Consumer's Equilibrium Flashcards
What is Utility?
Utility refers to the want satisfying capacity of a commodity.
What is Total Utility?
Total Utility refers to the total satisfaction derived by consuming all units of a commodity.
What is Marginal Utility?
Marginal Utility is the change in total utility due to an additional unit of commodity consumed.
MU = chage in TU/ change in units consumed = #TU/#Q
OR
MU = TUn - TUn-1
What is the relationship between Total Utility and Marginal Utility?
- When total utility rises, marginal utility falls but remains positive.
- When total utility is maximum, marginal utility is zero.
- When total utility falls, marginal utility becomes negative.
Units Consumed, Total Utility, Marginal Utility
1 _20_ -
2_28_8
3_34_6
4_34_0
5_32_-2
Cardinal Utility, Consumer’s Equilibrium in case of a single commodity
Consumer’s equilibrium can be defined as a situation in which a consumer consumes a commodity in such a manner that provides him maximum satisfaction and he has no incentive to increase consumption of the commodity.
Consumer’s equilibrium can be attained when marginal utility in terms of money is equal to the price of the commodity. This can be explained with the help of the following example based on the law of diminishing marginal utility.
Suppose the price of one chocolate is Rs.2 per unit and the Marginal Utility of money is equal to 4 utils. According to the conditions of consumer’s equilibrium the consumer will attain maximum satisfaction where :-
MUx/MUm = Px (Marginal Utility of Commodity/Marginal Utility of Money = Price)
From schedule, it can be concluded that the consumer’s equilibrium will be attained at the 5th unit as the Marginal Utility in terms of money equals price of the commodity.
Cardinal Utility, Consumer’s Equilibrium in case of two/several goods
A consumer consuming two commodities will be at equilibrium when he spends his income in such a manner that the ratios of marginal utilities of two commodities and their respective prices are equal.
The consumer’s equilibrium in case of two commodities can be studied by taking two goods X and Y.
According to the Law of Equi-Marginal Utility a consumer gets satisfaction when the following conditions are satisfied :-
MUx/Px = MUy/Py = MUm (Marginal Utility of Commodity/Price of Commodity = Marginal Utility of Money)
This can be explained with the following example. Suppose the monthly income of a consumer is Rs.5 that he wishes to spend on two commodities X and Y. Both the commodities are priced at Re. 1/ unit. A consumer can buy maximum 5 units of good X or 5 units of good Y.
From schedule, concluded that a consumer will attain equilibrium when MUx = MUy (as price of both commodities are equal). It happens when the consumer attains the same level of satisfaction from both the commodities i.e., 12 utils which also equals the marginal utility of 1 rupee (Px, Py).
Therefore the consumer will have 3 units of good X and 2 units of good Y in order to attain equilibrium.
What is an Indifference Curve?
An Indifference Curve is the locus of different combinations of two goods, the consumer consumes with each of the combinations having same utility.
OR
IC refers to the graphical representation of various alternative combinations of two commodities, with each combination providing same level of satisfaction to consumers.
Combination, Good X (units), Good Y (unit)
A - 14 - 1
B
C
D
E
What does monotonic preference mean?
It means as consumption increases, the total utility also increases alongwith.
OR
It means the consumer always chose bundle which has more of one good and no less of other commodity.
What is Marginal Rate of Subsitution?
Marginal Rate Of Substitution is rate at which a consumer is willing to sacrifice some units of one good to obtain one more unit of another good.
MRS = #quantity of Y willing to sacrifice/#quantity of X willing to obtain
MRS = #Y/#X
MRS decreases as consumer is willing to sacrifice lesser and lesser units of Good Y to gain additional unit of good X, due to law of diminishing marginal utility.
What are the properties of Indifference Curve?
1. AN INDIFFERENCE CURVE SLOPES DOWNWARD FROM LEFT TO RIGHT:
The curve is negatively sloped because to obtain more quantity of one good, consumer must give up some quantity of other good in order to remain at the same utility level.
2. AN INDIFFERENCE CURVE IS CONVEX TO THE ORIGIN :
The IC is convex to the origin because of diminishing MRS (Marginal Rate Of Substitution). This is due to the Law of Diminishing Marginal Utility. MRS of y for x (MRSyx) is the rate by which amount of y is sacrificed to obtain one additional unit of x. MRSyx is continuously falling because as the consumer obtains more and more of x, marginal utility of x falls and the consumer will like to sacrifice less units of y to obtain one additional unit of x.
3. HIGHER IC REPRESENTS HIGHER UTILITY : Because of the assumption that preferences are monotonic which means that consumption of more goods mean more satisfaction. One indifference curve represents only one level of satisfaction. For different levels of satisfaction, there are different indifference curves. A higher IC represents a higher level of satisfaction.
What is an indifference map?
A set of indifference curves representing different levels of satisfaction is known as an indifference map.
What is budget line?
It is the locus of different combinations of two goods, which the consumer consumes and which costs the consumer exactly his income.
The budget line is a downward sloping straight line because of constant Market Rate of Exchange (MRE).
What is budget set?
It is the locus of different combinations of two goods, which the consumer consumes and which costs the consumer less than his income or equal to his income.
Instead of =, Less than equal to is used <
What is the equation of Budget Line and Budget set?
Budget Line, X1P1 + X2P2 = M
Budget Set, X1P1 + XP2 < M
Where X1 is quantity of Good 1, X2 quantity of Good 2, P1 price of Good 1, P2 price of good 2
What is the slope of budget line?
Slope of budget line = MRE = Px/Py
Why may the budget line change?
Budget line is drawn with the assumption of constant income of the consumer and the constant prices of the two goods. The budget line changes due to the following reasons :-
Change in Income Of The Consumer : If the income of the consumer changes without any corresponding change in price of 2 goods , the budget line will shift towards right or left.
Change In Prices : If there is any change in price of any of 2 commodities assuming no change in the money income of the consumer , the slope of budget line will change as the price ratio changes (Since MRE changes, and slope of budget line = MRE)
Ordinal Utility, Explain Consumer’s Equilibrium through Indifference Curve Analysis/Approach.
Consumer’s equilibrium refers to a situation when a consumer spends his entire income to consume two goods in order to maximize his satisfaction. Consumer’s equilibrium through IC is obtained where following conditions are satisfied :-
- MRS = MRE
- MRS should fall
Since MRE equals the ratio of prices of two goods, the condition can also be stated as:-
MRS = Ratio of Prices = Px/Py
Given that two goods consumed X and Y. If a consumer wants to consume more of X, the MRS is the rate at which the consumer is willing to sacrifice Y to obtain one more unit of X, whereas , MRE is the rate at which the consumer must sacrifice Y units to obtain one more unit of X .
Further, MRS must be diminshing since if MRS were to be increasing, then consumer would have incentive to purchase more and would do so.
Hence, The consumer will consume until MRS = MRE and he has no incentive to buy more or less of X.
This can be explained with the help of the diagram :-
Given the indifference map and budget line, MRS = MRE condition graphically implies : MRS = MRE = Slope of IC = Slope of Budget Line
The two slopes are equal where the budget line is tangent to the indifference curve. The tangency condition is full filled at the meeting point, which is the consumer’s equilibrium where the consumer consumes 0X1 of Good X and 0Y1 of Good Y.
