CONSUMERS EQUILIBRIUM

Meaning: Consumers equilibrium is a situation where a consumer maximizes his

satisfaction with his limited income and has no tendency to change the pattern of
expenditure.
Basic Concepts:
Utility: It is the satisfaction that a consumer derives from the consumption of a
commodity.
It is of two types:
Total Utility: It is the sum of total satisfaction that a consumer derives when a certain
units of a particular commodity are consumed.
It is the sum of marginal utility.
TU = MU
Marginal Utility: It is the additional utility derived from the consumption of an
additional unit of the commodity.
It is also defined as net change in total utility due to a unit change in consumption of a
commodity.

Marginal Utility =
Marginal Utility is also defined as the additional satisfaction that is derived from the
consumption of the last unit of a commodity.
Marginal Utility = TUn TUn-1
Relationship between Total Utility and Marginal Utility
1. As long as total utility increases,
marginal utility remains positive.

2. When total utility reaches its maximum,

marginal utility becomes zero.

TU

3. When total utility falls, marginal utility

becomes negative.

Point of satiety
TU

Units of a commodity

Points to be noted:
1. If TU increases at increasing rate, MU
also increases.

MU

2. If TU increases at diminishing rate, MU

falls but remains positive.
Units of a commodity
Point of satiety- Saturation point (consumer
will not like to consumer more than this)

MU

Law of Diminishing Marginal Utility

The law explains the behavior of marginal utility when an individual consumer consumes
a commodity.

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According to the law, as more and more units of a commodity is consumed, the marginal
utility derived from each successive unit eventually decline. (The word eventually in the
definition signifies that marginal utility may initially increase)
The law of diminishing marginal utility forms the basis for determining the point of
consumers equilibrium.
Assumptions of the law:
1. Rational consumer: Consumer is assumed to be rational. He aims at maximizing
his benefits from consumption, given his income and prices of the goods.
2. Cardinal measurement: Utility can be measured in quantitative terms i.e.
individual can give a specific number to the amount of satisfaction they derive
from the consumption of the commodity.
3. Standard unit: It is assumed that reasonable amount of the commodity forms a
unit of the commodity.
4. No time gap: All the units of a commodity are consumed in a stipulated time
period, one after the other.
5. Constant Price: All units of the commodity are purchased at same price.
6. Constant marginal utility of money: Like other commodities marginal utility of
money should fall, however in the law it is assumed that marginal utility of
money remain constant.
The law can be explained with the help of a schedule and diagram
Units of a
commodity
1
2
3
4
5
6
7

TU

MU

10
18
24
28
30
30
28

10
8
6
4
2
0
-2

MU

MU
Units of a commodity

Two Approach to explain Consumers equilibrium

1. Marginal Utility Analysis
2. Indifference Curve Analysis
Marginal Utility Analysis
Assumptions: Same as for the law of diminishing marginal utility
Single Commodity Case:
A consumer spends her income on a commodity such that she derives maximum
satisfaction subject to her income and price of the commodity. While consuming a
commodity consumer has to pay a price for it. She would like to consume more units of a
commodity as long as its marginal utility in Rs is greater than the price paid for it. When
marginal utility in Rs become equal to the price of the commodity, she will stop the
consumption. This will be the state of equilibrium. She would not like to purchase more

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units as if she does so the marginal utility of the commodity in Rs becomes less than the
price of the commodity (due to the law of diminishing marginal utility). Its a situation of
loss for the consumer.
Thus a consumer is in equilibrium when:
1. Marginal utility of commodity in Rupee is equal to Price of the commodity.

Where: Marginal utility of commodity in Rupee =

2. Marginal utility must decline.
The concept can be explained with the help of an illustration (utility schedule) and
diagram:
Let Marginal utility of Rupee = 2
Price of commodity
=3
Units TU MU MU
Pric Behaviour
consu in
in
in Rs e
med
utils utils
10
P/
E
1
10
10
MU in Rs> P
=5 3
2
MU
P
consumption
8
2
18
8
MU in Rs> P
=4 3
2
MU
consumption

