Income Elasticity and Aspects of Utility Economics

Economics

“Income elasticity of Demand and Aspects of Utility”

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Income Elasticity and Aspects of Utility Economics

PREFACE

Assignments, Term reports and Internship programs are the vital

teaching techniques of University of the Punjab’s BBA Insurance & Risk

Management program. The aim of such activities is to develop a practical

evaluation approach in students along with their studies.

As an integral part of BBA studies, every student has to make research

reports.

In order to fulfill this purpose we selected Income Elasticity of Demand

and Aspects of Utility.

We are thankful to our respectable teacher Sir Shahid Maqbool who gave

us the chance to make this report.

We have tried our best to make this report comprehensive to provide

information about Income Elasticity of Demand and Aspects of Utility.

Authors

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Income Elasticity and Aspects of Utility Economics

AKNOWLEDGEMENT

I bow our heads in gratitude to almighty Allah, Who

blessed us with the ability and energy to complete this

work.”

The guidance of Holy Prophet (Peace be upon him) is the continuous

source of help for us in what so ever field we are. Through the blessing of

God and the spiritual efforts of the Holy Prophet I have been successful

in completing this report.

I wish to express our deep sense of gratitude to our honorable and loving teacher Sir Shahid Maqbool for his friendly behavior. She provided us guidelines to achieve our target. During the assignment whenever we faced any problem he said welcome us and solved our problem.

Authors

ABC

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Income Elasticity and Aspects of Utility Economics

TABLE OF CONTENTS

Topic Page #

DEMAND 05

Meaning 05

Definitions 06

INCOME ELASTICITY OF DEMAND 06

Definitions 07

Notation 07

Formula 07

METHOD TO CALCULATE 08

Calculating the Percentage Change in Quantity Demanded 08

Calculating the Percentage Change in Income 09

Final Step of Calculating the Income Elasticity of Demand 09

Income Elasticity 10

HOW DO WE INTERPRET THE INCOME ELASTICITY OF

DEMAND 11

UTILITY 12

UTILITY AND USEFULNESS 15

CARDINAL AND ORIGINAL UTILITY 16

ASPECTS OF UTILITY 17

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Income Elasticity and Aspects of Utility Economics

DEMAND Demand is one of the important concepts in economics. It emerges from human wants, which are the root cause of all economic activities.

Meaning: In common language the words ‘demand’, desire, and need are used in the same meaning. But in Economics, the word demand is used in three senses.

Demand is the effective desire to buy something.Demand = desire + purchasing power

Suppose a person desires to get a motorcycle. He knows the price and has enough to buy one. Then his desire becomes demand. If he is just empty pocket, he has desire but no demand.

Demand indicates quantity actually bought.Demand = quantity purchased at a particular price during a period of time.

If in a hockey match, the price of ticket is Rs. 20 and the total tickets sold are 1000. Then 1000 is the demand for tickets at this price.

Demand as a negative relationship between price and quantity i.e. Demand in the form of schedule of prices and quantities bought.

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Income Elasticity and Aspects of Utility Economics

Definitions:

Demand should not be confused with desire. Demand means desire to buy something plus ability to pay for it. So demand is defined as;

1. Demand refers to the quantity of a commodity which people are ready to buy at different prices.

2. Demand is a relation showing the various amounts of a commodity that buyers would be willing and able to purchase at alternative prices during a given time period, all other things remaining same.

INCOME ELASYICITY OF DEMAND

Income:

For individuals, money earned through employment and investments is known as income.Income is one of the determinants of demand. So, the concept of income elasticity is used to measure the effect of changes in income of the consumers on the demand for a commodity.

Elasticity: In economics, elasticity is the ratio of the percent change in one variable to the percent change in another variable. It is a tool for measuring the responsiveness of a function to changes in parameters in a relative way

An "elastic" good is one whose price elasticity of demand has a magnitude greater than one. Similarly, "unity elastic" and "inelastic"

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Income Elasticity and Aspects of Utility Economics

describe goods with price elasticity having a magnitude of one and less than one respectively

Definitions: It is defined as,

1. “Income elasticity of demand is the rate of responsiveness of demand to changes in the income of the consumer.”

2. “This measures the responsiveness of demand to a change in income.”

e.g. if your income increase by 5 % and your demand for mobile phones increased 20% then the YED = 20/ 5  = 4.

Notations:

Income elasticity = Ey Income elasticity = YED

Formula:

YED = % change in Q.D             % change in Income

YED= q /q * y/ y

Where as q is quantity demanded and q denotes change in quantity. y represents income while y indicates change income.

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Income Elasticity and Aspects of Utility Economics

METHOD TO CALCULATE

For example the original income is $40,000 and the new price is $50,000 so we have Income (OLD) =$40,000 and Income (NEW) =$50,000. From the chart we see that the quantity demanded when income is $40,000 is 150 and when the price is $50,000 is 180. Since we're going from $40,000 to $50,000 we have Demand (OLD) =150 and Qd (NEW)=180, where "Qd" is short for "Quantity Demanded". So you should have these four figures written down:

1. Income (OLD)=40,0002.Income (NEW)=50,0003.Qd(OLD)=1504.Qd(NEW)=180

Calculating the Percentage Change in Quantity Demanded

The formula used to calculate the percentage change in quantity demanded is:

[Qd (NEW) - Qd (OLD)] / Qd (OLD)

By filling in the values we wrote down, we get:

[180 - 150] / 150 = (30/150) = 0.2

So we note that % Change in Quantity demanded = 0.2 (We leave this in decimal terms. In percentage terms this would be 20%) and we save this figure for later.

