RBSE Class 12 Economics Notes Chapter 2 Consumers Equilibrium

Rajasthan Board RBSE Class 12 Economics Notes Chapter 2 Consumers Equilibrium

A consumer is that person or institution who purchases goods or services in order to fulfil his needs.

The main purpose of the consumers is to use their income on those goods or services, from which they can get optimum satisfaction.

Analysis on the consumer’s equilibrium is divided into two parts :

Cardinal analysis
Ordinal analysis.

The cardinal utility approach is proposed by economists Marshall, Pigou etc., who believe that utility is measurable, and the customer can express his satisfaction in cardinal or quantitative numbers, such as 1, 2, 3, and so On.

The neo-classical economists have developed the theory of consumption on the basis of perception that utility is measurable and can be expressed in cardinal form and in order to do so, they have designated a fictional unit “utils” to measure utility; here; one util is equal to one rupee and the utility of money remains constant.

Prof. J.R. Hicks and Prof. R.G.D. Allen propounded ordinal analysis to improve upon cardinal analysis as an alternative method.

The term ‘utility’ refers to that quality of a commodity by virtue of which our wants are satisfied; or want-satisfying power of a good or service is called Utility.

If the satisfaction of purchasing books is more than that in purchasing of shirts, then we state that a book gives more utility.

The utility of an object to people is different from one person to another, one place to another and one time to another.

Edgewoth (1881), Antonelli (1886) and Irving Fisher (1892) said that utility can be measured and it depends On the consuming quantity of different consumed goods.

The utility function of the consumer may be expressed as : U = U (X₁, X₂, X₃……….X_n), where X₁ is the quantity of commodity i, and so on.

William Stanly Jevons, Carl Menger, Leon Walras and Alfred Marshall state that utility can be measured like milk in litre, height in metre, distance in kilometre, temperature in degree.

The consumer is rational and compares the utility gained from various items and measures and chooses between them. The objective of the consumer is to maximize their utility.

It is also believed that the customer has full knowledge about choices and likes. The utility can be measured in money, and the marginal utility of money is constant.

Utility can be stated as Expected, Satisfaction and Realised. Utility is measured by utils but satisfaction cannot be measured.

In the given period, the total satisfaction received from the consumption of different units of an object is called the Total Utility of that object.

The point of maximum satisfaction is called ‘Point of Satisfy’ action.

Total utility of a commodity to a consumer is the sum of utilities which he obtains from consuming a certain number of units of the commodity per unit period of time.

In this way total utility is calculated: TU_n = U₁ + U₂ + U₃……U_n, TU_n = Total utility of n units of a commodity; U₁ = utility of first unit of commodity, U₂ = utility of second unit of commodity and U_n = utility of that unit of commodity.

Marginal utility of a commodity to a consumer is the extra utility which he gets when he consumes one more unit of the commodity. It is the addition made to the total utility when one more unit of a commodity is consumed by an individual.

Marginal utility can be expressed as under: MU_n = TU_n -TU_n-1
Here, MU_n = Marginal utility of the unit.
TU_n = Total utility of n units
TU_n-1 = Total utility of n – 1 units

At the the point where the total utility is the maximum, the marginal utility is zero. This point is called Saturation Point.

If the consumers consume beyond the point of saturation or fulfillment, then marginal utility becomes negative and total utility starts declining.

Law of diminishing utility was proposed by Prof. Heinrich Gossen in 1854. Pro. Jovans called it the First Law of Gosson, but there was a detailed discussion of this law by Professor Marshall.

Marshall, who was the famous exponent of the marginal utility analysis, has stated the law of diminishing marginal utility as follows :

The additional benefit which a person derives from a given increase of his stock of a thing diminishes with every increase in the stock that he already has.
This law is based upon two important facts. Firstly, while the total wants of a man are virtually unlimited, each single want can be saturated. The second fact on which the law of diminishing marginal utility is based is that the different goods are not perfect substitutes for each other in the satisfaction of various particular wants.

The law of diminishing marginal utility describes a familiar and fundamental tendency of human nature. This law has been arrived at by introspection and by observing how people behave.

While explaining the determination of prices of commodities, the law of diminishing marginal utility is of vital importance. The discovery of the concept of marginal utility has helped to explain the paradox of value which troubled Adam Smith in “The Wealth of Nations.”

It helps in deriving the law of demand and is able to show why the demand curve slopes downward to the right.

Another important use of marginal utility is in the field of fiscal policy. The concept of diminishing marginal utility demonstrates that transfer of income from the rich to the poor will increase economic Welfare of the community.

