Chapter 2 – Consumer Equilibrium

Consumer is an economic agent who consumes final goods or services for a consideration.

Thus Consumer behaviour is the study of how individual customers, groups or organizations select,
buy, use, and dispose ideas, goods, and services to satisfy their needs and wants. It refers to the actions
of the consumers in the marketplace and the underlying motives for those actions.

Cardinal Utility Approach (Marginal Utility Analysis or Marshall Utility Analysis):

It states that the satisfaction the consumer derives by consuming goods and services can be
measured with a number.It is measured in terms of utils.

Utility is want satisfying power of a commodity. There are two types:-

 Total utility is the total satisfaction derived from consumption of given quantity of
a commodity at a given time. In other words, It is the sum total of marginal utility.

 Marginal Utility is the change in total utility resulting from the consumption of an
additional unit of the commodity. In other words, it is the utility derived from each additional unit.

Relationship between marginal utility and total utility

1. When MU decreases, TU increases at a diminishing rate. (As shown in graph till

consumption level OQ).
2. When MU is zero, TU is constant and maximum at P.
3.  When MU is negative, TU starts diminishing.

Law of Diminishing Marginal Utility: Law of diminishing marginal utility states that
marginal utility derived from the consumption of a commodity declines as more units of
that commodity are consumed. This is the basis of law of demand.

Law of Equi-Marginal utility- It states that when a consumer spends his income on different
commodity he will attain equilibrium or maximize his satisfaction at that point where ratio between
marginal utility and price of different commodities are equal and which in turn is equal to marginal
utility of money.
Budget set is quantitative combination of those bundles which a consumer can purchase from his
given income at prevailing market prices. The group of all the bundles which the consumer is able to
buy with his/her income at the prevailing prices in the market is called the budget set of a consumer.
The budget set of a consumer is basically a collection of all bundles of goods and services which a
consumer can purchase by using the available income.
Consumer Budget:- A budget constraint represents all the combinations of goods and services that
a consumer may purchase given current prices within his or her given income. Consumer Budget
states the real income or purchasing power of the consumer from which he can purchase certain
quantitative bundles of two goods at given price. It means, a consumer can purchase only those
combinations (bundles) of goods, which cost less than or equal to his income.

Consumer’s Bundle is a quantitative combination of two goods which can be purchased by a

consumer from his given income.

Budget Line: A graphical representation of all those bundles which cost the amount just equal to
the consumer’s money income gives us the budget line. The budget line represents two different
combinations of goods which a consumer can purchase with the given income and prices of
commodities.
For example; -
Q1 be the amount of Good 1, Q2 be the amount of Good 2, P1 be the price of Good 1, P2 be the
price of Good 2, P1q1 = Total money spent on Good 1, P2q2 = Total money spent on Good 2.
Therefore, the equation of the budget line will be p1q1 + p2q2 = X. The budget set can be shown
in the below diagram:

Budget line always slope downwards so that consumer can increase the consumption of Good 1
only by decreasing the consumption of Good 2. If consumers desire to have one additional unit of
Good 1, then they can only have that additional unit if they manage to give up some quantity of
other good. Consumers have limited income. They have to decide whether to spend on either
Good 1 or Good 2.

Monotonic Preferences: Consumer’s preferences are called monotonic when between any two
bundles, one bundle has more of one good and no less of other good as it offers him a higher level of
satisfaction.
Change in Budget Line: There can be parallel shift (leftwards or rightwards) due to change in income
of the consumer and change in price of goods. A rise in income of the consumer shifts the budget line
rightwards and vice-versa. In case of change in price of one good, there will be rotation in the budget
line. Fall in price cause outward rotation due to rise in purchasing power and vice-versa.

Marginal Rate of Substitution (MRS) :It is the rate at which a consumer is willing to substitute
(good Y/ good X) one good to obtain one more unit of the other good. Generally, It is the slope
of indifference curve.

Indifference Curve: It is a curve showing different combination of two goods, each

combinations offering the same level of satisfaction to the consumer.
Characteristics of IC

1. Indifference curves are negatively sloped (i.e. slopes downward from left to right).
2. Indifference curves are convex to the point of origin. It is due to diminishing marginal rate of
substitution.
3. Indifference curves never touch or intersect each other. Two points on different IC cannot give
equal level of satisfaction.
4. Higher indifference curve represents higher level of satisfaction.

Preference of consumer is governed by monotonic preferences. Monotonic Preferences refers to a

situation, where the consumer will prefer more of a commodities than the combination providing lesser
commodities. OR A consumer’s preferences are monotonic if and only if between any two bundles, the
consumer prefers the bundle which has more of at least one of the goods and no less of the other good
as compared to the other bundle.

Consumer’s Equilibrium: A consumer is said to be in equilibrium when he maximizes his

satisfaction, given his money income and prices of two commodity. He attains equilibrium at that point
where the slope of IC is equal to the slope of budget line.
Marginal Rate Of Substitution:-
Marginal Rate Of Substitution MRS refers to the rate at which the consumer substitute one good to
obtain one more unit of the other good. The slope of the Indifference curve is

MRS = y •MR
x
MRS is never constant, it varies over the IC. As we move along Indifference Curve, MRS falls also
called Diminishing Marginal rate of substitution.