User:Rajalakshmy/Micro Economics

Consumer’s Equilibrium :
- The consumer’s preference scale is described by means of indifference mapping (i.e. a set of difference curves which rank the preferences of the consumer). At any given period of time the consumer’s money income is given and the prices of goods. The consumer has a given income which sets the limits to his maximizing behaviour. The slope of budget line is the price ratio of the commodities. Definition : The consumer attains the equilibrium when he is able to consume the most preferred commodity bundle which gives him highest level satisfaction. It is a state of stability where there is no tendency to rearrange the combinations of goods preferred by the consumer. It is a balance state with respect to his given level of income among various goods. Assumptions : 1. There are two goods i.e. X1 and X2. 2. The consumer’s preference scale for combination of two goods is exhibited by indifference map. 3. The consumer has a given income which sets to limits to his maximizing behaviour. 4. The prices of goods are given and remain constant. Conditions for consumer’s equilibrium : • A given budget line must be tangent to an indifference curve or marginal rate of substitution of X1 and X2 (MRS x1x2) must be equal to the price ratio between the two goods (Px1/Px2). • At the point of equilibrium indifference curve must be convex to the origin. [[Images;equilibrium.gpg]

A G Q2

0 Q 1B

The slope of the budget line is the price ratio of the commodities. The indifference map portrays consumer’s scale of preferences between various possible combinations of two goods. In the above diagram every combination i.e. G,E and H in the price line AB cost him the same amount of money. In order to maximize his satisfaction the consumer will try to reach the highest indifference curve which he could with a given expenditure of money and given prices of the two goods. Budget line forces the consumer to remain on the given price line and maximize his utility. The consumer attained equilibrium at point E where the indifference curve IC2 is the highest attainable indifference curve is tangent to the budget line. The consumer can not attain the indifference curve IC3 because of income constraint. At point E, OQ1 of X1 and OQ2 of X2 will be giving maximum satisfaction to the consumer. Any other possible combination of the two goods either would lie on a lower indifference curve gives less satisfaction or would be unattainable. For instant combination of goods at point G and H costs him the same as the combination E. But G and H lies on the lower indifference curve IC1 and therefore will give less satisfaction than E. Therefore E will be preferred to all other combinations on the price line AB. Similarly combination lying on indifference curve IC3 will give greater satisfaction to the consumer than Q1 but they are unattainable with the given money income and the given prices of the goods as represented by the price line AB. It is therefore concluded that with the given money expenditure and given prices of the goods as shown by AB the consumer obtain maximum satisfaction at point E, where the consumer can afford OQ1 of X1 and OQ2 of X2. At the tangency point E,the slopes of the price line PL and IC2 indifference curve are equal. Slope of the indifference curve shows the marginal rate of substitution of X1 for X2(MRS x1x2) while the slope of price line indicate the ratio between the prices of two goods (Px1/Px2). Thus at the equilibrium point E, Price of good X1 Px1 MRS X1X2 = --- = Price of good X2 Px2

The tangency between the given price line and an indifference curve is a necessary but not a sufficient condition for consumer’s equilibrium. The second condition is the indifference curve should be convex to the origin i.e. the MRS x1x2must be falling at the point of equilibrium.

In Fig-1 indifference curve IC2 is convex to the origin at point E is the optimum or best choice for the consumer and therefore he attain a stable equilibrium position. But in Fig-2, IC1 is concave to the origin at point E. Price line AB is tangent to indifference curve IC1 at point E and the marginal rate of substitution of X1 and X2 is equal to price ratio (PX1/PX2). But E cannot be a position of stable equilibrium because satisfaction would not be maximum. There are other combinations like G and H in the given price line will be on higher indifference curve.

The consumer’s equilibrium in regard to the allocation of his money expenditure on the purchases of two goods has been made entirely in terms of relative preferences of the various combinations of two goods.

Activity – 1 : Study the following diagrams and explain why consumer’s equilibrium cannot be established. Questions 1. Compare and contrast the consumer’s equilibrium in convex and concave indifference curve.

2. Explain conditions of consumer’s equilibrium.

Additional Readings :

Barmol.W.J, Economic Theory and Operations Analysis Kautoyianuis, A., Modern Microeconomics Ferguson, C.E &amp; Gould, J.P, Micro economics