CHAPTER 2 CONSUMER’S EQUILIBRIUM

Consumer: A consumer is a person or an individual who buys various goods & services in an economy for
satisfying his wants.
Utility: It refers to want satisfying power of a commodity. It is the satisfaction derived from the consumption of a
unit of a good. Utility depends upon the degree of want for the commodity. It is measured in terms of utils. Utility
is also expressed in terms of money a person is prepared to spend. Eg: If a person is prepared to pay Rs.10 for one
unit of a pen, it means that he gets utility from pen worth Rs.10.
Disutility is the opposite of utility. It refers to loss of satisfaction due to consumption of too much of a thing.
i. Utility depends upon urgency or intensity of wants
ii. Utility is subjective
iii. Utility is not essentially useful
iv. Utility is measurable: There are two approaches for the measurement of utility:
• Cardinal Utility Analysis: This is given by Marshall which measures utility in quantitative order like
1,2,3,4.. etc. The units of utility are called utils. It is measured in absolute numbers.
• Ordinal Utility Analysis: It is also known as Indifference curve analysis. This is given by Hicks and
Allen. It measures utility in qualitative order like first preference, second preference, third preference etc.
It is measured in ranks.
Marginal utility: It refers to the addition to the total utility when one additional unit of a commodity is consumed
i.e. additional utility derived from the consumption of one more unit of a given commodity.
MUn= TUn-TUn-1 (When units consumed change in consecutive order, one by one)
∆TU
MU= ∆Q (When units do not change in consecutive order)

Total Utility: It refers to the total satisfaction obtained from the consumption of all possible units of a commodity.
It refers to the sum of all the marginal utilities derived from the consumption of certain units of a commodity.
TU= ∑MU

❖ LAW OF DIMINISHING MARGINAL UTILITY

This law was given by German economist Gossen. That is why it is also popularly known as Gossen’s first law
of consumption. The law states that as more & more units of a commodity are consumed, the marginal utility
derived from each successive unit goes on falling. It is also called as Fundamental law of satisfaction or
Fundamental Psychological law.

➢ Assumptions
1. Cardinal measurement of utility: It is assumed that utility can be measured in quantitative terms such as
1,2,3, etc.
2. Fixed income and price: It is assumed that there is no change in price of the good and income of an
individual.
3. Consumption of reasonable quantity: It is assumed that a reasonable quantity of the commodity is
consumed. For example: we should compare MU of glassfuls of water & not of spoonfuls. If a thirsty

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 person is given water in spoon, then every additional spoon will yield him more utility. So, to hold the law
true, suitable & proper quantity of the commodity should be consumed.
4. Continuous Consumption: There should be no time gap between consumption of successive units of the
commodity. E.g. 1st chocolate in the morning & second in the evening. The law will not hold good in such
a case.
5. Rational Consumer: The consumer is assumed to be rational who measures, calculates & compares the
utilities of different commodities & aims at maximizing total satisfaction.
6. MU of rupee remains constant: MU of a rupee is the purchasing power of a rupee in terms of amount of
satisfaction a consumer receives from the consumption of a good. It is assumed that MU of a rupee remains
same for all the units of the commodity.
7. Homogeneous: It is assumed that all units of a good are identical.

Relationship between TU & MU

Units MU TU
1 12 12
2 10 22
3 7 29
4 3 32
5 0 32
6 -3 29

In the above diagram X axis measures units consumed & Y axis measures TU & MU:
1. As long as MU is positive, TU increases: When a consumer starts consuming a commodity his marginal
utility from the successive units keeps on falling. Till the time MU is falling but is positive as shown by
AB in the diagram, TU increases but at a diminishing rate. i.e. from 1 to 4 units.
2. When MU is zero, TU is maximum and constant: When MU becomes zero, due to further consumption,
TU reaches its maximum point as shown by point B in the diagram (at 5th unit). This point is called point of
satiety or point of maximum satisfaction.
3. When MU is negative, TU decreases: Further consumption will make MU negative which makes TU to
fall down i.e. after point B in the diagram (at 6th unit).

