Unit 2

Consumer’s Equilibrium
Utility:

A want satisfying power of a commodity is

known as utility.

There are two branches of utility analysis;

(a) Cardinal Utility Analysis

(b) Ordinal Utility Analysis

 
 (a) Cardinal Utility Analysis

Cardinal utility states that utility can be measured in cardinal

numbers such as 1, 2, 3, 4 etc.

It is based on the law of diminishing marginal utility analysis.

 Law of Diminishing Marginal Utility Analysis

This theory was formulated by Alfred

Marshall.
The law states that as the amount consumed
of a commodity increases, then utility derived
by the consumer from the additional unit goes
on decreasing.
 Assumptions
• There must be continuity in the consumption
• Quality of the commodity remains uniform
• income of the consumer and the price of goods and
services remains unchanged during the period of
consumption.
• The mental condition of the consumer should remain
normal during the consumption period
• Total Utility: It is the sum total of utility derived from
the consumption of all the units of a commodity
• Marginal Utility: It is the addition to total utility on
account of the consumption of an additional unit of a
commodity.
Quantity Total Utility Marginal utility
0 0 -
1 8 8
2 14 6
3 18 4
4 20 2
5 20 0
6 18 -2
 Relationship between TU and MU

(i) As more and more unit of commodity are

consumed MU derived from each successive
units tends to diminish.
(ii) So long as MU is positive, TU increases
(iii) TU is maximum when MU is zero
(iv) TU starts decreasing when MU is negative
• Qn 1
The total utility schedule of individual ‘A’ is
given below. Derive his MU schedule
Quantity 0 1 2 3 4 5
TU 0 15 28 40 51 61
 Concept of consumer’s Equilibrium

Consumer’s equilibrium refers to a situation of

maximum satisfaction while the consumer
spending his given income across different goods.
 Consumer’s Equilibrium: One Commodity Case
Consumer’s equilibrium refers to a situation of
maximum satisfaction while the consumer spending his
given income across different goods.
In one commodity case the consumer will achieve
equilibrium when MUx = Px
It can be explained with the help of a table and a diagram
Quantity of X Px (in Rupees) MUx (in Rupees)
1 5 8
2 5 6
3 5 5
4 5 4
5 5 3
 As per the above table the consumer
achieves equilibrium when he purchases 3
unit of commodity because MUx = Px.
If the consumer buys less than 3 units he
can not maximise satisfaction. (MUx is greater
than Px)
A consumer will not buy more than 3 units
of commodity X. This is because if he buys
more than 3 units of commodity X, then the
price he pays (Rs. 5) will be more than the MU
(4).
 In the above diagram X - axis mention price
and utility and Y - axis mention quantity of a
commodity.
At point ‘E’ the consumer achieves equilibrium
because MUx = Px. (OP is the equilibrium price
and OQ is the equilibrium quantity.)
 Consumer’s equilibrium in Two commodities case –
(Several commodities) Law of Equi Marginal Utility
(Australian economists H. H. Gossen)

• The condition for a consumer to maximize utility is

usually written in the following form:
MUX/PX = MUY/PY 
• So long as MUY/PY is higher than MUX/PX, the consumer
will go on substituting Y for X until the marginal utilities
of both X and Y are equalized.
• The marginal utility per rupee spent is the marginal
utility obtained from the last unit of good consumed
divided by the price of good (i.e., MU X/PX or MUY/PY). A
consumer thus gets maximum utility from his limited
income when the marginal utility per rupee spent is
equal for all goods.
This equi-marginal principle or the law of substitution can be
explained in terms of an arithmetical example. In Table we have
shown marginal utility schedule of X and Y from the different
units consumed. Let us also assume that prices of X and Y are
Rs. 4 and Rs. 5, respectively.
MUX and MUY schedules show dimini­shing marginal utilities for
both goods X and Y from the different units consumed. Dividing
MUX and MUY by their respective prices we obtain weighted
marginal utility or marginal utility of money expenditure. This
has been shown in Table.
• MUX/PX and MUY/PY are equal to 6 when 5 units of X and
3 units of Y are purchased.
• By purchasing these combinations of X and Y, the
consumer spends his entire money income of Rs. 35 (=
Rs. 4 x 5 + Rs. 5 x 3) and, thus, gets maximum satisfaction
[10 + 9 + 8 + 7 + 6] + [11 + 10 + 6] = 67 units.
• Purchase of any other combination other than this
involves lower volume of satisfaction.
• Graphical Representation:
• The above principle can also be illustrated in terms of a
figure. We have drawn marginal utility curves for goods X
and Y in Fig 2.12(a) and (b).
• Here we use marginal utility and price. Marginal utility per
rupee spent on good X = MUX/PX, and that of Y = MUY/PY.

