UNIT – II CONSUMER'S EQUILIBRIUM AND DEMAND

UTILITY ANALYSIS

Introduction
A consumer is one who buys goods and services for satisfaction of wants. The objective of a
consumer is to get maximum satisfaction from spending his given income on various goods
and services, given prices.
We start with a simple example. Suppose a consumer wants to buy a commodity. How
much of it should he buy? One of the approaches used for getting an answer to this
question is 'utility' analysis.
Before using this approach, we would like to familiarize ourselves with some basic
concepts used in this approach,

Utility: The term utility refers to the want satisfying power of a commodity. Commodity
will possess utility only if it satisfies a want. Utility differs from person to person, place to
place, and time to time
.
Cardinal Utility: When utility is expressed in exact units, it is called cardinal utility.

Ordinal Utility: When utility is expressed in ranks, it is ordinal utility.

Q. Law of Diminishing Marginal Utility: -

Statement of the Law: - Other things remaining constant, as we consume successive units
of a commodity, the additional benefit (MU) derived from each successive unit goes on
diminishing.

Marginal Utility: is the utility derived from the last unit of a commodity purchased. It can
also be defined as the addition to the total utility when one more unit of the commodity is
consumed. MUn = TUn – TUn-1 OR Change in TU / Change in qty

Total Utility: is the sum of the Marginal utilities from all the units consumed. TU = Sum.
MU
Schedule: -

Units Consumed Marginal Utility (Utils) Total Utility (Utils)

0 - 0
1 4 4
2 3 7
3 2 9
4 1 10
5 0 10
6 -1 9
Diagram: -

Explanation: -
We plot Units consumed on X-axis and TU and MU on Y-axis.
At zero units of commodity consumed, MU-undefined, TU-zero.
At unit 1, MU –max and TU – equals MU
As we consume successive units, MU – decreases, TU – Increases at a diminishing rate as
long as MU is positive.
When MU – zero, TU – Max and constant. This is called as Saturation Point or the Point of
maximum Satiety.
After Saturation Point, MU- negative, TU – decreases.

Assumptions: -
1. Utility can be Cardinally measured in units.
2. Utility is measured in monetary terms.
3. Consumer’s income and prices of commodities are given and constant.
4. Consumption of commodities is successive.
5. Consumer should be a rational consumer.
6. MU of Money is constant.
7. All units of the commodity consumed are homogenous.

Exceptions: - Miser, Hobbies, knowledge,

Q. Explain the relation between MU and TU. OR MU is the slope of TU. Justify.
Q. Calculate MU.
Units consumed TU MU
0 0
1 10
2 25
3 38
4 48
5 55

Q. Calculate TU and identify Saturation Point

Units consumed TU MU
0 -
1 10
2 6
3 2
4 0
5 -3

Q. Complete the following table:

Units consumed TU MU
0
1 50
2 90
3 30
4 140
5 150

Consumer Equilibrium: - An equilibrium in Economics is a state of rest, where the

consumer has no further tendency to change.
Definition: - Consumer Equilibrium refers to the level of consumption where the consumer
derives maximum satisfaction from consumption of one or more commodities, given the
income and prices of the commodities.
If the above situation changes, the level of satisfaction decreases.

One Commodity Case / Uni-Marginal Utility Analysis

Q. How many units of a good should a rational consumer decide to buy?
Ans. Under the One – commodity case a consumer is said to be in equilibrium when MU in
terms of money = Price of the commodity. i.e. Satisfaction = Sacrifice.
This can be explained with the help of the following Schedule:

Units consumed MU in rupees Price Consumer TU

 Surplus
0 - 3
1 8 3
2 7 3
3 5 3
4 3 3
5 2 3

Diagram: -

Explanation: -
As the consumer buys more units of a commodity, MU declines due to the operation of the
Law of Diminishing Marginal Utility. So, if initially MU >P, as the consumer buys more MU
declines.
The consumer stops when MU becomes equal to price (i.e., MU=P).
If the consumer buys more units after MU=P, MU will become less than P. It makes buying
more units disadvantageous to the consumer.
Let us take on example.
Suppose that price of good the consumer wants to buy is Rs. 3 per unit. Let the utility be
expressed in Utils which are measured in rupees. We are given the marginal utility
schedule of the consumer. When he purchases the first unit, the utility that he gets is 8 Utils
worth Rs. 8. He has to pay only Rs. 3/- for it. Will he buy the 1st unit? Obviously because he
gets more than what he gives. Similarly, we compare the utility received from other units
with the price paid. We find that he will buy 4 units. At the 4th unit, MU equals price. If he
buys the 5th unit, he is a looser because the utility that he gets is 2 Utils worth Rs.2 and
what he has to pay is Rs. 3. Therefore, the consumer will maximize his satisfaction by
buying 4 units of this commodity.
The condition for maximization of satisfaction when a good is purchased then is:
MU in terms of money = Price of commodity
1. Which of the shaded area in the diagrams below represent total utility? (1)

