Chapter 11: Consumer’s Equilibrium (Detailed Notes)
PART A: UTILITY APPROACH (MARSHALLIAN ANALYSIS)
1. Utility:
• Utility is the want-satisfying power of a good or service.
Types of Utility:
• Total Utility (TU): Total satisfaction from consuming all units of a good.
• Marginal Utility (MU): Additional satisfaction from consuming one extra unit of a
good.
MU = TU(n) – TU(n-1)
2. Law of Diminishing Marginal Utility (DMU):
"As a consumer consumes more and more units of a good, the marginal utility derived from
each successive unit goes on diminishing."
Assumptions:
• Standard units
• Continuous consumption
• No change in taste/income
• Rational behavior
Schedule:
Units Consumed TU MU
1 10 10
2 18 8
3 24 6
4 28 4
5 30 2
Units Consumed TU MU
6 30 0
7 28 -2
When MU becomes zero, TU is at maximum. Beyond that, MU becomes negative.
3. Consumer’s Equilibrium (One Commodity Case):
A consumer reaches equilibrium when:
MU = Price (P)
MU falls thereafter
Conditions:
1. MU = P
2. MU must fall after equilibrium
Numerical Example:
Units MU Price Decision
1 10 5 Consume
2 8 5 Consume
3 6 5 Consume
4 5 5 Equilibrium
5 3 5 Not Beneficial
PART B: INDIFFERENCE CURVE APPROACH
4. Indifference Curve (IC):
• A curve that represents combinations of two goods that give equal satisfaction to a
consumer.
Features of IC:
1. Downward Sloping
2. Convex to origin (due to diminishing MRS)
3. Higher IC = Higher satisfaction
4. ICs never intersect
5. Marginal Rate of Substitution (MRS):
MRS = units of Y given up / units of X gained
It diminishes as more of X is consumed in place of Y.
6. Budget Line / Budget Constraint:
Shows combinations of two goods that a consumer can buy with their income.
Equation: Px·X + Py·Y = M
Where:
• Px, Py = prices of goods X and Y
• M = income
Slope of Budget Line = Px / Py
7. Consumer’s Equilibrium (Two Commodity Case – IC Approach):
Equilibrium Conditions:
1. MRS = Px / Py
2. IC must be convex to origin (i.e., MRS must be diminishing)
3. Budget Line must be tangent to IC
At this point, the consumer maximizes utility under a given budget.
8. Shift in Equilibrium:
Factor Effect
Increase in Income Parallel rightward shift of budget line
Decrease in Income Parallel leftward shift of budget line
Change in Price of X Budget line rotates
Change in Price of Y Budget line rotates
9. Differences between Cardinal & Ordinal Approach
Basis Cardinal Utility Approach Indifference Curve (Ordinal) Approach
Measurement of Utility Quantitative (utils) Rank-based (ordinal)
Concept Used TU and MU IC and MRS
Equilibrium Condition MUx = Px MRS = Px/Py
Number of Commodities One commodity Two commodities
Important Definitions (Board-Oriented)
Term Definition
Consumer A state in which a consumer maximizes satisfaction given their budget
Equilibrium and market prices
A curve representing all combinations of two goods providing equal
Indifference Curve
satisfaction
MRS The rate at which a consumer is willing to give up one good for another
Line showing all affordable combinations of two goods given income
Budget Line
and prices
TU Total satisfaction from consuming goods
MU Change in TU from one additional unit