Chapter 2: CONSUMER EQUILIBRIUM

CONSUMER
Consumer is an economic agent who purchases goods and services to satisfy his/her wants directly.
EQUILIBRIUM
It’s a state of BALANCE

Or

It’s a state of rest position where two forces become equal and where there is no tendency to change.

OBJECTIVE OF CONSUMER EQUILIBRIUM

Consumer equilibrium is a DECISION MAKING CONCEPT. With the help of this approach a consumer decides
rationally whether a product should be purchased or not.

A consumer is supposed to be in equilibrium when:

PRICE = Satisfaction in terms of money.

OR

Whatever amount consumer actually does pay = whatever amount consumer is willing to pay

To understand CONSUMER EQUILIBRIUM we have to study two approaches:

1. MARSHALL APPROACH

o CARDINAL APPROACH / UTILITY APPROACH

2. HICKS & ALLEN APPROACH

o ORDINAL APPROACH / INDIFFERENCE CURVE APPROACH

# MARSHALL’S APPROACH

 Single commodity

 Several commodity

Determination of consumer equilibrium in Single commodity model (Marshall’s Approach)

Utility → It refers to the want-satisfying power of a commodity or it refers to satisfaction derived from commodity.

It’s a psychological concept but Marshall considered following assumptions / hypothesis:

1. Utility can be measured in cardinal numbers (like 1,2,3…).

2. Utility can be measured in a hypothetical unit: utils.

3. Each and every unit of commodity has its independent utility.

ASPECTS / TYPES OF UTILITY

1. Marginal Utility (MU) - It refers to change in total utility due to consumption of an additional unit of commodity.

Or, it refers to satisfaction derived from each individual unit of a commodity.

ΔTU
MU=TUn−TUn−1 Or MU=
Δ units consumed

[Link] Utility (TU) - It refers to the total satisfaction derived by consuming all the units of a commodity.

Or, it refers to the sum total of satisfaction derived from consuming all the units of a commodity.
 TU= ΣMU

Note: MU is also equal to satisfaction derived from each unit.

Units consumed Satisfaction TU MU

0th 0 0 0

1st 200 200 200

2nd 120 320 120

3rd 40 360 40

4th 10 370 10

5th 0 370 0

6th -40 330 -40

RELATIONSHIP B/W TOTAL UTILITY AND MARGINAL UTILITY

 When MU falls but above zero or remains Positive, TU rises.

 When MU becomes zero, TU at its MAXIMUM (such point is

known as point of satiety or full satisfaction).

 When MU becomes negative, TU falls.

NOTE 1: Shape of TU curve is Inverse 'U' shape.

NOTE 2: Shape of MU curve is Downward Sloping from left to right.

LAW OF DIMINISHING MARGINAL UTILITY

Introduction

The law of Diminishing Marginal Utility was initially propounded by a German economist H.H. Gossen but was given a
systematic formulation by Alfred Marshall. It is also known as the first law of Gossen.

Meaning

 This law states that when a consumer consumes an adequate quantity of a commodity continuously,
satisfaction derived from each individual unit keeps on diminishing.

 In other words, this law states that marginal utility from each successive unit keeps on diminishing as the
consumer increases its consumption continuously.

Assumptions of the Law

a. All the units of commodity must be same (adequate and suitable) in all respects (size, colour, quantity, quality, etc).
b. Consumption of commodity must be continuous without time interval.
c. There should be no change in taste and preferences of a consumer.
Schedule (Law of Diminishing Marginal Utility)

Units Marginal
Consumed Utility

0 0

1 400

2 200

3 120

4 40

5 10

6 0

7 -40

Exceptions of LDMU

1. Inadequate quantity

2. Time gap

3. Liquor use

4. Jewellery

5. Cash (in case of poor)

6. Rare commodities, antiques and monuments

7. Availability of substitutes

Conclusion

Law of Diminishing Marginal Utility is considered as the “Fundamental Law of Satisfaction” or “Fundamental
Psychological Law” because it has universal applicability.

