Consumer's Equilibrium Through Indifference Curve Analysis - Humanities/Arts PDF Download

Definition:

"The term consumer’s equilibrium refers to the amount of goods and services which the consumer may buy in the market given his income and given prices of goods in the market".

The aim of the consumer is to get maximum satisfaction from his money income. Given the price line or budget line and the indifference map:

"A consumer is said to be in equilibrium at a point where the price line is touching the highest attainable indifference curve from below".

Conditions:

Thus the consumer’s equilibrium under the indifference curve theory must meet the following two conditions:

First: A given price line should be tangent to an indifference curve or marginal rate of satisfaction of good X for good Y (MRS_xy) must be equal to the price ratio of the two goods. i.e.

MRS_xy = P_x / P_y

Second: The second order condition is that indifference curve must be convex to the origin at the point of tangency.

Assumptions:

The following assumptions are made to determine the consumer’s equilibrium position.

(i) Rationality: The consumer is rational. He wants to obtain maximum satisfaction given his income and prices.

(ii) Utility is ordinal: It is assumed that the consumer can rank his preference according to the satisfaction of each combination of goods.

(iii) Consistency of choice: It is also assumed that the consumer is consistent in the choice of goods.

(iv) Perfect competition: There is perfect competition in the market from where the consumer is purchasing the goods.

(v) Total utility: The total utility of the consumer depends on the quantities of the good consumed.

Explanation:

The consumer’s consumption decision is explained by combining the budget line and the indifference map. The consumer’s equilibrium position is only at a point where the price line is tangent to the highest attainable indifference curve from below.

(1) Budget Line Should be Tangent to the Indifference Curve:

The consumer’s equilibrium in explained by combining the budget line and the indifference map.

Diagram/Figure:

In the diagram 3.11, there are three indifference curves IC¹, IC² and IC³. The price line PT is tangent to the indifference curve IC² at point C. The consumer gets the maximum satisfaction or is in equilibrium at point C by purchasing OE units of good Y and OH units of good X with the given money income.

The consumer cannot be in equilibrium at any other point on indifference curves. For instance, point R and S lie on lower indifference curve IC¹ but yield less satisfaction. As regards point U on indifference curve IC³, the consumer no doubt gets higher satisfaction but that is outside the budget line and hence not achievable to the consumer. The consumer’s equilibrium position is only at point C where the price line is tangent to the highest attainable indifference curve IC² from below.

(2) Slope of the Price Line to be Equal to the Slope of Indifference Curve:

The second condition for the consumer to be in equilibrium and get the maximum possible satisfaction is only at a point where the price line is a tangent to the highest possible indifference curve from below. In fig. 3.11, the price line PT is touching the highest possible indifferent curve IC² at point C. The point C shows the combination of the two commodities which the consumer is maximized when he buys OH units of good X and OE units of good Y.

Geometrically, at tangency point C, the consumer’s substitution ratio is equal to price ratio P_x / P_y. It implies that at point C, what the consumer is willing to pay i.e., his personal exchange rate between X and Y (MRS_xy) is equal to what he actually pays i.e., the market exchange rate. So the equilibrium condition being P_x / P_y being satisfied at the point C is:

Price of X / Price of Y = MRS of X for Y

The equilibrium conditions given above states that the rate at which the individual is willing to substitute commodity X for commodity Y must equal the ratio at which he can substitute X for Y in the market at a given price.

(3) Indifference Curve Should be Convex to the Origin:

The third condition for the stable consumer equilibrium is that the indifference curve must be convex to the origin at the point of equilibrium. In other words, we can say that the MRS of X for Y must be diminishing at the point of equilibrium. It may be noticed that in fig. 3.11, the indifference curve IC² is convex to the origin at point C. So at point C, all three conditions for the stable-consumer’s equilibrium are satisfied.

Summing up, the consumer is in equilibrium at point C where the budget line PT is tangent to the indifference IC². The market basket OH of good X and OE of good Y yields the greatest satisfaction because it is on the highest attainable indifference curve. At point C:

 MRS_xy = P_x / P_y