CHAPTER - 2CONSUMER’S EQUILIBRIUM

UTILITY – Utility does not mean usefulness. The term utility refers to the want satisfying power of a commodity.

It means expected satisfaction to a consumer when he is willing to spend money on a stock of commodity which has the capacity to satisfy his want.

Or Utility is the power or capacity of a commodity or service to satisfy human wants.

Expected satisfaction is different from realized satisfaction. Realized satisfaction takes place only after the commodity has been consumed. Expend satisfaction takes place when the commodity has not been bought but the consumer is willing to buy it. A commodity has utility for a consumer

Total Utility (TU) - It is the sum of all the utility derived from consumption of a certain number of units of a particular

commodity. Mathematically, TU can be obtained by the sum of marginal utilities from the consumption of different units of the commodity.

TUn = MU1 + MU2 +..... + MUn

Marginal Utility (MU) - It is the additional (extra) utility derived from consumption of an additional unit of a

commodity. Mathematically, it is calculated as:MUn = TUn - TUn-1

Units of a commodity

Total Utility

Marginal Utility

1 2 3 4 5 6

8 14 18 20 20 18

8 6 4 2 0 -2

Relationship between TU and MU Curves The relationship is as follows on the basis of above table & figure 1:

i. TU curve starts from the origin, increase at a decreasing rate, reaches a maximum and then starts falling. ii. MU curve is the slope of the TU curve.iii. TU increases so long as MU is positive.iv. TU is maximum when MU is zero.v. TU starts declining when MU becomes negative.

[1]

Figure- 1

Saturation Point – It means TU is maximum and MU is zero.

The Law of Diminishing Marginal Utility or The First law of Gossen – This law is the foundation stone of utility analysis. The law of DMU states ‘as more and more units of a

commodity are consumed, marginal utility derived from each successive unit goes on falling.’The law of DMU is a psychological law arrived at by introspection and by empirical evidence.According to the law, TU increases but at a decreasing rate and MU falls.

Units of a commodity

Marginal Utility

123456

86420-2

Figure- 2

[2]Assumptions of the Law of DMU - The law of DMU holds good when the following assumptions are satisfied:

i. Standard unit of measurement is used. If the unit of measurement is very large or very small then the law will not hold. Examples of inappropriate units are: rice measured in grammas, water in drops and diamonds in kilograms.

ii. Homogeneous commodity - All units of the commodity consumed are homogeneous and perfect substitutes.

iii. Continuous consumption - The law of DMU holds only when consumption of successive units of a commodity is without a time gap.

iv. Mental and social condition of the consumer must be normal - The law will hold when consumer's mental condition is normal. His income and tastes are unchanged and his behaviour is rational.

Exceptions of Law of diminishing marginal utility – There are three cases, where the law of diminishing marginal utility does not apply. a) In case of

Money, b) Hobbies and c) liquor.

Why does the law of DMU apply?i. Goods are not perfect substitutes. (Bread & butter)ii. Satiability of particular wants. (Salt)iii. Paradox of value. (Diamond- water paradox)

Assumptions of the Utility Approach - The assumptions of the cardinal utility approach are:

i. Utility can be cardinally measurable, i.e. can be expressed in exact units. Utility is measurable in monetary terms.

ii. Consumer's income is given. iii. Prices of commodities are given and remain constant. iv. Constant Marginal Utility of Money - It means that importance of money remains unchanged. Marginal

utility of money is addition made to utility of the consumer as he spends one more unit of the money income. This is assumed to be constant.

Consumer's Equilibrium Meaning of Consumer’s Equilibrium – It refers to a situation where in a consumer gets maximum Satisfaction maximum satisfaction from the purchase of the commodity and he no tendency to make any change in his existing purchase has. In short, consumer's equilibrium represents the 'state of maximum satisfaction to the consumer from a given money-Income.

There are two approaches to explain the consumer's equilibrium: Utility Approach (Cardinal) and Indifference Curve Approach (Ordinal). These are discussed below:

(A) Utility Approach (Cardinal)(a) One Commodity Case Given that utility is a cardinal concept, the MU from different units of a good X can be measured in terms of money

Quantity of X Px (in Rupees) MUx (in Rupees)

1 5 72 5 63 5 54 5 45 5 3

[3]

Figure- 3

Above table shows that if Px = Rs. 5, then the consumer will buy three units of good X. If the consumer buys less than 3 units say 2 units then the MU he derives from 2 units is worth Rs. 6 and the price he pays is Rs. 5. Since his MUx > Px. he buys more. In other words, since price is less, he buys more which is the logical basis of the law of demand. A consumer will not buy more than 3 units of X. This is because if he buys 4 units of X then the price he pays (Rs. 5) will be more than the MU he derives which is worth Rs. 4. Hence, in order to maximize utility a consumer will buy that quantity of the good where the MU of the good is equal to the price that he has to pay. That is, consumer is in equilibrium where:

MUx/Px =MUm If Mum = 1 So, Marginal utility of the good = Price of good

Or MUx = Px

Means Utility of the price paid.