The MUX/PX curve has been shown in Fig. 2.12(a) while the

MUY/PY curve has been shown in Fig. 2.12(b). We have not

drawn negative portion of the marginal utility curves.
Now, by superimposing Fig. 2.12(b) on Fig. 2.12(a), we get
Fig. 2.13 in which we measure available income—00’—of the
consumer on the horizontal axis.
 Consumer’s equilibrium in Two commodities case –
(Several commodities) Law of Equi Marginal Utility
(Australian economists H. H. Gossen)

Consumer’s equilibrium refers to a situation of

maximum satisfaction while the consumer
spending his given income across different
goods.
In two commodities case the consumer will
achieve equilibrium when;
MUx = MUy
Px Py
It can be explained with the help of a table
Assumption: Px = Py = Rs 1 per unit

Commodity MUx MUy

1 25 30

2 20 26

3 15 15

4 10 2

5 0 0
 As per the above table the consumer gets
maximum satisfaction when he purchases 3
units of commodity X and Y respectively. It is
bacause MUx = MUy.
In this situation total utility is maximised.
(30+26+25+20+15+15 = 131) No other
combination of X and Y offer the consumer
higher than 131 utility.
 Criticism Of Marginal Utility Analysis

• Utility-not measurable:
• Maximise satisfaction
• There must be continuity in the consumption
• Man is not rational: This theory assumes that a consumer can
calculate the utilities and dis utilities of different commodities
and buys only those commodities which gives maximum
utility
• The mental condition of the consumer should remain normal
during the consumption period
• Quality of the commodity remains uniform
 (b) Ordinal Utility Analysis
(Modern economists, J.R. Hicks, and R.G.D. Allen)

• Ordinal utility analysis states that utility cannot

be measured in cardinal numbers but it can be
expressed or ranked like high, low, equal, good,
better, best, etc.
• Ordinal utility analysis is based on indifference
curve analysis. The indifference curve analysis is used
to explain how a consumer makes decision with
regard to his economic choices and preferences.
 The assumptions of the ordinal theory are the following:
(1) The consumer acts rationally so as to maximise
satisfaction.
(2) There are two goods X and Y
(3) The consumer possesses complete information
about the prices of the goods in the market.
(4) The consumer’s tastes, habits and income remain
the same throughout the analysis.
(5) He prefers more of X to less of Y or more of Y to less of X.
• Indifference Curve Analysis
IC can be defined as various combinations
of two goods which give the same level of
satisfaction to the consumer.

• It can be explained with the help of an

indifference schedule; An indifference schedule
is a table which shows different combination of
two commodities which gives equal level of
satisfaction.
Combinations Good X1 Good Y Total Utility

A 1 10 Z

B 2 7 Z

C 3 5 Z

D 4 4 Z
 Criticisms
• The Consumer is not Rational:
• Combinations are not based on any Principle:
• Two-Goods Model Unrealistic:
• Wrong assumption: The consumer’s tastes, habits and
income remain the same throughout the analysis.
• Wrong assumption: He prefers more of X to less of Y or
more of Y to less of X.
• Indifference Map
A group of Indifference curves are known as
Indifference map. Higher the indifference
curve shows higher the level of satisfaction.
• Marginal Rate of Substitution (MRS)

It is a rate at which the consumer is willing

to substitute one good for other without
changing the level of satisfaction.
 Properties (features) of an Indifference Curve

1. An Indifference curve slopes from left to right:

An indifference curve slopes downward

from left to right, i.e, it has negative slope
because when the consumer decide to have
more unit of one commodity, he has to
sacrifice some amount of other commodity.

 
2. An Indifference curve is convex to the origin:
It is because of diminishing marginal rate of
substitution. That is as the curve moves
downward, the rate at which ‘Y’ is given up for X
is going on decreasing.
3. Higher Indifference curve shows higher level
of satisfaction:
Higher the indifference curve shows higher
level of the satisfaction. It means if an IC is
very much far away from the origin, it shows
higher level of satisfaction.

 
4. An Indifference curve never intersects each other:

An important property of indifference curves

is that they may lie close to each other, but they
never intersect each other, because each IC
shows different level of satisfaction and if they
intersect each other, intersecting point shows
same level of satisfaction. (An IC shows same level of
satisfaction and different IC shows different levels of satisfaction)
5. An Indifference curve will not touch either X axis
or Y-axis –

If an IC touches either X and Y axis, the condition

of combination of two goods will not be satisfied.

That is if IC touches Y-axis, X will become Zero or

if it touches X-axis, Y will become zero.

 
 (a) Budget Line/Price line
Budge line shows that combinations of two
goods that a consumer can purchase with a given
amount of money income.
Budget line can be explained with the help of an
imaginary example;
Suppose that the consumer has income equal
to Rs.200/- to spend on two commodities i.e.
cloth and food.
The price of cloth is Rs.40 per unit and the price
of food is Rs.20/- per unit.
Combinations Cloth Food
(Rs.40 Per Meter) (Rs. 20 per unit)
A 5 0
B 4 2
C 3 4
D 2 6
E 1 8
F 0 10
 Change or Shift in Budget line
(a) When the income increases:

(b) When the income decreases:

(c) When the price of one commodity (X)

increases:

(d) When the the price of one commodity (X)

decreases:
 Consumer’s Eqiuilibrium
• Explain consumer’s equilibrium with the help of IC
analysis.
Consumer’s equilibrium is a point where the
consumer achieves maximum satisfaction with his
limited money income.
We combine the IC and Budget line on the same
diagram to illustrate consumer’s equilibrium.
A consumer gets maximum satisfaction when an
IC is tangent to the budget line. Ie; the tangency
point is the highest level of satisfaction that the
consumer can achieve with his limited income.