Consumer’s Equilibrium in case of Two Commodities:
The Law of DMU applies in case of use of a
commodity. However, 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 also known as:
(i) Law of Substitution
(ii) Law of maximum satisfaction
(iii) Gossen’s Second Law
(iv) Proportion Rule
(v) Law of Indifference
As law of Equi-marginal utility is based on Law of
DMU, all assumptions of DMU is also applied to law
of equi marginal utility. Let us now discuss
equilibrium of consumer by taking two goods: ‘x’ and
‘y’.
The same analysis can be extended for any number
of goods.’
In case of consumer equilibrium under single
commodity, we assumed that the entire income was
spent on a single commodity.
Now, consumer wants to allocate his money income
between the two goods to attain the equilibrium
position.
Being a rational consumer, he will be at equilibrium
when marginal utility is equal to price paid for the
commodity. We know, marginal utility is expressed in utils
and price is expressed in terms of money.
However, marginal utility and price can be effectively
compared only when both are stated in the same units.
Therefore, marginal utility in utils is expressed in terms
of money.
Marginal Utility in terms of Money = Marginal Utility
in utils/ Marginal Utility of one rupee
As utility is a subjective concept and differs from person
to person, it is assumed that a consumer himself defines
the MU of one rupee, in terms of satisfaction.
According to the law of Equi-marginal utility,
a consumer gets maximum satisfaction, when
ratios of MU of two commodities and their
respective prices are equal and MU falls as
consumption increases.
It means, there are two necessary conditions
to attain Consumer’s Equilibrium in case of
Two Commodities.
(i) Marginal Utility (MU) of last rupee spent
on each commodity is same.
(ii) MU falls as consumption increases.
(i) Marginal Utility (MU) of last rupee spent
on each commodity is same:
(a) We know, a consumer in consumption of first
commodity (say, x) is at equilibrium when
MUx/Px =MUM
(b) Similarly, consumer consuming another
commodity (say, y) will be at equilibrium when
MUY/PY =MUM
Equating 1 and 2, we get: MUX/PX = MUY/PY =
MUM
What happens when MUX/PX is Not Equal to MUY/PY
(i) Suppose, MUX/ PX>MUY/PY. In this case, the consumer is getting more
marginal utility per rupee in case of good X as compared to Y. Therefore,
he will buy more of X and less of Y. This will lead to fall in MU X and rise
in MUY. The consumer will continue to buy more of X till MU X/PX =
MUY/PY
(ii) When MUX/PX<MUY/PY, the consumer is getting more marginal utility
per rupee in case of good Y as compared to X. Therefore, he will buy more
of Y and less of X. This will lead fall in MU Y and rise in MUX. The
consumer will continue to buy more of Y till MU X/PX = MUY/PY.
It brings us to a conclusion that MU X/PX = MUY/PY is a necessary condition
to attain Consumer’s Equilibrium.
(ii) MU falls as consumption increases:
The second condition needed to attain consumer’s
equilibrium is that MU of a commodity must fall as more
of it is consumed.
If MU does not fall as consumption increases, the
consumer will end up buying only one good which is
unrealistic and consumer will never reach the
equilibrium position.
Finally, it can be concluded that a consumer in
consumption of two commodities will be at equilibrium
when he spends his limited income in such a way that the
ratios of marginal utilities of two commodities and their
respective prices are equal and MU falls as consumption
increases.
Example and Explanation of Law of Equi-
Marginal Utility:
The principle of equi-marginal utility can be
explained by taking an example. Suppose a
person has $5 with him whom he wishes to
spend on two commodities, tea and cigarettes.
The marginal utility derived from both these
commodities is as under:
39
39
A rational consumer would like to get maximum
satisfaction from $5.00. He can spend money in three
ways:
(i) $5 may be spent on tea only.
(ii) $5 may be utilized for the purchase of cigarettes only.
(iii) Some rupees may be spent on the purchase of tea and
some on the purchase of cigarettes.
If the prudent (careful , sensible ) consumer spends $5 on
the purchase of tea, he gets 30 utility. If he spends $5 on
the purchase of cigarettes, the total utility derived is 39
which are higher than tea.
In order to make the best of the limited resources, he
adjusts his expenditure.
(i) By spending $4 on tea and $1 on cigarettes, he
gets 40 utility (10+8+6+4+12 = 40).
(ii) By spending $3 on tea and $2 on cigarettes, he
derives 46 utility (10+8+6+12+10 = 46).
39
39
(iii) By spending $2 on tea and $3 on cigarettes, he gets 48 utility
(10+8+12+10+8 = 48).
(iv) By spending $1 on tea and $4 on cigarettes, he gets 46 utility
(10+12+10+8+6 = 46).
The sensible consumer will spend $2 on tea and $3 on cigarettes
and will get maximum satisfaction. When he spends $2 on tea and
$3 on cigarette, the marginal utilities derived from both these
commodities is equal to 8. When the marginal utilities of the two
commodities are equalizes, the total utility is then maximum, i.e.,
48 as is clear from the schedule given above.
