UNIT – 2

CONSUMER EQUILIBRIUM AND DEMAND

Consumer is an economic agent who consumes goods and services for the satisfaction of his/her
wants or he buys goods and services for satisfaction of his wants.

Consumer equilibrium is a way to decide how much units of a commodity should a consumer
buy so that he derives maximum satisfaction.

There are two approaches: -

 Cardinal approach:- (Marshall’s Utility Analysis)

 Ordinal approach:- (Hicksian Analysis)

CONSUMER’S BEHAVIOUR: - It is the behavior in which the consumer spends his limited
income on various goods and services in such a way that he obtains maximum satisfaction.

CONCEPT OF UTILITY

Utility is a quantitative measure of satisfaction.

Characteristics:-

1. Utility depends upon urgency or intensity of want.

2. Utility is subjective.
3. Utility is measurable.
4. Utility is not essentially useful.

Marginal Utility:- It is an addition made to total utility by consuming an additional unit of the
commodity or it is the additional utility derived from consumption of one more unit of the given
commodity.

2 units TU =34 and 3units TU =40 Find MU at 3rd unit

MUn = TUn – TUn-1 OR TU/ Q

MU3 =TU3 -TU3-1
MU3 =40-34= 6
For example :- If a consumer derives satisfaction from 1st unit is equal to 10 utils, 18 utils from 2
units and 24 utils from 3units , Marginal utility from 3rd units of consumption will be:
MU2 = TU2 – TU2-1
MU2 = 18 – 10 = 8 utils.
Total Utility:- It is defined as total psychological satisfaction, a consumer derives from
consumption of a certain amount of a commodity.

TUn = MU1+MU2+….MUn

For example :- If a consumer derives satisfaction from 1st unit is equal to 10 utils, 8 utils from 2nd
unit and 6 utils from 3rd, then total utility from all the three units of consumption will be:
TU3 = MU1+MU2+MU3

TU3 = 10 + 8 + 6 = 24 utils

THE LAW OF DIMNISHING MARGINAL UTILITY

This law was first given by a German economist Gossen. It is fundamental law of
consumption. This law states that as the stock of goods for consumption increases, the utility
derived from it decreases.

ASSUMPTIONS OF LAW:-

 All the successive units consumed are homogeneous in quality, size, taste marked by the
phrase’ other things being equal.’
 The consumption process should be continuous.
 The units of consumption are of reasonable or standard size.

According to law of DMU, as a consumer consumes more and more units of a commodity,
marginal utility derived from additional units goes on falling, utility derived from each
successive units falls. For example,

UNITS TU MU(UTILES)
(UTILES)
1 15 15
2 27 12
3 35 8
4 39 4 TU
5 41 2
6 41 0
7 39 -2
8 35 -4
MU

RELATIONSHIP BETWEEN TU AND MU

 As long as Mu is positive, TU increases.
  When MU is zero, TU is maximum and constant.
 When MU is negative, TU decreases.
 Total Utilities is summation of Marginal Utility.

CONSUMER EQUILIBRIUM (CARDINAL APPROACH)

In case of single commodity:-

Consumer equilibrium refers to a situation in which a consumer spends his income on purchase
of a commodity in such a way that gives him maximum satisfaction. Consumer equilibrium is
determined when following conditions are satisfied:

1. MUm = Price
2. Total gain decrease with additional purchase after equilibrium.

The following schedule depends upon three assumptions:

1) MU falls as law of DMU operates

2) MU of a rupee is 2 utils.
3) Price of commodity is Rs. 3 per unit.

Units MU MUm Price Gain/

Consume (Utils) (RS) Loss
d
1 10 5 3 2
2 8 4 3 1
3 6 3 3 0
4 4 2 3 -1
5 2 1 3 -2
6 0 0 3 -3
7 -2 -1 3 -4
8 -4 -2 3 -5
9 -6 -3 3 -6

It is clear from the above table that consumer equilibrium is determined at 3 units of the
commodity. It implies that the consumer should buy 3 units of the commodity, as at this level
marginal utility in Rs. = Price(PX) in rupees.

