CONSUMER'S EQUILIBRIUM

We buy many goods and services to satisfy our wants. Using up of goods and
services to satisfy wants is called consumption and the economic agent who
buys goods and services is called a consumer. When a consumer buys any good
or service, his/her main objective is to get maximum satisfaction from the
quantity of the commodities purchased by spending his/her income at the
given market price.
How does a consumer maximize his/her satisfaction from spending his/her
income on various goods and services is the subject matter of this chapter.
MEANING OF CONSUMER’S EQUILIBRIUM

 Equilibrium means a state of rest from where there is no tendency to change.

 A consumer is said to be in equilibrium when he/she does not intend to change his/
her level of consumption i.e., when he/she derives maximum satisfaction.
 Thus, consumer’s equilibrium refers to a situation where the consumer has
achieved maximum possible satisfaction from the quantity of the commodities
purchased given his/her income and prices of the commodities in the market.
 As the resources are scarce in relation to unlimited wants, a consumer has to follow
some principles or laws in order to attain the highest level of satisfaction.
 There are two main approaches to study consumer’s equilibrium. They are as
 follows:
 1. Cardinal utility approach (or Marshall’s utility analysis)
 2. Ordinal utility approach (or indifference curve analysis)
CARDINAL UTILITY APPROACH

 The theory of consumers behaviour by using utility approach was first given by the
noted economist Alfred Marshall.
 Before discussing how a consumer attains equilibrium , we need to understand the
concept of utility, marginal utility and total utility.
 (i) Utility
 Utility is defined as the power of a commodity to satisfy a human want.Utility of a
commodity is the total amount of psychological satisfaction that a person gets from
consumption of a good or service,
 e.g. a thirsty person derives satisfaction from drinking a glass of water. So a glass of
water has got utility for the thirsty person. Utility differs from person to person.
 Utility is subjective and cannot be measured quantitatively. Yet for the sake of
convenience it is measured in ‘utils’.
 Marshall suggested that the measurement of utility should also be done in monetary
terms by converting ‘util’ into money by using the following formula
 Utility in Money = Utility in Util/Utility of a rupee. Utility of rupee can be assumed
to be any number such as 1, 2, 3 ... .
 Let utility of a rupee is assumed to be 2 utils.
 Then 10 utils = 10/2 = Rs 5.
MARGINAL UTILITY (MU)

 Marginal utility is the addition to the total utility derived from the
consumption
 of an additional unit of a commodity.
 It can also be defined as the utility from the last unit of a commodity
consumed.
 Let us explain the concept of marginal utility with the help of an
example. Suppose, a consumer gets total utility of 10 utils from
consumption of one orange and 18 utils from two oranges. He gets 8 utils
from consumption of second orange. So, marginal utility of second orange
is 8 utils.
 If total utility derived from three oranges is 24 utils then marginal utility
of three oranges is 6 utils (i.e. 24-18 utils). In this case third orange is the
last orange.
 Thus marginal utility of 3 oranges is 6 utils.
 Marginal utility can be calculated bythe following formula:
 MUn = TUn – TUn–1
 Or
 MU = Δ TU / Δ X
 Where MUn = Marginal utility of nth unit of the commodity
 TUn = Total utility of n units
 TUn–1 = Total utility of n–1 units
 Xn = Quantity of nth unit of good X
 Xn–1 = Quantity or (n–1)th unit of good X
 “n” takes the values 1, 2, 3, ... .
TOTAL UTILITY

 Total utility is the total satisfaction obtained from the consumption of all possible
units of a commodity.
 For example, if the first orange gives you a satisfaction of 10 utils, second one
gives you 8 utils and third one gives you 6 utils, then total utility from three oranges
= 10 + 8 + 6 = 24 utils.
 Total utility can be obtained by summing up marginal utilities from consumption of
different units of a commodity.
 Thus, total utility can be calculated as:

 TUn = MU1 + MUZ + MU3 + ........ MUn

 or TUn = Σ MU , where, TUn = Total utility from n units of a given commodity

 MU1, MU2, MU3, MUn = Marginal utilities from 1st, 2nd 3rd and nth unit of the
commodity
RELATIONSHIP BETWEEN TOTAL UTILITY AND
MARGINAL UTILITY
 The relationship between total utility and marginal utility is explained with the help
of following table and Fig:

Units of Oranges) Marginal Total Utility

Utility(Utils) Consumed
(Utils

0 - 0
1 10 10
2 8 18
3 6 24
4 2 26

5 0 26

6 -2 24
 TU increases at diminishing rate (MU is positive).
 TU is maximum when MU is zero
 TU falls when MU is negative

