GEOMETRICAL ANALYSIS OF
CONSUMER EQUILIBRIUM
Appendix Ch.5
A Graphical Representation of
Consumer’s Choice Problem
Consumer Choice Problem:
• Recall that demand depends on income,
prices of goods and services, and preferences.
• Example: suppose the consumer is only faced
with goods C and F, and has to choose how
many units to consume of each.
• Required ingredients to be able to determine
how the final quantities of goods C and F will
be chosen:
1. Consumer Preferences
2. Budget constraint: in terms of income and prices
I. Consumer Preferences: Indifference Curves
• An indifference curve is a curve representing
different consumption bundles among which the
consumer is indifferent; i.e all are equally desirable.
• What are the features of IC?
• An Indifference curve is convex to the origin
• This means that the absolute value of the slope of the
indifference curve decreases (the curve gets flatter), as
we move to the right
• reflecting a property called the law of diminishing
marginal rate of substitution.
• MRS: measures how a person substitutes one good for
another.
– The scarcer a good, the greater its relative
substitution value; its marginal utility is higher
relative to the marginal utility of the good that has
become plentiful.
• From the previous graph, moving from A to B, you
would swap 3 of your 6 clothing units for 1 extra food
unit. But from B to C, you would sacrifice only 1 unit of
your remaining clothing supply to obtain a third food
unit—a 1-for-1 swap.
• If we join the points A and B, we find that the
slope of the resulting line (neglecting its
negative sign) has a value of 3. Join B and C,
and the slope is 1; join C and D, and the slope
is ½.
• These are the marginal rates of substitution
between the two goods.
• The slope of the indifference curve, ∆#⁄∆$
gives this MRS.
Deriving an expression for the slope of an
indifference curve:
• Let us look at the arc between A and B.
• We know that moving from A to B, total utility
remains constant. That is, the utility lost from
consuming less of C must be matched by the
utility gained from consuming more of F
• !"# . ∆& = −(!"* . ∆+)
• Rearranging terms, we obtain:
∆* -./
• = −( )
∆# -.0
The Indifference Map
II. Consumer Income: BUDGET LINE
• Now let us set a particular consumer’s
indifference map aside for a moment and give
the consumer a fixed income.
• He has, say, $6 per day to spend, and is
confronted with fixed prices for food and
clothing—$1.50 for food, $1 for clothing.
• To draw the budget line, we need to get two
points; horizontal intercept and vertical
intercept.
• The budget line NM has all possible combinations
of the two goods that would consume all of the
consumer’s income.
– The consumer is free to move anywhere along NM.
– Positions to the right and above NM are not possible
because they require more than $6 of income;
– Positions to the left and below NM are irrelevant
because the consumer is assumed to spend the full
$6.
• The slope of NM (neglecting its sign) is 3⁄2, which
! ! ! "% "%
is ( ÷ = × = − ).
"# "% "# ! "#
– The meaning of the slope is that, given these prices,
every time our consumer gives up 3 clothing units, he
can gain 2 units of food.
III. Equilibrium:
Now we are ready to put our two parts together
• The previous Figure demonstrates our
consumer problem:
– A consumer will choose from among affordable
combinations the one that maximizes utility.
– Graphically, the consumer will move along the
budget line until he is on the highest indifference
curve.
– This happens at point B in the figure.
– At this point, the budget constraint is just tangent
to the indifference curve
• In other words, consumer equilibrium is attained
at the point where the budget line is tangent to
the highest indifference curve.
– At B, the budget line just touches, but does not cross,
the indifference curve U3 .
• Implications of the tangency condition:
– When two curves are tangent, they have the same
slope.
– Geometrically, the consumer is at equilibrium when
the slope of the budget line (which is equal to "#!"$)
is exactly equal to the slope of the indifference curve
(which is equal to %&#!%&$).
• So our tangency condition is just another way
of stating that the ratio of prices must be
equal to the ratio of marginal utilities;
• In equilibrium, the consumer is getting the
same marginal utility from the last penny
spent on food as from the last penny spent on
clothing.
• Equilibrium condition:
Applications: Changes in Income and Price
1. Income Change
• Assume, first, that the consumer’s daily
income is halved while the prices of the two
commodities remain unchanged.
– The budget line thus makes a parallel shift inward.
– Implication: new utility-maximizing consumption
bundle will be chosen.
Income-Consumption Curve:
• This is the dark pink curve in the previous
graph.
• It traces out the utility maximizing
consumption bundles associated with each
income level.
2. Single Price Change
• Assume that the price of food rises from $1.50
to $3 while the price of clothing is unchanged.
– What will be the impact on the budget line?
– This time we find that the budget line will pivot on
point N.
– Implication: new utility-maximizing consumption
bundle will be chosen.
Price-Consumption Curve:
• This is the dark pink curve in the previous
graph.
• It traces out the utility maximizing
consumption bundles for each price of food.
DERIVING THE DEMAND CURVE
Look carefully at the previous figure.
• As we increased the price of food from $1.50 to
$3, we kept other things constant.
– Tastes as represented by the indifference curves did
not change,
– money income and the price of clothing stayed
constant.
• Therefore, we are in the ideal position to trace
the demand curve for food.
– At a price of $1.50, the consumer buys 2 units of food,
shown as equilibrium point B .
– When the price rises to $3 per unit, the food
purchased is 1 unit, at equilibrium point B”.
• Now plot the price of food against the
purchases of food, again holding other things
constant.
• You will have derived a neat downward-
sloping demand curve from indifference
curves.
• Note that we have done this without ever
needing to mention the term “utility”—basing
the derivation solely on indifference curves.