MU in Rs= P
3
24
6
=3 3

O
attain
Q1 Q
Q2
equilibrium
4
Units
of
commodity
4
28
4
MU in Rs< P
=2 3
2
consumed
consumption
0
5
28
0
MU in Rs< P
=0 3
2
In the diagram, Consumer
consumption
4
attains equilibrium at point E
6
24
-4
MU in Rs< P
=- 3
2
when she consumes OQ units of
consumption
2
a commodity. If she purchases
When the consumer consumes 1 st unit, she gets
OQ1 units Marginal utility is
marginal utility equal to Rs 5 whereas she pays Rs 3
more than the price, she can
for it, thus she will like to purchase more units. When further add to the utility and if
she purchases 2nd unit, she again derives utility higher she purchases OQ2 units
than the price, thus she will continue to buy more. As
marginal utility is less than the
she purchases the 3rd unit, utility becomes equal to
price paid, thus is a situation of
price which is the state of equilibrium. She will stop
loss for her.
the consumption here as if she purchases 4th unit utility
derived will be less than the price paid for it, which
will be a situation of loss for her.
What if conditions of equilibrium are not satisfied?
If MU in Rs > Price of the commodity, it means consumer is deriving greater
satisfaction from the commodity as compared to its price thus the consumer will
increase the consumption so that marginal utility falls and becomes equal to the
price (such that condition of equilibrium is satisfied).

ArchanaTrivedi/consumer-equi./xii/9827381257

If MU in Rs < Price of the commodity, it means consumer is deriving lesser

satisfaction from the commodity as compared to its price thus the consumer will
decrease the consumption so that marginal utility increase and becomes equal to
the price (such that condition of equilibrium is satisfied).

Two Commodity Case:

(Law of equi-marginal utility)
When a consumer consumes two commodities, she would like to maximize utility subject
to the constraints i.e. her income and price of two commodities.
Suppose consumer consumes two commodities X and Y.
If the consumer was consuming commodity X, she would be in equilibrium when:

= Px

Alternatively it can be written as;

= MUm

Similarly the consumer will attain equilibrium for commodity Y when:

= MUm

Since marginal utility of money is same in both equations, equation (i) is equal to
equation (ii), therefore

= = MUm

Thus a consumer is in equilibrium (when he consumes two commodities) when he spends

his limited income in such a way that the ratios of marginal utilities of two commodities
and their respective prices are equal.
The equilibrium conditions for consumer consuming two commodities are:
1. The ratio of marginal utility to its price of one commodity is equal to the ratio of
the marginal utility to the price of the second commodity.
2. Marginal utilities of both commodities must be decreasing.
3. Expenditure made on the two commodities must be equal to the income of the
consumer i.e. Px.Qx + Py.Qy = Y
The concept can be explained with the help of an illustration (utility schedule)
Let Price of commodity X = Rs 3 per unit
Price of commodity Y = Rs 2 per unit
Marginal utility of money = 2
Consumers income = Rs 18

Units consumed MU of X
MU of Y

1
24
14
8
7
2
18
10
6
5
3
12
6
4
3
4
9
4
3
2
5
6
2
2
1
According to the conditions of equilibrium:

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1.

The ratio of marginal utility to its price of one commodity is equal to the ratio of
the marginal utility to the price of the second commodity i.e.

= = Mum

The ratios are equal when (i) 4 units of X and 3 units of Y are consumed
(ii) 5 units of X and 4 units of Y are consumed.
2. Marginal utilities of both commodities must be decreasing as can be seen in the
schedule.
3. Expenditure made on the two commodities must be equal to the income of the
consumer i.e. Px.Qx + Py.Qy = Y
Thus:
(i) When 4 units of X and 3 units of Y are consumed
4 x 3 + 3 x 2 = 18 (equilibrium established)
(ii) When 5 units of X and 4 units of Y are consumed.
5 x 3 + 4 x 2 = 23 (over budget)
The condition is satisfied when 4 units of X and 3 units of Y are consumed.
What if ratios are not equal?

If > , it would mean that marginal utility of last rupee spent on good X is
greater than marginal utility of last rupee spent on good Y i. e. the satisfaction
from consumption of good X is more than the satisfaction from consumption of
good Y. Thus consumer can increase her satisfaction by spending a rupee more on
good X and a rupee less on good Y i.e. to attain equilibrium consumer should

increase the consumption of good X such that falls and decrease the
consumption of good Y such that

If

<

increases and the ratios are equal.

, it would mean that marginal utility of last rupee spent on good X is

less than marginal utility of last rupee spent on good Y. Thus consumer can
increase her satisfaction by spending a rupee more on good Y and a rupee less on
good X i.e. to attain equilibrium consumer should increase the consumption of
good Y and decrease the consumption of good X so that the ratios are equal.
Indifference Curve Analysis
Practically consumer finds it difficult to measure utility in utils. Instead consumer can
give preference for one combination of goods over another. A consumer would like to
purchase more quantity of goods but his income and prevailing prices of the goods
restrict his extent of consumption.
What consumer can afford to buy depends upon:
i.
Consumers income
ii.
Prices of two goods
The combination of the quantities of two goods is called as bundle. For example, (x1,x2)
would mean x1 quantity of good 1 and x2 quantity of good 2.
The Budget Set
The budget set refers to all those bundles of two goods that consumer can buy with given
income and prices of two goods. (It includes all those combinations of two goods which
either cost equal to or even less than consumers income).