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Income Elasticity and Aspects of Utility Economics

Calculating the Percentage Change in Income

Similar to before, the formula used to calculate the percentage change in income is:

[Income (NEW) - Income (OLD)] / Income (OLD) ]

By filling in the values we wrote down, we get:

[50,000 - 40,000] / 40,000 = (10,000/40,000) = 0.25

We have both the percentage change in quantity demand and the percentage change in income, so we can calculate the income elasticity of demand.

Final Step of Calculating the Income Elasticity of Demand

We go back to our formula of: YED = (% Change in Quantity Demanded)/(% Change in Income)

We can now fill in the two percentages in this equation using the figures we calculated earlier.

YED = (0.20)/(0.25) = 0.8

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Income Elasticity and Aspects of Utility Economics

INCOME ELASTICITY

Income elasticity is;

Income elasticity greater than zero but less than one (0> YED <1): Suppose a person was spending 10% of his income on petrol. Then his income rises and the proportion of his income spent on petrol falls to 8.This means YED is less than one.

Income elasticity greater than one (YED>1):

Income elasticity is more than unity if the proportion of income spent on goods increases after income increases.

Income elasticity equal to one (YED=1):

Income elasticity of demand is unity (equal to one) when the proportion of income spent on goods remains the same even after increase income e.g. if income doubles, demand also doubles.

Income elasticity less than zero (YED <0):

Income elasticity of demand is less than zero (negative) when percentage change in quantity demanded is less than percentage change in income i.e. with increase in income, demand falls.

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Income Elasticity and Aspects of Utility Economics

How Do We Interpret the Income Elasticity of Demand?

Income elasticity of demand is used to see how sensitive the demand for a good is to an income change. The higher the income elasticity, the more sensitive demand for a good is to income changes. A very high-income elasticity suggests that when a consumer's income goes up, consumers will buy a great deal more of that good. A very low price elasticity implies just the opposite, that changes in a consumer's income has little influence on demand. Most often asked questions are "Is the good a luxury good, a normal good, or an inferior good between the income range of $40,000 and $50,000?" To answer those use the following rule of thumb:

If YED > 1 then the good is a Luxury Good and Income Elastic. If YED < 1 and IEOD > 0 then the good is a Normal Good and

Income Inelastic. If YED < 0 then the good is an Inferior Good and Negative

Income Inelastic.

Factors affecting elasticity:

1. Availability of substitutes 2. Proportion of income spent 3. Durability4. Addiction5. Economic and human constraints6. Time period 7. Number of substitute uses (the more the more elastic)8. Type of product (luxury)

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Income Elasticity and Aspects of Utility Economics

UTILITY

Utility is an abstract concept rather than a concrete, observable quantity. The units to which we assign an “amount” of utility, therefore, are arbitrary, representing a relative value. Total utility is the aggregate sum of satisfaction or benefit that an individual gains from consuming a given amount of goods or services in an economy. The amount of a person's total utility corresponds to the person's level of consumption. Usually, the more the person consumes, the larger his or her total utility will be. Marginal utility is the additional satisfaction, or amount of utility, gained from each extra unit of consumption.

Although total utility usually increases as more of a good is consumed, marginal utility usually decreases with each additional increase in the consumption of a good. This decrease demonstrates the law of diminishing marginal utility. Because there is a certain threshold of satisfaction, the consumer will no longer receive the same pleasure from consumption once that threshold is crossed. In other words, total utility will increase at a slower pace as an individual increases the quantity consumed.

Take, for example, a chocolate bar. Let's say that after eating one chocolate bar your sweet tooth has been satisfied. Your marginal utility (and total utility) after eating one chocolate bar will be quite high. But if you eat more chocolate bars, the pleasure of each additional chocolate bar will be less than the pleasure you received from eating the one before - probably because you are starting to feel full or you have had too many sweets for one day.

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Income Elasticity and Aspects of Utility Economics

This table shows that total utility will increase at a much slower rate as marginal utility diminishes with each additional bar. Notice how the first chocolate bar gives a total utility of 70 but the next three chocolate bars together increase total utility by only 18 additional units.

The law of diminishing marginal utility helps economists understand the law of demand and the negative sloping demand curve. The less of something you have, the more satisfaction you gain from each additional unit you consume; the marginal utility you gain from that product is therefore higher, giving you a higher willingness to pay more for it. Prices are lower at a higher quantity demanded because your additional satisfaction diminishes as you demand more.

