User talk:Ali Khan

QNO1:

DEFINE UTILITY. EXPLAIN THE RELATIONSHIP BETWEEN TOTAL UTILITY AND MARGINAL UTILITY WITH THE HELP OF SCHEDULE AND DIAGRAM.

CONCEPT OF UTILITY

                                William Stanley Jevon the great neoclassical economist from (1835-1882) first introduced the concept of utility. He says (jevon)”utility” is the basic on which the demand of an individual for a commodity depends.

Utility

Utility is defined as the power of a commodity or service to satisfy human want. Therefore we can say that utility is that satisfaction which is derived from the consumption of the commodity. For instance, water has utility for us because we drink it. Paper has utility for us because we write on it. The nature of utility is subjective. It varies from person to person. What do we mean by utility? In a word utility, utility means satisfaction. More precisely, it refers to how consumers rank different goods and services. If basket A has higher utility then basket B for Saaid, this ranking indicates that Saaid prefers A to B, often. It is convenient to think of utility as the subjective pleasure or usefulness that a person derives from consuming a good or service. But you should definitely resist the idea that utility is a physiological function or feeling that can be observed or measured. Rather utility is a scientific construct that economist use to understand how rational consumers divide their limited. resources among the commodities that provide them with satisfaction. In theory of demand, we say that people maximize their utility, which means that they choose the bundle of consumption goods that they most prefer.

MARGINAL UTILITY: - Marginal utilities mean an additional or incremental utility. Marginal utility is the change in total utility that results from in one unit change in consumption of commodity with in a given period time. For example, when a person increases the consumption of eggs from one egg to two eggs, the total utility increases from 30 utils to 45 utils. The marginal utility here would be 15 utils of the 2nd egg consumed. Marginal utility thus, can also be described as the difference between total utility derived from one level of consumption and total utility derived from another level consumption. In general Mu = TU Q

It may be noted that as a person consumes more and more units of a commodity, the marginal utility of the additional units beings to diminish but the total utility goes on increasing at a diminishing rate. When the marginal utility comes to zero or we say the point to satiety is reached, the total utility is the maximum. If consumption is increased further from this point of satiety, the marginal utility becomes negative and the total utility beings to diminish. The relationship between total utility and marginal utility is now explained with the help of following schedule and a graph. Schedule showing total utility and marginal utility.

The above table shows that when a person consumer no apples, he gets no satisfaction. His total utility is zero. In case he consumes one apple a day, he gains seven utils of satisfaction. His total utility is 7 and his marginal utility is also 7. In case he consumes second apple, he gains an extra 4 utils (MU). Thus giving him a total utility of 11 utils from two apples. His marginal utility has gone down from 7 utils to 4 utils because he has a less craving for the second apple. Some is the case with the consumption of third apple. The marginal utility has now fallen to 2 utils while the total utility of three apples has increase to 13 utils (7+4+2). In case the consumer takes fifth apple, his marginal utility falls to zero urils and if he consumes sixth apple also, the marginal utility is reduced to negative (13-14 = -1). It is –1 utils. The table showing total utility and marginal utility is plotted in figure below:

                       Graphical Representation of Schedule

Apples consumed per day

1) The total utility curve starts at the origin, as zero consumption of apples yields zero utility. 2) The TU reaches at its maximum or a peak of M when MU is zero. 3) The MU curve falls throughout the graph. A special point occurs when the consumer consumes fifth apple. He gains no marginal utility from it. After this point, marginal utility becomes negative. 4) The MU curve can be derived from the total utility curve. It is the slope of the line joining two adjacent quantities on the curve. For example, the marginal utility of the third apple is the slope of line joining point a and b. the slope of such a line is given by the formula MU = TU . Here MU = 2

Q # 2 Explain Gossin,s 1st and 2nd law of utility with the help of schedule and

          diagram. Also write the importance of Gossin,s laws?