12

10

8
Marginal utility
6 Total utility
TU and MU
4

0
1 2 3 4 5 6
 MU is the rate of change of TU. It means that Total Utility increases as long as
marginal utility is positive.
 In the above table marginal utility is declining between the range AB but is
positive. So total utility is increasing at decreasing rate.
 Total Utility is maximum when marginal utility is zero. At point B, MU = 0, and the
corresponding point on TU is C where TU is maximum.
 Total utility starts declining when marginal utility becomes negative (i.e., less than
zero)
LAW OF DIMINISHING MARGINAL UTILITY

 It is a matter of common observation that as we get more and more units of a

commodity, the intensity of our desire for that commodity tends to diminish.
 The law of diminishing marginal utility also explains the same thing. It states that
‘as more and more units of a commodity are consumed, marginal utility derived
from each successive unit goes on diminishing.’
 The law can be explained with the help of an example.
 Suppose, a thirsty mandrinks water. The first glass of water he drinks will give him
maximum satisfaction (utility), say, 20 utils.
 Second glass of water will also fetch him utility but not as much as the first one
because a part of his thirst is satisfied by drinking the first glass of water .
 Suppose he gets 10 utils from the second glass. It is just possible that he may get
zero utility from the third glass because his thirst has now been satisfied.
 There will be negative utility from the fourth glass of water. Any rational consumer
will not consume additional glass of water when it gives disutility or negative utility.
ASSUMPTION OF LAW OF DIMINISHING MARGINAL UTILITY

 The law of diminishing marginal utility operates under certain specific conditions.
These are called assumptions of the law. Some important assumptions of the law
are:.
 1. It is assumed that utility can be measured and a consumer can express his
satisfaction in quantitative terms like 1, 2, 3 etc. We have already said that unit of
measurement of utility is ‘util’. So utility is cardinal.
 2. Quality of the commodity should not undergo any change. Take the above
example of glass of water. From the quality point of view a consumer who drinks a
glass of cold water must continue with the same. He or she cannot change its
quality from cold to normal as normal water give different satisfaction.
 3. Consumption should not proceed at intervals. It should be a continuous process.
Continuing with the above example, second glass of water, if consumed two hours
after the first glass of water was consumed, may give more, less or equal
satisfaction.
 4. Consumer should be a rational person. This means that he/she prefers more
quantity to less quantity of a good.
 5. Time period of consumption should not be too long. Consumer’s tastes, habits,
income etc. may change if the time gap is more.
 6. The price of the substitute and complementary goods should not change. If
these prices change, it may be difficult to predict about the utility derived from the
commodity in question.
CONSUMER’S EQUILIBRIUM IN CASE OF A SINGLE AND DOUBLE COMMODITY

 Equilibrium means a position of rest characterized by absence of change. Consumer

equilibrium is the situation when a consumer secures maximum satisfaction out of
his expenditure. Basically, he attains the equilibriumposition at a point when he
maximizes his total utility given his income and price of commodities he consumes.
 Consumer’s equilibrium in case of a single commodity can be explained on the basis
of the law of diminishing marginal utility. How does a consumer decide as to how
much to buy of a good? It will depend upon two factors.
 (a) The price she pays for each unit which is given and
 (b) The utility she gets At the time of purchasing a unit of a commodity, a consumer
compares the price of the given commodity with its utility.
 The consumer will be at equilibrium when marginal utility (in terms of money)
equals the price paid for the commodity say ‘X’ i.e. MUx = PX.
 (Note that marginal utility in terms of money is obtained by dividing marginal
utility in utils by marginal utility of one rupee).
 If MU of additional unit of a commodity is more than its price then consumer will
purchase the commodity, on the other hand if MU from the purchase of additional
unit is less than the price then he will not purchase the commodity. He will
purchase the commodity up to the point where MU derived from the purchase of
additional unit of commodity is equal to its price.
 In case of two or more commodities, consumer attains equilibrium at a point where
MU1=MU2=……….=MUn if price for all commodities are the same. But in case of
differences in prices, the equilibrium equation will be : MU1 /P1=MU2 /P2=…………
=MUn /Pn ,
 The law of diminishing marginal utility applies in case of one commodity only. But in
real life a consumer normally consumes more than one commodity.
 In such a situation, law of equi-marginal utility helps in optimum allocation of his
income.
 Law of equi-marginal utility is based on law of diminishing marginal utility.
 According to the law of equi-marginal utility a consumer will be in equilibrium when
the ratio of marginal utility of a commodity to its price equals the ratio of marginal
utility of other commodity to its price.
CONSUMER’S EQUILIBRIUM (IN CASE OF TWO GOODS)
SUPPOSE A CONSUMER HAS RS 24 WITH HIM TO SPEND ON TWO GOODS X AND Y. FURTHER, SUPPOSE PRICE OF EACH UNIT OF X IS
`RS 2 AND THAT OF Y IS `RS 3 AND HIS MARGINAL UTILITY