Curve/Diagram of Law of Equi-Marginal Utility:
The law of equi-marginal utility can be explained with the help of
diagrams.
In the figure, MU is the marginal utility curve for tea and KL of
cigarettes. When a consumer spends OP amount ($2) on tea and OC
($3) on cigarettes, the marginal utility derived from the consumption
of both the items (Tea and Cigarettes) is equal to 8 units (EP = NC).
The consumer gets the maximum utility when he spends $2 on tea
and $3 on cigarettes and by no other alternation in the expenditure.
We now assume that the consumer spends $1 on tea
(OC/ amount) and $4 (OQ/) on cigarettes.
If CQ/ more amounts are spent cigarettes, the added utility is
equal to the area CQ/ N/N. On the other hand, the expenditure
on tea falls from OP amount ($2) to OC / amount ($1).
There is a loss of utility equal to the area C /PEE.
In order to get maximum satisfaction, consumer spend $2 on
tea and $3 on cigarettes.
The Ordinal Utility
The ordinal utility approach is a school of
thought that believes that utility cannot be
measured quantitatively, that is, utility is not
additive rather it could only be ranked
according to preference.
The numbers 1st, 2nd, 3rd, and 4th, are
ordinal numbers. These ordinal numbers are
ranked or ordered.
• J. R. Hicks & R.G.D. Allen
Cannot be measured but compared as rank
The ordinal utility theory explains consumer
Assumptions of Ordinal Utility Approach
(i) Rationality: - The consumer is assumed to be
rational meaning that he aims at maximizing total utility
given his limited income and the prices of goods and
services.
(ii) Utility is Ordinal: - According to this assumption,
utility is assumed not to be measurable but can only be
ranked according to the order of preference for different
kinds of goods.
(iii) Transitivity and Consistency of Choice: - By
transitivity of choice, it means that if a consumer prefers
bundle A to B and bundle B to C, then habitually, the
consumer must prefer bundle A to C. Symbolically, it is
written as:
If A > B and B > C; then A > C.
By consistency of choice, it is assumed that the consumer is
consistent in his choice making. If two bundles A and B are
available to the consumer, if the consumer prefers bundle A
to B in one period, he cannot choose bundle B over A nor
treat them as equal. Symbolically:
If A > B, then B > A and A ≠ B
(iv) Diminishing Marginal Rate of Substitution (MRS):-
Marginal rate of substitution implies the rate at which a
consumer is willing to substitute one good (X) for another
good (Y), so that the total satisfaction remains the same.
iv. Non-satiety:
Implies that a consumer is assumed to be non-satisfied. In
other words, it is assumed that consumer does not reach the
level of satisfaction by consuming a good and always prefers
a large quantity of goods.
Meaning of Indifference Curve:
The Indifference Curve shows the different combinations of two
goods that give equal satisfaction and utility to the consumers.
This curve or graph is also called as iso-utility curve or equal
utility curve.
Many times, consumes wants to buy large number (different) of
goods, the consumer may substitute one commodity for another
and still be on the same level of satisfaction.
As the consumer increases the consumption of one of the
commodities, he must reduce the consumption of the second
commodity and vice versa, to maintain the same level of
satisfaction.
When plotted graphically, it gives rise to what is known as an
indifference curve.
Suppose you consume only two goods: kulfi and chocolate.
Start with any combination of these goods which you (the
consumer) may want to consume.
One possibility is, say, zero kulfi along with 40 chocolates. In
short, write this bundle as (0, 40).
Consider another bundle with 1 kulfi and some chocolates. Ask
yourself how many chocolates along with 1 kulfi will give you the
same satisfaction as the bundle (0, 40)?
Suppose it is 30 chocolates for you, that is, you
are ‘indifferent’ between the bundles, (0, 40) and
(1, 30).
Similarly, suppose that, if you consume 2 kulfis,
you need 22 chocolates to make you indifferent
between this bundle and the previous two.
Table lists various bundles, giving you equal
satisfaction, that is, you are indifferent between
any pair of bundles in the list.
Figure (a) graphs these bundles and joins them. The
resulting curve is an indifference curve, generally
defined as a locus (a particular position or place where
something occurs or is situated) of commodity bundles
along which a consumer is indifferent.
We use the abbreviation ‘IC’ for indifference curve.
Indifference Map
A collection of indifference curves is called an
indifference map.
Each indifference curve in an indifference
map stands for some level of satisfaction or
utility relative to some other level of
satisfaction
Figure above shows a typical indifference map.
Nowhere in the indifference curve analysis is the
consumer assumed to tell or ‘assign’ one particular
number to the level of satisfaction obtained from
consuming a bundle.