Gossin,s 1st Law:- Mr. H. Gossen, a German economist, was the first to explain this law in 1854. Alfred marshal later on restated this law in the following words: “ the additional benefit which a person derives from an increase of his stock of a thing diminishes with every increase in the stock that he already has”. The basis of the law is a fundamental feature of wants. It states that when people go the market for the purchase of commodities, they do not attach equal importance to all the commodities, which they buy. In case of some of commodities, they are willing to pay more and in some less. There are two main reasons for this difference in demand. (1) The liking of the consumer for the commodity and (2) the quantity of the commodity which the consumer has with himself. The more one has of a thing, the less he wants the additional units of it. In other words, the marginal utility of a commodity diminishes as the consumer gets larger quantities of it. This, in brief, is the axiom of law of diminishing marginal utility.

The following table and graph will make the law of diminishing marginal utility more clear.

From the following table, it is clear that is given span of time, the first glass of water of a thirsty man gives 20 units of utility. When he takes second glass of water, the marginal utility goes down to 12 units; when he consumes fifth glass of water, the marginal utility drops down to zero and if the consumption of water is forced further from this point, the utility changes into dis utility (-3).

Here it may be noted that the utility of the successive units consumed diminishes not because they are of inferior in quality than that of others. We assume that all the units of a commodity consumed are exactly alike. The utility of the successive units falls simply because they happen to be consumed afterwards.

A diagram can also represent the law of diminishing utility.

                    20		M           Initial Utility

                      8					Diminishing MU Curve

                     4
                     						  Zero MU

0 1 2 3 4 5 6 7 X MU M

In figure along ox we measure units of a commodity consumed and along oy is shown the marginal utility derived from them. The marginal utility of the first glass of water is called initial utility. It is equal to 20 units. The MU of the 5th glass of water is zero. It is called the satiety point. The MU of the 6th glass of water is negative –3. The MU curve here lies below the ox axis. The utility curve MM falls from left down to the right showing that the marginal utility of the success units of glasses of water is falling.

Gossin, s 2nd Law: -

                                       In cardinal utility analysis, Lipsey states this law in the following words. “The households maximizing the utility will so allocate the expenditure between commodities that the utility of the last penny spent on each item is equal”. As we know, every consumer has unlimited wants. However, the income at his disposal at any time is limited. The consumer is, therefore, faced with a choice among many commodities than he can and would like to pay. He therefore, consciously or unconsciously compares the satisfaction, which he obtains from the purchase of the commodity and the price, which he pay for it. He thinks the utility of the commodity is greater or at-least equal to the loss of utility of money price, he buys that commodity. As he buys more and more of the commodity, the utility of the successive units beings to diminish. He stops further purchase of the commodity at a point where the marginal utility of the commodity and its price are just equal. If he pushes the purchase further from his point of equilibrium, then the marginal utility of the commodity will be less than of price and the household will be a loser. A consumer will be in equilibrium with a single commodity symbolically when: -

MUx = Px

A prudent consumer in order to get the maximum satisfactions from his, limited means compares not only the utility of a particular commodity and the price but also the utility of the other commodities which he can buy with his scarce resources. If he finds that a particular expenditure in one use is yielding less utility than that of other, he will tiy to transfer a unit of expenditure from the commodity yielding less marginal utility to commodity yielding higher marginal utility. The consumer will reach his equilibrium position when it will not be possible for him to increase the total utility by transferring expenditure from less advantageous uses to more advantageous uses. The position of equilibrium will be reached when the marginal utility of each good is in proportion to its price and the ratio of the prices of all goods is equal to the ratio of their marginal utilities.

The consumer will maximize total utility from his income when the utility from the last rupee spent on each good is the same. Algebraically, this is when; MUa = MUb = MUc…….. MUn Pa Pb

 Pc	           Pn

Here (a), (b), (c)…n are various goods consumed.

The doctrine of qui marginal utility can be explained by taking an example, Suppose a person had Rs. 5.00 with him, which he wishes to spend on two commodities, tea and cigarettes. The marginal utility derived from both these commodities is as under:

The law of equi marginal utility can be explained with the help of Schedule.