Principle of equimarginal utility occupies an important place in marginal utility analysis. It is through this principle that consumer’s equilibrium is explained. It is also called Law of Substitution because in it for reaching equilibrium position consumer substitutes one good for another.

The marginal utility of money spent on a good is equal to the marginal utility of a good divided by the price of the good. In symbols,
\({ MU }_{ m }=\frac { { MU }_{ X } }{ { P }_{ X } } \)

The consumer will spend his money income on different goods in such a way that marginal utility of each good is proportional to its price. Thus, consumer is in equilibrium in respect of the purchase of two goods X and Y, when
\(\frac { { MU }_{ X } }{ { P }_{ X } } =\frac { { MU }_{ y } }{ { P }_{ y } } \)

The consumer will go on purchasing goods until the marginal utility of money spent on each good becomes equal. Thus, a consumer will be in equilibrium when the following equation holds good –
\(\frac { { MU }_{ X } }{ { P }_{ X } } =\frac { { MU }_{ y } }{ { P }_{ y } } ={ MU }_{ m }\)

In order to implement the law of equimarginal utility in real life, the consumer should take into account the marginal utility of different items. For this, they have to calculate and compare the marginal utilities obtained from different items. But it has been said that ordinary consumers cannot be so rational and calculated.

It is not possible for a consumer to measure utility cardinally. Being a state of feeling and also there being no objective units with which to measure utility, it is cardinally immeasurable.

Another limitation of the law of equimarginal utility is found in case of indivisibility of certain goods. Goods are often available in large indivisible units. Because the goods are indivisible, it is not possible to equate the marginal utility of money spent on them.

Two English economists, J.R. Hicks and R.G.D. Allen criticized Marshall’s consumer demand analysis on the basis of the cardinal measurement of its now famous letter ‘A Reconsideration of the Theory of Value’, and put forward the indifference curve approach on the basis of ordinal utility to explain consumer’s behaviour.

The indifference curve approach, like the cardinal utility approach, assumes that the consumer has ‘complete information’ about all the relevant aspects of economic environment in which he finds himself.

The fundamental approach of indifference curve analysis is that it has abandoned the concept of cardinal utility and instead has adopted the concept of ordinal utility.

The fundamental tool of Hicks-Alien ordinal analysis of demand is the indifference curve which represents all those combinations of two goods which give the same satisfaction to the consumer.

All combination of goods lying on a consumer’s indifference curve are equally desirable to or equally preferred by him.

A complete description of consumer’s tastes and preferences can be represented by an indifference map which consists of a set of indifference curves.

A higher indifference curve indicates a higher level of satisfaction than a lower indifference curve but “how much higher’ cannot be defined.

The rate at which the consumer is ready to barter goods X and Y is known as ‘Marginal Rate of Substitution.’ The concept of marginal rate of substitution is an important tool of indifference curve analysis of demand.

The Marginal Rate of Substitution (MRS) is the rate at which one commodity can be substituted for another, the level of satisfaction remaining the same. The MRS is given by the slope of the IC curve.
\({ MRS }_{ xy }=\frac { { MU }_{ x } }{ { PU }_{ y } } \)

It is believed that the consumer will always prioritize a large amount of goods for a small amount of goods, provided the other accessories remain unchanged at its disposal. This is a very reasonable and realistic assumption of indifference curve.

Suppose that there are three combinations of goods A, B and C. If the customer is frustrated between A and B and between B and C, it is believed that it will be neutral between A and C. This condition means that the consumer’s taste is quite consistent. This assumption is known as the Assumption of Transitivity.

It is assumed that more and more units of X are substituted for Y, the consumer will be willing to give up fewer and fewer units of Y for each additional unit of X, or when more and more of Y is substituted for X, he will be willing to give up successively fewer and fewer emits of X for each additional unit of Y. This rule about consumer’s behaviour is described as the principle of diminishing marginal rate of substitution.

There are four properties of indifference curve:

Indifference curves have a negative slope.
Indifference curves are convex to the origin.
Indifference curves do not intersect.
A higher indifference curve implies a higher level of satisfaction than the lower one.

The limitedness of income acts as a barrier on the utility maximizing behaviour of the consumer. This is known as Budgetary Constraint.
Budget line has a negative slope.

A consumer is said to be equilibrium when he is buying such a combination of goods as leaves him with no tendency to rearrange his purchase of goods. He is then in a position of balance in regard to the allocation of his money expenditure among various goods.

In the indifference curve technique, the consumer’s equilibrium is discussed in respect of the purchase of two goods by the consumer.