Determination of Consumer Equilibrium in case of Single Commodity

Meaning:
Consumer equilibrium refers to a situation when consumer can maximize his satisfaction within his given level of
income without making any change in his existing expenditure.

Assumptions:

1. Law of diminishing marginal utility should be applicable.

2. Consumer is a rational being.

3. Cardinal measurability of utility.

4. Taste and preference should be constant.

5. Price of commodity should be constant.

6. Marginal utility of money should be constant.

Condition of Equilibrium
Consumer equilibrium is attained when:
MUx MUx
= Px Or = MUm
MUm Px
Schedule :

Consumer Equilibrium in a single commodity model case is illustrated by numerical example in the given table.
Suppose the consumer wants to buy X commodity :

Units Consumed (x) MUx MUm Px MUx/Px +/-

0 0 4 2 -- --

1st 20 4 2 10 +3

2nd 16 4 2 8 +2 Consumer surplus

3rd 12 4 2 6 +1

4th 8 4 2 4 0 Consumer equilibrium

5th 4 4 2 2 -1
Consumer deficit
6th 0 4 2 0 -2

From the above schedule and diagram it can be concluded that:

 A rational consumer will purchase till 4th unit or until consumer equilibrium is reached i.e. will purchase 4
units of X commodity where
MUx
= Px (Consumer equilibrium is attained).
MUm

 From the first three units consumer is getting a surplus of Rs. 6 (3+2+1) → (Consumer surplus).

 A rational consumer would not purchase beyond 4th unit because consumer is in deficit where
MUx
< Px (Consumer deficit).
MUm

Determination of consumer equilibrium in case of several commodities (Two commodities model)

Base:
a. When a consumer wants to buy two or more commodities, his equilibrium will be determined by the Law of Equi-
Marginal Utility. In this case he will distribute his money income among those goods in such a way that he gets equal
marginal utility from all the goods.

b. The Law of Equi-Marginal Utility states that a consumer will attain the equilibrium when the marginal utilities of
the various commodities that he consumes are equal.

c. Law of Diminishing Marginal Utility also applies in the two-commodity case.

Conditions of Equilibrium

a. In case of two commodities a consumer gets maximum satisfaction when a rupee worth of marginal utility is
same for both commodities.

In other words, ratio of marginal utility to price in case of each good is same:

MUx MUy
= = MUm
Px Py
Note: Derivation of this condition
MUx MUy
If = MUm Or = MUm
Px Py
MUx MUy
Then, = = MUm
Px Py
b. Consumer has to spend his entire income, in other words, at equilibrium point the money is spent is just
equal to income:

( Px × Qx )+( Py × Qy )= Y
Tabular Presentation

This model can be explained with the help of following schedule:

Px=Rs.8/unit, Py=Rs.2/unit ,Y=Rs.38, MUm=8 utils

Units Consumed MUx MUy MUx/Px MUy/Py

0 80 40 10 20

1 72 36 9 18

2 64 32 8 16

3 56 28 7 14

4 48 24 6 12

5 40 20 5 10

6 36 16 4.5 8

7 32 12 4 6

8 24 8 3 4

9 16 6 2 3

10 8 4 1 2
From the above schedule, it can be concluded that the following bundles must be considered:

1. (1x, 6y) → 1×8 + 6×2 = Rs. 20

2. (3x, 7y) → 3×8 + 7×2 = Rs. 38 ✅

3. (5x, 8y) → 5×8 + 8×2 = Rs. 56

4. (7x, 9y) → 7×8 + 9×2 = Rs. 74

5. (9x, 10y) → 9×8 + 10×2 = Rs. 92

Hence, consumer equilibrium will be established at (3x, 7y).

a. The consumer will allocate his income of Rs. 38 among two commodities in such a way that ratio of marginal
utilities to prices is equal:

MUx MUy
= = MUm
Px Py
8 = 8 = 8

b. In equilibrium, consumer will buy 3 units of X commodity and 7 units of Y commodity.