Condition 1 MUx = Pricex

1. Why MUx = Pricex ?
Why not MUx > Pricex or MUx < Pricex
  When MUx > Pricex , a consumer gains more satisfaction as compared to sacrifice he makes
in terms of price paid by him. Hence, he gets prepared to buy more. MU falls as he buys
more and becomes equal to price of the commodity.
 When MUx < Pricex a consumer suffers losses as he is paying more than what he actually
gains. He reduces consumption of the commodity, MU begins to rise and becomes equal to
the price of the commodity.

So a consumer is at equilibrium when MUx = Px.

Condition 2. Total gain falls after equilibrium.

It is because marginal utility is falling and after equilibrium it becomes smaller than the price
paid for the additional units of the commodity.

To make MU comparable to price , we need to convert MU (Utils) into MU(in money terms).

MU in money terms/ Rupees = MU (utils)/ (MU of a rupee).

CONSUMER EQILIBRIUM IN CASE OF TWO COMMODITIES

In actual life consumer consumes more than one commodity. In such a case , Law of DMU is
extended to many goods which the consumer purchases.
LAW OF EQUI MARGINAL UTILTIY: It helps in determining consumer equilibrium in case
of two commodities.
According to this law, a consumer gets maximum satisfaction when ratios of MU of two
commodities to their respective prices are equal.
There are two ways in which consumer can equilibrium can be determined in case of two
commodities:
i) When price of each commodity is same.
ii) When prices of two commodities are different.
1. When Price of each commodity is same.
The conditions of equilibrium are
1. MUx = MUy
2. Law of DMU operates.
For example,
1. Price of one unit of each good is Rs. 1.
2. Money income of a consumer is Rs. 5.

Units of consumed MUx(utils) MUy(utils)

1 12 (I) 10(II)
2 10 (III) 8(IV)
3 8 (V) 6
4 6 4
 5 4 2
Being a rational consumer he will try to maximize his total satisfaction. He spends first
on ‘X’, second on ‘Y’, third on ‘X’, fourth on ‘Y’ and fifth on ‘X’. He gets maximum
satisfaction equal to 48 utils. If he spends his money on any other combination, total
utility would be less than 48 utils. Thus he buys 3 units of good X and 2 units of good Y.

MUx/Px == MUy/Py
2. When Price of each commodity is not same

If the price of two goods is different, then the conditions of consumer equilibrium are:

1. MUx/Px == MUy/Py = MU of last rupee spent.

2. Law of DMU operates.
3. Total expenditure = Money income i.e., P1X1+ P2Y1 =M
For example:-
a) Price of good 1 is Rs 10 per unit.
b) Price of good 2 is Rs 2 per unit.
c) Money income of the consumer is Rs. 30

COMMODITY ‘X’ COMMODITY ‘Y’

UNITS MUx Px MU of a rupee UNITS MU Py MU of a rupee utile

utile y MUy/Py
Mux/Px
1 100 10 10 1 24 2 12
2 80 10 8 2 22 2 11
3 60 10 6 3 20 2 10
4 40 10 4 4 18 2 9
5 20 10 2 5 16 2 8
6 0 10 0 6 14 2 7
7 -20 10 -2 7 12 2 6
Let us try , First ratio which is = 10 Second ration which is = 8
Condition -1 MUx/Px = MUy/Py Condition -1 MUx/Px = MUy/Py
100/10 = 20/2 = 10 80/10 =16/2 = 8
Condition 2 Exp. On x + Exp. On y = Money Condition -2 Exp. On x+ Exp on y = Money
Income Inome
P1X1+P2X2 = Y P1X1+P2X2 = Y
10*1 + 2*3 = 30 10*2+2*5 = 30
10 + 6 = 30 20+10 = 30
16 = 30 30 = 30
Hence (1,3) is not a possible combination to Hence (2,5) is a possible combination to
determine consumer equilibrium. determine consumer equilibrium.