Units MUX MUX/Px MUY MUY/PY

(A Rupee
worth Of
MU)
1 20 20/2=10 24 24/3 =8
2 18 18/2=9 21 21/3=7
3 16 16/2=8 18 18/3=6
4 14 14/2=7 15 15/3=5
5 12 12/2=6 12 12/3=4
6 10 10/2=5 9 9/3=3
 For obtaining maximum satisfaction from spending his income of ` 24, the consumer
will buy 6 units of X by spending RS 12 (RS12 = 2 × 6) and 4 units of Y by spending Rs
12 (RS 12 = 3 × 4).
 This combination of goods brings him maximum satisfaction (or state of equilibrium)
because a rupee worth of MU in case of good X is 5 (MUx/Px = 10/2) and in case of
good Y is also 5 (MUY/PY = 15/3) (= MU of last rupee spent on each good)
 It should be noted that, consumer’s maximum satisfaction is subject to-budget
constraints i.e. the amount of money to be spent by the consumer (RS 24 in this
example)
ASSUMPTIONS OF CARDINAL UTILITY ANALYSIS

 Every law in subject to clause “other things being equal” This refers to the
assumption on which a law is based.
 Main assumptions of this law are as follows:
 1. Utility can be measured in cardinal number system such as 1,2,3 _______ etc.
 2. There is no change in income of the consumer.
 3. Marginal utility of money remains constant.
 4. Suitable quantity of the commodity is consumed.
 5. There is continuous consumption of the commodity.
 6. Marginal Utility of every commodity is independent.
 7. Every unit of the commodity being used is of same quality and size.
 8. There is no change in the tastes, character, fashion, and habits of the consumer.
 9. There is no change in the price of the commodity and its substitutes.
CRITICISM OF THE LAW :

 This law has been subjected to the following criticism.

 1. Cardinal measurement of utility is not possible : Measurement of utility is not
possible. How can a consumer say that he would get 10 utils of utility from first
apple and 8 utils, of utility from the second. Unless marginal utility is estimated,
application of the law will remain suspicious.
 2. Consumers are not fully rational : The assumption that consumers are fully
rational is not correct. Some consumers are idle by nature, and so to satisfy their
habits and customs, they sometimes buy goods yielding less utility. Consequently,
they do not get maximum satisfaction.
 3. Shortage of Goods : If goods giving more utility are not available in the market,
the consumer will have to consume goods yielding less utility.
 4.Ignorance of the consumer : Consumer is ignorant about many things concerning
consumption. Many a times, he is ignorant about the right price of the goods.
 He is ignorant about the less expensive substitutes that may be way available in the
market.
 He is also ignorant about the different uses of goods. On account of this ignorance,
the consumer fails to spend his income in a manner that may yield him maximum
satisfaction.
 5. Influence of Fashion, Customs and Habits :
 Actual expenditure of every consumer is influenced by fashion, customs, and habits.
Under their influence, many a times the consumer buys more of such goods which give
less utility.
 Consequently, he buys less of those goods which give more utility. Hence he fails to
spend his income according to this law.
 6. Constant Income and Price :
 An important assumption of the law is that the income of the consumer and the price
of the goods should remain constant.
 Income of the consumer is limited, as such he cannot increase his satisfaction beyond a
particular limit.
 Likewise, prices being constant, he will get only as much of satisfaction as the amount
of goods that he can buy with limited income.
 He cannot extend his satisfaction beyond this limit.
 7. Change in the Marginal Utility of Money :
 The assumption that marginal utility of money remains constant is also unrealistic. In
actual life, marginal utility of money may increase or decrease.
 Due to increase in the marginal utility of money, a consumer will have to rearrange his
expenditure on different goods.
 8. Complementary Goods :
 The law does not apply to complementary goods. It is so because complementary
goods are used in a fixed proportion. By using less of one commodity, use of the other
cannot be increased
DERIVATION OF THE DEMAND CURVE: A STEP-BY-STEP ANALYSIS

