Chapter 2 CONSUMER’S EQUILIBRIUM
Consumer
A consumer is one who buys g oods and services for the satisfaction of wants.
He takes decisions with regard t o the kind of goods to be purchased in order to satisfy his wants
The main objective is to get maximum satisfaction from spending his income on various goods and services.
Approaches which are Used to Study Consumer‟s Behaviour
There are two main approaches to studying consumer‟s behaviour and consumer‟s equilibrium are :
(i) Cardinal Utility Approach (or Marshall‟s Utility
Analysis or Marginal utility Analysis).
(ii) Ordinal Utility Approach (or Indifference Curve
Analysis or Hicksian analysis).
Cardinal Utility Approach
Utility refers to want satisfying power of a commodity. It is the satisfaction, actual or expected, derived from the consumption of a commodity. Utility differs from person to person, place to place and time to time.
There was no standard unit for measuring utility. So, economists derived an imaginary measure known as „Util‟.
Example : Measurement of satisfaction in utils.
Utility can also be measured in terms of money or price, which the consumer is willing to pay.
Total Utility :
Total utility refers to the total satisfaction obtained from the consumption of all possible units of a commodity.
Total utility is zero at zero level of consumption.
TU = ∑ MU
TU can be calculated as : TUn
= U1 + U2+ U3 +..… + Un
Marginal Utility :
MU is the additional utility derived from the consumption of one more unit of the given commodity.
It is the utility derived from the last unit of a commodity purchased.
MU = ∆ππ/∆π
OR MU = TUn – TUn-1
As per given example, when 3rd ice-cream is consumed, TU increases from 36 utils to
46 utils. The additional 10 utils from the 3rd ice-cream is the MU.
MU of 3rd ice-cream will be : MU3
= TU3 – TU2
= 46 – 36 = 10 utils
Relationship Between TU And MU
1. When the 1st unit of commodity is consumed, MU is equal to TU. (MU = TU)
2. From 2nd consumption, MU goes on diminishing and TU increases at a diminishing rate. (MU↓. and TU ↑)
3. At a full satisfaction level, MU becomes zero & TU reaches at maximum level. It becomes constant. It is called point of satiety. (MU zero, TU maximum)
4. After a point of satiety, any additional consumption of unit results into negative MU while TU starts declining. (MU —ve, TU↓)
Law Of "Diminishing Marginal Utility‟
Law of DMU states that as we consume more and more units of a commodity, the utility derived from each successive unit goes on decreasing.
Law of DMU has universal applicability and applies to all goods and services.
It is also known as Gossen‟s first law of consumption as it is given by a German H.H. Gossen.
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Consumer‟s Equilibrium
Equilibrium means a state of rest or a position of no change.
A consumer is said to be in equilibrium, when he does not intend to change his level of consumption, i.e., when he derives maximum satisfaction.
/ A rational consumer aims to balance his expenditure in such a manner, so that he gets maximum satisfaction with minimum expenditure.
Consumer Equilibrium can be discussed under two different situations :
If the consumer spends his entire income on a single commodity (single commodity approach).
If a consumer spends his entire income on two commodities (two commodity approach).
Single Commodity Approach
All the assumptions of the Law of DMU are taken as assumptions of the consumer‟s equilibrium in the case of a single commodity.
The number of units to be consumed of the given commodity by a consumer depends on two factors :
Price of the Given Commodity.
Expected Utility (Marginal Utility) from each successive unit.
A consumer in consumptions of single commodity will be at equilibrium when
marginal utility (MUX) is equal to the price paid (Px) for the commodity i.e. MUx=PX
Case 1
If MUx> Px then the consumer is not at equilibrium and he goes on buying because the
benefit is greater than the cost.
As he buys more, MU falls because of the operation of the law of diminishing marginal
utility. When MU becomes equal to the price, consumer gets the maximum benefits and is in
equilibrium.
Case 2
If MUx < Px then also consumer is not at equilibrium as he will have to reduce
consumption of commodity x to raise his total satisfaction till MU becomes equal to
price.
Consumer‟s Equilibrium in Case of Single Commodity
Explanation :
From the above schedule and diagram, it is clear that the consumer will be at
equilibrium at point „E‟ when he consumes 3 units, because at point „E‟, MUx = PX
.
A consumer will not consume 4 units as MU of Rs. 4 is less than the price paid
of Rs. 10
Similarly, he will not consume 2 units as MU of Rs. 16 is more than the price
paid.
So, it can be concluded that a consumer in consumption of single commodity
(say, x) will be at equilibrium when marginal utility from the commodity
(MUx) is equal to price (Px) paid for the commodity.
Two Commodity Approach
The Law of DMU applies in case of either one commodity or one use of a commodity.
According to this approach, a consumer gets maximum satisfaction when ratios of MU of two
commodities and their representative prices are equal and MU falls as consumption increases i.e.
MUx/Px = MUy/Py
There are two necessary conditions to attain consumer‟s equilibrium in the case of two commodities :
1) The ratio of Marginal Utility to Price is the same in the case of both the goods.