What happens if MUx/Px is not equal to MUy/Py.

 a) MUx/Px >MUy/Py, the consumer gets more marginal utility from the last rupee spent on
X as compared to Y. Thus he would prefer to buy more of X and less of Y. Due to law of
DMU, it will cause fall in MUx and rise in MUy. The consumer will continue to buy
more of X till MUx /Px = MUy/PY.
b) MUx/Px <MUy/Py, the consumer gets more marginal utility from the last rupee spent on
Y as compared to X. Thus he would prefer to buy more of Y and less of X. Due to law of
DMU, it will cause fall in MUy and rise in MUx . The consumer will continue to buy
more of Y till MUx /Px = MUy/PY.

ORDINAL UTILITY ANALYSIS

CONSUMPTION BUNDLE : Consumption bundle is a combination of the quantities of two

goods. This is also called bundle of goods e.g. (X1,X2). It would denote a bundle having X1
amount of good 1. and X2 amount of good 2.

BUDGET SET:- It refers to all consumption bundles that the consumer can buy using his money
income at the prevailing market prices.

P1X1+P2X2 = Y

BUDGET CONSTRAINT:- It refer to those bundles which cost more than money income of
the consumer. P1X1+P2X2 > Y

BUDGET LINE:- A budget line represents the different bundles that the consumer can purchase
spending his entire income at given prices. P1X1+P2X2 = Y.
It is a graphical representation of all those bundles which cost the amount just equal to income of
the consumer.
For example, Price of good 1 is Rs 4 per unit.
Price of good 2 is Rs. 2 per unit.
Money income of the consumer is Rs 20.

COMBIN UNITS UNITS EXPENDITUR

ATIONS OF OF E = INCOME
GOOD GOOD y
X
A 0 10 4*0+2*10=20
B 1 8 4*1+2*8 =20
C 2 6 4*2+2*6 =20
D 3 4 4*3 +2*4 =20
E 4 2 4*4 +2*2 =20
F 5 0 5+2*0 =20

FEATUTRES OF BUDGET LINE:-

1. Budget line is a straight line assuming that the entire income is spent.
2. Slope of budget line depends upon prices of both the goods and size of the income of the
consumer.
3. It is negatively sloped curve or a downward sloping curve. It implies that increase in the
consumption of one commodity is followed by decrease in consumption of the other.
4. Slope of budget line is equal to price ration of 2 goods
Slope of budget line = (-) P1/P2
CHANGES IN BUDGET LINE
A) CHANGES IN INCOME:-
 An increase in income of the consumer causes a parallel rightward shift of the
budget line from AB to A1B1. Fig. 1
 A decrease in income of the consumer causes a leftward shift in the budget line
from AB to A1B1. Fig 2

B) CHANGES IN PRICE OF GOOD 1:-

 An increase in Price of good 1 will make the budget line steeper.
The consumer buy less of good 1,
so the curve rotates to left from AB to A1B1.
 A decrease in Price of good 1 will make the budget line steeper.
The consumer buys less of good 1,
so the curve rotates to left from AB to A1B1

C) CHANGES IN PRICE OF GOOD 2:-

 An increase in Price of good 2 will make the budget line steeper.
The consumer buy less of good 1,
so the curve rotates to left from AB to A1B1.

 A decrease in Price of good 2 will make the budget line steeper.

The consumer buy less of good 1,
so the curve rotates to left from AB to A1B1.

INDIFFERENCE CURVE AND CONSUMER EQUILIBRIUM

INDIFFERENCE CURVE:- It joins all points representing bundles which yield the
same satisfaction to the consumer. Thus, consumer is indifferent between combination
indicated by all points on one indifference curve.
INDIFFERNCE SET:- A set of all combinations on the indifference curve is called
indifference set.

BUNDLE GOODX GOOD Marginal Rate of

Y Substitution
A 1 10 -
B 2 7 3
C 3 5 2
D 4 4 1

MARGINAL RATE OF SUBSTITUTION OR SLOPE OF INDIFFERENCE

CURVE
Marginal rate of substitution is a tool of indifference curve analysis. MRS means the rate
at which a consumer will forgo (sacrifice) the successive units of one good for a marginal
increase of another good.

