Chapter 6: Consumer Choice &Demand

Chapter Outline:
1. Utility
2. Total and Marginal utility
3. Consumer equilibrium
4. Consumer equilibrium and demand
5. Consumer surplus
6. Indifference curves
7. Budget constraint
8. Consumer equilibrium and indifference curves.
Q. Define Utility. Explain the different types of Utility.
Answer: "Utility" is an economic term introduced by Daniel Bernoulli referring to the total
satisfaction received from consuming a good or service. The economic utility of a good or service
is important to understand because it will directly influence the demand, and therefore price, of
that good or service. A consumer's utility is hard to measure, however, but it can be determined
indirectly with consumer behavior theories, which assume that consumers will strive to maximize
their utility.
Types of Utility
Total utility (TU): It is defined as the total amount of satisfaction that a person can receive from
the consumption of all units of a specific product or service. Using the example above, if a person
can only consume three slices of pizza and the first slice of pizza consumed yields 10 utils, the
second slice of pizza consumed yields 8 utils and the third slice yields 2 utils, the total utility of
pizza would be 20 utils.
TU can be infinite. Its upper boundary is set by the total number of a good or service available for
consumption by a consumer.
Marginal Utility: Marginal utility (MU) is defined as the additional utility gained from the
consumption of one additional unit of a good or service. Using the same example, if the utility of
the first slice of pizza is 10 utils and the utility of the second slice is 8 utils, the MU of eating the
second slice is 8 utils. If the utility of a third slice is 2 utils, the MU of eating that third slice is 2
utils.
Q Explain Consumer Equilibrium in case of single commodity or one commodity.
A Meaning of Consumer Equilibrium :- It is a situation in which a costumer is getting maximum
satisfaction and he has no tendency to change his pattern of consumption.

Condition:- MUX = PX
Assumptions :-
a) Utility can be measured in terms of units.
b) Consumer is rational and wants maximum satisfaction.
c) Independent utility
d) MU of money is constant. MU of money is known as worth of a rupee.
e) Law of Diminishing Marginal Utility is applied here

Schedule:- Suppose a consumer is buying orange and the price of each unit of orange is rupee 4,
hypothetical MU of orange is given as

Units MUX PUX

1 8 4
2 6 4
3 4 4
4 2 4
Explanation of schedule :- It is evident from the schedule that consumer will purchase four
oranges and reaches an equilibrium position.
In this situation the position of the consumer equilibrium MUX (in rupee) is equal to PX is
satisfied.
Diagram:-

Q What changes does it make to the

equation of consumer equilibrium when he decides to spend his income on two
commodities rather than one?
OR
Explain consumer equilibrium in case of double commodity.

Meaning of Consumer equilibrium:- It is a situation in which a consumer is satisfied and he has

no tendency to change his pattern of consumption.

Condition:- MUx = MUY = MUM

PX PY
Assumption: -
a) Consumer is rational
b) Utility can be measured in term of money
c) MUM is constant
e) Only standard unit of commodity are consumed by consumer
f) Law of Diminishing Marginal Utility applied here
Diagram Explanation: -
PP1 represents MU x commodity whereas QQ1 represents MU of Y commodity. It shows
equality at A and A1. it is a ideal situation for the consumer where consumer will be in
equilibrium
Now if he spends one less unit of X and one more unit of Y then he will not be in position of
equilibrium then he will be at point B and B1 which is not a situation of equilibrium because he
gets one less unit of commodity X and one more unit of commodity Y.
Q Explain the following :-
a) Indifference set
b) Indifference Curve
c) Indifference Map
A a) Indifference set is a set of two commodities which offers the consumer same level
of satisfaction, so that he is indifferent between these combinations.
b) Indifference Curve is the diagrammatic presentation of an indifference set. it shows the set of
two commodities that offers the consumer the same level of satisfaction, so that he is indifferent
between these combinations.
c) Indifference Map refers to a set of indifference curve.
Q Explain relation between MU and TU. [Very Important] 3/4 marks
Q. Explain Consumer's Equilibrium Through Indifference Curve Analysis.

Definition:

"The term consumers equilibrium refers to the amount of goods and services which the
consumer may buy in the market given his income and given prices of goods in the market". The
aim of the consumer is to get maximum satisfaction from his money income. Given the price line
or budget line and the indifference map: "A consumer is said to be in equilibrium at a point
where the price line is touching the highest attainable indifference curve from below".

Conditions:

Thus the consumers equilibrium under the indifference curve theory must meet the following two
conditions:

First: A given price line should be tangent to an indifference curve or marginal rate of satisfaction
of good X for good Y (MRSxy) must be equal to the price ratio of the two goods. i.e.

MRSxy = Px / Py

Second: The second order condition is that indifference curve must be convex to the origin at the
point of tangency.

Assumptions:

The following assumptions are made to determine the consumers equilibrium position.

(i) Rationality: The consumer is rational. He wants to obtain maximum satisfaction given his
income and prices.

(ii) Utility is ordinal: It is assumed that the consumer can rank his preference according to the
satisfaction of each combination of goods.

