5 Types of Price Elasticity of

Demand – Explained!
Article Shared by Nitisha

ADVERTISEMENTS:

The extent of responsiveness of demand with change in the price is

not always the same.

The demand for a product can be elastic or inelastic, depending on

the rate of change in the demand with respect to change in price of a
product.

Elastic demand is the one when the response of demand is greater

with a small proportionate change in the price. On the other hand,
inelastic demand is the one when there is relatively a less change in
the demand with a greater change in the price.

ADVERTISEMENTS:

For better understanding the concepts of elastic and

inelastic demand, the price elasticity of demand has been
divided into five types, which are shown in Figure-1:

Let us discuss the different types of price elasticity of demand (as

shown in Figure-1).

1. Perfectly Elastic Demand:

When a small change in price of a product causes a major change in
its demand, it is said to be perfectly elastic demand. In perfectly
elastic demand, a small rise in price results in fall in demand to zero,
while a small fall in price causes increase in demand to infinity. In
such a case, the demand is perfectly elastic or ep = 00.
ADVERTISEMENTS:

The degree of elasticity of demand helps in defining the shape and

slope of a demand curve. Therefore, the elasticity of demand can be
determined by the slope of the demand curve. Flatter the slope of
the demand curve, higher the elasticity of demand.

In perfectly elastic demand, the demand curve is

represented as a horizontal straight line, which is shown
in Figure-2:

From Figure-2 it can be interpreted that at price OP, demand is

infinite; however, a slight rise in price would result in fall in demand
to zero. It can also be interpreted from Figure-2 that at price P
consumers are ready to buy as much quantity of the product as they
want. However, a small rise in price would resist consumers to buy
the product.

ADVERTISEMENTS:

Though, perfectly elastic demand is a theoretical concept and cannot

be applied in the real situation. However, it can be applied in cases,
such as perfectly competitive market and homogeneity products. In
such cases, the demand for a product of an organization is assumed
to be perfectly elastic.
From an organization’s point of view, in a perfectly elastic demand
situation, the organization can sell as much as much as it wants as
consumers are ready to purchase a large quantity of product.
However, a slight increase in price would stop the demand.

2. Perfectly Inelastic Demand:

A perfectly inelastic demand is one when there is no change
produced in the demand of a product with change in its price. The
numerical value for perfectly inelastic demand is zero (ep=0).
In case of perfectly inelastic demand, demand curve is
represented as a straight vertical line, which is shown in
Figure-3:

It can be interpreted from Figure-3 that the movement in price from

OP1 to OP2 and OP2 to OP3 does not show any change in the
demand of a product (OQ). The demand remains constant for any
value of price. Perfectly inelastic demand is a theoretical concept
and cannot be applied in a practical situation. However, in case of
essential goods, such as salt, the demand does not change with
change in price. Therefore, the demand for essential goods is
perfectly inelastic.

3. Relatively Elastic Demand:

Relatively elastic demand refers to the demand when the
proportionate change produced in demand is greater than the
proportionate change in price of a product. The numerical value of
relatively elastic demand ranges between one to infinity.
Mathematically, relatively elastic demand is known as more than
unit elastic demand (ep>1). For example, if the price of a product
increases by 20% and the demand of the product decreases by 25%,
then the demand would be relatively elastic.
The demand curve of relatively elastic demand is gradually
sloping, as shown in Figure-4:

It can be interpreted from Figure-4 that the proportionate change in

demand from OQ1 to OQ2 is relatively larger than the proportionate
change in price from OP1 to OP2. Relatively elastic demand has a
practical application as demand for many of products respond in the
same manner with respect to change in their prices.

For example, the price of a particular brand of cold drink increases

from Rs. 15 to Rs. 20. In such a case, consumers may switch to
another brand of cold drink. However, some of the consumers still
consume the same brand. Therefore, a small change in price
produces a larger change in demand of the product.

4. Relatively Inelastic Demand:

Relatively inelastic demand is one when the percentage change
produced in demand is less than the percentage change in the price
of a product. For example, if the price of a product increases by 30%
and the demand for the product decreases only by 10%, then the
demand would be called relatively inelastic. The numerical value of
relatively elastic demand ranges between zero to one (e p<1).
Marshall has termed relatively inelastic demand as elasticity being
less than unity.
The demand curve of relatively inelastic demand is rapidly
sloping, as shown in Figure-5:
ADVERTISEMENTS:

It can be interpreted from Figure-5 that the proportionate change in

demand from OQ1 to OQ2 is relatively smaller than the
proportionate change in price from OP1 to OP2. Relatively inelastic
demand has a practical application as demand for many of products
respond in the same manner with respect to change in their prices.
Let us understand the implication of relatively inelastic demand
with the help of an example.

Example-3:
The demand schedule for milk is given in Table-3:
ADVERTISEMENTS:

Calculate the price elasticity of demand and determine the type of

price elasticity.

Solution:
P= 15

ADVERTISEMENTS:

Q = 100

P1 = 20
Q1 = 90

Therefore, change in the price of milk is:

∆P = P1 – P

∆P = 20 – 15

∆P = 5

Similarly, change in quantity demanded of milk is:

∆Q = Q1 – Q

∆Q = 90 – 100

∆Q = -10

The change in demand shows a negative sign, which can be ignored.

This is because of the reason that the relationship between price and
demand is inverse that can yield a negative value of price or
demand.

Price elasticity of demand for milk is:

ep = ∆Q/∆P * P/Q
ep = 10/5 * 15/100
ep = 0.3
The price elasticity of demand for milk is 0.3, which is less than one.
Therefore, in such a case, the demand for milk is relatively inelastic.

5. Unitary Elastic Demand:

When the proportionate change in demand produces the same
change in the price of the product, the demand is referred as unitary
elastic demand. The numerical value for unitary elastic demand is
equal to one (ep=1).
The demand curve for unitary elastic demand is
represented as a rectangular hyperbola, as shown in
Figure-6:
From Figure-6, it can be interpreted that change in price OP1 to
OP2 produces the same change in demand from OQ1 to OQ2.
Therefore, the demand is unitary elastic.

The different types of price elasticity of demand are

summarized in Table-4:

No related posts.
Elasticity of Demand: 4 Types
Article Shared by Shivam N

ADVERTISEMENTS:

The following points highlight the four main types of

elasticity of demand. The types are: 1. Price Elasticity of
Demand 2. Cross Elasticity of Demand 3. Income Elasticity
of Demand 4. Advertising or Promotional Elasticity of
Demand.
Type # 1. Price Elasticity of Demand:
The elasticity of demand is the degree of responsiveness of demand
to change in price.