(a) (b) (c) (d)

Q. Explain how the consumer attains equilibrium when he consumes more than one
commodity?
Two-Commodity Case / Equi-marginal Utility Analysis.
A consumer buys not one good but many a goods. For simplification let us assume that the
consumer buys only two goods. Let these goods be X and Y. Given income, prices and MU
schedules, consumer equilibrium implies that the consumer will get
maximum satisfaction by spending his income in such a way that he gets the same utility
from the last rupee spent on each good. This is satisfied when:

1.Per Rupee Marginal Utility of Commodity X = Per Rupee Marginal Utility of Commodity Y
Formula: -

2. MU from the last rupee spent on each good is the same.

Let us explain these conditions.

Condition 1: - Per Rupee MUX > Per Rupee MUY

It means that per rupee MUx is higher than per rupee MUy. It further means that by
transferring one rupee from Y to X, the consumer gains more utility than he loses.
This prompts the consumer to transfer some expenditure from Y to X.
Buying more of X reduces MUx.
Px remaining unchanged, MUx/Px, i.e., per rupee MUx, is also reduced (Law of DMU).
Buying less of Y raises MUy.
Py remaining unchanged, it raises, per rupee MUy.
The change continues till per rupee MUx becomes equal to per rupee MUy.
This condition is also termed as the Law of Equi-Marginal Utility
Condition 2: - Per Rupee MUX < Per Rupee MUY

Q. How is the consumer likely to behave when Per Rupee MUX < Per Rupee MUY

Q. Navya consumes pizza and coke and finds her equilibrium. As the price of coke rises, her
MU for coke falls. State T or F. How is she likely to behave?

ORDINAL APPROACH (Also refer textbook pages 9 to 11)

Budget Set: -
Q 1. The disposable Income (M) of a consumer is 20 rupees. He consumes two
commodities, X and Y. Price of commodity X (Px) is 5 and Price of commodity Y (Py) is also
5. Identify the different combinations of the two commodities that the consumer can buy
given the prices and the Budget Constraint.

Define Budget Set: - A Budget Set refers to the different combinations of two commodities
that a consumer can buy with the given Disposable Income at prevailing prices of the
commodities.
Formula: - PxQx + PyQy < or = M
Define Budget Constraint: - refers to the limited disposable income available to the
consumer within which he can buy different combinations of two commodities.

Consumer Budget: It states the real income or purchasing power of the consumer from
which he can purchase the certain quantitative bundles of two goods at given price

BUDGET LINE
Plot a Budget line based on the information given in Q1 above.

Define Budget Line: - Is a locus of points representing combinations of two goods where a
consumer spends his entire disposable income.
Formula: - PxQx + PyQy = M

Points below the budget line represent bundles where the consumer spends less than the
Disposable income.

Points above the budget line represent unattainable combinations.

FEATURES OF BUDGET LINE

1.Downward sloping: -

2.Straight Line: -
Slope of the Budget line is also called Marginal Rate of Exchange (MRE)

Define MRE: - Refers to the rate at which the consumer is able to substitute Commodity Y
for Commodity X when he spends his entire Disposable income

Refer textbook page 11 for more concepts.

CHANGES IN BUDGET SET/BUDGET LINE

The budget set/line changes when there is a change in
1) Change in Disposable Income
2) Change in price of Commodity X
3) Change in price of Commodity Y

Original Situation: - The disposable Income (M) of a consumer is 20 rupees. He consumes

two commodities, X and Y. Price of commodity X (Px) is 5 and Price of commodity Y (Py) is
also 5. Thus, the consumer can buy M/Px = 20/5 = 4 units of Commodity X and zero units of
commodity Y OR M/Py = 20/5 = 4 units of Commodity Y and zero units of commodity X.
The original budget line is BL.