Unit of Money MU of Tea MU of Cigarettes 1.2.3.4.5.Rs.5 108642Total Utility = 30 1210863Total Utility = 39

A rational consumer would like to maximum satisfaction from Rs.5.00. He can expend this money in three ways:

Ø Rs.5.00 may be spending on tea only. Ø Rs.5.00 may be utilized for the purchase of cigarettes only. Ø Some rupees may be spend on the purchase of tea and some on the purchase of cigarettes.

If he spends Rs.5.00 on the purchase of tea, he gets 30 utility. If he spends Rs.5.00 on the purchase of cigarettes, the total utility derived is 39, which is higher than tea. In order to make the best of the limited resources he examines his expenditure.

1) By spending Rs.4.00 on tea and Rs.1.00 on cigarettes he gets 30 utility (10+8+6+4+12 = 40). 2) By spending Rs.3.00 on tea and Rs.2.00 on cigarettes he derives 46 utility (10+8+6+12+10 = 46). 3) By spending Rs.2.00 on tea and Rs.3.00on cigarettes he gets 48 utility (10+8+12+10+8 = 48). 4) By spending Rs.1.00 on tea and Rs.4.00 on cigarettes he gets 46 utility (10+12+10+8+6 = 46). The sensible consumer will spend Rs.2.00 on tea and Rs.3.00 on cigarettes and will get the maximum satisfaction. When he spends Rs.2.00 on tea and Rs.3.00 on cigarettes, the marginal utility derived from both these commodities is equal to 8. When the marginal utilities of the two commodities are equalized, the total utility is then maximum, i.e., 48 as is clear from the schedule given above. The law of equi marginal utility can be explained with the help of diagrams.

K Tea Cigarettes M 12 12 E E N 8 8 N

L 4 4 U 0 C P 0 C O 1 2 3 4 5 1 2 3 4 5

In this figure MU is marginal utility curve for tea and KL of Cigarettes. When a consumer spends OP amount (Rs.2.00) on tea and OQ (Rs.3.00) on cigarettes, the marginal utility derived from the consumption of both the items (tea & cigarettes) is equal to 8 units (EP = NC). Total utility in case of tea is OPEM and in case of cigarettes OQNK. The consumer gets the maximum utility when he spends Rs.2.00 on tea and Rs.3.00 on cigarettes and by no other alteration in the expenditure.

We now assume that the consumer spendsRs.1.00 on tea (OC) and Rs.4.00 (OQ) on cigarettes. If CQ more amounts are spends on cigarette, the added utility is equal to the area CQ NN. On the other hand, the expenditure on tea falls from OP amount (Rs.2.00) to OC amount (Rs.1.00). There is a loss of utility equal to the area CPEE. The loss in utility tea is greater than the cigarettes. The consumer is not deriving maximum satisfaction except the combination of expenditure of Rs.2.00 on tea and Rs.3.00 on cigarettes.

The law is known as the Law of Maximum satisfaction because a consumer tries to get the maximum satisfaction from his limited resources by so planning his expenditure that the marginal utility of a rupee spend in one use in the same as the marginal utility of a rupee spent on another use. It is known as the Law of substitution because consumer continues substituting one good for another till he gets the maximum satisfaction. It is called the Law of indifference because the maximum satisfaction has been achieved by equating the marginal utility in all the uses. The consumer then becomes indifferent to readjust his expenditure unless some change takes place in his income or the prices of the commodities, etc.

Importance of the Law: - The law of equi marginal utility is of great practical importance. The application of the principal of substitution extends over almost every field of economic inquiry. Every consumer consciously or unconsciously trying to get the maximum satisfaction from his limited resources acts upon this principle of substitution, same is the case with the producer. In the field of exchange and in theory of distribution too, this law pays a vital role. In short, despite its limitation, the law of maximum satisfaction is meaningful general statement of how consumers behave.