➢ Exceptions
1. Hobbies: In certain hobbies like stamp collection, collection of antique goods, collection of old coins etc.
every additional unit gives more satisfaction i.e., marginal utility increases with each additional unit.
Hence the law is not applicable.
2. Drunkards: The law does not seem to be applicable to a drunkard, as intoxication increases with every
successive dose of liquor.

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 3. Misers: In the case of a miser, it is pointed out that greed increases with every additional acquisition of
money. Hence the marginal utility of money increases with more & more money.
4. Music & Poetry: In the case of music & poetry, it is commonly experienced that a repeat hearing gives
better satisfaction than the first one.
5. Reading: Since more reading gives more knowledge, a person who loves reading would get more & more
satisfaction with every additional book.

❖ CONSUMER’S EQUILIBRIUM (Cardinal approach- 1 commodity case)

Equilibrium is a state of rest or position of no change. It refers to a situation in which a consumer spends his
money income on consumption in such a manner that he gets maximum satisfaction & has no desire to change.

Equilibrium Conditions
Equilibrium depends upon 2 things
• Marginal Utility
• Price

MUx
1. MUre
=Px
Marginal Utility is measured in utils, but to make MU comparable to price, we need to convert MU (utils)
in terms of MU (money terms).
2. Law of diminishing marginal utility operates

Consumer equlibrium can be explained with the help of following schedule & diagram:
Units MUx MUre 𝐌𝐔𝐱 Price Gain/Loss
𝐌𝐔𝐫𝐞
1 10 2 5 3 Gain
2 8 2 4 3 Gain
3 6 2 3 3 Equilibrium
4 4 2 2 3 Loss
5 2 2 1 3 Loss
6 0 2 0 3 Loss
7 -2 2 -1 3 Loss
8 -4 2 -2 3 Loss
9 -6 2 -3 3 Loss

In the above schedule, marginal utility of a rupee is the purchasing power of a rupee in terms of utils. It
refers to worth of a rupee defined by a consumer in terms of utility that he obtains from a given basket of
goods with a rupee. It is taken as 2 utils. A consumer’s utility schedule to consume a commodity X is
drawn on the basis of law of diminishing marginal utility. The consumer reaches equilibrium in above case
MUx
when he consumes 3 units of X as the conditions of equilibrium i.e = 𝑃𝑥 is satisfied.
MUre

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 If a consumer stops the consumption before this level, he will loose some of the utility. However, if he
consumes after the 3rd unit, his satisfaction would be less than the price. Thus, he will consume till 3 units
of X. i.e. at point E.
MUx slopes downwards indicating that MU falls with successive consumption of commodity due to
operation of law of Diminishing Marginal Utility.

Q. What will happen when marginal utility of a product in terms of rupee is greater than the price
paid ? (MUx/MUre > P)
Ans: A consumer always compares utility with the price. If he finds that utility derived from the successive
consumptions of a commodity X is greater than the price paid, he will consume more units of X. This will
reduce the marginal utility of commodity X due to the law of diminishing marginal utility. A consumer will
keep on consuming more units of X till his marginal utility becomes equal to Price.

Q. Explain the reaction of a consumer when his marginal utility of commodity X is less than the price
paid. (MUx/MUre < P)
Ans: A consumer always compares utility with the price. If he finds that utility derived from the successive
consumptions of a commodity X is less than the price paid, he will reduce his consumption of X. This will
make the marginal utility of commodity X higher. A consumer will keep on reducing his consumption of
X till his marginal utility becomes equal to Price.

❖ CONSUMER’S EQUILIBRIUM (Cardinal approach- 2 commodity case)

Equilibrium is a state of rest or position of no change. It refers to a situation in which a consumer spends his
money income on consumption in such a manner that he gets maximum satisfaction & has no desire to change.
Law of equi marginal utility helps in determining equilibrium in case of 2 commodities. Law of equi Marginal
utility states that a consumer will plan his expenditure in a manner that the utility gained from the last rupee spend
on each good is equal.