Absolute value of Slope of the budget line = Px/Py = 5/5 = 1

1) Effect of change in Disposable Income

Case A) Let M’ > M (Let us assume M’ to be 40)
The consumer will be able to buy more (M’/Px = 40/5 = 8 units of Commodity X and zero
units of commodity Y OR M’/Py = 40/5 = 8 units of Commodity Y and zero units of
commodity X)
Effect: - Causes an increase in Budget Set and Budget line will experience a parallel
rightward shift from BL to B’L’

Case B) Let M” < M (Let us assume M” to be 10)

The consumer will be able to buy less (M”/Px = 10/5 = 2 units of Commodity X and zero
units of commodity Y OR M”/Py = 10/5 = 2 units of Commodity Y and zero units of
commodity X)
Effect: - Causes a decrease in Budget Set and Budget line will experience a parallel leftward
shift from BL to B” L”

Absolute value of Slope of the budget line: Since there is no change in prices, the price ratio
remains unchanged. Thus, slope of the Budget line (MRE) remains same. (When two lines
have the same slope, they are parallel to each other)

Diagrams
Case A) Let M’ > M Case B) Let M” < M
 2) Change in price of Commodity X

Case A) Let Px’ > Px (Let us assume Px’ to be 10)

The consumer will be able to buy less (M/Px’ = 20/10 = 2 units of Commodity X and zero
units of commodity Y OR M/Py = 20/5 = 4 units of Commodity Y and zero units of
commodity X)
Effect: - Causes a decrease in Budget Set and the Budget Line swings inwards from BL to
BL’
Absolute value of Slope of the budget line = Px’/Py = 10/5 = 2. Slope increases and
the Budget line becomes steeper.

Case B) Let Px” < Px (Let us assume Px” to be 4)

The consumer will be able to buy more (M/Px” = 20/4 = 5 units of Commodity X and zero
units of commodity Y OR M/Py = 20/5 = 4 units of Commodity Y and zero units of
commodity X)
Effect: - Causes an increase in Budget Set and the Budget Line swings outwards from BL to
BL”
Absolute value of Slope of the budget line = Px”/Py = 4/5 = 0.8. Slope decreases
and the Budget line becomes flatter.

Diagrams

Case A) Let Px’ > Px Case B) Let Px” < Px

 3) Change in price of Commodity Y

Case A) Let Py’ > Py (Let us assume Py’ to be 10)

The consumer will be able to buy less (M/Px = 20/5 = 4 units of Commodity X and zero
units of commodity Y OR M/Py’ = 20/10 = 2 units of Commodity Y and zero units of
commodity X)
Effect: - Causes a decrease in Budget Set and the Budget Line swings inwards from BL to
B’L
Absolute value of Slope of the budget line = Px/Py’ = 5/10 = 0.5. Slope decreases
and the Budget line becomes flatter.

Case B) Let Py” < Py (Let us assume Py” to be 4)

The consumer will be able to buy more (M/P = 20/5 = 4 units of Commodity X and zero
units of commodity Y OR M/Py” = 20/4 = 5 units of Commodity Y and zero units of
commodity X)
Effect: - Causes an increase in Budget Set and the Budget Line swings outwards from BL to
B” L
Absolute value of Slope of the budget line = Px/Py” = 5/4 = 1.25. Slope increases
and the Budget line becomes steeper.

Diagrams
Case A) Let Py’ > Py Case B) Let Py” < Py

Attempt Qs 1 to 9 from Textbook Pg 34

Rank the following bundles on bases of your preferences
Combinations a b c d e f g h
Commodity X 2 1 2 3 1 3 3 4
Commodity Y 1 2 2 1 3 2 3 4

Define Monotonic Preferences: - When a consumer prefers a Bundle A (3,1) over Bundle B
(2,1) because Bundle A has at least one unit extra of one of the commodities but no less of
the other as compared to Bundle B, his preferences are said to be monotonic.

Attempt Qs 10 to 13 from Textbook Pg 34

INDIFFERENCE CURVES

If a consumer has well defined preferences among all bundles, he can rank them and
represent his preferences through indifference curves.

Define Indifference Curve: - An IC is a locus of points representing bundles of two

commodities among which the consumer is indifferent i.e. A curve joining all points
representing bundles among which the consumer is indifferent is called an Indifference
Curve.

Points Above the IC represent Preferred bundles.

Points Below the IC represent Inferior bundles.

Refer textbook pg 16 Fig 2.6

Features of Indifference Curves

1. Indifference Curves are downward sloping: - Let us take a point ‘a ‘on IC1’. If we
want to consume an additional unit of X without sacrificing some units of Y, that
would put us in a situation where we derive greater satisfaction from a bundle
giving more units of X but no less of Y. As per monotonic preferences, we would shift
to a higher IC2 [point b]. In order to remain on the same IC, the gain of satisfaction
from consumption of an additional unit of X has to be compensated by sacrifice of
satisfaction from consumption of Y [point c]. Since to gain additional units of X we
need to sacrifice of Y, the consumption of two commodities becomes rivalrous i.e.,
inverse. Because of this inverse relation, IC is downward sloping.
DIAGRAM
 2. Higher indifference curve gives higher level of satisfaction: - Let us assume a point
‘a’ on an indifference curve IC1. It represents a bundle with one unit of commodity X
and two units of commodity Y. There is also a point ‘b’ on a higher indifference
curve, IC2 where there is one unit extra i.e., two units of commodity X and the same
units i.e., two units of Y. As per monotonic preferences, a consumer prefers a bundle
which has at least one unit more of one commodity and no less of the other as
compared to the other bundle. Therefore, the satisfaction derived from bundle ‘b’
will be higher than that of bundle ‘a’. Since bundle ’b’ gives more satisfaction than
bundle ‘a’ and it lies on a higher indifference curve, the statement is proved that
higher IC higher satisfaction.
DIAGRAM