She is only required to compare or rank utility
between any pair of bundles. If both yield the same
level of satisfaction, then both lie on the same
indifference curve. In this sense, utility is
measured ‘ordinally’, not cardinally
Budget Constraint
There is a question.
How much of different goods a consumer would
buy depends on her preferences and budget.
Now we will look at her budget, meaning what
different bundles she can buy?
Common sense suggests that it should depend
on two factors:
(a) prices of various goods she wants to consume
and
(b) her income.
Suppose that the price of kulfi is Rs 15 per piece and that of a
chocolate bar is Rs 12.
Denote these prices respectively as pk= 15 and pc = 12.
Suppose Ravi’s income (say M) is Rs 300.
What different combinations (bundles) of kulfi and chocolates
can Ravi buy with his income and these prices?
Table lists some of these bundles. Note that the total cost of
each bundle is Rs 300 = M.
Figure (a) graphs the bundles in Table. Their joining line is the
price line or the budget line, defined as the locus of bundles of the
two goods the consumer can buy by fully spending her income,
given the prices and her income. Figure (b) has three (arbitrary)
price lines. Of these, for the moment, ignore the two dotted lines.
Note that a consumer can afford to buy any combination of goods
on or inside the price line. The area inside or on the price line is
called the budget set.
If a bundle is on the line then buying that bundle exhausts all
income. A bundle strictly inside the line means that the income is
not fully spent.
Shifts in Budget Line:
The budget line is determined by the income of the consumer and the
prices of goods in the market. If there is a change in the income of
the consumer or in the prices of goods, the budget line shifts in
response to a exchange in these two factors.
1. A change in the price of a good and the budget line
If income is held constant, and the price of one of the goods
changes then the slope of the curve will change. If the price of one
of the commodity increases, the budget line will move inwards and
vice versa.
Increase in price
of one commodity
If the price of one
of the commodity
increases, the
budget line will move
inwards.
Decrease in price of one commodity
If the price of one of the commodity decreases,
the budget line will move outwards. Here, the
price of commodity B had decreased and with
the decrease in price, the curve has moved
outwards.
2. A change in the Income of a good and the budget line
When there is change in the income of the
consumer, the prices of goods remaining the
same, the price line shifts from the original
position. It shifts upward or to the right hand
side in a parallel position with the rise in income.
A fall in the level of income, product prices
remaining unchanged, the price line shifts left
side from the original position. With a higher
income, the consumer can purchase more of
both goods than before but the cost of one good
in terms of the other remains the same.
Consumers
Equilibrium
By now, you are clear about indifference curves and the
budget line. Let’s look at consumers equilibrium next. A
consumer is in equilibrium when he derives maximum
satisfaction from the goods and is in no position to re-
arrange his purchases.
Assumptions
There is a defined indifference map showing the consumer’s
scale of preferences across different combinations of two
goods X and Y.
The consumer has a fixed money income and wants to
spend it completely on the goods X and Y.
The prices of the goods X and Y are fixed for the consumer.
The goods are homogenous and divisible.
The consumer acts rationally and maximizes his
satisfaction.
In order to display the combination of two
goods X and Y, that the consumer buys to be in
equilibrium, let’s bring his indifference
curves and budget line together.
We know that, Indifference Map – shows the
consumer’s preference scale between various
combinations of two goods.
Budget Line – depicts various combinations
that he can afford to buy with his money
income and prices of both the goods.
In the following figure, we depict an indifference map
with 5 indifference curves – IC1, IC2, IC3, IC4, and
IC5 along with the budget line PL for good X and good Y.
From the figure, we can see that the combinations R, S,
Q, T, and H cost the same to the consumer. In order to
maximize his level of satisfaction, the consumer will try
to reach the highest indifference curve. Since we have
assumed a budget constraint, he will be forced to remain
on the budget line.
So, which combination will he choose?
Let’s say that he chooses the combination R. From Figs, we
can see that R lies on a lower indifference curve – IC1. He can
easily afford the combinations S, Q, or T which lie on
the higher ICs. Even if he chooses the combination H, the
argument is similar since H lies on the curve IC1 too.
Next, let’s look at the combination S lying on the curve IC2.
Here again, he can reach a higher level of satisfaction within
his budget by choosing the combination Q lying on IC3 –
higher indifference curve level. The argument is similar for
the combination T since T lies on the curve IC2 too.
Therefore, we are left with the combination Q.
What happens if he chooses the combination Q?
This is the best choice since Q lies on his budget line and puts
him on the highest possible indifference curve, IC 3.
While there are higher curves, IC4 and IC5, they are beyond his
budget. Therefore, he reaches the equilibrium at point Q on curve
IC3.
Notice that at this point, the budget line PL is tangential to the
indifference curve IC3. Also, in this position, the consumer buys
OM quantity of X and ON quantity of Y.
Since point Q is the tangent point, the slopes of line PL and curve
IC3 are equal at this point. Therefore, we can say that consumers