(iii) Consistency of choice: It is also assumed that the consumer is consistent in the choice of
goods.

(iv) Perfect competition: There is perfect competition in the market from where the consumer is
purchasing the goods.

(v) Total utility: The total utility of the consumer depends on the quantities of the good consumed.

Explanation:
The consumers consumption decision is explained by combining the budget line and the
indifference map. The consumers equilibrium position is only at a point where the price line is
tangent to the highest attainable indifference curve from below.
(1) Budget Line Should be Tangent to the Indifference Curve:
The consumers equilibrium in explained by combining the budget line and the indifference map.
Diagram/Figure:

In the diagram 3.11, there are three indifference curves IC1, IC2 and IC3. The price line PT is
tangent to the indifference curve IC2 at point C. The consumer gets the maximum satisfaction or
is in equilibrium at point C by purchasing OE units of good Y and OH units of good X with the
given money income.
The consumer cannot be in equilibrium at any other point on indifference curves. For instance,
point R and S lie on lower indifference curve IC1 but yield less satisfaction. As regards point U on
indifference curve IC3, the consumer no doubt gets higher satisfaction but that is outside the budget
line and hence not achievable to the consumer. The consumers equilibrium position is only at
point C where the price line is tangent to the highest attainable indifference curve IC2 from below.
(2) Slope of the Price Line to be Equal to the Slope of Indifference Curve:
The second condition for the consumer to be in equilibrium and get the maximum possible
satisfaction is only at a point where the price line is a tangent to the highest possible indifference
curve from below. In fig. 3.11, the price line PT is touching the highest possible indifferent curve
IC2 at point C. The point C shows the combination of the two commodities which the consumer is
maximized when he buys OH units of good X and OE units of good Y.
Geometrically, at tangency point C, the consumers substitution ratio is equal to price ratio Px / Py.
It implies that at point C, what the consumer is willing to pay i.e., his personal exchange rate
between X and Y (MRSxy) is equal to what he actually pays i.e., the market exchange rate. So the
equilibrium condition being Px / Py being satisfied at the point C is:
Price of X / Price of Y = MRS of X for Y
The equilibrium conditions given above states that the rate at which the individual is willing to
substitute commodity X for commodity Y must equal the ratio at which he can substitute X for Y
in the market at a given price.
(3) Indifference Curve Should be Convex to the Origin:
The third condition for the stable consumer equilibrium is that the indifference curve must be
convex to the origin at the point of equilibrium. In other words, we can say that the MRS of X
for Y must be diminishing at the point of equilibrium. It may be noticed that in fig. 3.11, the
indifference curve IC2 is convex to the origin at point C. So at point C, all three conditions for the
stable-consumers equilibrium are satisfied.
Summing up, the consumer is in equilibrium at point C where the budget line PT is tangent to
the indifference IC2. The market basket OH of good X and OE of good Y yields the greatest
satisfaction because it is on the highest attainable indifference curve. At point C:
MRSxy = Px / Py

Q. Explain Budget line.

Answer: According to Hibbdon, the budget line is that line which shows all the different
combinations of the two commodities that a consumer can purchase given his money income and
the price of two commodities. Suppose, A consumer has an income of Tk 4.00 to be spent on
apples and oranges. Price of orange is Tk 0.50 per orange and that of apple Tk. 1.00 per apple.
With his given income and given prices of apples and oranges, the different combinations that a
consumer can get of these two goods are shown in below:
Alternative consumption possibilities
Income (Rs) Apples Oranges
Price= (Tk. 1.00) Price= (Tk. 0.50)
Four 0+ 8
Four 1+ 6
Four 2+ 4
Four 3+ 2
Four 4+ 0

Table shows that, if the consumer wants to buy oranges only then he can get maximum 8 oranges
with his entire income of Takas four. On the other hand, if the consumer wants to buy apples only
then he can get maximum 4 apples with his entire income of Takas four. Within these two extreme
limits of apples and oranges, the other possible combinations that a consumer can get are: 1 apple
+ 6 orange, 2 apple + 4 oranges, 3 apple + 2 oranges.
In above figure, different combination of goods has been shown by AB line. It is call budget line.
It is presumed that the consumer spends his entire income on the consumption of these two goods,
so AB budget line is the limit line of the consumer. Slope of budget line refers to the price ratio of
two goods, apples and oranges that is
Pa
Slope of budget line = Here, Pa=Price of Apples, P0= Price of oranges
P0
Q. Difference between total utility and marginal utility.
Answer:
Total Utility
Total utility is the sum total of utility derived
from all the units of a commodity consumed.
Total utility is the sum total of utility derived
from all the units of a commodity consumed.
However, total utility continues to increase
with every additional unit of the commodity
consumed till marginal utility becomes zero.
Total utility generally remains positive.
Total utility becomes maximum
Marginal Utility
Marginal utility is additional utility due to the
consumption of an additional unit of a
commodity.
Marginal utility, refers to change in total
utility due to a unit change in the
consumption of a commodity. It is the
difference between two successive total utility
figures.
Marginal utility tends to diminish as more of
the commodity is consumed.
Marginal utility may be zero or even negative.
Marginal utility is zero.