In the words of Prof. Lipsey:

ADVERTISEMENTS:

“Elasticity of demand may be defined as the ratio of the percentage

change in demand to the percentage change in price.”

Mrs. Robinson’s definition is more clear:

“The elasticity of demand at any price…. is the proportional change
of amount purchased in response to a small change in price, divided
by the proportional change of price.”

Thus, price elasticity of demand is the ratio of percentage change in

amount demanded to a percentage change in price.

ADVERTISEMENTS:

It may be written as:

EP = Percentage change in amount demanded/Percentage change in
price
If we use Δ (delta) for a change, q for amount demanded and p for
price, the algebraic equation is
Ep, the coefficient of price elasticity of demand is always negative
because when price changes demand moves in the opposite
direction. It is, however, customary to disregard the negative sign. If
the percentages for quantity and prices are known the value of the
coefficient Ep can be calculated.
ADVERTISEMENTS:

Price elasticity of demand may be unity, greater than unity, less than
unity, zero or infinite. These five cases are explained with the aid of
the following figures.

Price elasticity of demand is unity when the change in demand is

exactly proportionate to the change in price. For example, a 20%
change in price causes 20% change in demand, EP = 20%/20% =1.
In the diagrams of Figure 1, Δp represents change in price, Δq
change in demand, and DD the demand curve. Price elasticity on the
first demand curve in Panel (A) is unity, for Δq/Δp = 1.

When the change in demand is more than proportionate to the

change in price, price elasticity of demand is greater than unity. If
the change in demand is 40% when price changes by 20% then EP =
40%/20% = 2, in Panel (B),i.e. Δq /Δp> 1. It is also known as
relatively elastic demand.
If, however, the change in demand is less than proportionate to the
change in price, price elasticity of demand is less than unity. When a
20% change in price causes 10% change in demand, then EP =
10%/20% = 1/2 =<1, in Panel (C), i.e. Δq/Δp < 1. It is also known as
relatively inelastic demand.
Zero elasticity of demand is one when whatever the change in price,
there is absolutely no change in demand. Price elasticity of demand
is perfectly inelastic in this case. A 20% rise or fall in price leads to
no change in the amount demanded, EP = 0/20% = 0, in Panel (D),
i.e. 0/ΔP = 0. It is perfectly inelastic demand.
Lastly, price elasticity of demand is infinity when as infinitesimal
small change in price leads to an infinitely large change in the
amount demanded. Visibly, no change in price causes an infinite
change in demand, E = ∞/0 = ∞, in Panel (E), at OD price, the
quantity demanded continues to increase from Ob to Ob1…….np. It is
perfectly elastic demand.
Type # 2. Cross Elasticity of Demand:
The cross elasticity of demand is the relation between percentage
change in the quantity demanded of a good to the percentage
change in the price of a related good. The cross elasticity of demand
between good X and Y

Where, Qx = Quantity of good X, PY = Price of good Y and Δ =

change.
Given the price of X, this formula measures the change in the
quantity demanded of X as a result of change in the price of Y.
The cross elasticity of demand for good X may be positive, negative
or zero which depends on the nature of relation between the goods
X and Y. This relation may be as substitutes, complementary or
unrelated goods.

1. Substitute Goods:
ADVERTISEMENTS:

If X and 7 are substitute goods, a fall in the price of good Twill

reduce the quantity demanded of good X. Similarly, an increase in
the price of good Y will raise the demand for good X. Their cross
elasticity is positive because, given the price of X, a change in the
price of Twill lead to a change in the quantity demanded of X in the
same direction as in the price of Y.

The cross elasticity of substitute goods is explained in Table 5.

ADVERTISEMENTS:

It is clear from the above that the coefficient of cross elasticity of

substitute goods such as tea (X) and coffee (Y) is positive (+0.75)
when with the rise in price of coffee, the price of tea being constant,
the demand for tea also increases.

This is shown in Fig. 6 where the quantity of good X (tea) is taken

on X-axis and the quantity of good Y is plotted on Y-axis. When the
price of Y increases from OY to OY1, the quantity demanded of X
rises from OX to OX1. The slope of the demand curve downwards to
the right shows positive elasticity of both the goods.

2. Complementary Goods:
ADVERTISEMENTS:

If two goods are complementary (jointly demanded), rise in the

price of one leads to a fall in the demand for the other. Rise in the
prices of cars will bring a fall in their demand together with the
demand for petrol. Similarly, a fall in the prices of cars will raise the
demand for petrol. Since price and demand vary in the opposite
direction, the cross elasticity of demand is negative.

The cross elasticity of complementary goods is explained in Table 6.

In this case, the cross elasticity coefficient of complementary goods
such as tea and sugar or car and petrol is negative.

This is explained in Fig.7 where with the rise in the price of Y

(Sugar) from OY to OY1 the demand for X (tea) falls from OX to
OX1. The slope of the demand curve downwards to the right
indicates negative cross elasticity.
3. Unrelated Goods:
If the two goods are unrelated, a fall in the price of good Y has no
effect whatsoever on the demand for good X. In such a case, the
cross elasticity of demand is zero. For example, a fall in the price of
tea has no effect on the quantity demanded of car. The cross
elasticity of demand for unrelated goods is shown in Fig. 8. Even an
increase in the price of good Y from OY to OY1, the demand for good
X remains the same as OD. Hence, the cross elasticity of demand for
unrelated goods is zero.
Some Conclusions:
We may draw certain inferences from this analysis of the cross
elasticity of demand.

(a) The cross elasticity between two goods, whether substitutes or

complementaries, is only a one-way traffic. The cross elasticity
between butter and jam may not be the same as the cross elasticity
of jam to butter. A 10% fall in the price of butter may cause a fall in
the demand for jam by 5%.

But a 10% fall in the price of jam may lower the demand for butter
by 2%. It shows that in the first case the coefficient is 0.5 and in the
second case 0.2. The superior the substitute whose price changes,
the higher is the cross elasticity of demand.

This rule also applies in the case of complementary goods. If the

price of car falls by 5%, the demand for petrol may go up by 15%,
giving a high coefficient of 3. But a fall in the price of petrol by 5%
may lead to a rise in the demand for cars by 1%, giving a low
coefficient of 0.2.

(b) Cross elasticities for both substitutes and complementaries vary

between zero and infinity. Generally, cross elasticity for substitutes
is positive, but in exceptional circumstances it may also be negative.

(c) Commodities which are close substitutes have high cross

elasticity and commodities with low cross elasticities are poor
substitutes for each other. This distinction helps to define an
industry. If some goods have high cross elasticity, it means that they
are close substitutes.

