CONSUMER EQUILLIBRIUM

MEANING OF CONSUMER
A person who buys goods and services for the satisfaction of his/her wants is
called as a consumer. A rational consumer always aims at maximising his/her
satisfaction, given income and prices of goods and services.

MEANING OF UTILITY
Want satisfying power of a commodity is called as Utility.
Utility is the satisfaction derived by a consumer from consumption of a commodity.

MEASUREMENT OF UTILITY

There are two approaches which

define the measurement of utility
1. Cardinal Approach
2. Ordinal Approach
CARDINAL APPROACH
 Utility can be defined in terms of numbers
 Utility can be defined in terms of Utils
 Utils are psychological and imaginary terms
 Utils are highly subjective in nature and varies from person to person.
CONCEPT OF TOTAL UTILITY AND MARGINAL UTILITY
TOTAL UTILITY (TU)
 It refers to the total satisfaction derived from the consumption of all possible
units of a commodity.
 TUn = U₁+ U₂+ ... + Un

-TU is the total satisfaction

-U₁, U2, ………………., Un, are utilities derived from different units of consumption
-N is the number of units consumed.
MARGINAL UTILITY (TU)
 Marginal means "Additional"
 It refers to the addition to total utility by consumption of one additional unit
of a commodity.
 MUn = TUn -TUn-1
Change in Total Utility ΔTU
 MU = =
Change in Units of Consumption ΔQ

RELATIONSHIP BETWEEN TU AND MU

 With an increase in consumption of units
of a commodity, as long as MU is positive
and falling, TU increases at a diminishing
rate.
 When MU is Zero, TU becomes maximum
and constant. This is called as Point of
Satiety or Point of maximum satisfaction.
 When MU Becomes negative, TU begins to
fall.
Quantity (Units) Total Utility Marginal Utility Remarks
0 0 -
1 8 8 MU falls but remains
2 14 6 positive
3 18 4
4 20 2
5 20 0 MU becomes zero
6 18 -2 (Point of Satiety)
MU becomes negative

LAW OF DIMINISHING MARGINAL UTILITY

It states that on consuming more and more units of a commodity, utility derived
from each additional unit goes on diminishing.
The law of DMU is however, based on following assumptions:
 Consumer is rational that is, he/she always
aims at getting maximum satisfaction.
 Utility is cardinal. It can be measured in
terms of numerical units, Utils.
 Units are to be consumed continuously.
  The quality of the units consumed remains constant.
 There is no change in income of consumer and price of the commodity
CONSUMER EQUILIBRIUM UNDER CARDINAL APPROACH
(Marshall’s Utility Analysis or Marginal Utility Analysis)
Consumer Equilibrium refers to a point or situation which provides the consumer
with maximum satisfaction, out of his given income and price of the commodity.
Once the consumer has reached this point, he has no tendency to deviate from it.
The entire theory would be studied under following assumptions:
 Consumer is rational.
 Utility is cardinal in nature
 Income of consumer is fixed
 There is no change in price of the commodities

1.Price of the commodity (Px): It is the amount at which commodity is sold in the
market. It is measured in terms of rupees.
2. Marginal Utility of Good (MUx): It is the utility derived from the consumption
of each additional unit of a commodity. It is measured in terms of Utils.
3. Marginal Utility of Money(MUx): It refers to the satisfaction derived per rupee.
(It is assumed to be constant)
MU = MUx /MUx

CARDINAL UTILITY CONSUMER EQUILIBRIUM: ONE COMMODITY CASE

Assumptions
• Consumer is rational
• Utility is cardinal in nature
• Consumer consumes only one good "X"
• Income of consumer is fixed.
• Price of commodity X is constant
Conditions of Consumer Equilibrium
• MU = Px
• Law of Diminishing Marginal Utility operates
DISEQUILIBRIUM CASES
Case I: MU > Px
 It implies that utility derived in terms of rupees from the consumption of the
commodity is more than the price paid.
 A rational consumer will therefore, increase the consumption of Good X.
 MU falls due to law of DMU.
 This happens till the time, MU = Px
Case II: MU <Px
 It implies that utility derived in terms of rupees from the consumption of the
commodity is less than the price paid.
 A rational consumer will therefore, decrease the consumption of Good X.
 MU rises due to law of DMU.
 This happens till the time, MU = Px

CARDINAL UTILITY CONSUMER EQUILIBRIUM: TWO COMMODITY CASE

Assumptions
 Consumer is rational
 Utility is cardinal in nature
 Consumer consumes two goods, X and Y
 Income of consumer is fixed
 Price of commodity X and Y is constant