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The Budget Constraint

A budget constraint highlights what a consumer can afford. It states that a consumer can
spend his income on two goods in such a way that expenditure made on two goods is less
than or equal to his income. Mathematically it can be written as:
Px.Qx + Py.Qy Y where Px = Price of commodity X
Qx = Quantity of commodity X
Py = Price of commodity Y
Qy = Quantity of commodity Y
Y = Income of the consumer
Thus budget constraint shows the various bundles of two goods that a consumer can buy
given his income and prices of two goods.
Graphical presentation of budget constraint is the budget line.
Suppose a consumer has a budget of Rs. 20 to be spent on two goods: good 1 and good 2.
If price of good 1 is `4 each and price of good 2 is `2 each, the consumer can purchase
various bundles (combinations of two goods) which determine the budget line. The
possible combinations are:
Combinations Good 1
Good 2
A
0
10
B
1
8
C
2
6
D
3
4
E
4
2
F
5
0

Budget line is the locus of all bundles of two goods that a consumer can purchase with
his given income and prices of two goods. All points on or below the budget line are
affordable, whereas points above the budget line are not affordable.
In the diagram AB represents the budget
line. All points on budget line are affordable.
Point C lies within budget line and is
affordable but is considered inferior as
A
compared to the points on budget line as it
means lesser quantity of either one or both
Good 2
the goods.
.C
.D
Point D lies outside the budget line and thus
is not affordable.
B
Good 1
Budget line slopes downward, implying that if a consumer wants to increase the
consumption of good 1, he will have to give up some units of good 2. Thus it indicates
trade-off that a consumer has to make between the two goods. The extent of trade-off is
given by the slope of the budget line.

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Slope of Budget Line

Let us select two points, point C and point
D on the budget line. Equation of budget
line at different points would be:
At point C
P1x1+P2x2= M ------(i)
At point D
P1 (x1+x1)+P2(x2+x2)= M
Or
P1 x1+ P1x1+P2x2+ P2x2= M--------(ii)

A
C
(x1,x2)

Good 2
x2

(x1+x1,x2+x2)
x1 D
B
Good 1

By subtracting eq. (i) from eq. (ii)

P1x1+ P2x2=0
By rearranging the values
11
x2= 2
1

=-

2
1
2

Thus, Slope of budget line is the ratio of the prices of two commodities.
1
= - 2
Consumers Preferences
Consumers preferences highlights consumers wants. These preferences are graphically
represented through an indifference curve.
An indifference curve is the locus of all combinations of two goods which provide same
level of satisfaction. Since all combinations on an indifference curve give same utility, a
consumer is indifferent about any combination.
Assumptions:
1. Rationality: Consumer is assumed to be rational. He aims at maximizing his
benefits from consumption, given his income and prices of the goods.
2. Ordinality: Consumer can order or rank the subjective utilities derived from the
commodities. He has a scale of preference between different combinations of the
two goods thus can always tell his preference or indifference between different
alternatives.
3. Preferences are based on Diminishing marginal rate of substitution:
Marginal rate of substitution is defined as the rate at which a consumer is willing
to sacrifice one commodity to obtain some units of the other commodity.
It is assumed that with every increase in the quantity of one commodity the
consumer is willing to forego lesser quantity of the other commodity.
4. Monotonic preferences: A consumers preferences are monotonic if between any
two bundles, the consumer prefers the bundle which has more of at least one of
the goods and no less of the other good as compared to the other bundle. For
example a consumer with monotonic preference will prefer the bundle (2, 3) to
the bundles (2, 2), (1, 3) and (3, 1) bundles.
Indifference Curve and Indifference Map

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A consumers preferences over the set of available bundles can be represented

diagrammatically. Such a curve joining all points representing bundles among
which the consumer is indifferent is called an indifference curve.
An indifference curve is the locus of different combinations of goods that yield
the same level of utility to the consumer.
The diagram shows an indifference
curve. All points (e.g. point A and point
B) on this curve give same level of
Good 2
A
utility thus a consumer is indifferent
about these combinations.

