Chapter 2

Consumer's Equilibrium
 .
Consumer: A consumer is one who buys goods and services for satisfaction of wants. A
consumers main objective is to get maximum satisfaction from spending his income on
various goods and services.

Consumer behavior: It refers to the way in which consumers spend their income.

Equilibrium :- Refers to a state of rest or position of no change which provides maximum

benefit under a given situation

Consumer's equilibrium :- * Refers to the situation when a consumer is having maximum

satisfaction with limited income and has no tendency to change his pattern of existing
expenditure.

* He is at equilibrium when he aims to balance his expenditure to get maximum satisfaction with
minimum expenditure.
 Approaches to study consumer behavior:
A.Cardinal Utility Approach
B.Ordinal Utility Approach
Cardinal Utility Approach: Also known as Marshall Utility Analysis or Marginal Utility
Analysis. Under this approach satisfaction is measured in terms of cardinal number or units
like 1,2 and 3
Concept of Utility: * Refers to satisfaction derived from the consumption of a commodity.
• It is the want satisfying power of a commodity; it is the ability of a product to satisfy a
want.
• It differs from person to person, place to place and time to time.
How to measure utility:
• In terms of Utils; It is an imaginary and psychological unit used to measure satisfaction.
For ex. When you consume a cup of tea, you can express your satisfaction as equal to 2
utils or 3 utils
• In terms of money or price: Under this utility is measured in terms of money or pirce
which the consumer is willing to pay.
 Kinds of Utility:
1. Initial Utility: Utility derived from the first unit of a commodity is known as initial utility.
2. Totol Utility: Refers to the total satisfaction obtained by the consumption of all possible units
of a commodity. (TU = Summation of MU)
● It measures the total satisfaction obtained.
● It is zero at zero level of consumption .
3. Marginal Utility :- Refers to the additional utility derived from the consumption of one more
unit of the given commodity
● It is the addition made to the total utility by consuming one more unit of the product
● If consumption of additional commodity causes no changes in the TU then MU of the
additional unit is zero. This point is point of satiety or the point of maximum satisfaction.
● If TU increases from consumption of additional units then MU will be positive
● If TU decreases from consumption of an additional unit then MU of that unit is negative.
Concept of TU and MU
MU = Change in TU / Change in number of Units
MU = Tun – Tun-1

Relationship between TU and MU:

• TU increases at an increasing rate with an increase in consumption of a commodity, MU is

positive.

• TU increases at a decreasing rate, MU from each successive unit starts diminishing.

• When TU reaches its maximum , MU becomes zero ( this point is known as point of
satiety)
•
• Beyond the point of satiety TU starts falling, MU becomes negative - Disutility(loss of
satisfaction due to consumption of too much of a thing)
Law of diminishing marginal utility
It states that as we consume more and more
units of a commodity, the utility derived
from each successive unit goes on
falling/decreasing

It is also known as GOSSEN’S First law of

Consumption.
 Assumptions of the law
● Utility can be measured in quantitative terms (cardinal)
● Utility can be measured in monetary terms
● Reasonable quantity of the commodity should be consumed
● Consumption is a continuous process
● Quality of the commodity is uniform
● Main motto of the consumer is maximising total satisfaction
● Independent utilities
● MU of money remains constant
● Income of the consumer and price of the goods are constant
● Perfect knowledge of various choices
 . What is Marginal Utility of Money?
• MU of money refers to worth of a rupee to a consumer.
• A consumer defines it in terms of utility that he derives from consumption of goods that
he can buy with a rupee.
• For ex. If a rupee can buy 100g of sugar and 50g of salt and if total utility from these
goods is say 4 utils to the consumer, then 4 is to be taken as MU of money. This becomes
his standard reference whenever he is buying any commodity. Buying a unit of
commodity X for a rupee would mean the consumer expects 4 units of utility from the
consumption of commodity X. Therefore MUm becomes a measuring rod for a rupee
worth of satisfaction.

Important: It is assumed that Mum is constant, because it is a measuring rod for a rupee
worth of satisfaction
Let MUm for the consumer = 2 utils (i.e the utiloity consumer expects to receive when he
spends Rs.1) Let X be the commodity he indents to buy Let price of X = Rs4per
unit
 Consumer's equilibrium
Equilibrium :-Refers to a state of rest or position of no change which provides maximum benefit under a
given situation

Consumer's equilibrium :- Refers to the situation when a consumer is having maximum satisfaction with
limited income and has no tendency to change his pattern of existing expenditure.

He is at equilibrium when he aims to balance his expenditure to get maximum satisfaction with minimum
expenditure.

Situations of consumer's equilibrium :-

1. Consumer spends his entire income on single commodity: LDMU and its assumptions can be used to
explain Consumers Equilibrium in case of one commodity.