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Equilibrium Conditions
1. A consumer will attain equilibrium when ratios of Marginal utility of 2 commodities & their respective
prices are equal.
MUx 𝑀𝑈𝑦
=
Px 𝑃𝑦
2. Law of diminishing marginal utility operates.

Units consumed MUx (utils) MUy (utils)

1 12 (1) 11 (2)
2 10 (3) 8 (4)
3 8 (5) 6
4 6 4
5 4 2
Money income = Rs.5 Px = Re.1 Py = Re.1
Total utility = 12+11+10+8+8= 49
In the above table, depicting consumer’s equilibrium, it is assumed that a consumer has money income of Rs.5
which he wish to spend on the purchase of 2 commodities X and Y. Since the marginal utility initially is higher in
X so a rational consumer will spend his first rupee on the purchase of X. According to his utility he will spend his
second rupee on Y, third on X, fourth again on Y and fifth on X. Spending in this manner only he will be able to
maximise his satisfaction as his TU=12+11+10+8+8=49 utils.
Thus a consumer will be at equilibrium when he consumes 3 units of X and 2 units of Y. It implies that a consumer
will reach equilibrium when the utility derived from the last rupee spend on each good is equal.
Q. What will happen if MUx/Px > MUy/Py ? (means per rupee MUx is higher than per rupee MUy)
Ans. If the marginal utility derived from the consumption of X is greater than that of Y then a consumer will try to
consume more units of X and less of Y. This can be done by transfering some expenditure from Y to X. This will
lead to fall in MUx and rise in MUy. The consumer continue to buy more units of X till MUx/Px = MUy/Py.

❖ CONSUMER’S EQUILIBRIUM (Ordinal Approach)

Consumption bundle: It refers to combination of 2 commodities that a consumer can consume to satisfy his wants
yielding same level of satisfaction to him.
Budget set: It refers to all those combinations of 2 commodities which costs less than or equal to the money
income of the consumer.
P1x1 + P2x2 ≤ M
where x1 & x2 = Quantity of good 1 and good 2
P1 & P2 = Price of good 1 and good 2
M = Money income of the consumer

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Assuming P1 = Rs.4 P2 = Rs.2 M = Rs.20
The bundles are (0,10) (1,8) (2,6) (3,4) (4,2) (5,0) (2,5) (3,3) (4,2) (4,1) (1,7)
Here expenditure on good 1 & good 2 is less than or equal to income of the consumer.
Budget Line/Price Line: It refers to a line or diagram depicting all those points which denotes the combination of
2 commodities that a consumer can actually purchase or buy with his entire money income at the prevailing market
price. It is a locus of different combinations 2 goods which the consumer consumes & which costs exactly his
money income.
P1x1 + P2x2 = M
Assuming P1 = Rs.4 P2 = Rs.2 M = Rs.20

Combinations Quantity Quantity Expenditure=

of good 1 of good 2 Income
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 4×5+2×0
= 20
Observations:
1. Budget Line AF shows that entire money income is spent on good 1 and good 2.
2. Attainable combinations are shown by:
• All points on AF where P1x1 + P2x2 = M i.e. A,B, C, D, E, F
• All points inside (to the left of) AF where P1x1 + P2x2 < M i.e. P, Q, N. These show underspending.
3. Non Attainable combinations (consumer’s budget constraint) are shown by:
• All points to the right of AF where P1x1 +P2x2 > M i.e. S, T, U, V
Features of Budget Line
1. Budget line is a straight line assuming that the entire money income is spent.
2. Slope of budget line depends upon the prices of both the goods. Slope of budget line is equal to price ratio
of 2 goods.
Slope of budget line = (-) P1/P2
3. It is a negatively sloped curve or a downward sloping curve. It implies that increase in consumption of one
commodity is followed by decrease in consumption of the other.
4. The horizontal intercept is M/P1 if entire income is spent on good 1 & the vertical intercept is M/P2 if entire
income is spent on good 2.