 Understanding Diminishing Marginal Utility

 The principle of diminishing marginal utility is foundational in deriving the demand
curve.
 As a consumer consumes more units, the satisfaction from each additional unit
lessens, affecting their willingness to pay.
 Marginal Utility and Price: Equilibrium Analysis
 Consumers reach an equilibrium point where the MU of a good equals its price.
 This equilibrium is where consumers maximise their total utility given their budget
constraints.
 Plotting the Demand Curve: A Practical Approach
 To plot a demand curve, one must consider different quantities of a good and their
corresponding MU values.
 By plotting these points, with MU on the y-axis (as a proxy for price) and quantity on
the x-axis, the demand curve is formed.
 This curve is typically downward sloping, reflecting the law of diminishing marginal
utility.
 The Intricate Link: Marginal Utility and Demand
 Marginal Utility's Influence on Demand
 The level of MU at various price points determines the quantity of a good a
consumer is willing to purchase.
 As MU decreases, the consumer's willingness to pay for additional units decreases,
leading to a lower quantity demanded.
 How Price Changes Affect Demand
 A decrease in price generally leads to an increase in MU, which raises the quantity
demanded.
 Conversely, a price increase lowers MU, resulting in a decrease in quantity
demanded.
CASE STUDY: APPLYING UTILITY ANALYSIS TO DEMAND CURVE DERIVATION

 Consider a consumer's utility from consuming chocolate bars.

 As the consumer eats more bars, the MU for each additional bar decreases.
 By plotting these MU values against the number of bars consumed, one can visually interpret the
demand curve.
ORDINAL UTILITY APPROACH (INDIFFERENCE CURVE ANALYSIS)

 You have already studied the utility approach which was based on the assumption
that utility is measurable numerically (like 1 util, 2 utils, 3 utils). This is called
cardinal utility approach.
 Prof. J.R. Hicks criticized the utility approach as unrealistic because satisfaction
(utility) is a subjective phenomenon and so it can never be measured precisely.
 He, therefore, presented an alternative technique known as indifference curve
approach (also called ordinal utility approach).
 The word ordinal is synonymous to the word rank. We know that rank is not a
quantity; rather it indicates the position of something in a group in terms of
magnitude or satisfaction or any other attributes.
 It is based on the assumption that every consumer has a scale of preference in the
form of assigning ranks (like 1st 2nd, 3rd rank) to different combinations of two
goods called bundle and can tell which bundle he likes most.
 In economics, we use two main tools: indifference curves and budget lines. These
help us understand how people choose between different combinations of two
things they want to buy.
 Indifference curves show us all the combinations of two items where a person feels
equally satisfied or doesn't prefer one over the other. These curves tell us about
their preferences.
 On the other hand, budget lines show us the combinations of two items that a
person can buy with a certain amount of money. This line helps us understand what
they can afford based on their budget.
 So, indifference curves tell us about preferences, and budget lines tell us about
affordability. Together, they help us understand how people make choices in
economics.
INDIFFERENCE CURVE

 An indifference curve shows us different combinations of two things (like goods or

services) that make a consumer equally happy or satisfied.
 In simpler terms, it's a line that represents all the choices where someone feels just
as good, no matter which option they pick along that line.
 This helps economists understand what people like and how they make choices
between different items they want to buy. So, each indifference curve tells us what
a consumer prefers when it comes to two specific things they might buy.
Table : Indifference Schedule

Combinations Units of Orange Units of Patty

A 12 2
B 7 4
C 4 6
D 2 8
E 1 10
 In Table 4.2, there are different combinations of Oranges and Patties listed. Each
combination varies in the amount of Oranges and Patties it includes. When one
combination has more Oranges, it has fewer Patties, and vice versa. This is because
all combinations are designed to give the consumer the same satisfaction level.
 As the number of Patties increases in a combination, the number of Oranges
decreases. This shows that consumers are willing to give up some Oranges to get
more Patties, while keeping their satisfaction unchanged. This ability to swap
between Oranges and Patties is called substitution.
 However, the rate at which consumers are willing to substitute Oranges for Patties
may not be the same in every case. Sometimes they may give up more Oranges for
an additional Patty, and other times they may give up fewer Oranges. This rate of
substitution can vary depending on individual preferences and circumstances.
PROPERTIES OF INDIFFERENCE CURVES