MUx = MUy Px Py
2) MU falls as Consumption Increases.
The second condition needed to attain consumer‟s equilibrium is that MU of a commodity must fall as
more of it is consumed.
If MU does not fall, as consumption increases, the consumer will end up buying only one good which is
unrealistic and consumer will never reach the equilibrium position.
Case 1
If πππ± > πππ² then the consumer is getting more MU in the case of good X as compared to ππ± ππ²
good Y.
Therefore, he will buy more of X and less of Y.
This will lead to fall in MUx and a rise in MUY.
The consumer will continue to buy more of X till πππ± /ππ± becomes equal to πππ² /ππ²
Case 2
If πππ₯ /Px< πππ¦/Pythen the consumer is getting more MU per rupee in case of good Y as compared to good X.
Therefore, he will buy more of Y and less of X.
This will lead to falling in MUY and a rise in MUx. πππ₯ πππ¦
The consumer will continue to buy more of Y till ππ₯ becom?
Lest us now discuss the law of equi-marginal utility with the help of a numerical
example. Suppose, total money income of the consumer is ₹ 5, which he wishes to
spend on two commodities: „x‟ and „y‟. Both these commodities are priced at ₹ 1 per
unit. So, consumer can buy maximum 5 units of „x‟ or 5 units of „y‟. In Table, we
have shown the marginal utility which the consumer derives from various units of
„x‟ and „y‟.
Explanation :
From Table, it is obvious that the consumer will spend the first rupee on
commodity 'x', which will provide him utility of 20 utils. The second rupee will be
spent on commodity 'y' to get utility of 16 utils. To reach the equilibrium,
consumer should purchase that combination of both the goods, when :
a) MU of last rupee spent on each commodity is same; and
b) MU falls as consumption increases.
It happens at point E when consumer buys 3 units of 'x'
and 2 units of 'y' because :
a) MU from last rupee (i.e. 5th rupee) spent on commodity y
gives the same satisfaction of 12 utils as given by last rupee (i.e. 4th rupee) spent on commodity x; and
b) MU of each commodity falls as consumption increases.
The total satisfaction of 74 utils will be obtained when consumer buys 3 units of 'x' and 2 units of 'y'. It reflects the state of consumer's equilibrium. If the consumer spends his income in any other order, total satisfaction will be less than 74 utils.
Ordinal Utility Approach
Indifference Curves was made by J.R. Hicks and R.G.D. Allen, popularly known as Hicks and Allen. In 1934, they wrote an article, „A reconstruction of the theory of value‟, presenting the Indifference Curve Analysis.
According to them, a consumer can rank various combinations of goods and services in order of his preference.
A method of ranking the preferences is known as the „ordinal utility approach‟. Ordinal utility is the utility expressed in ranks.
Indifference Curve
Indifference Curve refers to the graphical representation of various alternative combinations of bundles of two goods among which the consumer is indifferent.
It is a locus of points that show such combinations of two commodities which give the consumer the same satisfaction.
As seen in the schedule, consumer is indifferent between five combinations of apple and banana.
Combination „P‟ (1A + 15B) gives the same utility as (2A + 10B), (3A + 6 B) and so on.
By joining these points, we get an indifference curve IC1
MRS is the slope of the Indifference Curve.
Every point on IC1 represents an equal amount of satisfaction to the consumer.
It means that a rational consumer always prefers more of a commodity as it offers him a higher level of satisfaction.
It implies that as consumption increases total utility also increases.
Monotonic Preferences
For Example : Consider 2 Goods : Apples (A) and Bananas (B).
a) Suppose two different bundles are: 1st : (10 A, 10 B) and 2nd: (7 A, 7 B). Consumer‟s preference of 1st bundle as compared to the 2nd bundle will be called monotonic preference as 1st bundle contain more of both Apples and Bananas.
b) If 2 bundles are: 1st : (10 A, 7 B) and 2nd: (9 A, 7 B).
Consumer‟s preference of 1st bundle as compared to the 2nd bundle will be called monotonic preference as 1st bundle contains more of apples, although bananas are same.
Indifference Map
It refers to the family of indifference curves that represents consumer preferences over all the bundles of two goods.
It represents all the combinations which provide the same level of satisfaction. Every higher or lower level of satisfaction can be shown on different indifference curves.
Explanation :
IC1 represents the lowest satisfaction, IC2 shows
satisfaction more than that IC1 and the highest level of satisfaction is depicted by indifference curve IC3.
However, each indifference curve shows the same level of satisfaction individually.
Higher Indifference Curves represent higher levels of satisfaction as higher indifference curve represents larger bundles of goods, which means more utility because of monotonic preference.
Marginal Rate of Substitution‟
It refers to the rate at which the commodities can be substituted with each other so that the total satisfaction of the consumer remains the same.
As seen in the above schedule and diagram, as the consumer moves from P to Q, he sacrifices 5 bananas for 1 apple and MRS comes
out to be 5:1. Similarly, from Q to R, MRSAB is 4: 1.
The MRS of apples for bananas is diminishing.
MRS measures the slope of the indifference curve.