(B) Many Commodities Case or Law of Equi-Marginal Utility or the Second law of Gossen

In reality, a consumer spends his income on many different goods. In such a case, the law of DMU (which holds in case of one good) is extended to many goods which the consumer buys with his income. The condition required by a consumer to maximize his utility for two commodities X and Y is given as:

MUx= Px (MU) (1) MUy= Py (MU) (2)

Divide equation (1) by (2), we get MUx=MUy

This is called the law of equi-marginal utility. According to this law, a consumer will so allocate his expenditure so that the utility gained from the last rupee spent on each commodity is equal. In other words, a consumer buys each commodity up to the point at which MU per rupee spent on it is the same as the MU of a rupee spent on another good. When this condition is met, a consumer cannot shift a rupee of expenditure from one commodity to another and increase his utility. The condition of consumer's equilibrium in case of two goods X and Y can be written as: 1) MUx/Px = MUy / Py = Mum (Consumer's Equilibrium Conditions from Utility Approach) 2) Subject to Px.x + Py.Y = M. (M is money income)

Suppose, a consumer has 8 and he wants to buy two commodities X and Y. The price of both commodities 1 / unit. Marginal utility of money is 25 utils, this is given and remains constant. Utilities from both goods given as below:

[4]

Units of a

commodity MUx MUy

1 45(1) 35(3)

2 40(2) 30(5)

3 35(4) 25(7)

4 30(6) 20

5 25(8) 15

6 20 10

7 15 5

8 10 0

In this situation, consumer would like to buy 5 units of X and 3 units of Y; from these goods he will obtain maximum satisfaction. Then we say that consumer is in equilibrium.

Figure- 4

(B) Indifference Curve Approach

'When utility from different units of a good is comparable or rankable, it is known as ordinal measurement of utility.' In this theory, utility of different units cannot be added or subtracted like cardinal measurement. For example, a consumer gets more utility from bundle A than from bundle B, therefore, he ranks bundle A above bundle B.

J .R. Hicks has explained consumer's behaviour on the basis of ordinal utility theory, famously known as Indifference Curve Approach. Meaning of Indifference Schedule / Curve An indifference schedule shows all those combinations 0f two goods based upon definite income budget, which give exact/ the same satisfaction to the consumer.

Indifferent ScheduleBundles Good 1 Good 2

A 1 12

B 2 8

C 3 5

D 4 3

E 5 2

[5]

The table shows five different bundles - A, B, C, D and E of good 1 and good 2. These different bundles give the same level of satisfaction to the consumer. It means whatever satisfaction a consumer derives from the bundle of 1 unit of good 1 + 12 units of good 2 (bundle A), the same satisfaction he derives from the bundle of 2 units of good 1 + 8 units of good 2 (bundle B) and also from 3 units of good 1 + 5 units of good 2 (bundle C) and so on. Thus, he likes all these bundles equally and remains indifferent between them. That is why we call this schedule as an indifference schedule.

Indifference curve refers to the graphical representation of various alternative combinations of the two goods (substitute), which provide same level of satisfaction to the consumer.

OrAn indifference curve is a graphical representation of an indifference schedule.

Or

An indifference curve is a locus of all such points, each of which represents a combination of two goods and yield equal satisfaction to the consumer.

Figure- 5

The graphical representation of indifference schedule becomes the indifference curve. Hence, ran indifference curve is one where different points on it show those bundles of goods which give equal satisfaction to the consumer) on the basis of indifference schedule given above an indifference curve is constructed in the diagram. Assumptions of the Indifference Curve

The indifference curve approach is based on a few simple yet powerful assumptions. These assumptions are:

1. Rationality-The consumer is assumed to be rational. He aims at maximising his benefits from consumption, given his income and prices of the goods.

2. Ordinality- Utility is expected satisfaction that a consumer gets from a given market basket. In indifference curve analysis, utility is an ordinal concept. Consumer can order or rank the subjective utilities derived from the commodities. A consumer has a scale of preference as between different combinations of the two goods. For example, if there are two goods X and Y, three possibilities exist for the consumer:*X is preferred to Y *Y is preferred to X *X and Yare equally preferred i.e., the consumer is indifferent between X and Y.

3. Diminishing Marginal Rate of Substitution- Scale of preferences are ranked in terms of indifference curves. Indifference curves are downward sloping convex-to-the origin curves. The slope of indifference curve is called Marginal Rate of Substitution (MRS) of X for Y. MRS is defined as the amount of good y the consumer is willing to give up to consume an additional unit of good X, while leaving total utility unchanged. An important assumption is that the MRS of X for Y, decreases with greater quantities of good X, i.e. the greater the quantities of X, the less willing the consumer will be to give up Y in exchange for X. This relationship is known as the Law of Diminishing Marginal Rate of Substitution.