In order to determine what a consumer's utility and total utility are, economists turn to consumer demand theory, which studies consumer behavior and satisfaction. Economists assume the consumer is rational and will thus maximize his or her total utility by purchasing a combination of different products rather than more of one particular product. Thus, instead of spending all of your money on three chocolate bars, which has a total utility of 85, you should instead purchase the one chocolate bar, which has a utility of 70, and perhaps a glass of milk, which has a utility of 50. This combination will give you a maximized total utility of 120 but at the same cost as the three chocolate bars.

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Income Elasticity and Aspects of Utility Economics

In economics, utility is a measure of the relative satisfaction from or desirability of consumption of various goods and services. Given this measure, one may speak meaningfully of increasing or decreasing utility, and thereby explain economic behavior in terms of attempts to increase one's utility. For illustrative purposes, changes in utility are sometimes expressed in units called utils.

The doctrine of utilitarianism saw the maximization of utility as a moral criterion for the organization of society. According to utilitarians, such as Jeremy Bentham (1748-1832) and John Stuart Mill (1806-1876), society should aim to maximize the total utility of individuals, aiming for "the greatest happiness for the greatest number". Another theory forwarded by John Rawls (1921-2002) would have society maximize the utility of the individual receiving the minimum amount of utility.

In neoclassical economics, rationality is precisely defined in terms of imputed utility-maximizing behavior under economic constraints. As a hypothetical behavioral measure, utility does not require attribution of mental states suggested by "happiness", "satisfaction", etc.

Utility can be applied by economists in such constructs as the indifference curve, which plots the combination of commodities that an individual or a society would accept to maintain a given level of satisfaction. Individual utility and social utility can be construed as the dependent variable of a utility function (such as an indifference curve map) and a social welfare function respectively. When coupled with production or commodity constraints, these functions can represent Pareto efficiency, such as illustrated by Edgeworth boxes in contract curves. Such efficiency is a central concept of welfare economics.

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Income Elasticity and Aspects of Utility Economics

UTILITY AND USEFULNESS

Utility doesn’t mean usefullness because many goods aren’t useful e.g bear cigarette etc. These gooda are injurious to health but they have utility because they satisfy human wants. For example Smoking cant be called useful although it has utility for smoker Utilty is simply the satisfication derived from the use of a good . The satisfied want may be good or bad. So we can say that Utilty and usefullness are like two poles which far away from each other

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Income Elasticity and Aspects of Utility Economics

CARDINL AND ORIGINAL UTILITY

Economists distinguish between cardinal utility and ordinal utility. When cardinal utility is used, the magnitude of utility differences is treated as an ethically or behaviorally significant quantity. On the other hand, ordinal utility captures only ranking and not strength of preferences. An important example of a cardinal utility is the probability of achieving some target.

Utility functions of both sorts assign real numbers (utils) to members of a choice set. For example, suppose a cup of orange juice has utility of 120 utils, a cup of tea has a utility of 80 utils, and a cup of water has a utility of 40 utils. When speaking of cardinal utility, it could be concluded that the cup of orange juice is better than the cup of tea by exactly the same amount by which the cup of tea is better than the cup of water. One is not entitled to conclude, however, that the cup of tea is two thirds as good as the cup of juice, because this conclusion would depend not only on magnitudes of utility differences, but also on the "zero" of utility.

It is tempting when dealing with cardinal utility to aggregate utilities across persons. The argument against this is that interpersonal comparisons of utility are suspect because there is no good way to interpret how different people value consumption bundles.

When ordinal utilities are used, differences in utils are treated as ethically or behaviorally meaningless: the utility values assigned encode a full behavioral ordering between members of a choice set, but nothing about strength of preferences. In the above example, it would only be possible to say that juice is preferred to tea to water, but no more.

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Income Elasticity and Aspects of Utility Economics

Aspects Of Utilities

Initial Utility:

Utilty of the first unit of the commodity consumed is called the initial utilty

Marginal Utility:

In economics, the marginal utility of a good or of a service is the utility of the specific use to which an agent would put a given increase in that good or service, or of the specific use that would be abandoned in response to a given decrease. In other words, marginal utility is the utility of the marginal use — which, on the assumption of economic rationality, would be the least urgent use of the good or service, from the best feasible combination of actions in which its use is included.[1][2] Under the mainstream assumptions, the marginal utility of a good or service is the posited quantified change in utility obtained by using one more or one less unit of that good or service.

This concept grew out of attempts by economists to explain the determination of price. The term “marginal utility”, credited to the Austrian economist Friedrich von Wieser by Alfred Marshall,[3] was a translation of Wieser's term “Grenznutzen”

Total utility:

Utility which is attained from the use of a specific number of the units of a commodity is called total utility. Total utility is equal to the sum of separate utility which is attained from every unit. For example if a man eats two apples while the utility of second apple is 10 and 5 is of second oneTotal utility will be10+5= 15

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Income Elasticity and Aspects of Utility Economics

Positive Utility:

As long as total utility keeps on increasing and marginal utility isn’t zero then utility is positive

Negative Utility:

When Utility of a good is zero but consumer consumes the unit more and more of it, then utility becomes negative. Total utility decreases instead of negative utility

Zero Utility

Zero utilty means that the consumer has no further desire for the commodity. It is also known as point of satiation

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