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Slope of Budget Line: Price ratio/ Market Rate of Exchange (MRE)
The slope of budget line is the rate at which the consumer is able to substitute one commodity for the other in the
market. It is equal to the price ratio of the 2 goods. It measures the amount of change in good 2 required per unit of
change in good 1 along the budget line. Price ratio or MRE is the rate at which the consumer has to sacrifice units
of Y to obtain one more unit of X.
Why slope of budget line is represented by Price Ratio?
A point on budget line indicates a bundle which the consumer can purchase by spending his entire income. So, if
the consumer wants to have one more unit of Good 1, then he will have to give up some amount of Good 2. The
number of Good 2 needed to be given up to gain 1 unit of Good 1 depends on the prices of both the goods.
In the example: Good 1 is priced at Rs.4 and Good 2 at Rs.2. It means, to gain one unit of Good 1, consumer will
have to reduce his expenditure on Good 2 by Rs.4 i.e. consumer will have to sacrifice 2 units of Good 2 to gain 1
unit of Good 1. It means, consumer will have to give PA/ PB units of bananas to gain one unit of Good 1.

Changes in Budget Line

Shifts in budget line can occur due to 2 reasons:
1. Change in Income of the consumer
2. Change in Price of the goods

Change in Income
Increase in income: Increase in income (when prices of both the goods remain constant) causes a parallel
rightwards in budget line from AB to A’B’. When the income of the consumer rises, the consumer can consume
more of both the commodities at the given price.
Decrease in income: Decrease in income (when prices of both the goods remain constant) causes a parallel
leftward shift in budget line from AB to CD. When the income of the consumer falls, the consumer can consume
less of both the commodities at the given price.

Reason for parallel shift

This is because the slope of budget line has not changed.
Since only the income of the consumer has changed and not
the prices of good 1 and 2 so there is no change in the slope
of budget line which is the price ratio of both the goods.

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Change in Price of the good
Both the goods become cheaper: If both the goods become cheaper then the consumer can buy more of both the
goods with his given income and the budget line will incur a parallel rightward shift as explained earlier.

Price of good 2 increases: If the price of good 2 increases (keeping the price of good 1 constant) then a consumer
can buy same amount of good 1 but less amount of good 2. The slope will be flatter and budget line will rotate
from AB to A’B. (Fig.1)
Price of Good 1 increases & Price of Good 2 decreases: In this case, the consumer can buy less of good 1 and
more of good 2 with his given money income. The slope will be steeper. Budget line will rotate from AB to A’B’.
(Fig.2)

➢ INDIFFERENCE CURVE
It refers to a curve which depicts all the possible combinations of 2 commodities that yields the same level of
satisfaction to the consumer & therefore he is indifferent towards them. It is the locus of all points that show
such combinations of 2 commodities which give the consumer same satisfaction.
AE is an indifference curve which shows different combinations a,b,c,d,e on it which are available to the
consumer and all these bundles give equal satisfaction to the consumer.

Bundles Good 1 Good 2 MRS

A 1 12 -
B 2 8 4:1 or 4
C 3 5 3:1 or 3
D 4 3 2:1 or 2
E 5 2 1:1 or 1

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Indifference Map: A set of indifference curves of a consumer
depicting different levels of satisfaction is called indifference map.

Marginal rate of Substitution (Slope of Indifference Curve)

It is the rate at which the consumer is willing to sacrifice one good to
obtain one more unit of another good so that the total satisfaction of the
consumer remains same.
units of a good to be sacrificed ∆Y
MRS= =
units of a good to be obtained ∆X

MRS falls as a consumer moves from one combination to another with the
same IC curve. It happens because as a consumer consumes more of good
X, MU falls (due to law of DMU). Due to this, the consumer is willing to
sacrifice less & less units of good Y to obtain one more unit of good X.

Features of Indifference Curve

1. Downward sloping Curve: IC is always a downwards sloping curve from left to right which implies that in
order to increase the consumption of one commodity, the consumption of other commodity needs to be
substituted in order to have same level of satisfaction. It has a negative slope.
2. Convex to origin: IC is always convex to origin because of diminishing marginal rate of substitution. It
implies that a consumer is willing to sacrifice less and less of one commodity for an additional unit gained
of another commodity. MRS declines because of law of DMU.
3. Higher indifference curve denotes higher level of satisfaction: An indifference curve which is at the right of
other, always denotes greater level of satisfaction. The curve at the right depicts all those combinations
which have more of one or both the commodities. Thus, a rational consumer gets higher satisfaction at a
higher indifference curve.
4. Non intersecting curves: Two indifference curves can never intersect each other because the satisfaction
level of 2 indifference curves at any point can never be the same. This can be explained with the help of
diagram. If they cut each other, the result will be a paradox (contradiction).

