Consumer Equilibrium – CBSE Notes for Class 12 Micro Economics

Notes for Class 12 Micro Economics

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Introduction

This chapter consists of a detailed account of concepts of Utility, Law of Diminishing Marginal Utility, Budget line, Budget Constraint, Monotonic Preferences, Indifference Curve, Consumer Equilibrium in Cardinal (single and several Commodities) and Ordinal (indifference curve) Approaches.

Utility

1. Utility is the power or capacity of a commodity to satisfy human wants. Alternatively, utility of a commodity means the amount of satisfaction that a person gets from consumption of a good or service.
2. There are two types of Utility:

1. 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.
   • Cardinal utility is measured in terms of utils (the units on a scale of utility or satisfaction).
   • According to cardinal utility the goods and services that are able to derive a higher level of satisfaction to a consumer will be assigned higher utils and goods that result in a lower level of satisfaction will be assigned lower utils.
   • Cardinal utility is a quantitative method that is used to measure consumption satisfaction.
2. Ordinal utility Approach (Indifference Curve Analysis or J.R. Hicks analysis):
   •  It states that the satisfaction the consumer derives from the consumption of goods and services cannot be measured in numbers.
   • Rather, ordinal utility uses a ranking system in which a rank is provided to the satisfaction that is derived from consumption.
   • According to ordinal utility, the goods and services that offer a customer a higher level of satisfaction will be assigned higher ranks and the goods and services that offer a lower level of satisfaction will be assigned lower ranks.
   • Ordinal utility is a qualitative method that is used to measure consumption satisfaction.

Cardinal Utility

3. Total utility is the total psychological satisfaction a consumer obtains from consuming a given amount of a particular good. Alternatively, total utility is the sum of marginal utilities obtained from consumption of successive units of a commodity. It is measured in utils.

TU = MUj + MU2 + MU3 + MUN
= IMU

 For example,
4. Marginal utility is the additional utility derived from consumption of an additional unit of a commodity.


5.

1. 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.
   
2. It’s can be seen from the above schedule that total utility increases at a diminishing rate, when marginal utility falls.
3. Law of diminishing marginal utility will operate only when consumption is a continuous process. For example, if one sandwich is consumed in the morning and another in the afternoon, the second sandwich may provide equal or higher satisfaction as compared to the first one.
4. Law of diminishing marginal utility will not be applied with regard to education/ knowledge because every effort to get education/ knowledge increases the utility.

6. 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.

Consumer Equilibrium Under Marginal Utility Analysis (Cardinal Approach)

1. Consumer’s Equilibrium refers to a situation where a consumer gets maximum satisfaction out of his given money income and given market price.
2. Consumer’s equilibrium through utility analysis can be ascertained with reference to:

1. A single commodity
2. Two or several commodities

(a) Single Commodity Consumer Equilibrium:

(i) When purchasing a unit of a commodity, a consumer compares its price with the expected utility from it. Utility obtained is the benefit, and the price payable is the cost. The consumer compares benefit and the cost. He will buy the unit of a commodity only if the benefit is greater than or at least equal to the cost.
(ii) Equilibrium Conditions for Single Commodity Consumer Equilibrium
• Necessary Condition

Where, MU of one rupee refers to the utility obtained from the purchase of commodities with one rupee.
In particular, the condition (a) says that the marginal utility of a product in terms of money should be equal to its price.
Sometimes, this is loosely stated as Marginal utility is equal to price, i.e.
MU = Price.
-> If MU > Price
-> As a rational consumer, he keeps on going to purchase an additional unit of a commodity as long as MU = Price.
-> MU > Price implies when benefit is greater than cost and whenever benefit is greater than cost a consumer keeps on consuming additional unit of a commodity till MU = Price.
-> It is so because according to the law of diminishing marginal utility, MU falls as more is purchased. As MU falls, it is bound to become equal to the price at some point of purchase.
-> If MU< Price
-> As a rational consumer he would have to reduce the consumption of a commodity as long as MU=Price.
-> MU < Price implies when benefit is less than cost and whenever benefit is less than cost, consumer keeps on decreasing the additional unit of a commodity till MU = Price.
-> It is so because according to the law of diminishing marginal utility, MU rises as less units are consumed. As MU rises, it is bound to become equal to the price at some point of purchase.
• Sufficient Condition: Total gain falls as more is purchased after equilibrium. It means that consumer continues to purchase so long as total gain is increasing or at least constant.
-> It can be explained with the help of the following schedule and diagram:

Suppose, the price of commodity X in the market is Rs.3 per unit. It means he has to pay Rs.3 per unit. Suppose, the utility obtained from the first unit is 5 utils (= Rs.5). The consumer will buy this unit because the utility of this unit is greater than the price. Whether the consumer consumes second unit or not depends on the utility obtained from the second unit. Suppose, it is 4 utils (= Rs.4). He will buy the second unit also. Again, suppose the utility of the third unit is 3 utils (= Rs.3). The price paid is also Rs.3. Since the utility equals to price he will buy the third unit also. Consumer will not buy the fourth unit because utility of this unit is 2 utils (= Rs.2) which is less than the price. It is not worth buying the fourth unit. The consumer will restrict his purchase to only 3 units.

The difference between utility and price of a unit of a commodity represents the gain to the consumer from that unit. For example, utility of first unit of X is Rs.5 and price paid is Rs.3, The gain is Rs.2 (= 5 – 3). Similarly, gain from the second unit is Rs.1 and from the third unit is zero. The total gain from the three units is Rs.3 (= 2 + 1 + 0). Marginal Gain from the 4th unit is negative, i.e. -1 (= 2 – 3). Total gain from 4 units is Rs.2 (= 2 + 1 + 0 – 1). The consumer maximises gain when he buys only 3 units.The conclusion is that in a single commodity case a consumer makes purchases only upto the point where MU = Price.

In the above diagram, consumption (demand) is recorded on the horizontal axis and marginal utility (price) is recorded on the vertical axis.

The MU curve is downward sloping from left to right. It is because it is assumed that there is inverse relation between consumption and marginal utility. MU is measured in terms of rupee and it is assumed marginal utility in terms of one rupee (MUR). According to the theory, the consumer compares MU (the benefit) with the price (the cost) and makes purchase upto the MU = Price level. If we assume that market price is₹3 per unit, the consumer will buy exactly 3 units. The consumer maximizes gains at 3 units. The equilibrium purchase is at E.
In a single commodity case a consumer is in equilibrium when marginal utility equals to the price.
-> If Marginal utility of Rupee is not equal to one, then the consumer equilibrium with the help of schedule is:

Suppose that the price of apple is 8 and marginal utility of a rupee is 3 utils.
It is clear from the above schedule that initially MU in terms of money is greater than the price of apple. For example, from consumption of the first apple, the consumer gets utility equal to 30 utils or utility worth Rs.10 (= 30 + 3) whereas he sacrifices utility of ?8 in the form of price. Thus, he gets benefit of Rs.2 (= 10 – 8) from the first apple. So, he will buy it.