In addition to its application to consumption, it applies equally to the theory of production and theory of distribution. In the theory of production, it is applied on the substitution of various factors of production to the point where marginal returns from all the factors are equal. The government can also use this analysis for evaluation of its different economic prices.

The equal marginal rule also guides an individual in the spending of his saving on different types of assets. The law of equi marginal utility also guides an individual in the allocation of his time between work and leisure. In short, despite limitation the law of substitution is applied to all problems of allocation of scarce resources.

Q # 3 Define law of demand. Why demand curve moves from left to right downward?

Law of Demand: - It is the experience of every consumer that when the prices of the commodities fall, they are tempted to purchase more commodities and when the prices rise, the quantity demand decreases. There is, thus, inverse relationship between the price of the product and the quantity demanded. The economist has named this inverse relationship between demand and price as the law of Demand.

Some well-known statements of the law of demand are as under. According to Prof. Samuelson. “The law of demand states that people will buy more at lower prices and buy less at higher prices, other things remaining the same”. E. Miller writes, “ other things remaining the same, the quantity demand of a commodity will be smaller at higher market prices and larger at lower market prices”.“Other things remaining the same, the quantity demanded increases with every fall in the price and decreases with every rise in the price”. In simple language we can say that when the price of a commodity rises, people buy less of that commodity and when the price falls, people buy more of it ceteris paribus (other things remaining the same). Or we can say that the quantity demanded varies inversely with its price. There is no doubt that demand responds to price in the reverse direction but it has got no uniform relation between them. If the price of a commodity falls by 1%, it is not necessary that the demand may also increase by 1%. The demand can increase by 1%, 2%, 10%, and 15% or as the situation demands. The functional relationship between the quantity demanded’ and the price of the commodity can be expressed in simple mathematical language as under:

Qdx = (Px, M, Po, T…)

Here Qdx = quantity demanded of commodity X F = a function of independent variables contained with in the parenthesis. Px = price of commodity X M = Money income of the household Po = price of other commodities T = Taste of the household The on the top of M. Po. T means that they are kept constant. The demand function can also be symbolized as under:

Qdx = f (Px) Ceteris paribus.

The demand curve generally slopes downward from left to right. It has a negative slope because the two important variables price and quantity work in opposite direction. As the price of a commodity decreases, the quantity demanded increases over a specified period of time and vice versa, other things remaining constant. The reasons for demand curve to slope downward are as fallow:

1) Law of diminishing marginal utility: - The law of demand is based on the law of

diminishing marginal utility. According to the cardinal utility approach, when a consumer purchases more units of a commodity, its marginal utility declines. The consumer, therefore, will purchase more units of total commodity only if its price falls. Thus, a decrease in price brings about an increase, in demand. The demand curve, therefore, is downward sloping.

2) Income effect: - Other things being equal, when the price of commodity decreases, the real income or the purchasing power of the household increases. The consumer is now in a position to purchase more commodities with the same income. The demand for a commodity thus increases not only from the existing buyers but also from the new buyers who were earlier unable to purchase at higher price. When at a lower price, there is a greater demand for a commodity by the household; the demand curve is bound to slope downward from left to right.

3) Substitution effect: - The demand curve slopes downward from left to right also because of the substitution effect. For instance, the price of meat falls and the price of other substitutes say poultry and beef remain constant. Then the household would prefer to purchase meat because it is now relatively cheaper. The increase in demand with a fall in the price of meat will move the demand curve downward from left to right.

4) Entry of new buyers: - When the price of a commodity falls, its demand not only increase from the old buyers but the new buyers also enter the market. The combined result of the income and substitution effect is that demand extends, ceteris paribus, as the price fall. The demand curve slopes downward from left to right.

Q # 4 WHAT IS ELASTICITY OF DEMAND? WRITE DOWN ITS VARIOUS TYPES AND LEVEL.