Conditions of Consumer Equilibrium

𝐌𝐔𝐱 𝐌𝐔𝐲
 =
𝐏𝐱 𝐏𝐲
This is called as Law of Equi Marginal Utility. It means that ratio of marginal
utility to price will be equal for all the commodities consumed by the consumer.
This is however, subjected to Budget Constraint that is, Px. Qx + Py .Qy, = M.
 Law of Diminishing Marginal Utility operates.
Disequilibrium Cases
𝐌𝐔𝐱 𝐌𝐔𝐲
Case I: >
𝐏𝐱 𝐏𝐲
 It implies that Marginal utility of money from commodity X is more than the
marginal utility of money from commodity Y.
 This means that consumer derives more benefit from the consumption of
commodity X as compared to Y.
 A rational consumer will therefore, increase the consumption of X and
decrease the consumption of Y.
 MU, falls and MUy rises due to operation of Law of DMU.
𝐌𝐔𝐱 𝐌𝐔𝐲
 This happens till the time =
𝐏𝐱 𝐏𝐲
𝐌𝐔𝐱 𝐌𝐔𝐲
Case I: <
𝐏𝐱 𝐏𝐲
 It implies that Marginal utility of money from commodity X is less than the
marginal utility of money from commodity Y.
 This means that consumer derives more benefit from the consumption of
commodity Y as compared to X.
 A rational consumer will therefore, increase the consumption of Y and
decrease the consumption of X.
 MUx rises and MUy, falls due to operation of Law of DMU.
𝐌𝐔𝐱 𝐌𝐔𝐲
 This happens till the time =
𝐏𝐱 𝐏𝐲

ORDINAL APPROACH
 Rather, a rational consumer can only rank the commodities based on his/her
preferences.
 If there are two combinations available A and B, then Consumer's
Preferences are of three types:
• A consumer will always prefer A over B.
• A consumer will always prefer B over A.
• A consumer is indifferent between A and B that is, both the
combinations provide the consumer with same level of satisfaction.
For Example, if there are two goods available, Pizza and Burger. Then, there will be
some set of individuals who will always prefer pizza over burger, there will be
others who will always prefer burger over pizza. Then, there will be third kind
who can have anything, as they only care about satisfying their hunger. This third
set of preference is called as "Being Indifferent".
CONCEPT OF INDIFFERENCE CURVE
 It is a graphical representation of various
possible combinations of two goods that
provide the consumer with same level of
satisfaction.
 In the diagram, combinations A, B, C, D are on
the same Indifference curve which means
that they all provide the consumer with same
level of satisfaction.

CONCEPT OF INDIFFERENCE MAP

 It is the graphical representation of family of
Indifference Curves.
 Each indifference curve represents a different
level of satisfaction.
 Farther the IC is from origin, higher is the level
of satisfaction.
 In the diagram, U(IC₁) < U(IC₂) < U(IC3)
[U stands for Utility]

MONOTONIC PREFERENCES
Monotonic means "More is better”
A rational consumer will always prefer a combination where he gets more of at
least one good and no less of the other.
For Example,
 Between combinations A(5, 7) and B(5, 8)Consumer will always prefer bundle
B as he is getting more of Y and same units of X.
 Between combinations A(5, 7) and C(6, 7): Consumer will always prefer
bundle C as he is getting more of X and same units of Y.
 A(5, 7) and D(6, 8): Consumer will always prefer bundle D as he is getting more
of both X and Y.
 It is due to monotonic preferences that farther the IC is from origin, higher is
the level of satisfaction.
MARGINAL RATE OF SUBSTITUTION (MRS)
 Marginal means "additional". Rate of substitution means "ratio in which units
of one good are substituted with units of another good".
 It refers to the rate at which consumer is willing to substitute units of one good
with units of the other good to remain on same level of satisfaction.
No. of units of a good sacrificed
 MRSxy =
No. of units of a good gained
ΔY
 MRSxy =
ΔX
ΔY = Change in number of units sacrificed
ΔX = Change in number of units gained
 It is called as slope of Indifference curve.

PROPERTIES OF INDIFFERENCE CURVE

1. ICs are Downward Sloping
a) IC slopes downwards from left to right.
b) It means to increase the consumption of one
good, consumer is willing to sacrifice the
units of the other good.
c) This is done to remain on the same level of
satisfaction.
2. ICs are Convex to Origin
a) This is due to diminishing MRSxy
b) It means to increase the consumption of one good, consumer is willing to
sacrifice less and less units of the other good
c) This is due to the operation of Law of DMU. Due to this law, satisfaction of
consumer from every additional unit of consumption will decrease. Therefore,
he will not find it worth enough to sacrifice more of the other good.