c. At equilibrium point, the consumer spends entire income:

( Px × Qx )+( Py × Qy )= Y
3x8 + 7x2 = 38

Diagrammatic presentation

Explanation:

 It is clear from the diagram that consumer will get maximum satisfaction if he buys only that quantity of each
MUx
good that gives him same utility from the last rupee spent on each good. In other words, must be equal
Px
MUy
to .
Py
 MUx MUy MUx MUy
 If is not equal to , then the consumer is not in equilibrium. If >
, per rupee MUx > per
Px Py Px Py
rupee MUy. He will buy more of X and less of Y good. This will reduce MUx and increase MUy. These changes
MUx MUy
will continue till = and he will be in equilibrium.
Px Py
CONSUMER EQUILIBRIUM BY HICKS AND ALLEN APPROACH

The indifference curve approach was fully developed by J.R. Hicks and David Allen.
Indifference curve analysis is based on the idea of ordinal utility or ordinal approach.

 Ordinal utility means the consumer can rank the preference whether one commodity is preferred over
another.

 According to this approach, consumer equilibrium can be determined with the help of Indifference Map and
Budget Line.

INDIFFERENCE CURVE

Meaning:
It is that graphical presentation which shows various possible combinations of two goods which gives the same level
of satisfaction. Thus, the consumer is indifferent between the various combinations on a given indifference curve.

Indifference Schedule

It is a tabular statement showing different combinations of two goods which presents equal satisfaction to
consumer.

Combinations X (Apples) Y (Oranges) Satisfaction

A 1 15 100

B 2 10 100

C 3 6 100

D 4 3 100

E 5 1 100

Diagrammatic Presentation

 In the diagram, A, B, C, D, and E are the five

different combinations or bundles of X and Y
commodities.

 By joining these combinations, we get

indifference curve (IC), which gives equal
satisfaction to the consumer.

 IC is also known as ‘Iso-Utility Curve’.

FEATURES / CHARACTERISTICS OF INDIFFERENCE CURVE (IC)

1. It is a downward sloping curve from left to right (shape)

This is because it represents a combination of two goods which gives the same level of satisfaction. In order to
maintain the same level of satisfaction, when consumer increases the consumption of one good he has to sacrifice
the consumption of the other good.

2. Indifference Curve is Convex to the origin (Slope)

This is because of diminishing marginal rate of substitution of X for Y (MRSxy).
MRSxy is the rate at which one product can be substituted by another.
Δchange in loss of Y
MRSxy=
Δchange in gain of X

This implies that in order to get one unit of a commodity, the consumer will give up progressively less and less units
of the other commodity under a given price-income situation.

3. IC never touches x and y axis

This is because it represents a combination of two goods and to attain the same level of satisfaction, therefore, one
of any goods cannot be zero. So, IC never touches any of the axis.

4. Higher the indifference curve, higher the level of satisfaction:

A combination on a higher IC will give more satisfaction than on a lower IC,
because higher IC will represent more amount of both the commodities.

5. Two indifference curves can never intersect each other:

 a. Each indifference curve represents a

different level of satisfaction but each point
on the indifference curve shows a level of
equal satisfaction.

 b. By the assumption of consistency and

transitivity, if satisfaction at A is equal to
satisfaction at B and satisfaction at A equals
to satisfaction at C, then satisfaction at B and
C should be equal. Hence, the assumption is
not fulfilled if two ICs intersect each other.

Indifference Map

When more than one indifference curve is shown in one diagram, then such a diagram is termed as indifference map
or in other words, family of IC is also termed as IC map.

In the diagram there are three indifference curves i.e. IC1, IC2, IC3. Each IC represents different level of satisfaction.
It is clear from the diagram that IC2 shows satisfaction more than IC1 and IC3 shows satisfaction more than IC2.
Marginal Rate of Substitution (MRS)

Meaning

 MRS is the rate at which the consumer is willing to substitute one good for another, without changing the
level of satisfaction.

