CONSUMER’S EQUILIBRIUM USING INDIFFERENCE CURVE ANALYSIS

 

 Learning Contents:                                                            

·         Concept of consumer’s equilibrium

·         Assumptions of consumer’s equilibrium

·         Conditions of consumer’s equilibrium using indifference curve analysis and Budget constraints.

Consumer’s equilibrium

A consumer is in a state of equilibrium when he spends his entire income on the purchase of one or more goods in such a way that his level of satisfaction is maximized and has further no desire to change his level of expenditure. Here, the concept of indifference curve and budget line would be used to understand the concept of consumer’s equilibrium.

Consumer’s equilibrium= Maximization of satisfaction+ Full utilization of budget.

Assumptions of consumer’s equilibrium

1. Two Goods:

The consumer purchases only two goods, X and Y.

 2. Fixed Price:

The prices of the goods are given & constant named as p_x and p_Y. The consumer cannot change or influence these prices. He can only decide how much the goods he can buy at the given prices.

3. Fixed Income:

The consumer’s income to be spent on the goods is given and constant.

4.      Indifference Map:

The indifference map for commodities X and Y is given. The indifference map is based on the consumer’s preferences for the goods. Higher indifference curve indicates higher level of satisfaction whereas lower indifference curve indicates  lower level of satisfaction to the consumer. So, consumer can rank his preferences acc. to the utility provided by each indifference curve.

5. Rational Consumer:

The consumer behaves rationally and his aim would be to maximize his level of satisfaction.

6. Goods are homogeneous and divisible.

7. Tastes and preferences of the consumer remain constant. 

Conditions of Consumer’s equilibrium using indifference curve analysis.

A consumer reaches at equilibrium when two conditions are satisfied mentioned below:

1. IC and Price Line are tangent to each other that means,

     OR

Slope of IC= Slope of Price Line

To be in a state of equilibrium, IC and Price Line are tangent to each other.

2. IC is convex at the point of equilibrium.

To understand consumer’s equilibrium, we have to study the concept of Indifference curve and budget line together.

1. Indifference curve and budget line are tangent to each other

To understand how a consumer attains equilibrium let’s first understand the concepts mentioned below:

Indifference curve refers to all those combinations of two goods that give a consumer an equal level of satisfaction or utility. All the combinations lying on the indifference curve gives a consumer an equal level of satisfaction. Hence it is named as indifference curve.

Budget Line refers to various combinations of two goods that a consumer can afford to buy with his money income and prices of both the goods and if the budget line is tangent to indifference curve then absolute value of slope of indifference curve is equal to slope of budget line.

 Slope of the indifference curve or MRS is the rate at which the consumer is willing to substitute one good for the other. In other words, MRS_xy represents the maximum amount of y a consumer is willing to give up in exchange for one unit of x, it also represents how much importance a consumer places on x in terms of y.

The slope of the budget line is the rate at which the consumer is able to substitute one good for the other in the market. Hence, a consumer will strike equilibrium when MRS_xy = P_x/P_y

As discussed in previous topics, using marginal analysis, a consumer will continue to purchase more of good until the marginal benefit is equal to the marginal cost. This means

·         If MRS_xy > Px/Py, the consumer will consume more x and less y.

·         If MRS_xy < Px/Py, the consumer will consume less x and more y.

·         If MRS = Px/Py, the consumer will not change their consumption.

Explanation:

In figure, 1.1 AB is the budget or price line that indicates the spending restriction for a consumer. A consumer can buy the various combinations of Good- X and Good- Y at the given price of both the goods and income. Points C, D, and E indicate various combinations of x and y that a consumer can buy.  Point A indicates only Good -Y none of Good- X whereas point B indicates only Good- X and none of Good –Y. IC₁, IC_2, and IC₃ are indifference curves. A consumer cannot buy any combination on IC₃ as it is beyond the budget line or beyond his income.

Combinations or points on Budget line indicating less satisfaction.

At point C, where MRS _xy >P _x/P _y i.e. a consumer has more units of Y and less of X i.e. in order to increase his utility a consumer should sacrifice more units of Y and purchase more of X until he reaches point E on IC₂ i.e. In other words, a consumer should increase the consumption of x and reduce the consumption of y for maximizing his utility.

At point D, where MRS _xy <P _x/P _y i.e. a consumer has more units of X and less of Y i.e. in order to increase his utility consumer should sacrifice more units of X  and purchase more units of Y until he reaches point  E on IC₂. In other words, a consumer should reduce the consumption of x and increase the consumption of y in order to maximize his utility.

Combinations or points on Budget line indicating maximum satisfaction or optimal choice.

At point E, the indifference curve IC₂ and Budget line AB intersect or the slope of IC₂ = Slope of budget line AB. At this point MRS_xy= P_x/P_y   Hence, a consumer is in equilibrium at this point because price line or budget line are IC are tangent to each other.

 

2. Indifference curve must be convex to the origin: 

Indifference curve should be convex to the point of origin  indicates that MRS is declining or it falls continuously i.e. a consumer is always willing to sacrifice less and less amount of Good –Y for every additional unit of Good -X.  If indifference curve is concave and not convex to the origin, then it will not be the point of equilibrium.  

Explanation:

In figure 1.2 at point G on IC ₁ indicates MRS is increasing instead of diminishing. It means, by moving left or right of point E, a consumer can obtain a higher amount of either Good- X or Good -Y. Thus point G is not an equilibrium point.  Whereas, at point E on IC ₂ where MRS is falling or budget line AB is tangent and also convex to the point of origin.

Let's Try some Quiz Questions!

Choose the Correct Answer

1. According to IC analysis, a consumer attains equilibrium when:

a. MRS_xy= P_x/P_y  

b. MRS_xy > P_x/P_y  

c. MRS_xy< P_x/P_y  

d. none of these

2. In a situation when MRS_xy > P_x/P_{y   ,} the consumer would react by:

a. reducing the consumption of Good-X

b. increasing the consumption of Good-Y

c. increasing the consumption of Good-X

d. none of these

3. A consumer’s spending is restricted because of

a. Utility maximization

b. Budget constraint

c. Demand curve

d. Marginal utility

4. The consumer is in equilibrium at a point where the budget line:

a. is above an indifference curve

b. is below an indifference curve

c. is tangent to an indifference curve

d. cuts an indifference curve

5. The other name of Budget Line is –

a. Demand Line

b. Price Line

c. Supply Line

d. None of the above

 

6. Indifference curve approach assumes

a. Income of the consumer is fixed.

b. all commodities are homogeneous and divisible.

c. prices of commodities remain the same throughout the analysis.

d. all of the above.

 

Answer Key

 

1.a	2.c	3.b
4.c	5.b	6. d

 

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