Firms producing them can be regarded as one industry. A good

having a low cross elasticity in relation to other goods may be
regarded a monopoly product and its manufacturing firm becomes
an industry by determining the boundary of an industry. Thus cross
elasticities are simply guidelines.
Application of Cross Elasticity in management:
The cross elasticity of demand has much practical importance in the
solution of various business problems.

1. In Production:
A firm wants to know the cross elasticity of demand for its goods
while considering the effect of change in the price of its competitor’s
goods on the demand for its own goods. It is important for a firm to
have a knowledge of it while making its production plan.

2. In Demand Forecasting and Pricing:

Its knowledge helps the firm in estimating the potential impact of
the pricing decisions of its competitors and associates on its sales so
that it prepares its pricing strategies.

3. In International Trade and Balance of Payments:

The utility of this concept is significant in the area of international
trade and balance of payments. The government wants to know how
the change in domestic prices affects the demand for imports.

Domestically produced goods being close substitutes if the cross

elasticity of demand for imports is high and if the prices of domestic
goods increase due to inflation, the demand for imports will
increase substantially which will deteriorate the balance of
payments position.

Type # 3. Income Elasticity of Demand:

The concept of income elasticity of demand (E) expresses the
responsiveness of a consumer’s demand (or expenditure or
consumption) for any good to the change in his income. It may be
defined as the ratio of percentage change in the quantity demanded
of a commodity to the percentage change in income. Thus
Where Δ is change, Q quantity demanded and Y is income.

The coefficient Ey may be positive, negative or zero depending upon

the nature of a commodity. If an increase in income leads to an
increased demand for a commodity, the income elasticity coefficient
(Ey) is positive. A commodity whose income elasticity is positive is a
normal good because more of it is purchased as the consumer’s
income increases.
On the other hand, if an increase in income leads to a fall in the
demand for a commodity, its income elasticity coefficient (Ey) is
negative. Such a commodity is called inferior good because less of it
is purchased as income increases. If the quantity of a commodity
purchased remains unchanged regardless of the change in income,
the income elasticity of demand is zero (Ey =0).
Normal goods are of three types necessaries, luxuries and comforts.
In the case of luxuries, the coefficient of income elasticity is positive
but high, Ey >1. Income elasticity of demand is high when the
demand for a commodity rises more than proportionate to the
increase in income.
Assuming prices of all other goods as constant, if the income of the
consumer increases by 5% and as a result his purchases of the com-
modity increase by 10%, then Ey = 10/5 = 2(>1). Taking income on
the vertical axis and the quantity demanded on the horizontal axis,
the increase in demand Q1Q2 is more than the rise in income Y1 Y2, as
shown in Figure 9. The curve Dy shows a positive and elastic income
demand.
In the case of necessities, the coefficient of income elasticity is posi-
tive but low, Ey <1. Income elasticity of demand is low when the
demand for a commodity rises less than proportionate to the rise in
the income. If the proportion of income spent on a commodity
increases by 2% when the consumer’s income goes up by 5%, E y =
2/5(<1) Figure 10 shows a positive but inelastic income demand
curve Dy because the increase in demand Q1 Q2 is less than
proportionate to the rise in income Y1 Y2.

In the case of comforts, the coefficient of income elasticity is unity

(Ey =1) when the demand for a commodity rises in the same
proportion as the increase in income. For example, a 5% increase in
income leads to 5% rise in demand, Ey =5/5 = 1. The curve Dy in
Figure 11 shows unitary income elasticity of demand. The increase
in quantity demanded Q1 Q2 exactly equals the increase in income
Y1 Y2.
The coefficient of income elasticity of demand in the case of inferior
goods is negative. In the case of an inferior goods, the consumer will
reduce his purchases of it, when his income increases. If a 5%
increase in income leads to 2% reduction in demand, Ey = -2/5 (<0).
Figure 12 shows the Dy curve for an inferior goods which bends
upwards from A to B when the quantity demanded decreases by
Q1 Q2 with the rise in income by Y1 Y2.

If with increase in income, the quantity demanded remains

unchanged, the coefficient of income elasticity, Ey = 0. If, say, with
5% increase in income, there is no change in the quantity
demanded, then Ey = 0/5 = 0. Figure 13 shows a vertical income
demand curve Dy with zero elasticity.
Measuring Income Elasticity of Demand: The Engel Curve:
Each Dy curve expresses the income-quantity relationship. Such a
curve is known as an Engel curve which shows the quantities of a
commodity which a consumer would buy at various levels of
income.
In Figure 9, we have explained income elasticity of demand with the
help of linear Engle curves. Income elasticity in terms of non-linear
Engel curves can be measured with the point formula. In general,
the Engel curves look like the curves E1, E2 and E3, as shown in
Figures 14, 15 and 16.
(1) Consider Figure. 14 where LA is tangent to the Engel curve E 1 at
point A. The coefficient of income elasticity of demand at point A is

This shows that the curve E1 is income elastic over much of its range.
When the Engel curve is positively sloped and Ey >1, it is the case of
a luxury goods.
(2) Take Figure 15 where NB is tangent to the Engel curve ED 2 at
point B. The coefficient of income elasticity at point B is

This shows that the income elasticity of E2 curve over much of its
range is larger than zero but smaller than 1. When the Engel curve is
positively sloped and Ey <1, the commodity is a necessity and is
income inelastic.
(3) In Figure 16, the Engel curve E3 is backward-sloping after point
B. In the backward-sloping range, draw a tangent GC at point C. The
coefficient of income elasticity at point C is

This shows that over the range the Engel curve E3 is negatively
sloped. Ey is negative and the commodity is an inferior good. But
before it bends backward, the Engel curve E3 illustrates the case of a
necessary good having income inelasticity over much of its range.
Determinants of Income Elasticity of Demand:
There are certain factors which determine the income elasticity of
demand.

1. The Nature of Commodity:

Commodities are generally grouped into necessities, comforts and
luxuries. We have seen above that in the case of necessities, Ey< 1, in
the case of comforts, Ey = 1, and in the case of luxuries, Ey> 1.
2. Income Level:
This grouping of commodities depends upon the income level of a
country. A car may be a necessity in a high-income country and a
luxury in a poor low-income country.

3. Time Period:
Income elasticity of demand depends on the time period. Over the
long-run, the consumption patterns of the propel may change with
changes in income with the result that a luxury today may become a
necessity after the lapse of a few years.

4. Demonstration Effect:
The demonstration effect also plays an important role in changing
the tastes, preferences and choices of the people and hence the
income elasticity of demand for different types of goods.

5. Frequency:
The frequency of increase in income also determines income
elasticity of demand for goods. If the frequency is greater, income
elasticity will be high because there will be a general tendency to buy
comforts and luxuries.