3. Two Indifference curves never intersect: - In the above diagram we have Points ‘a’
and ‘b’ which lie on the same IC and give same level of satisfaction. We can say that
satisfaction from Bundle ‘a’= satisfaction from Bundle ‘b’. ---[1]
Similarly, Points ‘a’ and ‘c’ which lie on IC2 would also be giving the same level of
satisfaction. Hence satisfaction from Bundle ‘a’= satisfaction from Bundle ‘c’---------- [2]

From [1] and [2] we conclude that: -

the level of satisfaction derived from bundles b=a=c i.e., b=c.

But ‘b’ and ‘c’ lie on different ICs and cannot give the same level of satisfaction. From the
contradictions, we conclude that two ICs will never intersect.

DIAGRAM
 4. Indifference curves are convex to the origin: -
Definition: The Marginal Rate of Substitution [MRS] refers to the ratio of units of
Commodity Y sacrificed to gain an additional unit of commodity X such that the level of
satisfaction remains unchanged
Formula: Sacrifice of satisfaction from Com Y/Gain of satisfaction from Com X.
As we go on consuming additional units of Commodity X, the utility derived from each
successive unit goes on diminishing, hence every time the units sacrificed of Commodity Y
to gain an additional unit of Commodity X decreases. This can be understood with the
following table and graph.

Schedule: -
Combinations Commodity Y Commodity X MRS
= Change in Y
/Change in X
a 14 1 -
b 8 2 6
c 4 3 4
d 2 4 2

DIAGRAM

Consumer equilibrium by Ordinal Approach / Indifference Curve Analysis

OR Optimum Choice / Bundle of the consumer by Indifference Curve Analysis
OR
Q. State the conditions of consumer equilibrium in Indifference curve Analysis and
explain the Rationale behind these analysis
Consumer Equilibrium refers to the level of consumption where the consumer derives
maximum satisfaction from consumption of one or more commodities, given the income
and prices of the commodities.

Budget Line is a locus of points representing combinations of two goods where a consumer
spends his entire disposable income.

An Indifference Curve is a locus of points representing bundles of two commodities among

which the consumer is indifferent

A family of Indifference curves is called an Indifference Map.

We can identify Consumer Equilibrium by superimposing the Budget line on the

Indifference Map

Diagram

In the above diagram we plot units of Commodity X on the x-axis and units of Commodity Y
on the y-axis.
The indifference map comprises of 3 ICs, and the Budget line is BL.

The Budget line is tangent to IC2 at point ‘a’. This is the point of Consumer equilibrium.

This can be proved by Proof of Negation

Let us assume Points ‘b’ or ‘c’ where budget line intersects IC1 to be consumer equilibrium.
But these points are on a lower Indifference Curve IC1. Here the consumer spends his entire
disposable income but the level of satisfaction derived is less than point ‘a’ which is on a
higher IC2. Hence points ‘b’ or ‘c’ cannot be consumer equilibrium.

Let us assume Point ‘d’ on higher IC3 to be consumer equilibrium. But this point is beyond
the budget line and hence an unattainable bundle for the consumer.

Hence, it is proved that Point ‘a’ is the level of consumer equilibrium.

Conditions of Consumer Equilibrium

1. The budget line is tangent to IC i.e., MRE=MRS
If MRE<MRS the consumer will move downwards along the budget line.
If MRE>MRS the consumer will move upwards along the budget line.

2. The point of tangency is when IC is convex to the origin i.e., MRS is decreasing.

Q. Distinguish between Cardinal and Ordinal approach

Basis Cardinal Approach Ordinal Approach

Definition Utility derived from a Utility derived from a
commodity can be measured commodity cannot be
cardinally i.e. in numbers measured cardinally
however, the level of
satisfaction can be ranked
Given By Alfred Marshall Hicks and Allen
Conditions of Consumer a) One Commodity Case: - 1) MRE = MRS
Equilibrium MUx = Px 2) MRS is decreasing
b) Two Commodity Case: -
Per rupee MUx = Per rupee
MUy when the consumer
spends his entire disposable
income.
Income and Substitution Cannot be shown Can be shown
Effect