Elasticity: - The quantity of a commodity demanded per unit of time depends upon various factors such as the price of a commodity, the money income of consumers, the price of related goods, the taste of the people, etc; etc. whenever there is a change in any of the variables stated above, it brings about a change in the quantity of a commodity purchased over a specified period of time. The elasticity of demand measures the responsiveness of quantity demanded to a change in any one of the above factors by keeping other factors constant.

When the relative responsiveness or sensitiveness of the quantity demanded is measured to change in price, the elasticity is said be price elasticity of demand. When the change in demand is the result of the given change in income, it is named income elasticity of demand. Sometimes, a change in the price of one good causes a change in the demand for the other. The elasticity here is called cross elasticity of demand.

Types of elasticity of demand: -

The three main types of elasticity are now discuss in brief.

1) Price elasticity of demand:- The concept of price elasticity of demand is most Commonly used in economic literature. Price elasticity of demand is the responsiveness of quantity demanded to a change in price. The formula for price elasticity of demand is the ratio of percentage change in price. Stated mathematically:

Price elasticity of demand = % change in quantity of demanded

                                                      %         Change in price

This can be written as:

q

             		  q      *  100		p	 p

Ed = p = q * q p * 100

The concept of price elasticity of demand can be uses to divide the goods into three groups.

(a) Elasticity: - 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. When elasticity of demand is greater than one, a fall in price increases the total expenditure and rice in price lowers the total expenditure.

(b) Unitary elasticity: - When the percent change in quantity of a good equal’s percent change in its price, the price elasticity of demand is said to have unitary elasticity. When elasticity of demand is equal to one or unitary, a rise or fall in price leaves total expenditure unchanged.

(c) Inelastic: - When the percent change in quantity of a good is less than the percent change in price, the demand is called inelastic. When elasticity of demand is inelastic or less than one, a fall in price decreases total expenditure.

2) Income elasticity of demand:- Income is an important variable effecting the demand for a good. When there is a change in the level of income of a consumer, there is a change in the quantity demanded of a good, other factor remaining the same. The degree of change or responsiveness of quantity demanded of a good to a change in the income of the consumer is called income elasticity of demand. Income elasticity of demand can be defined as the ratio of percentage in the amount of a good purchased, per unit of time to a percentage change in the income of a consumer. The formula for the income elasticity of demand is the percentage change in demand divided by the percentage change in income. Putting this in symbol gives;

Ey = % q % p

3) Cross elasticity of demand:- The demand for many products is effected by the prices of other products. Where this relationship can be measured, we may express it as the cross elasticity of demand. Cross elasticity of demand refers to the response of demand for one product to the change in price of another product. We can say that cross elasticity of demand measures the degree of responsiveness of the quantity demanded of one good (B) to changes in the price of another good (A).

The formula for measuring the cross elasticity of demand is:

Exy = %change in quantity demanded of B = % QB % Change in price of A %PA

Q#5 WHAT ARE THE VARIOUS METHODS TO MEASURE THE PRICE ELASTICITY OF DEMAND? ALSO EXPLAIN ITS DETERMINANTS.

There are three methods of measuring price elasticity of demand.

Ø Total expenditure method. Ø Geometrical method or point elasticity method. Ø Arc method.

1) Total expenditure method:- The price elasticity can be measured by noting the changes in total expenditure brought about by changes in price and quantity demanded.

(a) When with a percentage fall in price the quantity demanded increases so much that it result in the increase in total expenditure the demand is said to be elastic (E p>1).

For example,

Y

D 20 A B

E F 10 D

0 C G X 10 20 30

      Quantity demanded

Figure shows that at price of Rs.20 per apple, the quantity demanded is ten apples the total expenditure OABC (Rs.200). When the price falls down to Rs.10 the quantity demanded of apples is thirsty. The total expenditure is OEFG (Rs.300). Since OEFG is greater than OABC, it employs that change in quantity demanded is proportionately more than the change in price. Here is demand is elastic more than one E p>1.

(b) When a percentage fall in price raises the quantity demanded so much as to leave the total expenditure unchanged, the elasticity of demand is said to be unitary (E p = 1).