Use of Income Elasticity in Business Decisions:

The income elasticity of a product has great significance in long-
term planning and in the solution of strategic problems, particularly
during trade cycles.

1. Planning of the Firm’s Growth:

The knowledge of income elasticity of demand is very important for
both the firms and the government. Firms whose demand function
is income elastic, the scope of their growth is generally wide in an
expanding economy but they are very insecure during recession. So
such firms must consider their all economic activities and their
potential growth rate in future.

On the contrary, firms whose products are less income elastic, they
will neither obtain more profit with the expansion of the economy
nor will they incur specific loss during recession in the economy.
Such firms consider it necessary to bring variety in different
products or in a different industry.

For example, agricultural products are less income elastic while

industrial products are income elastic. Moreover, since the
coefficient of income elasticity of inferior goods is negative, the sale
of such products will decline with economic growth.

2. In Formulation of Farm Policy:

Farmers’ products are less income elastic because they cannot
generally bring variety in their products like income elastic
products. Hence, in the coming years the danger of such agricultural
problems is likely to remain particularly in developing countries.
Therefore, the Government of India has considered it necessary to
continue and increase various agricultural subsidies.
3. In Forecasting Demands:
The concept of income elasticity can be used in forecasting future
demand provided the firm knows the growth rate of income and
income elasticity of demand for the good. It is often believed that
the demand for goods and services increases with the rise in GNP
that depends on the marginal propensity to consume.

But it may be proved true in the context of aggregate national

demand while it is not necessary to be true for a particular good. For
this, the income of the related income class should be used. It is also
useful for avoiding the problem of over-production or under-
production.

4. In Formulating Marketing Strategies:

The income elasticity of demand of potential buyer class for
products affects the number, nature and location of sales centres,
nature and level of advertising and the policies related to other sales
promotion activities.

For instance, the sales centres of ice-creams will be located in the

prosperous town areas where the people have sufficient income and
their incomes are likely to increase sufficiently in future. Here, the
expected rise in demand in the context of increased income has been
discussed. But this rise will be compensated in more or less quantity
by the expected fall in demand with the increase in price.

Type # 4. Advertising or Promotional Elasticity of

Demand:
In the modern competitive or partial competitive market economy,
advertising has a great significance. Under advertising, various
visible or verbal activities are done by the firm for the purpose of
creating or increasing demand for its goods or services. Informative
advertising is very helpful for the consumer in making rational
purchase decisions.

But the extension of demand through advertising can be measured

by advertising or promotional elasticity of demand (EA) which
measures the expected changes in demand as a result of change in
other promotional expenses. The demand for some goods is affected
more by advertising such as the demand for cosmetics. Following is
the formula for advertising elasticity,
EA = ΔQ/ΔA x A/Q
Where, Q = quantity sold of good X; A = units of advertising
expenses on good X;

ΔQ = change in quantity sold of good X; and ΔA = change in

advertising expenses on good X.

The elasticity of demand for a good should be positive because there

is the possibility of extension of demand and market for the good
with advertising expenditure. The higher the value of this elasticity,
the greater will be the inducement of the firm to advertise that
product. It is on the basis of advertising elasticity that a firm decides
how much to spend on advertising a product.

Factors Influencing Advertising Elasticity of Demand:

The main factors influencing advertising elasticity are as
follows:
1. Stage of Product’s Development:
The advertising elasticity of demand for a product may vary with
different levels of sales of the same product. It is different for new
and established products.

2. Degree of Competition:
The advertising effect in a competitive market is also determined by
the relative effect of advertising by competing firms.

3. Effects of Advertising in Terms of Time:

The advertising elasticity of demand depends upon the time interval
between advertising expenditure and its effect on sales. This
depends on general economic environment, selected media and type
of the product. This time interval is large for durable goods than for
non-durable goods.
4. Effect of Advertising by Rival Firms:
The advertising elasticity also depends as to how other rival firms
advertise in comparison to the advertisement of the firm. This, in
turn, depends on the levels of advertisement and advertisements
done in the past and present by rival firms.

Application of Elasticity in Managerial Decisions:

Now we shall consider the application of concepts of elasticity.
Economists measure how responsive or sensitive consumers are to
change in the price or income or a change in the price of some other
product. Managerial economists measure the degree of elasticity by
the elasticity co-efficient. Managerial decisions aim at the best
alternative.

Managerial decisions are of two types: programmed decisions and

non-programmed decisions. But the decision making process may
be required in four areas of work: location decision, growth
decision, financial decision and operating decision. The price-
quantity relationship comes under operating decision.

1. Managerial Decision and Income Elasticity:

Income elasticity measures the ratio of percentage change in
quantity demanded to percentage change in income. A positive
income elasticity suggests a more than proportionate increase in
expenditure with an increase in income. If income elasticity is
negative it implies that the commodity is inferior.

Among the several income concepts, the most commonly used term
is the personal disposable income per head. The other income
concepts important for durable goods are that of transitory income
i.e., fluctuation in the short run income and discretionary income
i.e., that part of the income which is left over after deductions.

Economic development will be closely associated with increase in

the sales of quality goods. An efficient businessman is really
interested in knowing whether the sale of his goods will lead to
economic development.
The relationship between demand and income changes is not always
positive. It depends on the permanent change in income. If the
income elasticity is greater than one, the sales of his goods will
increase more quickly than general economic development. If the
income elasticity is greater than zero but less than one, sales of the
goods will increase but at a lower rate than economic development.

2. Managerial Decision and Industry Elasticity:

From the managerial point of view, it is thought useful to explain
industry elasticity. We know from the law of demand that when the
price of a commodity falls, the quantity demanded increases and
vice versa. The relation of price to sales is known in economics as
the demand.

The relation of price to demand or sales has been a major interest of

economist for a long time. If we like to have a good knowledge of
their relations, it gives better results to management. The industry
elasticity means that there is a change in complete industry sales
with a change in the general level of prices for the industry. The
industry demand has elasticity due to competition from other
industries.

3. Managerial Decision and Expectation Elasticity:

Expectation elasticity indicates the responsiveness of sales to buyers
guesses about the future values of demand determinants. In most
companies, a knowledge of condition in the immediate future is
essential for evolving a suitable production policy. Formulating
suitable production policy is necessary to avoid the problem of over
production or the problem of short supply.

Once the demand potential is assessed it will be easier for the

company to engage in long term planning. Like the future price of a
commodity or of its substitute, future income of buyers, prospects of
easy availability or otherwise in the future or future outlays, price
and income expectations are the most important among them.

