Lecture 5.

Law of Equi-marginal Utility: Definition, Consumer’s equilibrium, assumptions,

limitations and applications - Indifference curve analysis: definition, properties of
indifference curves, budget line and consumer’s equilibrium.

LAW OF EQUI-MARGINAL UTILITY

This law is also referred as Gossen’s second law. Law of equi-marginal utility
explains how a consumer allocates his limited income among different commodities in his
consumption basket. The law states that consumer would buy a good only (i.e. each good is
demanded) up to the point where the MU of the last rupee spent on it, is exactly the
same as the MU of the last rupee spent on any other good.
In other words law of equi-marginal utility states that the consumer is in
equilibrium when the ratio of marginal utility to its price is equal for all the
commodities.
For eg: if there are 1 ………n, commodities then the consumer will allocate his
MU 1 MU 2 MU N
income. Such a way that: = =
P1 P2 PN
This is because if anyone commodity gives more MU per rupee, then more income
will be spent on that commodity till the MU is reduced to the level of other commodities. If
any commodity gives less MU per rupee than the equilibrium level, the less money is spent
on that commodity till the MU of that commodity has increased to the level of equilibrium.
For single commodity, equilibrium condition is MUx=Px
Example consider the following consumption basket:
No. of MU
units Mangoes Potatoes Oranges
1 12 11 14
2 10 8 12
3 6 6 10
4 4 4 6
5 2 0 4
6 0 -3 0
7 4 -5 -6
Consider a consumer has 65 Rupees and price per unit is Rupees 5. If he spent Rs. 20
on Mangoes, 25 on Potatoes and 25 an Oranges, then his total utility is:
 Units consumed MU TU
4 Units of Mango 4 32
5Units of Potatoes 0 29
4 Units of Oranges 6 42
Total utility 103
As per the law of equi-marginal utility, he must buy more orange and less of other
goods to maximize his utility. Suppose he substitutes oranges for potatoes, then MU and TU
would be:
Units consumed MU TU
5Units of Oranges 4 46
4 Units of Mango 4 32
4 Units of Potatoes 4 29
Total utility 107

This condition of equal MU’s will give maximum satisfaction because total utility is
greatest in this combination. No other combination of these articles will yield more
satisfaction than this (i.e. 107 utils).
Limitations of Law
1. In practice, very accurate calculations as there in the law may not be possible.
2. Some of our decisions are governed by habits and not utility alone. That is to say
consumers may also have irrational preferences.
3. Lack of knowledge about substitutes may limit the operation of this law.
4. Some commodities are not divisible for equalization of marginal utilities.
Practical importance of the law of equi - marginal utility
The law is applicable in all branches of economics.
In consumption it explains how to get maximum satisfaction for limited resources. In
production qui-marginal concept is used to explain the most economical combination of
factors of production. Here one factor is substituted for another till marginal product from all
other factors is same.
ORDINAL APPROACH

INDIFFERENCE CURVE
The indifference curve analysis was developed by Slutsky (1815 A.D.) F. Y.
Edgeworth (1831, . D.), Irving Fisher (1892 A.D.) and Vilfredo Pareto (1905 A.D.) But it
was J. K. Hicks and R. G. D. Allen in 1934 gave scientific explanation to IC Analysis. This
analysis is popular ly known as substitution analysis.
IC is defined as the locus of points denoting various combinations of two
commodities which yield the same level of satisfaction so that the consumer is in
difference to any particular combination.
Indifference schedule
The above indifference schedule shows various combinations of two commodities.
All the combinations yield same level of satisfaction to the consumer. So the consumer is
indifference to any particular combination since all of them give same level of satisfaction.

Combination
Banana (X1) Biscuits (X2)
s
1 1 20
2 2 15
3 3 12
4 4 10
5 5 9
25
X2

20

15
indifference curve

10

0
1 2 3 4 5 X1

We get the indifference curve when we present the data in the indifference schedule in
a graph.
Mathematically indifference curve can be denoted as
U = f(x1, x2………..xn) = K
Where K = is a constant
An indifference map can be derived by assuming every possible value to K.
Indifference Map
Indifference map shows all the indifference curves which rank the preference of the
consumer. Combination of goods situated on an IC yield same level of satisfaction.
Combination of goods on a higher IC yield higher level of satisfaction. IC3 yield higher level
of satisfaction then IC1 or IC2
X2

IC3

IC2

IC1

X1
Properties Of Indifference Curve
1. IC has a negative slope
Which denotes that if Quantity of one commodity decreases, the quantity of the other
must increases, for the consumer to remain at the same level of satisfaction.
2. IC,S which lies farther away from the origin denotes higher level of satisfaction

X2

IC2
IC1

X1
Though, IC’1, AND IC2 have same quantity of X2. IC2 has more X1 than IC1. Hence
IC2 will give higher satisfaction.
 3. IC,s do not intersect
X2

X1

If they intersect, the point of intersection will denote same level of satisfaction for two
IC’s which is against the definition of IC.
At point C, Both IC1 and IC2 have same combination of X1 and X2 and hence same
level of satisfaction.But, according to property-2above higher level of satisfaction. So
intersection of IC’s is not theoretically correct.
4. IC’s are convex to the origin.
It means slope of IC decreases when we move from left downward to right i.e.
diminishing MRS of commodities.
5. ICfor perfect substitutes is a downward slopping straight line and IC for
complementary goods is a downward sloping curve.