 In other words, MRSxy is defined as the amount of Y commodity the consumer is willing to give up to get one
additional unit of X commodity so that the same level of satisfaction is maintained.

 MRSxy is the quantity of Y commodity forgone for getting one additional unit of X commodity.

 The slope of the indifference curve shows the MRSxy because it indicates the rate at which the consumer is
willing to substitute one good with the other.

MRS – Schedule

X Y
Combinations Satisfaction MRSxy
commodity commodity

A 1 30 100 -

B 2 25 100 5:1

C 3 21 100 4:1

D 4 18 100 3:1

E 5 16 100 2:1

It is clear from the schedule that, when consumer moves from combination A to B, he is willing to give up 5 units of
commodity Y for 1 unit of X i.e. MRS of X for Y is 5:1. In the same way from B to C, MRSxy is 4:1.
It is clear from the table that MRS of Y for X is diminishing.

Why does MRS decrease?

There are two reasons for this:

1. The want for a particular good is satiable, so that when a consumer has more of it, his intensity of want for
it decreases.
→ Thus, when the consumer has more units of X commodity, his intensity or desire for additional units of X
decreases.

2. Most of the goods are imperfect substitutes of one another. If they could substitute one another perfectly,
MRS would remain constant.
Note: When MRSxy is constant and two goods are perfect substitutes to each other, then:
Slope of IC (curve) will be Straight Line.

NOTE: When MRSxy is increasing, then IC can be CONCAVE to the origin.

Budget Line:

It is that graphical presentation which shows various possible combinations of two goods that can be purchased
within given monetary income, assuming that prices of two goods are constant.

Example:
Let suppose Income be (Y) = Rs. 100
Price of x commodity = Rs. 10/unit
Price of y commodity = Rs. 20/unit

Slope = Δy / Δx or
Comb. X Y
MRE = Px / Py

A 0 5

B 2 4 ½ = 0.5

C 4 3 0.5

D 6 2 0.5

E 8 1 0.5

F 10 0 0.5

Budget line Equation:

 Px Qx + Py Qy = Y
Budget Line Constraint:

 Px Qx + Py Qy ≤ Y
Marginal Rate of Exchange (Slope of Budget Line):

It is the rate at which one product can be exchanged by other.

Δchange in loss of Y
MRE=
Δchange in gain of X

Note:

 MRE is constant, so it is a straight-line curve.

 It is downward sloping, as the income is fixed.

Attainable and Unattainable Combinations

 A, B, and C are attainable combinations because they are on the budget line.

 H is also attainable combination because it is inside the budget line.

 L is unattainable combination because it is outside the budget line.

Shifting of Budget Line

Case 1: Shifts from left to right Case 2: Shifts from right to left

Reason: Monetary Income increases Reason: Monetary Income decreases

OR OR
Prices of both the goods decreases Price of both the goods increases

Rotation of Budget Line

Case 1 :

Reason: Price of only x commodity decreases but monetary income

is constant.

Case 2 :

Reason: Price of only x commodity decreases but monetary

income is constant.

Consumer Equilibrium (Hicks and Allen Approach)

Given the indifference map of the consumer and budget line, we can find out the combination (bundle) which gives
maximum satisfaction to the consumer i.e., equilibrium point.

According to this approach, consumer equilibrium will be determined where the following conditions are fulfilled:

Conditions of Consumer Equilibrium

The conditions of consumer's equilibrium where he would maximise

his satisfaction are as follows:

1. The budget line should be tangent to the IC

Or
MRSxy=MRE
Or
𝑃𝑥
MRSxy=
𝑃𝑦
 2. Expenditure = Income
PxQx + PyQy=Y
 In the diagram, MN is the budget line. IC3 and IC4 indifference curves have become irrelevant to a consumer
because both lie outside the price space of the consumer. IC1 and IC2 are only relevant indifference curves in
the budget space.

 A consumer will maximise his total satisfaction at point E where slope of IC2 is equal to the slope of MN
budget line. A consumer would get maximum satisfaction by buying OX1 units of X commodity and OY1 units
of Y commodity.