• A consumer purchasing a singal commodity will be at equilibrium, when he is buying such a

commodity, which gives him maximum satisfaction. Which depends upon the following factors”

a. Price of the given commodity b. MU of the commodity c. MU of money

  Equilibrim conditions:
 When MUx = Px or When the ratio of MU of good X to the Price of good X is equal to MU of
money, i.e Mux = Px or MUx / Px = MUm
 MU falls as consumption increases because of operation of LDMU

When MUx > Px : Consumer is not at equilibrium and he goes on buying because benefit is more than cost.
As he buys more, MU fall due to operation of LDMU. When MU becomes equal to price consumer will
achieve equilibrium MUX MUx >Px , he will increase his consumption of X)

When MUx<Px : Consumer is not at equilibrium as he will have to reduce consumption because benefit is
less than cost which will raise his total satisfaction till MU becomes equal to price and equilibrium is
achieved.
2. Consumers Equilibrium in case of two commodity: Consumer spends his entire income on
two commodities.

● Consumer will be at equilibrium in case of two commodities when the following

conditions are fulfilled:-
● When the ratio of marginal utility of X to its price is equal to the ratio of marginal utility of
Y to its price is equal to marginal utility of money.
i.e. MUx/Px = MUy/Py = MUm
● MU falls as consumption increases.
● Equation used to calculate consumer equilibrium = PxQx + PyQy = M

If, MUx/Px > MUy/Py - Here the consumer is getting more MU in case of good X so he will buy
more of X and less of Y which will lead to a fall in MUx and rise in MUy. He will continue to buy
more of X till MUx/Px = MUy/Py.

If, MUx/Px < MUy/Py - Here the consumer is getting more MU in case of good Y so he will buy
more of Y and less of X which will lead to fall in MUy and rise in MUx. He will continue to buy
more of Y till MUx/Px = MUy/Py
 Ordinal Utility Approach
This approach does not use cardinal values like 1, 2, 3, 4, etc. Rather, it makes use of
ordinal numbers like 1st, 2nd, 3rd, etc.which can be used only for ranking. Such a
method of ranking the preferences is known as 'ordinal utility approach’. Ordinal
utility is the utility expressed in ranks.

This approach also known as Indifference Curve Approach or Hicksian Analysis.

● Monotonic preferences :- Means that a rational consumer always prefers

more of a commodity which offers him higher level of satisfaction. He prefers
the bundle which has more of atleast one of the goods and no less of the other
good as compared to the other bundle.

Example:- consider 2 goods apples and bananas

1. Suppose two different bundles are: 1st - (10A,10B); and 2nd - (7A,7B).
Consumer's preference of 1st bundle as compared to 2nd bundle will be called
monotonic preference as 1st bundle contains more of both apples and bananas

2. If 2 bundles are : 1st - (10A,7B); 2nd - (9A,7B).

Consumer's preference for 1st bundle as compared to 2nd bundle will be called
monotonic preference as 1st bundle contains more of apples, although bananas are
same.

● Marginal Rate of Substitution (MRS):- Refers to the rate at which the

commodities can be substituted with each other, so that the total satisfaction of
the consumer remains the same i.e.the number of units of a commodity the
consumer is willing to sacrifice to gain an additional unit of another commodity
so that he maintains the same level of satisfaction.

MRS = Units of a commodity willing to be sacrificed / Units of a commodity willing to

gain
MRS Schedule
● Indifference Curve –Refers to the graphical representation of all possible
combinations of bundle of two goods which gives the consumer same level of
satisfaction.
● Indifference map - Refers to the family or set of indifference curves that
represent consumer preferences over all the possible bundles of two goods at
various income
levels of the
consumers
 ● Assumptions of indifference Curve -
● Only 2 commodities are there in an economy
● Consumer has a fixed amount of money which he spends on the 2 goods
● Price of both the goods are constant
● Consumer has not reached the point of saturation i.e. he tries to move to a
higher indifference Curve to get higher and higher satisfaction.
● Consumer can rank his preferences on the basis of satisfaction
● A consumer's main motto is to attain maximum satisfaction.

Properties of indifference curve :-

1. Indifference curves are always convex to the origin - due to diminishing MRS
because of LDMU.
2. IC slope downwards - as a consumer consumes more of 1 good he must
consume less of the other good.
3. Higher IC represents higher level of satisfaction - higher IC represents large
bundle of goods, which means more utility because of monotonic preference.

4. Indifference curves can never intersect each other - as two indifference

curves cannot represent the same level of satisfaction they can not intersect each
other.