4. Managerial Decision and Market Share Elasticity:

As regards a particular firm, the market share elasticity is most
important. This is influenced by rival’s changes in prices and
promotional efforts both qualitative and quantitative.

A thorough knowledge of market share elasticity will help the

managerial economist to the profitable results of the concern. The
market share elasticity indicates that there has been a change in
company’s wide sales to the price differential between the
company’s price and the industry-wide price level.

5. Managerial Decision and Promotional Elasticity:

Many of the firms spend huge amounts every year on advertising
their products to boost up sales. There is a direct relationship
between the extent of advertisement and volume of sales.

The promotional elasticity of demand is also called the advertising

elasticity of demand. It measures the responsiveness of demand to
change in advertising. The reason for finding out the advertisement
elasticity of demand by the company manager is to determine the
effects of advertisement on sales.

No related posts.
Methods for Measuring
National Income: 3 Methods |
Economics
Article Shared by Nipun S

ADVERTISEMENTS:

The following points highlight the three methods for measuring

national income. The methods are: 1. The Product (Output) Method
2. The Income Method 3. The Expenditure Method.

1. The Product (Output) Method:

The most direct method of arriving at an estimate of a country’s
national output or income is to add the output figures of all firms in
the economy to get the total value of the nation’s output. The
outputs can be grouped into certain product categories
corresponding to industries or to sectors (such as the primary
sector, secondary sector and the tertiary sector).
Problems:
When we use the output approach, one major problem arises. This
is known as the problem of double counting. It arises due to the fact
that the industry’s output is often the input of another industry. This
is why when we add up the values of all sales, the same output is
counted again and again as it is sold by one firm to another. This
problem is avoided by using the concept of ‘value added’, which is
the difference between output value and input at each stage of
production.

In other words, each firm’s value added is the value of its output
minus the value of the inputs that it purchases from other firms.
Thus, an automobile manufacturing company’s value added is the
value of its output (i.e., the market value of cars) minus the value of
tyres and tubes, glass, steel batteries it buys from other firms as also
the values of any other inputs, such as electricity and fuel oil that it
purchases from other firms.

As Lipsey has put it, “A firm’s output is defined as its value

added; the sum of all values added must be the value, at
factor cost, of all goods and services produced by the
economy”.
ADVERTISEMENTS:

While referring to the concept of value added economists draw a

distinction between intermediate goods (like tyres and types which
are used as inputs into a further stage of production) and final goods
that are the outputs of the economy after eliminating all double
(multiple) counting and are used for consumption and not for
further production.

In our example, tyres and tubes, glass, steel, electricity were all
intermediate goods used at various stages in the production process
while cars were final goods. In fact, all investment products used at
various stages in the process lead to the final produce, car.

In short, the output approach measures national output called gross

domestic products (GDP) in terms of the values added by each of the
sectors of the economy. To avoid the problem of double or multiple
counting we must either use the value added method or count the
total value of all final products.
Exports:
ADVERTISEMENTS:

If we use the value added method of estimating national output, we

have to include exports but exclude imported materials and services.
Imports are automatically excluded since we only record the values
added in this country. This will give us the GDP. In general, the GDP
is measured at market prices, giving the market value of all output.
To this, we must add (or from this we must subtract) the net factor
property.

Income from Abroad:

What is the gross national product? GNP is the name we give to the
total rupee value of the final goods and services produced within a
nation during a given year. It is the figure one arrives at when one
applies the measuring rod of money to the diverse goods and
services—from computer games to machine tools—that a country
produces with its land, labour, and capital resources and it equals
the sum of the money values of all consumption and investment
goods, government purchases, and net exports to other countries.

GNP is used for various purposes, but the most important one is to
measure the overall performance of an economy.

The gross domestic product (or GDP) is the most comprehensive

measure of a nation’s total output of goods and services. It is the
sum of the dollar values of consumption, gross investment,
government purchases of goods and services, and net exports
produced within a nation during a given year.

2. The Income Method:

The second approach is to measure incomes generated by
production. The main items of income are shown in Table 1.

Income from employment (item no. 1 in the Table) is wages and

salaries. Income of self-employed persons (item number 2) includes
both wages and return on capital owned by self-employed persons
(who are treated as firms in microeconomics). Item number 3 is to
be interpreted in a broad sense. It includes not only the rent of land
but also the rent of buildings, plus royalties earned from patents and
copyrights. Thus, it is a partly of return to land and partly a return
to capital. Item number 4 is the major part of return on capital to
the private sector.

Likewise, item number 5 is the major part of the return to capital for
the public sector. Item number 6 is depreciation which is the
reduction in the value of capital goods due to their contribution to
the production process. Depreciation or capital consumption
allowance represents that part of the value of output which is not
earned by any factor but is the value of capital used up in the
process of production. This depreciation is to be treated as part of
the gross return on capital.

Stock appreciation:
ADVERTISEMENTS:

Item number 8 involves stocks and its appreciation. The first one is
concerned with the valuation of stock of goods produced but not
sold in the same year. These are valued at market prices. This
creates a problem in the sense that there is need to record as part of
current output (and income) the profits that will be received by the
firm only when, and if at all, the goods are sold. Thus, if aggregate
inventories of Indian companies go down, national income will
raise.

In a year of inflation, it is necessary to make an adjustment for the

purely monetary changes in the value of stocks. It is so because a
rise in prices increases the value of existing stocks even when there
is no change in their volume. As G.F. Stanlake has put it, “In order
to obtain an estimate of the real changes in stocks it is
necessary to make a deduction equal to the ‘inflationary’
increase in value.”
This deduction is treated as stock appreciation in the national
income tables (see Table 1). Thus, in order to avoid distortions
caused by stock appreciation in an inflationary period, a correction
has to be made to eliminate changes in the value of stocks due to
price changes alone.

As Lipsey has put it, changes in stocks only contribute to changes in

GDP when their physical quantities change. The correction for the
change in the value of existing stocks yields GDP, valued at factor
cost and calculated from the income side of the economy. See Fig.1.

ADVERTISEMENTS:

In short, the income approach measures GDP “in terms of the

factor-in- come claims generated in the course of
producing the total output.”
Transfer Income:
When we use the income method we have to exclude all transfer
incomes such as unemployment benefit, widow pension, child
benefits or even interest on government bonds. These are transfer
incomes since they are not payments for services rendered — there
is no contribution to current real output by the recipients.

ADVERTISEMENTS:

Thus, while using the income method we must only take into
account those which have been earned for services rendered and in
respect of which there is some corresponding value of output.
Interest paid on government bonds is to be excluded for a simple
reason.