On IC1 there are 2 points a and b

Therefore a=b

On IC2 there are 2 points a and c

Therefore a=c
If a=b & a=c So, b=c but b≠c, as b>c because it lies
on a higher IC

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 5. Indifference curve never touches x axis or y axis: IC analysis is based on ordinal utility analysis which
assumes consumption of 2 goods. If it touches x axis or y axis, it will be against the assumption as it will
denote consumption of only one good and consumption of other will be zero.

Monotonic Preferences
It means that a rational consumer always prefers more of a commodity as it offers him a higher level of satisfaction
i.e. he will always prefer a bundle having either more of both the goods or more of at least one good & same of the
other good. Eg: A consumer always prefer bundle (4,20) over the bundle (1,16)
Assumptions of Indifference curve
1. Ordinality: It is assumed that the utility of a consumer is ordinal which means that a consumer is capable to
rank his preference of consumption.
2. Rationality: A consumer is assumed to be rational consumer which means he wants to maximize his
satisfaction out of his limited resources. He wants to reach the highest possible IC.
3. Diminishing Marginal rate of substitution: IC analysis assumes diminishing MRS. Due to this assumption,
an IC is convex to origin.
4. Two commodities: It is assumed that the consumer has a fixed money income, whole of which is to be
spent on 2 goods, given constant prices of both the goods.
5. Monotonic Preference

CONSUMER EQUILIBRIUM
Equilibrium is a state of rest or position of no change. It refers to a situation in which a consumer spends his
money income on consumption in such a manner that he gets maximum satisfaction & has no desire to change.
Equilibrium Conditions
A consumer reaches equilibrium when the following 2 conditions are satisfied:
1. Slope of IC = Slope of Budget Line
Px
MRSxy = (-) Py
2. MRSxy continuously falls
In the diagram, AF is the budget line representing all the combinations of 2
commodities that a consumer can purchase with his entire money income.
IC1, IC2, IC3, IC4 are the different curves with different levels of
satisfaction. A consumer will be at equilibrium when he buys only that
combination of 2 goods that is shown at the point of tangency of the budget
line with an indifference curve i.e. at point E. Both the conditions of
equilibrium are satisfied at this point. At points B & S the price line
intersects IC1, but they are not tangents. Therefore, their slopes cannot be
equal. Also, they lie on a lower IC, hence are not desirable. Points G & H
on IC3 & IC4 are desirable but are not attainable as they are to the right of
budget line.

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When MRSxy ≠ Price ratio (MRE)
Assuming that the consumer wants more of X in place of Y, then MRS is the rate at which the consumer is
willing to sacrifice units of Y to obtain one more unit of X. MRE is the rate at which the consumer has to
sacrifice Y units to obtain one more unit of X.

If MRSxy > Price ratio (MRE)

It means to obtain one more unit of X, the consumer is willing to sacrifice more units of Y than what the
market requires. He is willing to pay a price which is higher than the market price as he values X more than
the market values it. As he buys more units X, & less of Y, MRS begins to fall till it becomes equal to
MRE/ Price ratio.

If MRSxy < Price ratio (MRE)

It means to obtain one more unit of X, the consumer is willing to sacrifice lesser units of Y than what the
market requires. He is willing to pay a price which is lower than the market price. It induces him to reduce
consumption of X & increase consumption of Y. MRS begins to rise till it becomes equal to MRE/ Price
ratio.

MRS MRE
MRS is based on consumer’s willingness. MRE is based on Market rate.
MRS is the slope of Indifference Curve MRE is the slope of Budget Line
MRS falls continuously MRE remains constant
Law of DMU applies in case of MRS No law applies in case of MRE

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