its price but also on many factors like consumer‟s
income, their tastes and preferences, price of the substitute etc.An increase or decrease in demand
due to any of the factors other than price is known as shift in demand. A change in demand shifts
the demand curve either upwards or downwards.

Extension and contraction in demand:

The change in demand due to change in price when other factors remain constant is known as
extension and contraction of demand.

Contraction of demand means decline in demand due to a price in price and an extension of demand
means an increase in demand due to fall in price.

When the price of a product falls the quantity demanded increases this is called extension of
demand. When the price of a product rises the quantity demanded decreases. This is called
contraction in demand
ELASTICITY OF DEMAND

It is Alfred Marshall who introduced the concept of elasticity of demand in economic analysis for
the first time. Demand for any commodity is said to be elastic or sensitive when a rise or fall in
the price causes a marked fall or rise in the amount demanded. Demand is said to be inelastic or
unresponsive, when a rise of fall in price causes relatively little fall or rise in the amount demanded.

Elasticity of demand primarily refers to the demand price relation. Elasticity of demand in broader
terms ,speaks of the extent of relationship or the degree of responsiveness of demand to the change
in its various determinants. Demand elasticity is the percentage increase in sale that accompanies
one percentage increase in any demand determinants.

Types

Price elasticity

Income elasticity

Cross elasticity

Advertising elasticity.

 Price Elasticity:

It is generally referred to as elasticity of demand. It is the change in quantity demanded on account

of a change in price. The rate at which the demand for a commodity changes in relation to its
change in price is known as the elasticity of demand. It may be defined as the responsiveness of
demand to a change in the price of a commodity. Price elasticity measures the degree at which
demand response to price.
ep = % change in quantity demanded ÷ % change in price

There are three methods to measure price elasticity of a demand

1) Algebraic or percentage methods

2) Arithmetic or total outlay method
3) Geometric method
1. Algebraic or percentage method:
There are two methods to measure price elasticity
a) Point elasticity:
This is the elasticity of a particular point on a demand curve
ep = -(dQ/dP X P/Q)
b) Arc elasticity:
This is the average elastic over a segment of the demand curve. This is usually
used when there is substantial change in price of the product
ep= -(dQ/dP) X (P1+P2)/(Q1+Q2)
2. Arithmetic or total outlay method:
 Perfectly elastic demand: If a very small fall in price leads to an unlimited increase
in demand. The elasticity of demand is infinity.
 Perfectly inelastic demand: Whether the price falls or rises there is no change in
demand.Demnad is non-responsive to price changes, indicating that the demand is
perfectly inelastic. The elasticity of demand is zero.
 Unit elasticity: When a change in price brings about an equal and proportionate
change in demand. The elasticity of demand is equal to one.
 Relatively elastic demand: A small change in price causes a more than
proportionate change in the quantity demanded. The elasticity of demand is greater
than one.
 Relatively inelastic demand: When a change in the price of a commodity produce
a less than proportionate change in quantity demanded. The elasticity of demand is
less than one.
 3. Geometric method:
Elasticity at any point on a straight line demand curve can be measured by the geometric
principle
Ep= lower segment / upper segment

 Income elasticity

It refers to the change in demand due to the change in the income of a buyer. It measures the
responsiveness of demand for a commodity to a change in consumer‟s income. Income elastic for
superior goods is positive and that for inferior goods is negative. Income elasticity is generally
higher for durable goods than for non-durable goods.

ei = % change in the quantity demanded ÷ % change in income

Types of Income Elasticity

 Zero Income Elasticity: Here change in income does not change demand of a product. The
change in income does not affect the demand.
 Negative Income Elasticity: An increase in the income of the consumer causes a decrease
in the quantities demanded by him. These types of goods are called inferior goods .
 Positive Income Elasticity: An increase in income results an increase in demand. Demand
for superior goods increases when income increases.

Measurement of income elasticity

Point elasticity

ey = -(dQ/dY) X (Y/Q)

Arc elasticity

ey = -(dQ/dY) X (Y1+Y2/Q1+Q2)

Uses of Income Elasticity concept.

Demand Forecasting

Product line planning

Advertisement planning

Planning production according to business cycle

 Advertisement Elasticity

It is otherwise called promotional elasticity. It is defined as the ratio of a proportionate change in

the volume of sales to a proportionate change in the selling cost. It measures the responsiveness of
demand to change in advertisement. Advertisement elasticity is always positive

ea = % change in sales ÷ % change in advertisement expenditure

Point elasticity

ea = (dS/dA) X (A/S)
 Arc elasticity

ea = -(dS/dA) X (A1+A2/S1+S2)

Determinant of Adverstiment elasticity

Level of the total sales

Effectiveness of competing firms advertisements

Cumulative effect of past advertisements

Other factors affecting demand

 Cross Elasticity

It can be defined as the percentage change in the demand for one good X,in relation to the
percentage change in the price of another good Y.

ec = % Change in demand for tea ÷ % change in price of coffee

Point elasticity

ec = (dQa/dPb) X (Pb/Qa)

Arc elasticity

ec = -(dQa/dPb) X (Pb1+Pb2/Qa1+Qa2)

Uses of Cross elasticity

Decisions regarding price changes

Estimating the effect of competitors pricing decisions

Fluctuation in price of substitutes and complements

DEMAND FORECASTING:

Demand forecasting helps to assess future demand and to plan production accordingly. A forecast
is an estimate of a future situation. Forecast of demand is an estimation of the future level of
demand. It is necessary to take steps for the acquisition of the various factors of production like
raw materials, labor, capital land ,building etc at the right time.

Demand forecasting may be done at macro level, industry level, and firm level .Macro level
forecasting deals with the business conditions prevailing in the entire economy. Industry level
forecast is made by various trade association and is made available to its members. Firm level
forecast helps the manager very much in his decisions. Demand forecasting necessitates an
analysis of past trends and present economic conditions. This analysis helps to make inferences
about the future. An analysis of the past trends brings to light the various factors that affected the
business.

Forecasting may be done for a short period or for a long period. Short run forecasting may be for
2 months or even one year. It is concerned with the day to day working of the business. The long
run forecasting may be for a period ranging from 5 to 20 years. The period depends on the nature
of the business.

Short term demand forecasting may be used for the following purpose.

To evolve a suitable production policy

To reduce the cost of purchase

To determine appropriate price policy

To set sales targets and establish control

To forecast short term financial requirements.

Long term demand forecasting used for the following purpose

Planning of a new unit or expansion of an existing unit

Planning of long term financial requirements

Planning of man power requirements Forecasting demand for new products

Forecasting demand for new products is very important for two reasons.

Diversification of existing business means introduction of new products

When an existing products dies the company goes in for new products

Essential of good forecasting methods

Accuracy

Plausibility

Durability

Flexibility

Availability

Economy