UNDERSTANDING CONSUMERS EQUILIBRIUM
Let’s look at consumers equilibrium next. A consumer is in equilibrium when he derives maximum satisfaction from the goods and is in no position to rearrange his purchases.
- There is a defined indifference map showing the consumer’s scale of preferences across different combinations of two goods X and Y.
- The consumer has a fixed money income and wants to spend it completely on the goods X and Y.
- The prices of the goods X and Y are fixed for the consumer.
- The goods are homogenous and divisible.
- The consumer acts rationally and maximizes his satisfaction.
In order to display the combination of two goods X and Y, that the consumer buys to be in equilibrium, let’s bring his indifference curves and budget line together.
We know that,
- Indifference Map – shows the consumer’s preference scale between various combinations of two goods
- Budget Line – depicts various combinations that he can afford to buy with his money income and prices of both the goods.
In the following figure, we depict an indifference map with 5 indifference curves – IC1, IC2, IC3, IC4, and IC5 along with the budget line PL for good X and good Y.
From the figure, we can see that the combinations R, S, Q, T, and H cost the same to the consumer. In order to maximize his level of satisfaction, the consumer will try to reach the highest indifference curve. Since we have assumed a budget constraint, he will be forced to remain on the budget line.
So, which combination will he choose?
Let’s say that he chooses the combination R. From Fig. 1, we can see that R lies on a lower indifference curve – IC1. He can easily afford the combinations S, Q, or T which lie on the higher ICs. Even if he chooses the combination H, the argument is similar since H lies on the curve IC1 too.
Next, let’s look at the combination S lying on the curve IC2. Here again, he can reach a higher level of satisfaction within his budget by choosing the combination Q lying on IC3 – higher indifference curve level. The argument is similar for the combination T since T lies on the curve IC2 too.
Therefore, we are left with the combination Q.
What happens if he chooses the combination Q?
This is the best choice since Q lies on his budget line and pts puts him on the highest possible indifference curve, IC3. While there are higher curves, IC4 and IC5, they are beyond his budget. Therefore, he reaches the equilibrium at point Q on curve IC3.
Notice that at this point, the budget line PL is tangential to the indifference curve IC3. Also, in this position, the consumer buys OM quantity of X and ON quantity of Y.
Since point Q is the tangent point, the slopes of line PL and curve IC3 are equal at this point. Further, the slope of the indifference curve shows a marginal rate of substitution of X for Y (MRSxy) equal to
UNDERSTANDING INDIFFERENCE CURVE
UNDERSTANDING CONSUMERS EQUILIBRIUM THROUGH INDIFFERENCE CURVE
Understanding Consumer’s Equilibrium by Indifference Curve Analysis!
Consumer equilibrium refers to a situation, in which a consumer derives maximum satisfaction, with no intention to change it and subject to given prices and his given income. The point of maximum satisfaction is achieved by studying indifference map and budget line together.
On an indifference map, higher indifference curve represents a higher level of satisfaction than any lower indifference curve. So, a consumer always tries to remain at the highest possible indifference curve, subject to his budget constraint.
Conditions of Consumer’s Equilibrium:
The consumer’s equilibrium under the indifference curve theory must meet the following two conditions:
(i) MRSXY = Ratio of prices or PX/PY
Let the two goods be X and Y. The first condition for consumer’s equilibrium is that
MRSXY = PX/PY
a. If MRSXY > PX/PY, it means that the consumer is willing to pay more for X than the price prevailing in the market. As a result, the consumer buys more of X. As a result, MRS falls till it becomes equal to the ratio of prices and the equilibrium is established.
b. If MRSXY < PX/PY, it means that the consumer is willing to pay less for X than the price prevailing in the market. It induces the consumer to buys less of X and more of Y. As a result, MRS rises till it becomes equal to the ratio of prices and the equilibrium is established.
(ii) MRS continuously falls:
The second condition for consumer’s equilibrium is that MRS must be diminishing at the point of equilibrium, i.e. the indifference curve must be convex to the origin at the point of equilibrium. Unless MRS continuously falls, the equilibrium cannot be established.
Thus, both the conditions need to be fulfilled for a consumer to be in equilibrium.
Let us now understand this with the help of a diagram:
In Fig. 2.12, IC1, IC2 and IC3 are the three indifference curves and AB is the budget line. With the constraint of budget line, the highest indifference curve, which a consumer can reach, is IC2. The budget line is tangent to indifference curve IC2 at point ‘E’. This is the point of consumer equilibrium, where the consumer purchases OM quantity of commodity ‘X’ and ON quantity of commodity ‘Y.
All other points on the budget line to the left or right of point ‘E’ will lie on lower indifference curves and thus indicate a lower level of satisfaction. As budget line can be tangent to one and only one indifference curve, consumer maximizes his satisfaction at point E, when both the conditions of consumer’s equilibrium are satisfied:
(i) MRS = Ratio of prices or PX/PY:
At tangency point E, the absolute value of the slope of the indifference curve (MRS between X and Y) and that of the budget line (price ratio) are same. Equilibrium cannot be established at any other point as MRSXY > PX/PY at all points to the left of point E and MRSXY < PX/PY at all points to the right of point E. So, equilibrium is established at point E, when MRSXY = PX/PY.
(ii) MRS continuously falls:
The second condition is also satisfied at point E as MRS is diminishing at point E, i.e. IC2 is convex to the origin at point E.