Consumer’s Equilibrium

A consumer is in equilibrium when he maximises his utility under the given income and market
prices. In other words, equilibrium is attained when the consumer reaches the highest possible
indifference curve given his budget constraint. It is the situation where a consumer does not want to change his
consumption pattern as he will be getting maximum satisfaction. Consumer’s maximum satisfaction is determined
at the point where budget line is tangent to highest possible indifference curve. That is the tangency point between
budget line and indifference curve defines the consumer’s equilibrium point. Consumer’s equilibrium point must
lie on the budget line and must give the most preferred combination of goods and services.

Assumptions
1. Rationality of consumer
2. Ordinal measurement of utility
3. Diminishing Marginal Rate of Substitution
4. Transitivity and Consistency of Choice
5. Prices of two goods and income of the consumer must be constant

Technically there are two conditions that must be fulfilled for the consumer to be in equilibrium by indifference
curve approach are:
1. Necessary Condition (1st order condition): The budget line is tangent to highest possible indifference curve
or the slope of IC should be equal to the slope of budget line.
𝑷𝒙
𝑴𝑹𝑺 = 𝑷𝒚……………(i)
The first equilibrium condition is necessary but it is not a sufficient condition.
2. Sufficient Condition (2nd order condition): Diminishing MRS is the second equilibrium condition.
It is known as stability condition. It means, for a stable equilibrium, MRS must be continuously falling.
This condition means that the indifference curve is must be convex to the origin.
Diminishing MRS………..(ii)
The consumer’s equilibrium can be explained with the help of the following figure;
Y

A
Good - Y

E
Ye
IC3
IC2
IC1
0 Xe B X
Good - X
In the fig., IC1, IC2, and IC3 are three indifference curves which represent the difference level of satisfaction.
Here, the consumer is equilibrium at point ‘E’ on indifference curve, IC2. The consumer maximizes his utility
by buying Xe units of good X and Ye units of good Y. Any combination that lies on the IC1 below the IC2
represent lower level of satisfaction. So, the consumer is better off by moving back up towards point E.
similarly, any combinations that lies on IC3 higher than IC2 are desirable but not attainable with his income.
Thus, point E is the consumer’s equilibrium point where both the equilibrium conditions are fulfilled. At point
E,
[Slope of indifference curve] = [slope of budget line]
Concept of Price Effect, Income Effect and Substitution Effect
Price Effect
Change in price of commodity also causes change in quantity demanded. Price effect refers to the rate of change
of quantity demanded of a commodity due to change in its own price while consumer’s income, and price of other
goods remain constant. Thus, price effect is the change in the quantity of commodities or services purchased due
to a change in the price of any one of the commodities. Price effect is said to be the summation of income effect
and substitution effect.

Income Effects
The income effect is the change in consumption patterns due to the change in purchasing power. This can occur
from income changes, price changes or currency fluctuations. Decrease in price causes increase in purchasing
power, allowing a consumer to buy a better product or more of the same product. Thus, income effect refers to
the rate of change in quantity demanded due to change in income of the consumer. It is important to note that we
are only concerned with relative income, i.e., income in terms of market prices.
Income effect is either negative or positive. If income effect is positive, the commodity is regarded as normal
good whereas, if the income effect is negative i.e. with the increase in income (real income) resulted from a given
fall in price of a commodity the consumer will demand less of it and vice versa; the commodity is regarded as
inferior good.

Substitution Effect
Substitution effect arises due to a change in the relative price. When the price of one commodity decreases it
become cheaper than the others. The consumers have a natural tendency to substitute cheaper goods for relatively
expensive one. Thus, the rate of change in quantity demanded for a commodity due to change in price of related
commodity is known as substitution effect. Substitution effect is always negative in the sense that with the fall in
price, the more quantity will be demanded of it and vice versa.

Decomposition of Price Effect into Income Effect and Substitution Effect

To decompose the price effect into IE and SE from this approach, the consumer’s money income should be
compensated in such a way that the consumer will be able to attain same level of satisfaction as before the change
in price. In other words, we adjust the income of the consumer so as to offset the change in satisfaction and bring
the consumer back to his original indifference curve. This method is also known as compensating variation in
income. Following fig. shows the decomposition of price effect into SE and IE.
Y
Compensating Variation
A
Good-Y

C
E1
E2

Substitution E3 IC2
effect IC1 Income effect

0 K L B M D B’ X
Good –X (Normal Good)
In the fig., AB is the initial budget line and the consumer is equilibrium at point E1 purchasing Ok quantity of
good X. Suppose the price of X falls. This causes outward swing in the budget line to the position AB’. With new
budget line AB’, he is in equilibrium at point E2 purchasing OM quantity of X. Movement of consumer from E1
to E2 is price effect.
Now, with the decrease in income by compensating variation, budget line shifts to CD which has been drawn
parallel to AB’ so that it just touches the initial indifference curve IC1 where he was before the fall in price of
‘X’.
Now, X being relatively cheaper, the consumer substitutes X for Y. Thus, when the consumers’ money income is
decreased by AC in terms of Y, or B’D in terms of X, the consumer moves along the same indifference curve IC1
and substitute X for Y. With the new budget line CD consumer is equilibrium at point E 3. This movement of
consumer from E1 to E3 is substitution effect.
If the decrease money income is return back to him than consumer will move from E3 on IC1 to E2 on higher
indifference curve IC2. This movement from E3 to E2 is income effect. The whole effect can be written as;
Price Effect = movement from E1 to E2= KM
Substitution Effect = movement from E1 to E3= KL
Income Effect = movement from E3 to E2= LM
Thus, KM = KL+LM
Price effect =Substitution Effect + Income Effect

When ‘X’ is Inferior Good

Y
Compensating Variation

A
Good-Y

E2
C
E1
IC2

Substitution
E3
effect Income effect
IC1

0 K L B M D B’ X
Good –X (Inferior good)

Price Effect = E1 to E2= KM

Substitution Effect = E1 to E3= KL (-ve)
Income Effect = E3 to E2= LM (-ve)
Substitution effect > Income effect
When ‘X’ is Giffen Goods

Y
Compensating Variation
A
E2

C IC2
Good-Y

E1

Substitution E3
effect Income effect
IC1

0 M K L B D B’ X
Good –X (Giffen Good)

Price Effect = E1 to E2= KM

Substitution Effect = E1 to E3= KL (-ve)
Income Effect = E3 to E2= LM (-ve)
Income effect > Substitution effect