The government imposes taxes on some people to pay interest to

others. But, the total output (or income) of society does not increase
in the process. We may also refer to private transfer in this context.
If you receive a gift from your father who is also a resident of India,
India’s national income will remain unchanged.

Disposable Income:
Factor incomes are normally recorded gross (i.e., before taxes are
paid), because this is the measure of the factors’ contribution to
output. If we subtract all direct taxes as also provident funds
contributions and interest paid by individuals on loans (say to
HDFC or to Citi Bank credit cards) from national income we arrive
at disposable income. It is so called because people can dispose it off
as they wish.

ADVERTISEMENTS:

Personal Incomes:
National income is not the sum of all personal incomes. The reason
is simple. All the income generated in production does not find its
way into personal incomes. A certain portion of company profit is
added to reserves (and not distributed as dividends among
shareholders). Likewise, the profits of public sector (state)
enterprises are appropriated by the government and not by persons.
But, these undistributed surpluses must be added on to the total of
factor incomes received by persons to arrive at national income.
Net Factor (Property) Income from Abroad:
It is also to be noted that some of the income derived from economic
activity within the country will be paid to foreign owners of assets
located in India, while income from Indian-owned assets abroad
will be moving in the opposite direction. The income account,
therefore, must be adjusted by including the item ‘net income from
abroad’. Thus, if you receive a dividend income $ 1,000 from an U.S.
multinational it will be a part of India’s national income.

Stock Adjustment and Capital Gains and Losses:

Finally, stock appreciation adjustment has to be made in order to
eliminate the element of windfall gain in the profits received.
Similarly, capital gains and losses are to be excluded from national
income to avoid double counting. Thus, if you sell shores in the
stock exchange and make a gain of Rs. 100,000 it will not be a part
of India’s national income. However, if a certain portion of it
includes factor payment such as broker’s commission it will be a
part of national income.

3. The Expenditure Method:

From the expenditure side national income is calculated by adding
up the flows of expenditure needed to purchase the nation’s output.
However, while estimating the value of national product by the
expenditure method we must only record final expenditures.

We have to exclude all the expenditure on intermediate goods and

services. While measuring national income total final expenditure
(TFE) is divided into four broad categories: consumption,
investment, government expenditure (spending), exports and
imports. These four components may now be further developed.

Consumption:
Consumption expenditure refers to all purchases by households of
currently produced goods and services, except new houses which are
counted as investment. Secondly, consumption of second hand
goods like used cars is to be excluded to avoid double counting.
Thirdly, we have to measure purchases of goods and services made
in a year. We need not measure their actual consumption that
occurs during the year (or any other period under consideration).

Investment:
Investment is expenditure on currently produced capital goods like
plant and equipment and housing. Stocks are also included.
Investment may be gross or net. Gross investment less depreciation
is net investment, or net addition to (purchase of) society’s stock of
capital.

Government Expenditure:
Money that government spends falls into two categories, one is
called transfer payments. These are money paid out for which
nothing is given back to the government. One good example is
pension paid to retired people. There is a sort of transfer of money
from tax-payers to the people receiving pensions.

These transfer payments are not part of the GNP, since they do not
arise from production. It is government spending for goods and of
services that enters the GNP. Thus, the purchase of a wagon for the
Railway Board and the wages of postal workers are put of the GNP.

Only government expenditure on currently produced goods and

services is to be included. This is known as exhaustive expenditure.
All transfer expenditure is to be excluded to avoid double counting.
As Lipsey has put it, “All government payments to factors of
production in return for factor services rendered or payments for
goods and services are counted as part of the GDP.”

Examples are wages and salaries of government employees,

government expenditure on goods purchased from farmers for
distribution through the public distribution system (ration shops)
and on medicines purchased from the private sector for distribution
through government hospitals.

Exports and Imports:

Since exports represent foreigners’ expenditure on domestic output
these are included in GDP. Likewise imports are domestic
consumers’ expenditure on foreign goods. Hence, they are not a part
of GDP. In the language of Lipsey, “expenditure approach
measures the GDP in terms of the categories of
expenditure required to purchase the total output of
society”.
Market Price Measure Vs. Factor Cost Measure:
National expenditure is measured at market prices. These prices
differ from the factor cost values by the amount of taxes and
subsidies they contain. Thus, national income at market price-
indirect taxes + subsidies = national income at factor cost. See Fig.
2.

Residual Error:
All these measures of national income are supposed to give the same
final figure. Any discrepancy among the three measures is due to
statistical error. This is known as rounding-up error or residual
error, i.e., the error of calculation (not due to any conceptual or
methodological problem).
Problems:
However, various measurement problems crop up in practice.

These are the following:

1. Price Level Changes:
Firstly, price level changes create complications. Such changes make
it difficult to compare the value of output in one year with that of
another year. Do we express statistics in terms of market prices or
constant prices?

If in terms of market prices, then figures will be distorted by

inflation even though national output may have remained the same.
To overcome this, statistics are often expressed in terms of constant
prices. This means that a particular year’s prices are chosen to
calculate the value of output. In India, for example, 1980-81 is taken
as the base year.

2. Public Goods:
Secondly, difficulties arise in case of public goods like road,
hospitals, defence, schools, etc., which do have market prices. They
are parts of GDP because they satisfy human wants and make use of
scarce resources. So, the solution lies in measuring their values ‘at
cost’. The salaries of government school teachers and policemen are
taken as a measure of the values of their outputs.

The education and health expenditures are included at their cost

since they are obviously no different from similar services for which
people pay. All government services are therefore included at cost in
national output despite the argument that in some instances this
could amount to double counting because these services are
financed out of people’s taxation.

3. Self-Supplied Goods and Services:

Thirdly, people produce same goods and services for themselves.
For example, many teachers teach their own children, farmers
produce food for themselves and many people drive their own cars,
and many people even make their own clothes. In such cases, it is
not possible to arrive at a market measurement of the value of the
output.

If identical goods and services are sold in the market place it is

possible to give self-provided goods and services an imputed
valuation — an estimate of their values can be included in the
national income figures. This method is usually used in case of
owner-occupied houses (i.e., income from house property).

The market rents of similar properties are used as measuring rod for
the imputed rents of premises occupied by their owners. If there is
no reliable market indicator, the assumed (imputed) value must be
an arbitrary estimate or the national income accountant may decide
to omit the commodity (service) from the calculations of the
national output. This latter solution is adopted in case of free
services rendered by housewives like coaching their own children, or
cooking food or drawing water from the roadside tube-well or even
washing clothes.

In short, certain goods and services may be provided by a person for

himself or herself and it is very difficult to include these in
calculations altogether. Many of these self-supplied goods and
services will be omitted from national income. However, an imputed
value is given to owner occupied houses and an estimate is made of
the value of food consumed by farmers themselves.