 (i) Indifference Curves are always convex to the origin

 Indifference curves are always convex to the origin because of diminishing marginal
rate of substitution.
 As the consumer consumes more and more of one good, his marginal utility of this
good keeps on declining and he is willing to give up less of other good. Therefore,
indifference curves are convex to the origin.
 (ii) Indifference Curves slope downwards
 It implies that as a consumer consumes more of one good, he must consume less
quantity of the other good so that the total utility remains the same.
 (iii) Higher Indifference Curves represent Higher level of satisfaction
 (iv) Indifference Curves can never Intersect
MARGINAL RATE OF SUBSTITUTION (MRS)
 Definition and Explanation:
 The concept of marginal rate substitution (MRS) was introduced by Dr. J.R. Hicks
and Prof. R.G.D. Allen to take the place of the concept of
diminishing marginal utility. Allen and Hicks are of the opinion that it is unnecessary
to measure the utility of a commodity. The necessity is to study the behavior of the
consumer as to how he prefers one commodity to another and maintains the same
level of satisfaction.
 For example,
 there are two goods X and Y which are not perfect substitute of each other. The
consumer is prepared to exchange goods X for Y. How many units of Y should be given
for one unit of X to the consumer so that his level of satisfaction remains the same?
 The rate or ratio at which goods X and Y are to be exchanged is known as the
marginal rate of substitution (MRS).
 In the words of Hicks: “The marginal rate of substitution of X for Y measures the
number of units of Y that must be scarified for unit of X gained so as to maintain a
constant level of satisfaction”.
 Marginal rate of substitution (MRS) can also be defined as: “The ratio of exchange
between small units of two commodities, which are equally valued or preferred by a
consumer”.
 Formula: MRS xy =∆Y /∆X
 Combinations Units of Units of MRS of X
good X good Y for Y
A 1 13 _
B 2 9 4:1
C 3 6 3:1
D 4 4 2:1
E 5 3 1:1

 In the table given above, all the five combinations of good X and good Y give the
same satisfaction to the consumer. If he chooses first combination, he gets 1 unit of
good X and 13 units of good Y. In the second combination, he gets one more unit of
good X and is prepared to give 4 units of good Y for it to maintain the same level
satisfaction. The MRS is therefore, 4:1.
 In the third combination, the consumer is willing to sacrifice only 3 units of good Y
for getting another unit of good X. The MRS is 3:1.
 Likewise, when the consumer moves from 4th to 5 th combination, the MRS of
good X for good Y falls to one (1:1). This illustrates the diminishing marginal rate of
substitution.

DIMINISHING MARGINAL RATE OF SUBSTITUTION:

 In the above schedule, we have seen that as the consumer moves from combination
first to fifth, the rate of substitution of good X for good Y goes, down. In other
words, as the consumer has more and more units of good X, he is prepared to forego
less and less of good Y.
 For instance, in the 2nd combination, the consumer is willing to give 4 units of good
Y in exchange for one unit of good X, in the fifth combination only one unit of Y is
offered for obtaining one unit of X.
 This behavior showing falling MRS of good X for good Y and yet to remain at the
same level of satisfaction is known as diminishing marginal rate of substitution
THE BUDGET (PRICE) LINE:

 A budget line incorporates information on both the limited income of the consumer
to spend and the prices of two purchasable goods.
 A budget line is a locus of points showing alternative combinations of two goods
that can be purchased with a fixed amount of money income given prices of the
two goods.
 If we know the budget (or the spending power) of the consumer and his
Indifference Map we can find out what quantity of each commodity he will
purchase. With the same information we can measure the effect of changes in the
prices of commodities and of changes in the income of the consumer.
 P1X + P2Y = M

g P1X + P2Y = M
o
o
d

good X
CONSUMER EQUILIBRIUM
 Consumer Equilibrium will be reached when he is deriving Maximum possible
Satisfaction from the Goods & is in no Position to Rearrange his Purchase of Goods.
 The Indifference Map in Combination with the Budget Line allows us to Determine
the One Combination of Goods and Services that the Consumer most wants and is
able to Purchase. This is the Consumer Equilibrium.

G
o PL - Budget Line
o
d Points R, S, Q, T, H

Y all lie on Budget

Line But Q is

Equilibrium Point.

M
CONSUMER EQUILIBRIUM

 At the Tangency Point Q, the slopes of the Price Line PL And Indifference Curve IC3
are equal.
 Slope of Indifference Curve shows MRS of X for Y (MRSxy)
 At Equilibrium Point Q,
 MRSXY = MUX/MUY =PX/PY