X2
X2

X1

X1 Complementary
Substitues

Marginal rate of Substitution (MRS)

MRS is defined as the number of units of Y that must be given up in exchange for an extra
unit of X so that the consumer maintains the same level of satisfaction.
MRSXY = RS/ST = ΔY/ΔX
 Y MRS = ST/RS = ΔX/ΔY

Negative slope of IC at anypoint is called MRS.V

We can relate MRS and MU, by realizing the fact that all combination of X and Y on
an IC gives same levelof total utility and MRS in nothing but the rate of substitution between
X and Y Relationship between MRS and MUis:
When the consumption of X is increased, there will be decrease in consumption of Y.
Increase in consumption of X results in a gain of MUx. X utilty. Decrease in consumption of
Y results in a loss of MUy, Y utility. Gain in utility and loss in utility must be equal, so that
the consumer will remain in the same level of utility.
Therefore, MUX. ΔX = MUY.ΔY
Therefore MUX/MUY = Δ Y/ΔX =MRS XY
MRSXY = MUX/MUY and MRSYX = MUY/MUX
i.e. MRS between two commodities is equal to the ratio of MU’s of two goods.

Even though MRS can be found out using marginal utilities, in IC analysis MU
concept is not used. In IC, MRS in found out by directly asking how much one commodity
will be given up in exchange of the other, so that consumers maintain the same level of
satisfaction.
Illustration of Diminishing MRS
While moving down the IC from point A to B consumer reduces some quantity of Y,
for a gain in X, so that he remains on the same level of satisfaction. Reduction in quantity of
Y is, decreasing when we move from A to E. But gain in X is uniform when we move from A
to E. the length of vertical line is diminishing indicating MRS is diminishing. If the
indifference curve is convex to the origin, MRS will be diminishing.
 Y A

C
D
E

IC

Combinatio Commodities ΔX ΔY Rate of Substitution

n MRSXY = ΔY/ΔX
X Y
1 1 20 - - -
2 2 15 1 -5 -5/1 = 1:5
3 3 12 1 -3 -3/1 = 1:3
4 4 10 1 -2 -2/1 = 1:2
5 5 9 1 -1 -1/1 = 1:1

Consumer Equilibrium under IC approach

The consumer is in equilibrium when he maximizes his utility, given his income and
market prices. This he achieves when he reaches the highest possible IC, given his budget
line. The necessary and sufficient conditions to achieve the above said equilibrium of the
consumer are;
1. The necessary condition (or first order condition) is MRS be equal to price ratio
MRSx,y= Px/Py
2. The sufficient condition (or second order condition) is IC be convex to the origin.
This condition is fulfilled by the assumption of diminishing MRS x,y(i.e. slope of IC
decrease as we move left to the right downwards).
Budget Line

Y Y/Py

Budget Line

Y/Px
O X

Consider the income as Y and commodity prices as Px and Py. If consumer spends all
his incomes on commodity ‘Y’ he can buy y/Py units of Y.
If consumers spent all his incomes on commodity ‘X, he can buy Y/Px units of X.
Point A and B denote the above points. Joining these points give Budget line. Budget
line is the Income constraint for maximizing utility.
Slope of Budget line is =OA/OB
= Y/PY = PX
Y/PX PY
Graphical presentation of equilibrium
Y

Equilibrium point

K
Budget line

X
Equilibrium of the consumer is defined by the point of tangency of the budget line
with IC. At this point slope of the budget line (Px/Py) and slope of IC (MRS xy = ΔY/ΔX)
are equal.
The first order condition is denoted by the tangency of IC and budget line. Second
order condition is satisfied by convex slope of IC.
Although measurement or MU is not required in the IC approach, MU is implicit in
the definition of the slope of the IC.
 Comparison of Marginal UtilityAnalysis and IC Analysis

Sl.N
Marginal utility analysis IC Analysis
O
1. Cardinal approach Ordinal approach
2. Developed by Marshall Developed by Allen & Hicks
Does not involve measuresment
of MU; MRS is found out
3. Involves measurement of MU directly by asking how much one
commodity will be givenup for
the gain in the other.
4 Assumes constant MU of Money Does not make the assumption
It is based or two or more
5. Based on only one commodity
commodities.
(i) MRSXY = PX/PY
6. Equilibrium condition is MUx = Px.
(ii) Diminishing MRS