MRSAB = ππ§π’ππ¬ π¨π πππ§ππ§ππ¬ π π°π’π₯π₯π’π§π ππ¨ π¬πππ«π’ππ’ππ OR MRS = ∆ π
ππ§π’ππ¬π¨πππ©π©π₯ππ¬ π π°π’π₯π₯π’π§π ππ¨π ππ’π§ ∆π
MRS diminishes because of the Law of DMU.
In the given example of apples and bananas, Combination „P‟ has only 1 apple and, therefore, apple is relatively more important
than bananas. Due to this, the consumer is willing to give up more bananas for an additional apple. But as he consumes more and more of apples, his marginal utility from apples keeps on declining. As a result, he is willing to give up less and less of bananas for each additional apple.
Properties of Indifference Curve
1) Indifference Curves are Always Convex to the Origin
2) Indifference Curve Slopes Downwards
3) Higher Indifference Curves Represent Higher Levels of Satisfaction
4) Indifference Curves can Never Intersect Each Other
Budget Line
We have discussed different combinations of two goods that provide same level of satisfaction. But, which combination, will a consumer actually purchase, depends upon his income („consumer budget‟) and prices of the two commodities.
Consumer Budget states the real income or purchasing power of the consumer from which he can purchase certain quantitative bundles of two goods at given price.
It means, a consumer can purchase only those combinations (bundles) of goods, which cost less than or equal to his income.
Budget line is a graphical representation of all possible combinations of two goods which can be purchased with given income and prices, such that the cost of each of these combinations is equal to the monetary income of the consumer.
Schedule of Budget Line
Suppose, a consumer has a budget of ₹ 20 to be spent on two commodities : Apples (A) and Bananas (B). If apple is priced at ₹ 4 each and banana at ₹ 2 each, then the consumer can determine the various combinations (bundles), which form the budget line. The possible options of spending income of ₹ 20 are given in Table.
Explanation :
The number of apples are taken on X-axis and bananas on the Y-axis.
At Point „E‟, the consumer can buy 5 apples by spending his entire income of Rs. 20 only on apples.
At Point „J‟, the entire income is spent only on bananas.
By joining other combinations like F, G, H and I, we get a straight line „AB‟ known as Budget Line or Price Line.
Every point on this budget line indicates those bundles of apples and bananas, which the consumer can purchase by spending
his entire income of ₹ 20 at the given prices of goods.
Budget Set
It is the set of all possible combinations of two goods which a consumer can afford with his given income and prices in the market.
It is a quantitative combination of two goods which can be purchased by a consumer from his given income.
Equation of a Budget Line
M = (PA x QA) + (PB x QB);
Where : M = Money Income;
QA = Quantity of Apples (A); QB = Quantity of Bananas (B); PA = Price of each apple;
PB = Price of each Banana.
Indifference Curve Analysis Approach
Consumer‟s equilibrium refers to a situation, in which a consumer derives maximum satisfaction with no intention to change it and subject to given prices and his given income.
The point of maximum satisfaction is achieved by taking the Indifference map and Budget Line together.
On an indifference map, a higher indifference curve represents a higher level of satisfaction.
Therefore, a consumer always tries to remain at the highest possible indifference curve, subject to his budget constraint.
Consumer‟s Equilibrium under indifference curve theory must meet the following two conditions :
Case 1. MRSXY = Ratio of prices or ππ₯ ππ¦
a) If there are two gods X and Y then the first condition to be fulfilled is MRSXY = ππ₯ ππ¦
b) If MRSXY > ππ₯ , it means that to obtain one more unit of good X, the consumer is willing to ππ¦
sacrifice more units of good Y as compared to what is required in the market.
As consumption increases the satisfaction of good X falls because of the Law of DMU.
As a result, MRS falls and continues to fall till MRSXY = ππ₯ ππ¦
c) If MRSXY < ππ₯, it means that to obtain one more unit of good X, the consumer is willing to sacrifice ππ¦
less unit of good Y as compared to what is required in the market.
It induces the consumer to buy less of X and more of Y. As a result, MRS rises till it becomes equal to the ratio of prices and the equilibrium is established.
Case 2. MRS Continuously Falls
The second condition for consumer‟s equilibrium is that MRS must be diminishing at the point of equilibrium, i.e. the indifference curve must be convex to the origin at the point of equilibrium.
Thus, both the conditions need to be fulfilled for a consumer to be in equilibrium.
Explanation :
IC1, IC2 and IC3 are three indifference curves and AB is the budget line.
With the constraint of the budget line, the highest indifference curve, which a consumer can reach, is IC2.
The Budget Line is tangent to the indifference curve IC2 at point E.
This is the point of consumer equilibrium where the consumer purchases OM quantity of commodity „X‟ and ON quantity of commodity „Y‟.
As Budget Line can be tangent to one and only one indifference curve, the consumer maximizes his satisfaction at point E, where both the conditions of the Consumer‟s Equilibrium satisfy i.e.
a) MRSXY = Ratio of prices or ππ₯ ππ¦
b) MRS continuously falls.
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