For example,

Y

D 10 A B

E F 5 D

0 C G X 20 40 60

      Quantity demanded

Figure shows that at price of Rs.10 per pens, the total expenditure is OABC (Rs.300). At a lower price of Rs.5, the total expenditure is OEFG (Rs.300). Since OABC = OEFG, it employs that the change in quantity demanded is proportionally equal to change in price. So the price elasticity of demand is equal to 1 = (E p = 1).

(c) When a percentage fall in price raises the quantity demanded of a good so as to cause the total expenditure to decrease, the demand is said to be inelastic or less than one (E p<1).

For example,

8 D

6 A B 4

2 E F D 0 C G X 20 40 60 80 100

      Quantity demanded

In the figure at a price of Rs.5 per pen the quantity demanded is 60 pens. The total expenditure is OABC (Rs.300). At a lower price of Rs.2 the quantity demanded is 100 pens The total expenditure is OEFG (Rs.200). Since OEFG is smaller than OABC, this employs that the change in quantity demanded is proportionately less than the change in the price. Hence price elasticity of demand is less than one or inelastic.

2) Geometric method or 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 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.

(a) Measurement of elasticity on a linear demand curve: - The price elasticity of Demand can also be measured at any point on the demand curve. If the demand curve is linear “straight line” it has a unitary elasticity at the mid point. The total revenue is maximum at the point. Any point above the midpoint has an elasticity greater than 1. Here price reduction leads to an increase in the total revenue expenditure. Below the mid point elasticity is less than 1. Price reduction leads to reduction in the total revenue of the firm.

Y

8 A

6 4 2 0 200 400 600 800 X

   Quantity

The formula applied for measuring the elasticity at any point on the straight line demand curve is Ep = q p p * q

The elasticity at each point on the demand curve can be traced with the help of point method as under: Ep = Lower segment

Upper segment

In the figure AG is the linear demand curve (a) 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 and to the left of D, the elasticity is greater than unity.

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

(2) Elasticity of demand at point E GE 200 = EA = 600 = 33(<1)

(3) Ed at point C GC 600 = CA = 200 = 3(>1)

(4) At point A, the Ep is infinite

(5) At point G, the elasticity of demand is zero

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.

(b) Measure of elasticity on a non-linear demand curve: - If the demand curve is non- linear, then elasticity at a point can be measured by a drawing a tangent at the particular point. This is explained with the help of figure given below:

Y

A6

K4

X 0 200 400 600

In figure the elasticity on DD demand curve is measured at point C by drawing a tangent. At point C.

Ed BM BC 400 = MO = CA = 200 = 2 = (>1)

Here elasticity is greater than unity. Point C lies above the midpoint of the demand curve DD. In case the demand curve is a rectangular hyperbola, the change in price will have no effect on the total amount spent on the product. As such, the demand curve will have a unitary elasticity at all points.

3) Arc elasticity: - Normally the elasticity varies along the length of demand curve. If we are to measure elasticity between any two points on the demand curve, then the Arc elasticity methods, 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.

Arc elasticity is calculated by using the following formula.

Ep = q p1+p2

p	.	q1+q2

 q  denote change in quantity.
 p  denotes change in price.

q1 signifies initial quantity. q2 denote new quantity. P1 stand for initial price. p2 denote new price.

Graphic presentation of measuring elasticity using the Arc method.

Y 10 Arc method

                             4
                             
       2

                              0		2	4	6	8	10	12	X

Quantity

In this figure it is shown that at a price of Rs.10, the quantity of demanded of apples is 5kg per day. When it price falls from Rs.10 to Rs.5, the quantity demanded increases to 12kgs of apples per day. The arc elasticity of AB part of demand curve DD can be calculated as under.

Ep = q p1+p2 P * q1+q2

= 7 10+5 7 15 7 15 21 5 * 5+12 = 5 * 17 = 5 * 17 = 17 = 1.23

The arc elasticity is more than unity.