The consumer has a given indifference map exhibiting his scale of preferences for various combinations of two goods X and Y.

He has a fixed amount of money to spend on the two goods. He has to spend whole of his given money on the two goods.

The goods whose consumption increase with increase in consumer’s income are called ‘Normal Goods.’

Income consumption curve may be defined as the locus of points representing various combinations of two commodities purchased by the consumer at different levels of his income, all other things remaining the same.

An inferior good is one whose consumption decreases with the increase in consumer’s income. In other words, when income-effect on the consumption of a commodity is negative, the commodity is said to be inferior.

Engle curve is a graphical representation of relations between an object and the balance amount purchased from the consumer’s income. It should be kept in mind that the Income Consumption Curve (ICC) and Engle curve are not the same.

The consumer will be in a stale of equilibirum, where he has maximised his satisfaction. In neutrality curve analysis, the following conditions are necessary for consumer equilibrium –

The point of equilibrium of a consumer is that point where the budget curve touches the equilibrium curve. This is the point of maximum satisfaction.
The point of consumer equilibrium is that point, where the marginal rate of substitution is equal to the ratio of prices.\({ MRS }_{ xy }=\frac { { P }_{ x } }{ { P }_{ y } } \). This is an essential condition of consumer equilibrium.
The third essential condition of consumer equilibrium is that the marginal rate of substitution should be decreasing at the point of equilibrium, i.e. the equilibrium curve should be convex on the origin.

Important Glossary

1. Consumer : A person who purchases goods and services for personal use.
2. Goods : An object on a physical, tangible object that satisfies some human wants or needs or something that people feel to be useful or desirable and they attempt to achieve it.
3. Services : Such a utility which is provided to fulfil public needs, such as transport, communication facilities, hospital or energy supply, which is provided by the government or any official body and managed in an organized manner.
4. Expenditure : Fees against the available funds in the form of evidence of an invoice, receipt, voucher, or other such documents as a liability.
5. Purchase : A product or service bought by a person or business.
6. Indifference Curve : An indifference curve shows a graph that gives the consumer the same satisfaction and usefulness in use of variying products. Each point on the indifference curve indicates that a consumer is satisfied between two and all points, and obtains the same utility.
7. Consumer’s Equilibrium : It is a situation in which a person gets maximum satisfaction.
8. Indifference Map : Indifference map refers to a set of indifference curves.
9. Indifference Set : It refers to attainable combinations of sets of two commodities at a given prices of commodity and a certain income of the consumer.
10. Money : It is the medium of exchange that settles payments. People accept money in exchange of goods and services. Nothing is owed anymore.
11. Income : Income is money that a person or business receives in terms goods or services, or in return for capital investment.
12. Optimum : Be able to obtain or obtain the greatest degree or best results in specific situations.
13. Cardinal Utility : Cardinal utility is the utility wherein the satisfaction derived by the consumers from the consumption of goods or services can be expressed numerically.
14. Ordinal Utility : Ordinal utility states that the satisfaction which a consumer derives from the consumption of goods or services cannot be expressed in numerical units.
15. Utility : Want-satisfying power of any commodity is known as utility.
16. Total Utility : It is the sum total of utility derived from the consumption of all units of a commodity.
17. Marginal Utility : It refers to additional utility on account of the consumption of a unit of a commodity.
18. Point of Satisfaction : The point of maximum satisfaction is beyond which, the satisfaction per unit expenditure decreases for a consumer.
19. Commodity : A commodity is a markeatable item produced to satisfy wants or needs.
20. Declining : To slope downward.
21. Substitute : A person or thing that works or serves in place of another.
22. Paradox : Logically unacceptable.
23. Slopes : Tilted towards a horizontal or vertical line.
24. Tendency : Leaning towards a particular attribute or type of behaviour.
25. Equimarginal Utility : It is also known as the Law of Maximum Satisfaction or Replacement or Gossen’s Second Law.
26. Measurable : Can be measured.
27. Reconsideration : On second thought.
28. Barter : Exchange of commodity.
29. Budget Line : It refers to attainable combinations of sets of two commodities at given prices of commodity and income of the consumer.
30. Allocation : Actions or process of assigning or distributing something.
31. Normal Goods : Normal goods can be defined as those things, for which, when the income of the consumer increases and falls, the price of the goods remain stable.
32. Inferior Goods : Inferior goods are those goods whose demand decreases when the income of consumer increases.
33. Engle Curve : Engle curve is a graphical representation of relationship between an object and the balance amount purchased from the consumer’s income.