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    Ch 3 Consumer Equilibrium

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    Ch 3 Consumer Equilibrium

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    Ch 3 Consumer Equilibrium

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    Cy-3 GONSUMER’S EQUILIBRIUM ANALYSIS: Definition: A consumer is in equilibrium when he maximizes his satisfection, giver hia income ar. market prices A rational consumer will balance his expenditure or aitte-sn commodities in such 2 way that wie, him maximum satisfaction. There are two approaches to study consumer's equilior: tn 1) Utility Analysis 2) Indifference Curves Analysis CONCEPT OF UTILITY: Utility is the want satisfying power of a commodity. Utility can also be defined as the salisfaction derived by » pe son from the consurt pion of a gcod Utility is subjective and cannot be measurad. But for our analysis we measure it in psychological units of satisfaction called “UTILS”, Two important concepts of utility are Marginal Utility (MU) ard Total Utility (TU), 1) Marginal Utility: It is the additional utility denved from the consumption of an aciditionad und of ‘commodity OR Is the audition made to the T.U by consuming one more uri of the commodity. OR Lis the utllty of the last unit consumed. ( MUn = TJn - 1Un-1) 2) Total Utility: It is the total satisfaction that the consury2r obtains from consuming @ given amount of a particular good. {tts the sum of Marginal Utilities obtained from consumption cf successive units of a commodity LAW OF DIMINISHING MARGINAL UTILITY: that as more and more units of a commodity are consumed, ths MU derived trom successive units goes on decreasing. Thi because the intensity of want for the commodity dacreases as one has mons of t. The 1U continues to rise til the point in consumption: 1s reached where MU becomes negatwe The following hypothetical schedule can be used to illustrate the law. _ Tu) Units of Oranges Tuy ulin 1 1 9 2 18 cm 3 | 23 5 4 , 25 2 4 26 1 0 26 | Oe eee eocos oe ? | 230 | 8 AR Dig UT TY /Ne A THE ? inp, but MU keeps on decreasing a3 more and more units of a commcdily oan “The 8 orange gives zero MU and the 7" orange gives negative MU a \ J onal consumer wil never consume the 7* orange. If oranges wers (ree, he mig ne sm 6" orange whore his TU is maximum But, since he has to pay for them, he may eee ey and would like to Know how much uuiily he could have obtained If he hod se carson many ang wo ny crngeew cme wou same % Tenend not only on MU and TU, tut also on the price of oranges. Lopicel OPO: If my > Ke, Comaume rove of foot. Aska poste. oF x <<” jas (Dmud -Lbaes Prods cameban eM JTILITY ANALYSIS e muy = &. Assumptions: 1) Consumer is rational (tries to get maxirnum satisfaction with limited income) 2) Utility is cardinal (ie it can be measured) 3) MU of money is constant (Assume MU at Rape used utb) 4) Quality of different units of 2 commodity does not change ONE COMMODITY CASE: Condition: A consumer is in equilibrium when MU of a commodity in terms of money is equal to ils price mvx = Fe oe MS = MU pen PU upeo Equilibrium condition can be loosely stated as MU of, of the product [Reeye Condition The eauife.am anaists can be explained wth the help of @ schedule Sy ice of each o is” Rs. ais pees O Geet Bey SRO IS Rem | Units of Oranges MU in terms of money Price of oranges Remarks 1 10 a 2 Ux > Px | 2 8 2 MUx > Px ' 3 5 2 MUx> Pe | 4 d2 a 2. MUx= Pe | i 5 1 - a MUx < Px | 6 ° . 2 Mux< Px | ‘he consumer consumes firs throw oranges as MU of oranges in terms of money is greater than tha price of oranges. For the fourth orange. MUX = Px and the consumer le -inaifferent” Gut he will not buy more than four oranges because for any level of consumption beyond that, MUx < Px Thus the, consumes reachas equilibrium when he buys four oranges Pete: donee Lflanntion oe Le” giuaces ‘YY CASE two commodity case, the consumer is said to be mt equilibrium when he spends his incame in such @ way that the utility (satisfaction) of the lest rupee spent on the two commodities ( X and Y) the same. This can be mathematically expressed as: o” "Mids 7 Muy vere Law oF Eaui-MARGINAL UTILITY Px Py slanen (2) subject to Px X + Py. Y =M_ (where Mis the money income) Inia can be explained by taking a contradictory situation MUx MUy 7 + The means that MU trom the last rupe rupee spent on good Y. + This induces the consumer to transfer funds from good Y to good X * The consumption of good X rises. while that of good Y falls. As he consumes mora af good X inal Utility). cn 2” and the consumer attains equilibrium