BUNDLE GOODX GOODY Marginal Rate of Substitution =

LOSS/GAIN
A 1 12 -
B 2 8 4:1
C 3 5 3:1
D 4 3 2:1
E 5 2 1:1

For example when a consumer shifts from bundle A to B i.e., when he wants to consume
unit of good 1, he has to sacrifice 4 units of good 2.
MRSx1x2 = Loss/gain or X2/ X1
As a consumer increase consumption for 1 good, MRS decreases.
It is because in order to get every succesive unit of good1.
PROPERTIES OF INDIFFERNENCE CURVE
1. An indifference curve slopes downwards:-
It means that an indifference curve has a
negative slope. It is because, if the
consumer wants to have more units of one
good, he will have to reduce the number of
units of another good in order to maintian
the same level of satisfaction
 2. An indifference curve is convex to the point of origin.
It is because of diminishing MRS or slope of
indifference curve. In order to gain an additional
unit of good1, the consumer is prepared to give up
less and less unit of good 2. This causes diminishing
MRS and accordingly convex IC.
3. Higher indifference curve shows higher satisfaction.

When there is a set of indifference curves called

indifference map, higher indifference curve
represents higher level of satisfaction or right side of
IC gives you more satisfaction as compared to IC
lying towards left.

Here IC1< IC2< IC3< IC4

4. Indifference curves do not intersect each other. I
It is because, if they cut each other, the result will
be paradox, On IC1, there are two points a and b
a=b
Also, on IC2, there are two points a and c
a=c
If a = b and a – c
b should also be equal to c(b=c) but b is not equal to
c , as b>c, because b lies on higher IC than point c.

CONSUMER EQUILIBRIUM THROUGH INDIFFERENCE CURVE ANALYSIS

Consumer equilibrium with the help of IC analysis is determined at a point where, what
consumer wants to buy coincides with what he can buy. Therefore, we make use of :

 Price line / Budget line

 Indifference map

to determine consumer’s equilibrium.

CONSUMER EQUILIBRIUM
Consumer equilibrium refers to the optimum choice of the consumer. It is reached when he
maximizes his satisfaction. To determine consumer equilibrium both the price line and
indifference map are combined together.

At equilibrium point, the conditions are:

i) Price line should be tangent to the indifference curve,

ii) Indifference curve should be convex to the point of origin.
iii) Slope of Indifference curve(MRS)should be equal to the slope of price line.(Px/Py).

A consumer is in equilibrium, when on the basis of a given budget line, he moves to the highest
possible indifference curve.

As per given figure, point E is the equilibrium point.

It satisfies all the three conditions:

1. At point E, AF is tangent to IC2.

2. At point E, the indifference curve IC2 is convex to the
point of origin.
3. At point E, the slope of IC2 is equal to the slope of
price line (Px/Py).

A consumer is in equilibrium when he buys only that combination of the two goods that is shown
at the point of tangency of the budget line with an indifference curve. In fig point B and S the
price line intersects IC1, but they are not tangents. Therefore their slope cannot be equal.

Also point B and S lie on lower indifference curve, hence not desirable.

Point G and H are desirable but not attainable as they are to the right of Budget line. Hence,
point E is the optimal choice.
 ASSSIGNMENT -3

CONSUMER EQUILIBRIUM PRACTICAL QUESTION

1. A person’s marginal utility schedule is given below. Derive his total utility schedule.

Units 1 2 3 4 5 6
Marginal Utility 7 10 8 6 3 0
2. Complete the following Table:

Units MU (Utils) TU(Utils)

1 - 12
2 10 -
3 8 -
4 - 34
5 1 -
3. Complete the table:-

Units TU (Utils) MU(Utils)

1 9 -
2 - 7
3 - 6
4 27 -
5 - 2
6 27 -
4. Ice creams sells for Rs 30. Laxmi who loves ice cream has already eaten3. Her marginal utility
from eating ice cream is 90. Suppose further that for her, the marginal utility of one rupee is 3.
Should she eat ice cream or should she stop?
5. Marginal utility of a good is 60 utils and its price is Rs 12 per unit. Suppose marginal utility of
money for the consumer is 6 utils, should he increase or decrease his consumption to attain
equilibrium and why?
6. Given below is the utility schedule of a consumer for a commodity X. The price of the
commodity is Rs. 6 per unit. How many units should the consumer purchase to maximize
satisfaction? (1 util = Rs. 1) . Give reason for your answer.