[6]

4. Consistency of Choice-Consumer is consistent in his choice. It means that if good X is preferred over good Yin one time period, then consumer will not prefer Yover X in another time period.

5. Transitivity of Choice- Consumer's choices are characterised by the property of transitivity. If good X is preferred to good Y and good

Y is preferred to good Z, and then good X is preferred to good Z.6. Monotonic Preference-

A consumer's preferences are monotonic if and only if between any two bundles, the consumer prefers the bundle which has more of at least one of the goods and no less of the other good as compared is the other bundle.

Properties of Indifference Curve 1. An indifference curve always slopes downward from left to right:

It implies that as the consumer increases the consumption of one commodity, he will have to reduce the consumption of another commodity, so as to remain on the same level of satisfaction. We can see in fig. when the consumer moves from point A to B, he has more units of X-commodity and less units of Y-commodity, but equal satisfaction on both the points. Thus, the indifference curve must be downward sloping. This is shown as in the figure-6.

Figure-62. Indifference curves are convex to the origin:

It implies that as the consumer substitutes X for Y, the marginal rate of substitution between them goes on diminishing. It is shown in fig. MRS is continuously diminishing in additional combinations. Therefore IC is shown as convex to the origin. This is shown as in the figure-7.

Figure-73. Indifference curve never intersect each other:

It means that each indifference curve has its own level of satisfaction; therefore, two ICs on an IC map can never intersect each other. If at all, they intersect each other, we cannot call them as genuine indifference curves. This is shown as in the figure-8.

Figure-8

[7]

4. Higher the Indifference curve, higher is the level of satisfaction:

On higher Indifference curve, we can get more goods without reducing another, therefore higher the IC, higher is the level of satisfaction. This is shown as in the figure-9.

Figure-9

Budget Set- It is a set of bundles of goods available to the consumer.

Budget Line / Consumption Possibility Line / Price Line-It is a line showing different possible combinations of two goods, which a consumer can buy, given his budget and the prices of both goods.

Budget Constraint- It shows that a consumer can choose any bundle as long as it costs less or equal to the income she has, given income and prices of goods.

Figure- 10

Slope of Budget Line-Slope of the budget line measures the amount of change in good Y required per unit change in good X along the budget line.

The absolute slope of the budget line equals the Px / Py ratio. The economic meaning of the slope is that, given

these prices, how much is the opportunity cost of X in terms of Y sacrificed or given up. In other words, the price ratio is effectively a measure of rate at which the consumer is able to substitute good X for good y.

[8]

Figure- 11

Shifts in Budget Line- Shift in the budget line can take place when there are:

(a) Changes in the price of good X or good Y or both, and

(b) Changes in money income of the consumer.

1.Change in Price

(a) Suppose, price of good X falls. Then new budget line will pivot on or rotate about point A and shift toward becoming flatter. The new budget line ABI shows that with a fall in price of X, consumer can buy more of X. The slope of the line AB changes. The flatter budget line, ABI, implies that the relative price of good X is lesser.

Figure- 12

2.Change in Income

Suppose money income of the consumer increases then the new budget line will make parallel shift outward. The new budget line A1B1 is parallel to AB. The slope of both the budget lines is same, i.e. prices have not changed. The consumer can buy more of both the goods with increased income (cost of one good in terms of the other good remaining constant). When income falls, budget line will make parallel shift inward.

Figure- 13

[9]

Consumer's Equilibrium or Optimal Choice

A consumer is in equilibrium when he maximises his utility, given income and market prices. In other words, equilibrium is attained when the consumer reaches the highest possible indifference curve given his budget constraint. Consumer's equilibrium point must lie on the budget line and must give the most preferred combination of goods and services.

Figure- 14

In the above figure, at point of equilibrium (E), the consumer's budget line is tangent to the indifference curve; it is the point of consumer's equilibrium. If the consumer moves away from any point on the budget line, he will be on a lower indifference curve I1' at point F, consumer's MRS is less than the price ratio. So, the consumer is better off by moving back up towards point E. The optimum point would be always located on the budget line. Points to the right of E are desirable but not attainable. Thus, point E shows the maximum satisfaction of the consumer when X* units of good X and Y* units of good Yare consumed.

[Slope of indifference curve] = [slope of budget line]

MRSxy = Px / Py

It means that when the consumer is in equilibrium the MRS is equal to the ratio of the prices of the two goods.Thus the conditions that must be fulfilled by the consumer to be in equilibrium by indifference curve approach are:

MRSxy = Px / Py --------- (i)

Diminishing MRS -------(ii)

[10]