tet Pent on good X is greater than MU from the last + th process continues un AMES Po Pe Me > Mey . eK ? “ vee . chen Mra/p, > M*r/[p, —P POW X jas LAS PROx Siw ord 30 INDIFFERENCE CURVE ANALYSIS The utility analysis assumed that utility i ‘ utility is cardinal 1 measur act ani ver sty ‘sa pyeelegica!prenemonan aera cs cream en! sn Now nerefore, Prof. Hicks developed an alternative technique called the Indifference Circe Analysis which assumes that utility is ordinal i.e. i a Analysis lity is ordinal i.e. it can be ranked ard compared but can't be An indifference curve shows different combinations of two gouds that give sania /eve! of satisfaction to the consumer. Assumptions: 1 Rationali : The consumer is assumed to be rational. Thus, he aims. at maximizing hs satisfaction from consumption, given his income and prices of the goods. N Ordinality: In Indifference curve analysis, utility is an ordinal concep'. A consumer has a scale of preference between different combinations of the two goods. Consumor can rank the subjective utilities derived from the commodities. For e.g. if there are two goods X and Y, three possibilities exist for the consumer: * Xs preferred to Y « Yis preferred to X * Xand Y are equally preferred i.e. consumer is indifferent betwen X and Y 3 Transitivity of choice: Consumer's choices are characterized by the property of transitivity. If X is preferred over Y and Y is preferred over Z, then X is. preferred over Z. 4 Monotonic Preference: Monotonic preferences means that a >onsumet aways prefers the combination, which has either more of both the goods cr more of at last one good and no less of the other goods as compared to any other sundle. For e.9. A consumer will prefer bundle (4,5) to (4,1) and (3,5) bundles. Properties of Indifference Curve: 1. Downward sloping from left to right: The curve is downward sioping because in order to have more units of one good the consumer will have to recuice the quantity of the other good in order to keep the level of satisfaction same. 2. Convex to the origin: The indifference curve 1s convex to the origin because of diminishing Marginal Rate of Substitution (MRS) 34 Diminis: i clin shing Marginal Tate of Substitution (MRS) | ve slope of wnetite additions yy, lofined as the amount of one ood sacrificed do ona MARS moune it ihe thar, without changing the level of eadadecters Ore hr} and more of one commodity. his Jost consume ecucas at as ha 'S and less of another com es desire to consume it red ne et reducns and ay fe modity his dasire to consume it rises ‘ 4 ay (aca AYIAR | 3. Higher 1 ent a higher satisfaction: Any point on 3 higher neiffere ws one He mole A both the goods or the same quantity of one good and mare jwentity of pee g The indifference curve analysis is based on the assuretin thet Preferences are monotonic which means that consumption of more goods manns nore satisfaction. Therefore, higher indifference curve represents higher level of setistaction Gray 7 @ fe iia a 4. Two Indifforonce curs never intersect. éach each indifference represents a particular level of.satisfaction, therefore, two IC’s on an IC map can never intersect each other In the given figure point A ancl Point B on IC, grves sare satisfaction. Similarly point A and point C on IC2 also give the zame level «! satisfaction, I means that point B = point C. Howevor tris is not possible, us 4 une ( he of two different indifference curves and represent different level of satisfac x jood ¥ h Ce ee Berg Es x / ; indifference Map. A sel of inditoroncd pees representing various levels of saliatecian know? as annindifference imap Got y 7 \ SOME IMPORTANT CONCEP’ Budget Si A budget set is a collection of all combinations (bundles) of two comnwmeiitien (hat tre consumer can buy with given income and prevailiny market prices. ‘The combination that the consumer will actually purchase depends upan Na money ‘nen and the prices of the two commodities. It means that tie consumer can purshame amty mere combinations of goods which will cost lass or equat fo hs income For eg. A consumer has an income of Rs.40 and he vas to spend it on two cormmedies and Y. Both are priced at Rs.10 each Now the possible combinations are (0,0) (0,1) (0,2) (0,3) (0,4) (1,0) (4.1) (1,2), (1,3) (2.0) (2,1) (2,2) (3,0) (3.1) (4,0) All the combinations cost either less than Rs.40 or exactly Rs 40. Thus, the sat of all Dundies which are available to the consumer within the income 1s called the budget set Budgetling | >< -~peneln ¢ wa's “OS = A budgetjline represents those combinations of two commodities thet « conswner can purchase] given prices