Similarly, some goods and services, e.g., services given by

housewives, cannot be valued at all and are omitted. However, this
creates a difficulty because a housekeeper’s services are calculated
in national income.

4. Underground Economy:
Moreover, work done in the ‘Black or Underground Economy’, for
which there is no official record, is not included in calculations. This
is a serious problem in all market-based economies.

5. Double Counting:
This problem arises because the outputs of some firms are the
inputs of other firms. There are two possible ways of tackling this
problem. Prima facie, national income can be measured by adding
the values of the final products’.

A preferable alternative is to total the values added at each stage of

production. Double counting is a common problem faced by all
countries. Transfer payments should not be included in the
calculations of GNP. In addition, from the value of the products of
industries must be deducted the cost of raw materials and products
and services provided by other industries. Only the value added is
included. Stock appreciation must also be deducted. This occurs
when the value of stocks increases because of inflation. But, it
represents no increase in real output.

6. Factor Cost:
The value of the national output is measured at factor cost, that is,
in terms of the payments made to the factors of production for
services rendered in producing that output. As Stanlake has put it,
“Using market prices as measures of the value of output can be
misleading when market prices do not accurately reflect the costs of
production (including profits)”.

In fact, the market prices of most of the commodities that we buy

include indirect taxes and some of them include an element of
subsidy. Therefore, if we are to arrive at the factor cost value, we
have to deduct taxes on expenditure and add subsidies to the market
price valuations. It would be misleading to the figures for national
income at market prices since it would mean that the value of
national output could be increased by raising the rates of indirect
taxes such as sales tax or excise duty.

So, in spite of the supreme importance of the national income

estimates, a lot of difficulties arise in calculating national income
properly.

The following are some major difficulties:

(a) Inadequacy, non-availability and unreliability of accurate data
relating to the various sectors of the economy;

(b) Difficulties of reducing the various, diverse economic activities

of the people to a common measurable denominator;

(c) Difficulties in excluding raw materials and semi-finished goods

from the estimates of national income, in order to avoid the errors
of double counting;

(d) Difficulties in discovering true transfer payments (e.g.,

unemployment allowances or interest on public debts, relief
payments or old-age pensions) for their exclusion from the national
income estimates;

(e) Difficulties in making proper adjustment of the changes in the

price-level in the national income estimates;

(f) Difficulties in treating some major items like government taxes

and expenditure, the earnings from abroad, etc., in calculating the
national income;

(g) Difficulties in expressing the national product in terms of money

owing to the fluctuations in the value of money, existence of non-
mentioned transactions, unpaid services and non-monetary
economic activities, voluntary work, illegal transactions, etc.; and

(h) Conceptual difficulties in defining national income properly for

calculating it with accuracy. These difficulties are also to be faced in
estimating India’s national income.

Summary and Conclusion:

Despite these difficulties involved in the satisfactory calculation of
the national income, the latter serves as a broad indicator of a
country’s material welfare and a summary measure of aggregate
economic performances of a country. But, some American writers
like William Nordhaus, James Tobin and Paul Samuelson suggest
some readjustments in the traditional GNP to compute Net
Economic Welfare (NEW) “to gauge quality of economic life” and to
get a more meaningful measure of growth in a country.

No related posts.
Principle of Equi-Marginal
Utility (Explained with
Diagram)
Article shared by :  <="" div="" style="margin: 0px;
padding: 0px; border: 0px; outline: 0px; font-size: 16px; vertical-align: bottom;
background: transparent; max-width: 100%;">

ADVERTISEMENTS:

Principle of equi-marginal utility occupies an important place in the

marginal utility analysis. It is through this principle that consumer’s
equilibrium is explained. A consumer has a given income which he
has to spend on various goods he wants.

Now, the question is how he would allocate his money income

among various goods that is to say, what would be his equilibrium
position in respect of the purchases of the various goods. It may be
mentioned here that consumer is assumed to be ‘rational,’ that is, he
coldly and carefully and substitutes goods for one another so as to
maximize his utility or satisfaction.

Suppose there are only two goods X and Y on which a consumer has
to spend a given income. The consumer’s behavior will be governed
by two factors: first, the marginal utilities of the goods and secondly,
the prices of two goods. Suppose the prices of the goods are given
for the consumer.

ADVERTISEMENTS:
The law of equi-marginal utility states that the consumer will
distribute his money income between the goods in such a way that
the utility derived from the last rupee spend on each good is equal.
In other words, consumer is in equilibrium position when marginal
utility of money expenditure on each goods is the same.

Now, the marginal utility of money expenditure on a good is equal

to the marginal utility of goods divided by the price of the goods.

In symbols:
MUe= MUZ/PZ
ADVERTISEMENTS:

Where MUe is marginal utility of money expenditure and MUz is the

marginal utility of the goods X and Pz is the price of X. The law of
equi-marginal utility can, therefore, be stated thus: the consumer
will spend his money income on different goods in such a way that
marginal utility of each good is proportional to its price. That is,
consumer is in equilibrium in respect of the purchases of two goods
X and Y when
MUz/ PZ = MUz / PZ
Now, if MUz / PZ and MUy/ PZ are not equal and MUz / PZ -is greater
than MUz / PZ then the consumer will substitute goods X for goods
Y. As a result of this substitution the marginal utility of goods Y will
rise. The consumer will continue Substituting goods X for goods Y
till MUy/ PZ becomes equal to MUy / PZ When MUZ/ PZ becomes equal
to the Muy/ PZy consumer will be in equilibrium.
But the equality of MUZ / PZ with MUy/PZ can be achieved not only at
one level but at different levels O expenditure. The question is how
far a consumer goes on purchasing the goods he wants. This is
determined by the size of his money expenditure. With a given
expenditure a rupee has a certain utility for him: this utility is the
marginal utility of money by him.
ADVERTISEMENTS:

Since the law of diminishing marginal utility applies to money also,

the greater his money expenditure the consumer will go on
purchasing goods till the marginal utility of expenditure on each
good becomes equal to the marginal utility of money to him.

Thus, the consumer will be in equilibrium when the

following equation holds good:
MUZ,/PZ = MUY/Py = MUm
ADVERTISEMENTS:

If there are more than two goods on which the consumer is spending
his income, the above equation must hold good for all of them.

Let us illustrate the law of equi-marginal utility with the

aid of an arithmetical table given as follows:
Table-Marginal Utility of Goods X and Y:

Units ADVERTISEMENTS: MUY (Units)

 MVZ (units)

1 20 24

2 18 21

3 16 18

4 14 15

ADVERTISEMENTS: 12 9

6 ADVERTISEMENTS: 2

10

Let the prices of goods X and Y be Rs. 2 and Rs. 5 respectively.