Units TU MU
1 10 10
2 18 8
3 25 7
4 31 6
5 34 3
 6 34 0

7. Given below is the utility schedule of a consumer for commodity X.

UNITS 1 2 3 4 5 6
MU 22 18 18 15 12 9
a) How many units should the consumer purchase to maximize his satisfaction if price of the
commodity is Rs. 6 per unit and marginal utility of money for him is 3 utils?
b) How many units of the commodity, the consumer would like to buy when price falls to Rs. 4 per
unit?
8. Satish has Rs. 88 with him. He intended to purchase goods X and Y with his money. The market
price of X and Y per unit is Rs. 8. The marginal utility schedule of good X and good Y is given
below. Find out how many units of X and Y should Satish purchase so that he will get maximum
satisfaction?

Units MU of X MU of Y
1 80 40
2 70 36
3 64 24
4 56 20
5 48 16
6 40 12
7 32 8
8 24 4
9 16 0
10 8 0

9. You are given the following marginal utilities of goods X and Goods Y obtained by consumer.
Given that price of X= Rs. 5 , price of Y = Rs. 10 and income = Rs 60, determine the position of
consumer equilibrium.

UNITS 1 2 3 4 5 6
MUx 45 40 35 30 25 20
MUy 60 50 40 30 20 10
10. On the basis of the information given below determine the level of consumption at which the
consumer will be in equilibrium.(Assuming marginal utility of money for the consumer is 4 utils).

UNITS 1 2 3 4 5 6 7 8
MUx 92 88 84 78 72 64 56 46
Price 18 18 18 18 18 18 18 18
11. A consumer consumes only two goods X and Y. Marginal utilities of X and Y are 4 and 3
respectively. Price of X and Price Y is Rs 3 per unit. Is consumer in equilibrium? What will be
further reaction of the consumer? Give reasons.
12. A consumer consumes only two goods X and Y. The marginal utilities of X and Y is 3. Prices of X
and Y are Rs.2 and Rs.1 respectively. Is consumer in equilibrium? What will be further reaction
of the consumer? Give reasons.

ASSIGNMENT -2
CONSUMER BEHAVIOUR
Very Short Answer Type Questions (1 Mark)
1. Define Marginal Utility.
2. Define Total Utility.
3. What is the meaning of utility?
4. What would be the impact on Total Utility, if Marginal Utility curve lies below X-axis?
5. What happens to marginal utility when Total utility is maximum?
6. Explain the condition of consumer equilibrium in case of single commodity.
7. Explain the condition of consumer equilibrium in case of two commodities.
8. Define budget set.
9. What is meant by monotonic preferences?
10. Define budget line.
11. Define Indifference curve.
12. Define Indifference map.
13. Why two indifference curves cannot intersect each other?
14. When a consumer is below the budget line, what does it mean?
15. Why a higher indifference curve represents a higher level of satisfaction?
16. What is MRS?
Short Answer Type Questions (3/4 Marks)
17. Explain the law of Diminishing Marginal Utility with the help of the utility schedule.
18. Explain the relationship between TU and MU.
19. What is the difference between cardinal utility and ordinal utility?
20 A consumer consumes two goods. Explain consumer equilibrium with the help of an example.
21. Given the price of a good, how will a consumer decide as to how much quantity of that good
to buy? Use Utility Analysis s to explain the answer.
22. How is equilibrium of the consumer affected in case, when MUx is rising and Px is constant?
23. Explain the meaning of diminishing marginal rate of substitution with the help of an
example.
24. What is a budget line? Why is it downward sloping?
25. Why is an indifference curve convex to the origin?
26. Explain the distinction between budget set and budget line.
Long Answer Type Questions (6 Marks)
27. Explain the three properties of Indifference curve.
28. Explain the conditions of consumer equilibrium with the help of indifference curve analysis.
29. Explain the concept of MRS by giving an example. What happens to MRS when consumer
moves downwards along the Indifference curve? Give reasons for your answer.