5. An indifference curve can never touch X-axis or Y-axis - IC analysis assumes

consumption of 2 goods. If IC touches Y-axis, it means consumption of commodity X
is 0 and vice-versa.
 Budget Line
● Consumer Budget - States the income or purchasing power of the consumer from
which he can purchase bundles of 2 goods at a given price.
- A consumer can purchase only those combinations of goods which cost less than or
equal to his income.
● Budget Line - Is a graphical representation of all possible combinations of two
goods which can be purchased with given income and prices so that the cost of each
of these combinations is equal to the income of the consumer. Under budget line
consumer spends his entire income to purchase the bundles at he given price.
 Example - A consumers income is ₹20 which he wants to spend on 2 commodities
which are priced at ₹10 each. He has the following three options :-
(2,0) ; (0,2) or (1,1)
 Budget line slopes downwards as more of one good can be bought by decreasing
some units of the other good.
 Bundles which cost exactly equal to consumer’s income lie on the budget line.
 Bundles which cost less than consumer’s income shows under spending . This lies
inside the budget line.
 Bundles which cost more than consumer’s income are not available to the
consumer. This lies outside the budget line
 When all these 3 bundles are represented graphically we get a downward sloping
straight line known as budget line.
 Budget line is also known as Price Line, because the slope of Budget Line is the ratio
of the prices of goods taken on each axis.
 The bundles of budget line always lie on the budget line.
● Diagrammatic explanation of Budget Line - Suppose consumer's income is
₹20 price of Apples is ₹4 each and price of banana ₹2 each.
 Budget Set
● It is the set of all possible combinations of 2 goods which a consumer can
afford with his income and price in the market.
● It includes all the possible bundles with cost less than or equal to consumers
income at the given prices.
● Budget set lies either on or below the budget line.

Algebraic expression of Budget Line/ Equation of Budget Line

M = (Px × Qx) + (Py × Qy)

Where,

M = Money income Qx = Quantity of X Qy = Quantity of Y

Px = Price of X. Py = Price of Y
 Slope of the Budget Line
- It is the number of units of a commodity the consumer is willing to sacrifice to
gain an additional unit of another commodity.
- Slope of Budget Line = ∆in units of banana gained/∆ in units of apple sacrificed
- The slope of Budget Line is represented by the price ratio.
- Price ratio - It is the ratio of the price of the goods on the X-axis to the price of
the good on the Y-axis i.e. Px/Py
- Properties of Budget Line -
1. Budget line is downward sloping - As more of one good can be brought by
decreasing some units of the other good.
2. Budget Line is a straight line - As the slope of budget line is represented by
the price ratio which is constant.
3. Bundles which cost equal to consumers income lies on budget line.

4. Bundles which cost less than the consumers income lies inside the budget line
which shows underspending.

5. Bundles which cost more than the consumers income lies outside the budget line
which shows overspending.

● Change in Budget Line -

A. Shift in Budget Line: Due to change in income

B. Rotation in Budget Line: Due to change in price

● Change in Budget Line -
A. Shift in Budget Line
- Due to change in income
- It leads to either increase in income or
decrease in income.
- When income increases, the consumer will
be able to buy more bundles of goods,
which will shift the budget line to the right.
- When the Income decreases, the consumer
will be able to buy less bundles of goods,
which will shift the budget line to the left.
B. Rotation in Budget Line - Due to change in
price.

- Change in price of X :- Either there will be

increase in price or decrease in price.
- When there is an increase in price consumer
will buy less of goods X and BL will rotate
towards left.
- When there is a decrease in price the
consumer will buy more of good X which will
rotate the BL towards right.
- Change in price of Y :- Either there will be
increase in price or decrease in price.
- When there is an increase in price
consumer will buy less of goods Y and BL
will rotate towards left.
- When there is a decrease in price the
consumer will buy more of good Y which
will rotate the BL towards right.
 Consumer’s Equilibrium by Indifference Curve
Analysis
A consumer will be at equilibrium under the indifference curve theory when
the following conditions are fulfilled:
 The slope of indifference curve should be equal to the slope of budget line. i.e
MRS xy = Price ratio or px/py (in other words when the budget line is
tangent to indifference curve )
 If MRS xy> px/py : It means that to obtain one more unit of X, the consumer is
willing to sacrifice more units of Y . It induces the consumer to buy more of X.
As a result MRS falls and continue to fall till it becomes equal to the ratio of
prices and equilibrium is established.
 If MRSxy < px/py: It means that to obtain one more unit of X, the consumer is
willing to sacrifice less units of Y. It induces the consumer to buy less of X and
more of Y. As a result, MRS rises till it becomes equal to the ratio of prices and
the equilibrium is established.
 MRS continuously falls: MRS must be diminishing at the point of equilibrium.
Unless MRS continuously falls, the equilibrium cannot be established.