Economics notes-Consumer Equilibrium

2. Consumer Equilibrium and Demand

Utility: It is the want-satisfying power of a commodity. According to Cardinal Approach, utility can be measured in cardinal numbers, such as 1,2,3 and 4.

Total utility: It is the total satisfaction derived from the consumption of a given units of a good.

Average utility: It is utility per unit of the good. It is calculated by dividing the total utility by the number of units consumed.

Marginal utility: It is the addition to the total utility derived from the consumption of an additional unit of the good.

Law of Diminishing Marginal Utility: According to this Law, as more units of a good are consumed continuously and in standard units, the marginal utility derived from the consumption of every additional unit will keep diminishing.

Units consumed	Total Utility (in utils)	Marginal Utility (in utils)
1	10	10
2	18	8
3	22	4
4	22	0
5	20	(-) 2

Consumer Equilibrium

Consumer equilibrium is defined as the situation in which a consumer’s utility is maximized and from which he has no tendency to move.

Consumer equilibrium can be analysed in terms of a single commodity and many commodities as well.

In case of a single commodity, a consumer is said to be in equilibrium when the price of the good is equal to the marginal utility derived from a good divided by the marginal utility of a rupee.

The most important assumption of this analysis is that Marginal utility of a rupee is standard (constant).

Marginal utility of a rupee: It is defined as the additional utility that a rupee spent will give to a consumer. A consumer will always have the idea of marginal utility of a rupee whenever he spends a rupee.

For example, if a rupee can buy an ice cream or a candy or a biscuit and if any of the above goods will give the consumer 4 utils, then the marginal utility of a rupee is said to be 4 utils. A consumer will always look for at least 4 utils whenever he spends a rupee.

Let marginal utility of a rupee is 4 utils. The consumer wants to buy orange and the price of an orange is Rs. 4.

Marginal utility of the consumer is given below.

Units of orange purchased	Total Utility (in utils)	Marginal Utility (in utils)
1	20	20
2	38	18
3	54	16
4	64	10
5	64	0
6	59	(-) 5

Due to the Law of Diminishing Marginal Utility, the marginal utility will keep falling. However, the consumer has to decide about how many units of orange he should purchase so that his total utility is maximized.

MU of a rupee is 4 utils and the price of an orange is Rs.4. Therefore, it has given him Rs.5 worth of utility (MU of 20 utils/Price of orange). So, he will purchase the first unit.

The second unit of orange gives him utility equal to Rs.4.5. Since he pays only Rs.4 for the second unit, he will buy the second unit also.

The third unit of orange gives him utility equal to Rs.4 which is equal to what he has paid. So, he will purchase the third unit as well.

However, if he goes for the fourth unit, he gets utility equal to Rs.2.5. Since what he pays (Rs.4) is more than what he gets in terms of rupee (Rs.2.5), he will not buy the fourth unit.

Thus, a consumer is in equilibrium where

Price of X = Marginal Utility of X/Marginal Utility of a rupee

P_x = MU_X/MU_Re

Consumer Equilibrium: Two goods (or several goods case)

Similar to the single good case, a consumer will reach equilibrium in case of two (or several) goods in the same way. Since

P_x = MU_X/MU_Re for good X and P_Y = MU_Y/MU_Re for good Y, then the equilibrium condition can be stated as follows.

MU_Re = MU_X/P_X = MU_Y/P_Y

This can be explained with the help of the following schedule.

A consumer has Rs.88 with him. He wants to purchase good X and good Y with his money. The market price of X and Y per unit is Rs.8. the marginal utility schedule of goods X and Y are given below.

Units of good	MUX	MUY
1	88(1)	40(7)
2	72(2)	36(8)
3	64(3)	24(10)
4	56(4)	20
5	48(5)	16
6	40(6)	12
7	32(9)	8
8	24(11)	4
9	16	0
10	8	(-) 5

In case of two goods, a consumer strikes equilibrium when

MU_X/ P_X = MU_Y/ P_Y

OR

MU_X/ MU_Y = P_X/ P_Y

In this case, P_X and P_Y are Rs.8 per unit so that equilibrium will b arrived at when MU_X = MU_Y

or when MU_X/ MU_Y = 1.

The equilibrium occurs when the consumer buys 8 units of good X and 3 units of good Y.

His total utility will be 424 utils from good X and 100 utils from good Y, thus totaling 524 utils.

If he chooses any other combination of goods X and Y in order to maximize his total utility, then it will be either his money is not completely spent or he cannot afford to buy that combination because it is beyond his budget.