Combination Units of Good X Units of Good Y MRT

A 0 100 -
B 1 60 40Y : 1X
C 2 30 30Y : 1X
D 3 10 20Y : 1X
E 4 0 10Y : 1X
3. Higher the IC, Higher is the Level of Satisfaction
a) This is due to monotonic preferences.
b) 'Monotonic' means that more is better.
c) A consumer will always prefer a combination
where he gets more of at least one good and no
less of the other.
d) Farther the IC is from origin, higher is the level of
satisfaction.
4. Two ICs Can Never Intersect
a) Let us assume that two ICs can intersect each other.
b) On IC₁, there are two bundles A and B which
provide the consumer with same level of
satisfaction. [U(A) = U(B)]
c) On IC2, there are two bundles B and C which
provide the consumer with same level of
satisfaction. [U(B) = U(C)]
d) This means that A and C should also provide
same level of satisfaction. [U(A) = U(C)]
e) This is however, not true as both the combinations lie on different ICs.

CONCEPT OF BUDGET LINE AND BUDGET SET

Expenditure on any good is denoted as Price × Quantity.
A consumer will always plan his expenditure in such a
manner that any one of the following cases will take
place:
 Total Expenditure < Income
that is, Px Qx+ Py.Qy < M
This case allows the consumer to make some
savings or spend remaining amount to have more
satisfaction.
 Total Expenditure > Income
that is, Px Qx+ Py.Qy > M
This case is possible when consumer incurs his expenditure by borrowing the
amount.
 Total Expenditure = Income that is, Px Qx+ Py.Qy = M
 Budget Line Budget Set
The graphical representation of all possible The graphical representation of all possible
combinations of two goods such that total combinations of two goods such that total
expenditure is exactly equal to income of expenditure is less than or equal to income.
the consumer.
Px Qx+ Py.Qy = M Px Qx+ Py.Qy ≤ M
It is a narrow concept It is a broader concept

MARKET RATE OF EXCHANGE (MRE)

 It refers to the rate at which market allows the consumer to exchange the
units of one commodity with the units of another commodity. This is done
because income of consumer is fixed.
Change in number of units sacrificed
 MRE =
Change in number of units gained
ΔY Px
 MRE = = (-) Py
ΔX
 Since Px and Py are assumed to be constant, therefore, the value of MRE also
remains constant throughout.
 It is called as Slope of Budget Line.

PROPERTIES OF BUDGET LINE

1. Downward Sloping in Nature
 Budget line slopes downwards from left to
right.
 It means to increase the expenditure on one
good, consumer has to decrease the
expenditure on the other good.
 This is done because income of consumer is
fixed.
2. Straight Line
Px
 The slope of budget line is (-) . Since the values of Px and Py are assumed
Py
to be constant. Therefore, the value of slope is also constant.
 It is because of this reason that budget line is a straight line.
CONSUMER'S EQUILIBRIUM UNDER ORDINAL APPROACH
(Indifference Curve Analysis or Hicksian Analysis)
Assumptions
 Consumer is rational.
 Utility is ordinal in nature.
 Consumer consumes two goods, X and Y.
 Income of consumer is fixed.
 Price of commodity X and Y is constant.

Conditions of Consumer's Equilibrium

 Slope of Indifference curve = Slope of budget line (subjected to budget
constraint)
Px
 That is, MRSxy = subjected to Px Qx+ Py.Qy = M
Py
(Absolute values of slopes are taken into consideration)

 MRS should fall continuously. (It means that ICs should be convex to origin)

Disequilibrium Cases

𝐏𝐱
Case I: MRSxy > (Point A)
𝐏𝐲
a) It means that consumer is willing to sacrifice more units of Good Y for an
additional unit of X as compared to the market.
b) A rational consumer will therefore, increase the consumption of X and
decrease the consumption of Y.
c) MRS will fall due to operation of Law of DMU
Px
d) This happens till the time MRSxy =
Py

𝐏𝐱
Case II: : MRSxy < (Point B)
𝐏𝐲
 a) It means that consumer is willing to sacrifice less units of Good Y for an
additional unit of X as compared to the market.
b) A rational consumer will therefore, increase the consumption of Y and
decrease the consumption of X.
c) MRSxy will rise due to operation of Law of DMU.
Px
d) This happens till the time MRSxy =
Py
• Consumer cannot be in equilibrium on points A and B as both of them represent
the disequilibrium cases.
• Consumer cannot be in equilibrium on IC3, as it is not affordable by given income
and prices.
Thus, consumer will be in equilibrium on point E where budget line is tangent to
Indifference curve. (Tangent means that the slope of indifference curve MRS is equal
to the slope of budget line)
Basis Cardinal Utility Analysis Ordinal Utility Analysis
1.Concept Utility is measurable and Utility is a psychological
quantifiable concept. concept
2.Expressed in Utility is expressed Utility is expressed in terms
numerically in utils of ranking
3.Propounded by Given by Prof. Alfred Marshall Given by Prof. J.R. Hicks

Situations Implications Consumer’s Reaction

Px falls MUx
>
MUy • Increase good x
Px Py • Decrease good y
Px rises MUx
<
MUy • Decrease good x
Px Py • Increase good y
Py falls MUx
<
MUy • Decrease good x
Px Py • Increase good y
Py rises MUx
>
MUy • Increase good x
Px Py • Decrease good y

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