Reconstructing the above table by dividing marginal

utilities of X (MUZ) by Rs. 2 and marginal utilities of Y
(MUY) by Rs. 3 we get:
Table-Marginal Utility of Money Expenditure:

Units MUZ/PX MUY/PY

1 10 8
 2 9 7

3 8 6

4 7 5

5 6 3

6 5 1

Suppose, the consumer has Rupees 19 with him to spend on the two
goods X and Y. By looking at the table it is clear that MUZ/PX is equal
to 6 units when the consumer purchases 5 units of goods X; and
MUZ/PX is equal to 6 units when he buys 3 units of goods y.
Therefore, consumer will be in equilibrium when he is buying 5
units of good X and 3 units of goods Y and will be spending (Rs.
2×5+ Rs. 3×3) = Rs.19 on them.
The law of equi-marginal utility can be graphically illustrated in
another way also. Consider Figure 4. Suppose a consumer has got
OO amount of money income which he has to spend on two goods X
and Y. In this figure, curve AB shows the marginal utilities of
successive rupees spent on commodity X with O as the point of
origin. CD shows the marginal utilities of successive rupees spent on
commodity Y with O as the origin.
It is worth noting that we read the number of rupees spend on
commodity X from left to right and read the number of rupees spent
on commodity y from right to left. It will be seen from this figure
that the two curves AB and CD showing the diminishing marginal
utility of rupees spent on X and Y respectively, intersect at point E.

That is, at point E marginal utility of rupee spent on commodity X

(MU) is equal to the marginal utility of rupee spent on commodity Y
(MUy). Thus, when OM amount of money is being spent on
commodity x and the remaining O’M is being spent on commodity
Y, marginal utility of a rupee spent on these two commodities in the
same.
This represents consumer’s equilibrium in respect of the
expenditure of a given amount of money income OO” on the two
commodities X and Y and in this position consumer will be getting
maximum satisfaction from the given amount of money income,
now, it can be proved that if we spend a little more amount on one
commodity and the same amount of money less on the other, the
satisfaction will decline.

Thus, if a consumer spends MN amount of money more on

commodity X and therefore MM amount of money less on
commodity Y, his gain in satisfaction will be equal to MEHM and his
loss in satisfaction will be equal to MEHN. It is, thus, clear that the
loss in satisfaction is greater than the gain in satisfaction by
spending MN amount of money more on X and the same amount of
money less on Y. We therefore, conclude that the consumer derives
maximum satisfaction when he is allocating money expenditure
among different commodities in such a way that the marginal utility
of money spent on each of them is the same.

The above equimarginal condition for the equilibrium of the

consumer can be stated in three ways.

(1) A consumer is in equilibrium when he equalizes weighted

marginal utilities of all goods, that is, when the marginal utility of
each good weighted by its price is equal.

In other words, when MUZ/ Pz = MUY/Py = MUN /PN = MUm

(2) A consumer is in equilibrium when he equalises the ratios of
marginal utilities of goods with the ratio of corresponding prices for
each pair of goods consumed, that is, when MUZ/PZ = PZ/ Py and
MUY/MU =Py /PZ and so forth
(3) Since MUZ/PZ measures the marginal utility of a rupee’s worth of
each good consumed at the given prices, consumer can be said to be
in equilibrium when the marginal utility of a rupee spent on each
good purchased in equal. Marginal utility of a rupee spent on a good
means the marginal utility of a rupee’s worth of the good.
Marginal Rate of Substitution (MRS)
By ADAM HAYES

 Updated Nov 7, 2019

What Is the 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. It's used in indifference theory to
analyze consumer behavior. The marginal rate of substitution is calculated
between two goods placed on an indifference curve, displaying a frontier of
utility for each combination of "good X" and "good Y."

Volume 75%
 

1:23
Marginal Rate of Substitution
Understanding Marginal Rate of Substitution
MRS economics is used to analyze consumer behaviors for a variety of
purposes. The marginal rate of substitution is an economics term that
refers to the amount of one good that is substitutable for another. MRS
economics involves a sloping curve, called the indifference curve, where
each point along it represents quantities of good X and good Y that you
would be happy substituting for one another.

The slope of the indifference curve is critical to marginal rate of substitution

analysis. At any given point along an indifference curve, the MRS is the
slope of the indifference curve at that point. Note that most indifference
curves are actually curves, so the slopes are changing as you move along
them. Most indifference curves are also usually convex because as you
consume more of one good you will consume less of the other. Indifference
curves can be straight lines if a slope is constant, resulting in an
indifference curve represented by a downward-sloping straight line.

If the marginal rate of substitution is increasing, the indifference curve will

be concave to the origin. This is typically not common since it means a
consumer would consume more of X for the increased consumption of Y
and vice versa. Usually, marginal substitution is diminishing, meaning a
consumer chooses the substitute in place of another good rather than
simultaneously consuming more.

The law of diminishing marginal rates of substitution states that

MRS decreases as one moves down a standard convex-shaped curve,
which is the indifference curve.

KEY TAKEAWAYS

 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 comparable 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.
 When the law of diminishing marginal rates of substitution is in effect,
the marginal rate of substitution forms a downward, negative sloping,
convex curve showing more consumption of one good in place of
another.
Calculating the MRS Formula
The marginal rate of substitution (MRS) formula is:

\begin{aligned} &|MRS_{xy}| = \frac{dy}{dx} = \frac{MU_x}

{MU_y} \\ &\textbf{where:}\\ &x, y=\text{two different goods}\\
&\frac{dy}{dx}=\text{derivative of y with respect to x}\\
&MU=\text{marginal utility of good x, y}\\ \end{aligned}∣MRSxy
∣=dxdy=MUyMUxwhere:x,y=two different goodsdxdy
=derivative of y with respect to xMU=marginal utility of good x, y
Example of How to Use the Marginal Rate of Substitution
For example, a consumer must choose between hamburgers and hot dogs.
In order to determine the marginal rate of substitution, the consumer is
asked what combinations of hamburgers 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 hamburgers they have relative to hot dogs, the
fewer hot dogs they are willing to consume. If the marginal rate of
substitution of hamburgers for hot dogs is -2, then the individual would be
willing to give up 2 hot dogs for every additional hamburger consumption. 

Investopedia/Julie Bang
Limitations of Marginal Rate of Substitution
The marginal rate of substitution does not examine a combination of goods
that a consumer would prefer more or less than another combination. This
generally limits the analysis of MRS to two variables. Also, 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.