B
IC
Good 1
An indifference curve slopes downward from left to right. It reflects that in order
to consume more units of good 1 consumer needs to give up some units of good 2.
Indifference Map: A collection of indifference curves that represent different levels of
satisfaction that a consumer derives from consuming different bundles of two
commodities is called an indifference map.
A consumer can have many indifference
curves. All points on IC1 shows that a
Increasing utility consumer derives same level of
Good 2
IC3
satisfaction by choosing any combination.
IC2
However if he moves to IC2 the
IC1
satisfaction increases as he is able to get
Good 1
more of either one or both the goods. Thus
a higher IC represents greater level of
satisfaction or utility for the consumer.
Properties of indifference curves
1. Indifference curves always slope downwards from left to right. As one
increase the consumption of one commodity he forgoes the consumption of
some units of the other commodity.
2. Indifference curves are always convex to origin. As the consumer is willing to
sacrifice lesser units of one commodity when he consumes more of the other
commodity i.e. due to diminishing marginal rate of substitution.
3. Two indifference curves can never intersect each other. As the two curves
represents different levels of satisfaction and point of intersection would mean
same level of satisfaction which is not possible.
4. Higher indifference curve higher satisfaction. As lower indifference curve
mean lesser quantity of two goods and higher indifference curve means more
quantity of two goods or atleast one good and since consumers preferences are
monotonic he will always prefer higher indifference curve.

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Concept of Marginal rate of substitution: The rate at which a consumer is

willing to sacrifice the units of one good one to get an additional unit of another
good.
1
MRS = 2

= = 1
MRSxy is the marginal rate of substitution of Good X for Good Y i.e. the rate at
which consumer is willing to decrease consumption of Y to increase that of Good
X so that he remains on the same indifference curve.
Good 1
Good 2
MRS
1
8
2
4
4/1 = 4
3
2
2/1 = 2
4
1
1/1 = 1
It is noticed that consumer is willing to give lesser and lesser units of good 2 to
get an additional unit of good 1 i.e. MRS diminishes along the indifference curve.
Diminishing MRS gives rise to convex shaped indifference curves.

Good 2

x2{
x1

Good 1

Consumers Equilibrium: Optimal Choice of the consumer

A consumer is said to be in equilibrium at a point where he maximizes his satisfaction
levels (represented by indifference curves) subject to his budget constraint.

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Good 2
X2

In the diagram, IC3 gives the highest level

of satisfaction but the consumer cannot
purchase any bundle on this curve as are
out of his budget. The highest level of
satisfaction that he can reach is at IC2,
which just touches the budget line at point
E. At this point consumer can purchase X1
amount of good 1 and X2 amount of good
2. This is his optimum bundle as he is
maximising his utility subject to budget
constraint. At this point budget line is
tangential to the indifference curve.
Any point below E is feasible bundle but
will give lesser satisfaction i.e. point A and
S are feasible but are on IC1 which gives
lesser satisfaction to the consumer

IC3
IC2
S IC1

X1
Good 1

Thus a consumer attains equilibrium when:

Condition 1 : Slope of indifference curve is equal to the slope of the budget line i.e.
budget line forms a tangent to the indifference curve.
Mathematically
1
(Slope of indifference curve) MRS1,2 = 2 (Slope of the budget line)
What if consumer is not in equilibrium? (Explanation of condition of
equilibrium)
There are two possibilities:
1
MRS1,2 > 2 : It means to obtain one more unit of good 1, the consumer is
willing to sacrifice more units of good 2 as the consumer values good 1 more than
good 2. Thus to maximize satisfaction, Consumer should increase the
consumption of good 1and decrease the consumption of good 2 such that MRS
declines and become equal to the relative price of two commodities.
1
MRS1,2 < 2 : It means to obtain one more unit of good 1, the consumer is
willing to sacrifice less units of good 2 as the consumer values good 2 more than
good 1. Thus to maximize satisfaction, Consumer should increase the
consumption of good 2 and decrease the consumption of good 1 such that MRS
increases and become equal to the relative price of two commodities.
Condition 2: Indifference curve is convex to origin i.e. MRS must decline
A
good 2
E
B
IC1 IC2 IC3

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10

good 1
Concavity implies increasing marginal rate of substitution of X for Y .The
consumer will choose or buy only one good. The price line AB is tangent to the
indifference curve IC2 . But the consumer cannot be in equilibrium at point E
because she can obtain greater satisfaction by moving along the given price line.
Consumers satisfaction increases by either moving upward or downward till she
reaches the extremity points A on the y-axis or B on the x axis. Thus
Indifference curve should be convex to origin or MRS must decline along
indifference curve for a consumer to be in the state of equilibrium.

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11