and money income. as 3. . ae ne : A budget line represents the budget constraint of the consumer, It is aise ‘known income fine or the price line. When all bundles costing exactly the money income are represented graphically, « downward sloping. straight line is obtained which is known es the budget line (refer to the above budget set example) COMBINATION mio} a} Thus the budget line indicates that the consumer is spending his entire incamie on buying two nods X and Y Equation of budget line: Rxt RYE M . = budget Setg: tt PY SM CRudtet Seb feo wuiface ocr oak Conbtraim tt * =a Where, Px = Price of good X, Py = Prica of good Y Burcbget Comstoint X= Units of good X, Y = Units of good Y, 'M = Mohey income of the consumer Slope of budget line:(-) Px Py ci aaa 8 in budget tino and Daca Constructed on the basis of the consumer's income (M), price of geet changes. Y (Py). Therefore, if any one of these determinants change, the bude a) Change in income : i there is any change in the iricome, assumin: J . 19. NO change in the price of geen * 9 eee Y, then the budget line will make a parallel shift eae ‘shift: Budget line shifts to the right from BL. to B)L, due to the ircreee = Leftward shift: Budget line shifts to the left from BL to B2 L2 due to decreas in ince \ Bee red x + It ls assumed thatthere is a change in the pico good X and no change in income and price of good Y. Budget line Adafasfrom BL to BL; due to decrease in the price of good X and from Ei. B Lz due to increase In the price of good X. ( i tis assumed fhat there fe re in the pres af good Change in price of good Y. and no change in income and price of good X. Budget line; fom BL to B; L due to decrease in the price of good ¥ and from BL to B; L due to increase in the price of good Y. & good Y & 4) Analysis of Consumer's equilibrium with the help of Indifference Curve Consumer is in equilibrium when he allocates his fnitad resources in auch 2 way inat he maximizes his satisfaction. Assumptions: 1. Consumer has an indifference map showing his scae of preferences, All prices are given and constant. . All goods are homogeneous and divisible |. Consumer is rational. DON DIAGRAMMATIC EXPLANATION Conditions for consum librium 1 Budget line should be tangent to IC 2. ICis convex to the origin Tho budget lino represents the budget constraint A consume!’ would have to choosa a combinatiqn of two commodities that lle on the budgat line In the diagram above, a consumer would like to purchase 1D combination that lies on IC; , bul this is unattainable as it lies outside the budget constraint. Combination A und B are on the same IC and hence represent the same level of satisfaction Combination C ties an IC7 and hence fepresents highur lavel of satisfaction as compared to points A and B on IC, Also G les on the budget line and satisfies both the conditions of consumer's equilibrium. MATHEMATICAL EXPLANATION Conditions for consumor’s equilibrium 1 OMRSy=Px TPs NRE MAS Me “es (Or) MRSxy = Price ratio of two goods (01) Slope of indifference curve = Slopo of budget lina 2. MRSxy continuously falls Let the two goods be X and Y. MRSzxy is the number of units of good Y the consumer is willing to sacrifies to obtain one extra nit of good X. The ratio of prices Is Px/Py which indicates the number of units of ¥ that reads to be sacrificed to obtain one extra unit of X in the market, OMB Sey? fxf Py) Initially when the consumer starts purchasing, MRSxy is rector than PwPy, It means that to obtain one extra unit of X the consumer is willing to sacrifice more of good Y than what he hes to sacrifice actually. The consumer gains and increases the consumption of good X. As he goes ‘on obtaining more and more units of X, marginal utility of X goes on declining. Therefore the consumer is willing to sacrifice less and less of Y each time he obtains one extra unit of X. As 4 result MRSxy falls and ultimately becomes equal to Px/Py at some combination of X and Y At this combination the consumer is in equilibrium. q P; the ML Roy ff fy obtain more units of X beyond the equilibrium level, May wit become less than Px/Py. It means that to obtain one extra‘unit of X the Consumer ie willing to sacrifice less of Good Y than is actually required in the market. The consumer loses and reduces the consumption of Good X. As consumption of Good X decreases, its marginal utility increases. Thus, MRSxy increases and ultimately becomes equal to Px/Py at some combination of X and Y Unass MRSxy contnuoualy fal, he equim cannot bp epabished idnoads wed Byun Che Comnolitioas of Cour

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