 All the conditions of equilibrium are fulfilled at point E. They are not fulfilled at point A and B.

Consumer Equilibrium in Terms of Price Ratio and MRS

 MRSxy is the number of units of Y commodity which the consumer is willing to sacrifice to obtain one extra
unit of X commodity without affecting the level of satisfaction.

 The ratio of prices in the market (which also equals the ratio of the number of units of Y required to be
sacrificed to obtain one extra unit of X in the market.
𝑃𝑥
1. MRSxy >
𝑃𝑦
𝑃𝑥
 Initially when the consumer starts purchasing, MRSxy > . It means that to obtain one extra unit of X
𝑃𝑦
commodity, the consumer is willing to sacrifice more than what he has to sacrifice actually.
 The consumer gains as he goes on obtaining more and more units of X. MU of X commodity goes on
declining. Therefore, the consumer is willing to sacrifice less and less of Y each time for one extra unit of X.
𝑃𝑥
 As a result, MRSxy falls and ultimately becomes equal to at some combination of X and Y (at E point).
𝑃𝑦
At this combination, the consumer is in equilibrium.
𝑃𝑥
2. MRSxy <
𝑃𝑦
If the consumer attempts to obtain more units of X beyond the equilibrium level, then MRSxy will become
𝑃𝑥
less than and he will start losing. So, the consumer will not try to obtain more units of X.
𝑃𝑦

𝑃𝑥
MRSxy Equilibrium or Disequilibrium Changes
𝑃𝑦
5:1 2:1
𝑃𝑥
4:1 2:1 MRSxy > Consumption of X ↑
𝑃𝑦

3:1 2:1

𝑃𝑥
2:1 2:1 MRSxy = Equilibrium point
𝑃𝑦

𝑃𝑥
1:1 2:1 MRSxy < Consumption of X ↓
𝑃𝑦

HOTS

Q.1 Define MUₘ?

Ans: Marginal utility of money refers to the worth of a rupee to a consumer.
Q.2 Define law of Equi-marginal utility.
Ans: It states that a consumer will attain the equilibrium when the marginal utilities of the various commodities that
he consumes, are equal.
Q.3 Why does MRSxy always diminish?
Ans: Consumer’s capacity to sacrifice units of a good is greater when it is plentiful and less when it is scarce.
Initially at combination A, consumer had 1 unit of shirt and 20 units of trousers. Here, consumer's capacity to
sacrifice or forego trousers is greater than capacity to sacrifice units of shirt. Therefore, he can sacrifice a larger
quantity of trousers in favour of a smaller quantity of shirt.
Here, shirt is more important than trousers.

But if we compare it with a movement from D to E where trousers now become relatively important than the shirts
(because of scarcity of trousers), consumer is willing to give up only small number of trousers (only 1 unit) for an
additional unit of shirt.
Therefore, MRS diminishes as the stock of trousers decreases.

Q.4 Define “monotonic preferences”.

Ans:

a. Monotonic preference means that the consumer always prefers that combination which has either more of both
the goods or more of at least one good and no less of the other good as compared to another bundle.

b. For example, there are two commodities – X and Y:

 (i) If two bundles of X and Y commodities are:

(a) (20X, 20Y) and
(b) (10X, 10Y)
→ The consumer will prefer (a) because it contains more of both X and Y commodities.

Q.5 What is a bundle?

Ans: A combination of two goods consumed by a household is called a bundle.

Q.6 Define budget set.

Ans: A budget set is the collection of all bundles of two goods that a consumer can buy within his given level of
income, at the prevailing market prices.

Q.7 Define MRSxy.

Ans: MRSxy is the rate at which one product can be substituted by another product without changing level of
satisfaction.
Δchange in loss of Y
MRSxy=
Δchange in gain of X

Good X Good Y MRSxy

1 30 -

2 25 5

3 24 4

4 18 3

5 16 2

Q.8 What is indifference set?

Ans: All those combinations that offer the same level of satisfaction